RBI’s Demonetisation Cross

CThe sequence of events leading to the demonetisation move are becoming more convoluted as more information is revealed. At this point, it is starting to resemble a comedy of errors at best and an insidious plot at worst. We attempt to delineate the sequence of events that led to November 8, 2016, and understand the role of one of India’s most credible institution, Reserve Bank of India (RBI) in the larger scheme of things.

The central bank has informed the Parliamentary Committee that it acted on the government’s advice on demonetisation. This is at odds with the minister of state of power, coal, new and renewable energy, Piyush Goyal’s remarks in the Rajya Sabha. He said that the government merely approved the RBI Board’s decision.

The RBI note to the Parliamentary Committee says that “the introduction of new series of notes could provide a very rare and profound opportunity to tackle all the three problems of counterfeiting, terrorist financing and black money by demonetizing the banknotes in high denominations… Though no firm decision was taken initially, whether to demonetize or not, preparations still went on for introduction of new series notes, as that was needed in any case.” RBI cannot make these claims with a straight face. First, it is evident that RBI was grossly unprepared for the move. Second, all three above-stated reasons for demonetisation have been proven false. RBI has itself stated that there are no additional security features in the new notes; so, the problem of counterfeiting will persist. Finally, several people, including terrorists, have already been caught possessing crores of new currency notes.

In a separate RTI response, RBI had stated that the decision to introduce new notes of R2,000 denomination was taken in a meeting on May 19, 2016. However, the minutes of the RBI Board meeting only mention the design of the new notes. As per the RBI Act, it is mandated to reveal the decision to introduce the new notes which it did not. Similarly, the government waited till November 8 to notify the new notes.

On November 8, the prime minister announced the demonetisation of the 500- and 1,000-rupee bills. He also made certain announcements related to dates for exchange of currency notes at banks (December 30, 2016), at RBI counters (March 31, 2016) and withdrawal limits at ATMs/through cheques. Alongside, he mentioned the objectives of demonetisation and the secrecy of the move. He also introduced the 2,000-rupee bill. Indians lauded as this a step towards penalising the growing breed of corrupt and extinguishing the existing stock of black cash in the economy. Consequences of sucking out 86% of the currency included long queues at banks, malpractices at bank branches, and attenuated consumption, but the nation has stood by the decision believing in the intent of the act.

Reserve Bank of India, as the issuer of currency, was responsible for replenishing currency in the system. As days passed, RBI issued multiple notifications on how, why and who could withdraw how much currency. At last count, in a 50-day period the RBI issued 74 such notifications. This is astounding agility for any central bank and raises questions if RBI was at all prepared for such an act? Or does it indicate that the RBI Board succumbed to external pressures to approve demonetisation? If RBI is an independent regulator, insulated from all political influence and could not see itself implementing the move, there is little reason why it did not refuse to be an accomplice. And finally, if RBI’s economic talent pool was on ground with this, cognizant of leaving a nation with 15% of the currency in circulation, the citizens have a right to know the reasoning.

The institution denied a RTI query on disclosure of minutes of the board meeting on the demonetisation decision, citing exemption clause Section 8(1)(g), i.e., endanger(ing) the life or physical safety of any person or identify(ing) the source of information or assistance given in confidence for law enforcement or security purposes. While the intent of demonetisation has been fluid beginning from targeting black money, and counterfeiting to digitising the economy.

Post the demonetisation announcement, RBI disclosed data related to the receipt of old currency on a daily basis. Regular reporting of data, in line with the ethos of the institution was appreciated by the public. According to the last disclosure made on December 12, 2016, RBI had received R12.44 lakh crore. However, it abruptly stopped sharing the data when it seemed imminent that most of the approximately R15 lakh crore of demonetised notes will be returned.

 The increasing opacity of RBI’s role in demonetisation goes against the global trend of increasing monetary policy transparency. We should ask RBI to disclose detailed notes of the minutes of its Board meeting. As of now, there is no clarity on the nature of background work undertaken by RBI to assess the move and the institution’s conviction to go ahead and implement the same. It is unfortunate that the very custodian of demonetisation is unable to exonerate itself by coming out with reliable facts, that would convince the common man and investors alike, of its intentions and independence. If policymakers have decided to operate in secret, then we should consider amending our Constitution to reflect that the government is not responsible to the people.
This article first appeared in Financial Express.
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Calling for a Head

We will state our baseline assumption first; the “implementation” of the demonetization exercise, though admittedly an historically unprecedented exercise in its scale and timelines, could still have been far better. We will not get into whether the exercise was justified or not or the reasons for its failure, but focus on the institutional failure in the exercise.

