Financial inclusion without sacrificing stability
Banking regulators come in two varieties: consumer advocates and prudential regulators. The former worry about exploitation of poor people through unfair contracts, fraud and excessive prices and interest rates, and propose strong rules to protect them. Thus, they urge caps on interest rates, low or no bank charges and prudential regulation – akin to that of banks – of specialised financial service providers like microfinance providers.
Prudential regulators, on the other hand, worry about the integrity of individual institutions and of financial system as a whole. They ask financial institutions to be conservative, go for good credits and maintain a strong capital base. This limits banks’ incentives to seek business among the poor.
So, a combination of well-meaning efforts to protect the poor and ensure stability of the financial system may lead to an outcome where the poor cannot get the services they are willing to pay for because no one is willing to supply them. Is there a best-fit solution? What kind of regulation is appropriate if we wish to achieve the benefits of financial inclusion without sacrificing financial stability?
A recent BIS paper argues regulation should be designed according to the type of service and attendant risks. A reliable legal framework with enforceable contracts is the foundation on which all financial services are built. Better financial services help poor people cope better with the everyday risks of fraud and theft.
At the same time, new services such as mobile payment systems can also give rise to fraud. If a modern system like M-Pesa were to be plagued by systematic fraud, the political fallout could be significant. Hence, from that perspective as well adequate conduct, regulation is important.
Prudential regulation has an important role, and comes into play if the services generate a float that is invested. It should be focused on this functional building block. In doing so, it is advisable to try and remain technology-neutral to leave space for further innovation. The key is to regulate the service provided, not the institution. Second, regulation should take systemic dimensions into account.
In calibrating the regulatory framework for basic financial services to the poor, regulation should be calibrated according to the risks incurred for the financial system. In the case of systemically-important financial institutions whose failure can lead to large economic costs within a country or even beyond, regulation that seems costly from a short-term perspective may easily pay for itself by staving off costly financial crises.
In the case of basic financial services for the poor, the danger seems not so much systemic repercussions that might impose large financial costs; the danger is more that such services do not emerge in the first place, and financial inclusion simply does not happen. In that perspective, it may be advisable to experiment and to encourage the emergence of a wide range of specialised, ‘unbundled’ financial services for the poor – like the no-frills account that we have tried in India? – and consider a stronger regulatory response if and when particular bundles of service emerge and grow towards a size and importance that could pose risks for financial stability.
The success of M-Pesa in Kenya seems to indicate that basic payment services are perhaps the most important financial service for poor people. Luckily, such systems can be developed at a low risk because, even if successful, the absolute amounts remain small. And provided the objectives are clear, regulation targeted directly on the type of service is appropriate from the viewpoint of the overall financial system.
This is what the Central Bank of Kenya has done. By allowing M-Pesa to experiment, it has helped provide useful insights into new possibilities for financial services. The problem is that regulatory measures are themselves subject to the influence of particular interests.
Therefore, possible market failure needs to be weighed against possible regulatory failure: regulatory efforts may be captured by commercial interests or affected by political considerations – an additional reason not to stifle promising approaches through regulatory responses to innovation and new business models that can help poor people.