On December 30 2016, the President signed the Specified Bank Notes (Cessation of Liabilities) Ordinance, 2016 which extinguished liabilities of the Reserve Bank for the currency withdrawn. From January 2 2017, the next working day post the signing of the ordinance, the RBI was not liable to exchange old notes for new. Only NRIs who can prove that they were not in the country during the 50-day period are now allowed to exchange their old currency at the RBI. On November 8 2016, the RBI had clearly said that those who are unable to exchange old notes during November 8 to December 30 2016 in banks shall be able to do the same at RBI offices till March 30, 2017. It is unclear why RBI and the incumbent Government waited till the last day to rescind the March 30, 2017 deadline. Considering that RBI released 74 notifications in the 50-day period, there is little rationale to justify this last-minute rescindment.  To add to the woes of common man, the announcement came over the new year weekend, and was absorbed only when business opened on January 2 2017. Prior to this, on November, 24 RBI had advanced the date of exchanging old currency at branches from December 30 to November 24 itself. Preponement of critical deadlines, without any reasonable explanation from the central bank, not only questions the foresight of policymakers; it also creates a trust deficit among the citizens. The Reserve Bank of India is known for exemplary policy making and execution. However, when it issued bizarre notifications such as those which mandated depositors to provide explanations for depositing old currency towards the fag end of the 50-day period, its institutional repute appeared to be on a free fall.

The demonetization drive led to an acute cash crunch. People had to wait for hours to withdraw cash. The country’s 2.2 lakh ATMs needed to be recalibrated for the new currency notes. This took more than six weeks and reportedly is still going on in rural areas. So, while people were eligible to withdraw INR 2,500 per day from the ATMs, more than 90% of the machines did not work in the first few weeks. In response to an RTI query, RBI stated that it had printed bills of INR 2,000 amounting to INR 4.95 lakh crore of currency before November 8. In light of the mayhem caused by sucking out 86% of the currency in circulation, it is worth understanding what had prevented RBI from circulating these bills into the system or was it mindful of the “top secret”.

Post the demonetization announcement, RBI disclosed data related to receipt of old currency on a daily basis. According to the last disclosure made on December 12, 2016, RBI had received INR 12.44 lakh crore. However, it abruptly stopped sharing the data when it seemed imminent that most of the approximately INR 15 lakh crore of SBNs will be returned. It followed up this decision with curbs on deposit of currency notes asking for clarification of why the notes were not deposited much before the deadline. It seemed that the RBI does not want to honor the signed commitment on each currency note. This, and many such instances have caused the many to believe, that RBI’s decisions are based on factors undisclosed or unknown. The double counting of currency argument does not hold any water because any banker can tell you that cash is accounted for every night in every bank branch. There is never any double counting if there were we have a bigger problem with the efficacy of the banking system than we imagined. Banks simply do not make mistakes while executing credit or debit entries.

That a demonetization was being contemplated was kept a secret for good reason. But, little was achieved by not keeping even a single RBI official in the loop who could have been consulted on the availability of new currency, printing capacity, readiness of the banking system and other operational procedures. If an RBI official was consulted, then he clearly is not up to the job.

Concerns have been previously raised about the presence of only 8 out of 10 members on the RBI board meeting which approved the demonetization. The RBI Act prescribes 21 board members of which 11 have not been appointed at the moment. Only the number of government appointees is compliant with the RBI Act (at 2). This seriously compromises the independence of the RBI Board. Refusal by the RBI to furnish the minutes of the RBI Board meeting and other information under the RTI has further led to the belief that the RBI has become the opposite of the transparent organization that was hoped with setting up of the MPC, MPC minutes disclosures and an inflation targeting framework. The RTI act mandates that any written record that comes under the RTI and needs to be disclosed if asked for.

The idea of an independent monetary authority is not a very old one. It is a 20th century creation to act as a counterbalance to the populist tendencies of governments. The idea is that if a government is fiscally profligate, an independent central bank will raise interest rates to control inflation thereby maintaining monetary stability in the country. This idea gained worldwide acceptance after inflation wreaked havoc with economies from Germany to Latin America. The RBI governor on behalf of the Government of India is the guarantor who signs on currency notes promising to pay holder. He is the most well informed person on the banking sector in the country. If he had an iota of doubt about the capacity of the banking system to handle the exercise he should have shut the idea down. The prerogative was on him and the RBI board. On the other hand, if they succumbed to pressure from the government, then investors should reconsider India as an investment destination. I would like to direct Dr. Patel to his own brilliant report on monetary policy which argued for an independent MPC and why central banks should have an independent and targeted focus.

The Government announced demonetization in less than two months of Dr. Patel’s appointment as the RBI head. The nation expected him to speak on the announcement, and address the concerns caused by a act of such humongous scale. Dr. Urijit Patel’s silence on a decision, that comes under the realms of the RBI Act, led to wide spread speculation, on both, his stance and consent. Even a single press address by Dr. Patel would have gone a long way in reposing the faith of common man, in the institution that was responsible for implementing the exercise as the banking regulator.

The RBI as the issuer of currency in India and the banking regulator has done an extremely shoddy job of handling the exercise and as it stands, the current leadership has substantially harmed the institutional credibility of a venerated institution. It goes without saying that Dr. Urjit Patel had big shoes to fill. He was well regarded and considered a good fit for the job. Since that veneer has been removed, it is best that the task of restoration of the credibility of the RBI falls to someone else; perhaps Professor Viral Acharya.

This article first appeared in thedialogue.

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Unemployment as a Societal Problem

East Asia went through an economic miracle between 1960 and 1990, with income per capita nearly tripling. The four Asian Tigers, including Hong Kong, Singapore, Taiwan and South Korea, achieved impressive growth rates of more than 7% for more than three decades. Japan went through a similar phase till the 1980s. This prolonged period of economic growth is attributed to export-oriented policies, investment in health and education, high savings rate and capital accumulation. Studies have examined the influence of demographic transition on economic growth [Bloom and Williamson: 1998]. If most of a nation’s population falls within the working ages (15-60), the productivity of this group can produce a ‘demographic dividend’ of economic growth, assuming that policies to take advantage of this are in place. The combined effect of a large working-age population and health, family, labor, financial, and human capital policies can create virtuous cycles of wealth creation.

India faced a similar scenario with fertility rate declining in the 1980s leading us to today; where we are one of the youngest populations in the world and the largest workforce on the planet at the exact time China’s labor force begins to decline. India currently has 120cr people with a median age of 26 years. By 2030, India is projected to have 1.4bn people, of which over 100cr will be in the age group 15-64 (productive workforce).

This is a boon as well as a challenge. To consider the scale of the challenge, the working-age population, aged between 15 and 64, will rise by 12.5cr in the current decade, and by a further 10cr in the following decade. A third of this growth will come from poorer and less literate states, particularly Bihar and Uttar Pradesh [Literacy: 69.8% and 69.7%; GDP per capita: 31k and 37k respectively in 2014]. To employ this population, India needs to create 10cr net new jobs in the next 10 years. From 2002 to 2012, China created 13cr net new jobs in services, however in India, no net new jobs were created from 2005-2010.

India’s youth unemployment rate currently stands at 12.9% compared to an overall 4.9% unemployment rate in the country. Compared to advanced economies, overall rates of unemployment in developing countries are generally lower than observed in developed economies because most individuals cannot support themselves and their families through social protection schemes.

According to a survey [National Employability Report: 2013], almost half the graduates are unemployable in the market, while according to labor ministry statistics, almost one in three graduate up to the age of 29 is unemployed. The Economist estimates that India produces twice as many new graduates each year as it can absorb. The problem lies not just in the quantity of jobs. India’s incomplete economic liberalization since 1991 has left the country with few good employment opportunities for unskilled workers who do not have much education. Statistics verify what is plain to see; all cities have an army of liftmen, guards, peons and delivery boys. About 85% of the jobs are in the informal sector, another 11% are casual jobs with formal companies. IT firms account for only a few tens of lakhs of jobs out of a total of about fifty crore. 23% of Indian workers are categorized as working in “industry”, compared to nearly 30% in China and 22% in Indonesia. However, half of India’s industrial workers are in construction. India’s manufacturing jobs also do not involve exposure to modern machinery, techniques or training. More than half of Indians in the manufacturing sector work in facilities without electricity.

The skills mismatch in the youth labor markets has become a persistent and growing trend. Over-education and over-skilling coexist with under-education and under-skilling and increasingly with skills erosion brought about by long-term unemployment. There hasn’t been much growth in manufacturing to create lower-skilled jobs. Young men often have no choice but to stay in low-paying idle jobs. This is a result of supply driven education and a lack of interface between the various stakeholders’ viz. industry, education institutions, and education and labor ministries.

Our leaders have long said they are committed to generating employment, but have shown little stomach for the economic upheaval that rapid job creation entails. China’s policymakers accepted that the process of adding jobs overall often destroyed jobs in particular industries and places. Politicians have preferred economic palliatives such as NREGA and subsidies for the needy. The lack of political resolve means India is unlikely to summon up the single-minded dedication with which South Korea, Taiwan and China created industrial jobs. India’s demographic dividend will yield only a fraction of what it could, and the problem of low-quality employment will continue.

In the rural areas, majority of the population is engaged in the primary sector resulting in low productivity and persistent poverty. There is also a need to increase formal employment which currently constitutes only 8% of the labor force.

Impact of Unemployment: Brain-strain (stressed to be employed)

How is this going to affect India? Hundreds of millions of young people are or soon will be looking for jobs and spouses. If those hopes aren’t fulfilled, aspiration will turn into frustration. And, frustration can manifest itself in rising crime. Long-term youth unemployment drains the motivation and ambition of those it afflicts and makes them more cynical. This is evident all around the world, including developed economies such as the US. Prolonged high levels of youth unemployment may lead to a risk of social instability. Unable to become part of the rising middle class in India, this rising army of unemployed could fuel violence and destructive politics thereby destabilizing the country. It can result in a vicious circle of inter-generational poverty, social exclusion and trigger violence.

Does the frustration of India’s youth help explain the prevalence of sexual harassment and violence against women? India already fares badly in terms of the demographic divide between males and females with 933 women for every 1000 men. This number looks dire with the youth sex ratio standing at 908 and adolescent (10-19) sex ratio at (898). Certainly, the patriarchal society and other reasons play a part, but it is worth exploring the role of economic and social frustration. Women in India describe daily incidents of harassment: taunts, stalking and groping. Most of the time, the culprits are relatively young men with lots of time on their hands and nothing productive to do.

The Justice Verma Committee Report, speaks of the “mass of young, prospect-less men whose sexual harassment of women may tip over into more aggravated assault. These men are fighting for space in an economy that offers mainly casual work.” And concluded that “large-scale disempowerment of urban men is lending intensity to a pre-existing culture of sexual violence”.

Prof. Craig Jeffrey, Professor of Development Geography at Oxford University, an expert on India’s unemployed youth, has a sociological term for the act of loafing around with nothing to do: “timepass.” “Rapid social change in provincial India has created a vast army of educated and semi-educated ‘loafers’ among young men. Young men find themselves with little or no opportunities or resources and find it difficult to get married. They hang about near college campuses or even by the roadside, taking out their frustration on women. ‘Time-passers’ aren’t just unemployed or underemployed; they’re often also unattached. After decades of skewed sex ratios at birth, India now has approximately 37 million more men than women. This excess supply of men, combined with falling fertility rates has led to a ‘marriage squeeze’.” [Craig Jeffery: 2010]

The combination of young men with few prospects and the frustration of being single is especially pronounced in North India, where sex ratios are the most skewed. Sexual harassment is just one of the social pathologies that can arise from these economic and demographic trends.

Insurgency has been in the limelight, which too is related to the challenges of youth unemployment and underemployment [Magioncalda: 2010]. Regions with inadequate employment opportunities have witnessed serious problems. Similarly, the Arab spring, London riots of 2011 and Occupy Wall Street movements were to an extent an expression of the disenchantment with the lack of opportunity in the respective countries. It does not take much for such small-scale movements to become a destabilizing force.

India may discover that demographic dividend has its perils.

This article first appeared in Governance Now

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Fintech Opportunities for Financial Inclusion

There has been so much noise around fintech recently that it is very easy to do both either get caught up in the hype or believe that it is another tulip mania. Matt Levine in a brilliant piece in Bloomberg wrote about the three ways fintech companies are trying to disrupt banking; 1. with the same business model, 2. with more computers or 3. by wearing a hoodie because being cool is a technology. He goes on to elaborate how most fintech companies are not replacing banking but just disaggregating services or making it customer friendly, something that banks can easily co-opt.

While technology companies are gung-ho about their ability to develop a great front end product while banks lag in customer experience, very few have any experience in dealing with the myriad regulations and licenses that come with handing public money. Because of this inherent weakness, fintech companies have been happy to outsource the back-end operations to banks. This essentially amounts to outsourcing the banking to banks. The net effect being that banks remain entrenched in the system without much disruption. A beneficiary of this has been Cross River Bank which is pitches itself as the bank of choice for fintech companies and has in the process become the darling of Silicon Valley venture capitalists, a strategy being replicated in India by RBL Bank. Quite a few people have expressed similar apprehensions with payment banks and online wallets not being a panacea of financial inclusion problems as they are not disruptive enough or have viability issues (Payment Banks).

For all the calls to sobriety, there are many things fintech companies can do to address failures of the banking system in providing access to the financial system at the bottom of the pyramid. At the annual conference of the Bank of International Settlements, a paper discussed that the cost of financial intermediation has remained constant at 2 per cent across many developed countries for the past 100 years, implying that the gains from technology have not been passed to consumers. Eliminating the cost of opening a savings account can increase the uptake, savings levels and reduce informal savings according to studies in Sub-Saharan Africa. Similarly, in Nepal ease of access to basic bank accounts via tellers visiting houses led to significant uptake and increase in welfare (GONESA). These costs of financial intermediation can easily be eliminated by the use of technology.

Accounts which apply behavioral insights can further increase the benefits for the poorest. A study by RAND revealed that less educated people are more likely to choose the default options in any financial product. This should allow companies to make products that further the objective of increasing savings for the poor by introducing commitment or lock-in features to bank accounts.

The poor live risky lives. The limited research into insurance shows significant benefits for the poor from insurance products. Crop insurance and micro-insurance products though proven to be effective from a welfare perspective, do not scale without government subsidy. ICICI Bank has had a crop insurance product for over a decade but it cannot be considered successful by any stretch. Finally, lack of information about credit-worthiness and lack of screening ability among lenders hinders the efficacy of any rural lending programs. Traditional banks are not profitable in these areas without high transaction costs.

Access to digital payment services is a potential platform for providing insurance to the poor because firstly, they reduce financial institutions costs while enabling informal P2P risk sharing by enabling easy payment services. Like in other industries, fintech companies propose disruptive innovations for specific services. Their key advantage is that they aren’t held back by legacy systems like most banks and are more focused on data. Are there viable models to insure poor households? How does a company scale digital credit on a small scale? How to support the delivery of advanced savings products and not the no-fills account that are pervasive in policymaking circles? Finally, finance is just a means to an end. We need to achieve tighter linkages between finance interventions and other sectors to magnify impact. These are some of the key questions that fintech companies can answer to be as transformative as Grameen Bank was.

This article first appeared in thedialogue.

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Game Theory and Traffic

The below rant got published in GovernanceNow.

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Game Theory of Traffic

For those of you who have ever argued with me, you would know how I ascribe the traffic conditions on Indian roads to low IQ. That obviously is hyperbole but, this is my attempt to coherently put down my thoughts on it. Arguing that it essentially is a failure to solve a repeated prisoners dilemma game.

Driving on a road can be modeled as a game. I can choose to cooperate and be stuck behind the car in front of me, or I can choose to not cooperate and not cooperate and overtake the car. Now, let us break this down.

Round 1: If I am new to a city/country/planet and am only going to be there for a day. I see that I am stuck behind a car whereas the opposite lane is completely empty. I have every incentive to not cooperate and switch to the opposite lane. Thus saving time and I win.

Round 2: Other people see this and see that it is in their interest to not follow lane rules and decide to not-cooperate. Which brings us to a situation where it is a loosing strategy to cooperate and everyone loses out due to the sub-optimal Nash equilibrium.

Hence, it can be argued that the chaos that is driving in India is essentially a sub-optimal Nash equilibrium.

Now, things get interesting. the way around this dilemma is to repeat the action of the opposing player i.e. if he cooperates, you cooperate in the next round, if he does not cooperate, you punish him by not cooperating in the next round. This is helpful if one of the players is illogical and there is some amount of randomness in the choices he makes. If on the other hand, everyone is logical (as economist are wont to argue) one bad move or initial condition, and the system again gets stuck in a sub-optimal equilibrium. The solution to this problem is “altruism” i.e. you need to forgive the other player after a certain number of moves. If everyone is logical then at some point, an optimal equilibrium will be achieved.

In 70 years, Indian drivers have failed to solve this basic problem hence my argument that the sub-optimal driving conditions result from either a low-IQ or a lack of social capital. The development of social capital is beyond the scope of this post so let us leave it here and assume that it has been achieved.

At some point in the future, let is imagine that India becomes like Germany and everyone chooses to cooperate every time. Now let us play the game again. Do I cooperate or not? If I choose to not cooperate, I have an empty lane to take advantage of whereas all the lemmings follow the rules! Oops!

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Regulation in the 21st Century

In 2012, the state of Minnesota in the US briefly banned free online education. That’s right, a government thought it was a bad thing for people to educate themselves for free. The government essentially banned universities from offering classes online without taking permission from the regulatory body which included a registration fee. We in India are no strangers to stranger regulations; the banning of surge pricing by taxi platforms in Delhi in April 2016, during the odd-even experiment, is one of many examples. However, the Uber/Ola debate does not seem to go away. Recently, taxi unions in Delhi were on strike (again!) protesting against aggregators taking away their jobs. This is nothing new and strikes have been happening in Delhi and Mumbai since Uber and Ola set up shop. For that matter, textile workers in the 18th century broke spinning jennies to protest the imminent loss of jobs. In fact, Uber has faced challenges in almost every jurisdiction from strikes by Paris taxi drivers to falling foul of New York city’s transport authority.

The “gig economy” or the “sharing economy” refers to online platforms that let workers sell their services or products directly to consumers on their own time. The 20th century was characterized by people staying in one company for their lives. The corporation was the mode via which the workforce was organized. The current workforce changes jobs several times in their lives. The gig economy is an evolution of that trend where people work when it suits them or when they need money. There are many benefits of a gig economy. It enables better utilization of resources, increasing supply. By lowering prices, it adds to real disposable income, stimulating demand. It creates new markets which generate employment opportunities in other sectors. Online platforms also enable more efficient pricing and better supply-demand matching. Its impact in developed markets has been powerful, increasing supply, reducing prices and compressing profit margins and surely raising consumer welfare.

The advantage of the digital economy is the reduction of transaction costs which make customized transactions viable and thereby reduce under-utilization of assets. Data is at the heart of this revolution and manifests in the way that people consume goods and services. This results in a challenge to an existing player that is subject to existing government taxes and regulations. Their favoured response, that is, to strike informs even more people about the existence of alternatives and is akin to shooting oneself in the foot. The challenge for regulators is to avoid stifling innovation but at the same time ensure equitable application of rules that have been set up to regulate businesses and protect consumers. Platforms are able to provide solutions to some governance failures too. There is a security concern in using shared services. But, by verifying identity and reputations, platforms can mitigate such scenarios. They can also enforce requirements for criminal checks or insurance.

The government must remember that the ultimate purpose of regulation is to tackle market failures so that commercial exchange is not stifled by information asymmetries or blocked by firms with too much market power. Profit is a more powerful driver for quality than regulatory compliance (in the presence of competition). In the gig economy, reputation serves as the institution that protects buyers and prevents the market failure that policymakers worry about. Regulation to maintain quality is an option but if a hotel room is dirty, a bad rating and review on TripAdvisor would hinder future business and act as an incentive to maintain quality.

Reputation is definitely important in the gig economy, but biases may affect ratings. In a society cleaved by differences for millennia, we cannot afford to let these propagate as they would further the economic and social exclusion of individuals. Algorithms need to correct for biases so that these reputation systems don’t create a barrier to access. Biases exist in the traditional workplace too but as we look forward we should aim higher. With big data and artificial intelligence (AI) developing fast, it should be possible to correct these. Reputation is going to be the gateway to access and the government can mandate supervision of algorithms to recognize bias and remove it. This works the same way as anti-discrimination laws. As an example, credit card approvals were fraught with biases in the 1980s in the US against black applicants and applicants from certain locales. But, banks recognized this and have designed credit scores that calculate the probability of fraud more objectively and minimize bias.

Arguments can be made against some aggregators on the basis of predatory pricing. It would be interesting to see how they fare without subsidizing consumers and service providers. There are also arguments to be made that sharing platforms have economies of scale that encourage a monopoly and should be regulated like utilities. But, these platforms are not silent intermediaries. The seek to actively shape markets they create. Because the potential of these platforms is huge, they will be highly disruptive in the short term. The government has a very important role to play in establishing contracts but should be careful to not try to guide development with too little information. For even with a lot of information, the platforms themselves are not sure yet and are experimenting with various business models.

The internet has rapidly evolved from information sharing to e-commerce and now into a method of accessing real world services. This takes us back to the basic tenets of capitalism where everyone is capable of being a business owner and set prices for their services. The growth of sharing economy companies like Taskrabbit or Elance has enormous implications for how we look at work in the 21st century. Social security, labour laws and retirement plans will need to take into account the greater prevalence of freelance workers. We will soon be facing a world with driverless cars and the government should be aware of the changes it would need in terms of regulation to allow them. AI bots are now being employed by law firms, call centre workers will soon be replaced by Siri. Do we know how to respond?

This article first appeared in Livemint

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Payment Banks – A mobile wallet is a depreciating currency

It comes as no surprise that after Cholamandalam, Dilip Sanghvi along with IDFC Bank and Telenor Financial Services have decided to give up their interest to start a payment bank. The entities that were granted an in-principle approval for starting a payments bank were given a year to launch the bank and in turn gain a payment bank license. After eight months, a JV between a group with deep pockets, a bank, and a telecom player decided that it made no economic sense to start and operate a payments bank. Considering the stringent regulations and restrictions on operations, it seems very likely that more players will drop out of starting small and payments banks in the near future. The RBI had engineered a similar fiasco with the Local Area Banks in 1997. Of the 10 licensees, only 4 are in existence at present. The LABs were similarly constrained by regulations requiring them to remain in unprofitable rural markets and allowed to open only 1 branch in an urban area per district (maximum of 3).

The basis for the payment bank model has been envisaged based on the success of m-pesa in Sub Saharan Africa. A study by the Bill and Melinda Gates Foundation identified four reasons why m-pesa was able to reach a level of penetration that banks did not in Kenya. One, the cost of transferring cash to the villages from the cities was extremely high (sometimes 20%). There was also a lack of safety in sending cash. Two, Safaricom, a telecom company, is a highly trusted brand, more so than Kenyan banks. Three, Kenyan banks were restricted from utilizing banking correspondents beyond a certain distance, thereby limiting their scope of reach. Four, for nearly five years, Safaricom enjoyed a monopoly because banks did not have branches in remote areas due to high costs and because Safaricom made m-pesa easily available by strategically tying up with those vendors who provided mobile phone services and recharge.

The extent of similarity between India and Kenya ends is limited to lack of bank branch networks in remote areas. India banks too find it unprofitable to have branches in rural areas. Cost of transferring money in India is very low. Once bank accounts are opened under the current push under Pradhan Mantri Jan Dhan Yojna, operating bank accounts via mobile or through banking correspondents which include payments, savings and in limited cases credit services is not very hard or expensive. One wonders if a mobile money system would not be tantamount to a platform which already exists in the banking sector viz. National Payments Corporation of India and Universal Payments Interface.

Under the current regulatory framework, payment banks are not allowed to lend so their classification as banks in itself incorrect. Their only purpose is to make payment services ubiquitous, which means, they may be more appropriately governed under the Payments and Settlements Act 2007. Payments banks have been mandated to hold 75% of their liabilities in SLR securities (yielding ~7.3%) and the remaining 25% as deposits with other banks (yielding ~8%). This means that payment banks have no risk on the asset side of the balance sheet. Assuming that the cost of funds for these payments banks will be comparable to current scheduled commercial banks, (we are stretching our imagination here), that leaves absolutely no net interest margin for these banks to cover their costs.

The cost of funds for payment banks (and even small banks) will definitely be higher than full service banks which have better credit as well as access to inter-bank and RBI for overnight liquidity requirements. To counter this, the balances held with payment banks will give lower returns than the balances held with scheduled commercial banks. There will thus be no incentive for customers to hold deposits in these payment banks. This leaves charging for payments as the only possible source of revenue for payments banks. This begs the question why would anyone keep any float in a payments or small bank account which presumably would not pay any interest (paytm wallet, m-pesa or airtel money earn no interest currently). Almost all banks in India have implemented a core banking solution and are able to provide payment services via internet banking at almost negligible cost. There is a near zero transaction cost for a consumer (on most platforms) on transfer of money to anyone else in the country be it a business or another individual via NEFT or RTGS. Debit cards and ATM machines are also available widely but with an urban bias for now. The assumption seems to have been that payments banks will leverage technology and have minimal operating costs. Payments business is different from banking. It enables the transfer of funds from a payer to a beneficiary. Banks, payments networks like Visa, Mastercard and cash were the only mode of payments for a very long time. In the last decade with the advent of technology, banks have faced a challenge to their monopoly on payments by a clutch of technology and telecom companies, most notably; m-pesa, apple pay, google wallet and the like. India has been at the forefront of the payments revolution with systems like NEFT, RTGS and ECS which were promoted by the RBI and led to massive improvement in performance and customer services by banks. In the second version of this revolution companies like paytm and other digital wallets have garnered a lot of traction with technology savvy consumers. Payment services like m-pesa or airtel money however have not taken off like they did in sub-Saharan Africa.

What the RBI needs to consider is that there are not many telecom or financial companies more trusted that some of the big PSU banks in India. They have a reach and presence that is unmatched by anyone else anyone else apart from India Post. A mobile wallet is a depreciating currency in the sense that every transaction incurs a transaction fee. Would the poor not prefer to transact via normal banks and not mobile money if a similar payment and banking services are provided by banks? It was obvious that because of the restrictions imposed by the RBI, payment banks have no business model. Of all the payment banks licensed, only telecom companies, IT players and retail chains have a different cost structure and technology platform than regular banks. These players were already in the payments business via wallets and mobile money applications. If only these companies had to remain in the fray, the RBI need not have gone through the whole licensing charade, instead the RBI could have taken marginal yet effective measures to legitimize and rationalize the operations of existing players in the field.

This article first appeared on Financial Express.

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Designed to Fail – Payments Banks

This was written about 6 months ago but it became appropriate to bring it out from the cold storage given recent events. Updated a bit…

After Cholamandalam, Dilip Sanghvi along with IDFC Bank and Telenor Financial Services have decided to give up the in principal approval to start a payment bank. The entities that were granted an in-principle approval for starting a payments bank were given a year to launch the bank and in turn gain a payment bank license. After eight months, a JV between a group with deep pockets, a bank and a telecom player have decided that it makes no economic sense to start a payments license.

The Reserve Bank of India had granted 11 licenses to companies for starting so called “payments banks” in India which are licensed to provide payment services in the country. Following which, the RBI granted 10 licenses for starting small banks which are allowed to provide a whole suite of banking products like deposits, credit but in a limited area of operation. The stated objective for these licenses is to promote financial inclusion in the country and provide banking services to areas and people where they do not exist.

Considering the stringent regulations and restrictions on operations, it seems very likely that more players will drop out of starting small and payments banks in the near future. The RBI had engineered a similar fiasco with the Local Area Banks in 1997. Of the 10 licensees, only 4 are in existence at present. The LABs were similarly constrained by regulations requiring them to remain in unprofitable rural markets and allowed to open only 1 branch in an urban area per district (maximum of 3).

Payment banks by regulation are not allowed to lend so their classification as banks is incorrect and they may be more appropriately governed under the Payments and Settlements Act 2007. These payments banks have been mandated to hold 75% of their liabilities in SLR securities (yielding ~6.5%) and the remaining 25% as deposits with other banks (yielding ~7.25%). This means that payment banks have no risk on the asset side of the balance sheet. Assuming that the cost of funds for these payments banks will be comparable to current private sector banks (we are stretching our imagination here), that leaves absolutely no margin for these banks to cover their operating costs. The assumption is that payments banks will leverage technology and have minimal operating costs.

The cost of funds for payment/small banks will definitely be higher than full service banks which have better credit as well as access to inter-bank and RBI for overnight liquidity requirements. To counter this, the balances held with these banks will yield less than balances held with SCBs. There will be no incentive for customers to hold deposits in these accounts.

This leaves charges for payments as the only possible source of revenue for payments banks. Almost all banks in India have implemented a core banking solution and are able to provide payment services for free via internet banking. There is zero transaction cost for a consumer (on most platforms) on transfer of money to anyone else in the country be it a business or another individual via NEFT or RTGS. Debit cards and ATM machines are also available in most places now. This begs the question why would anyone keep any float in a payments or small bank account which presumably would not pay any interest (paytm wallet, m-pesa or airtel money earn no interest currently). There is also a matter of a transaction cost however small that a payments bank may charge whereas bank payment services are free.

It was obvious from the start that payment banks under the restrictions of the RBI have no business model. Of all the payment and small banks set up, only telecom companies and IT players and retail chains have a different cost and technological platform than regular banks. These players were already in the payments business via wallets and mobile money applications. In the end if only these companies had to remain, the RBI need not have gone through the whole licensing charade but could have legitimized their operations.

Payments business is different from banking. It enables the transfer of funds from a payer to a beneficiary. Banks, payments networks like Visa, Mastercard and cash were the only mode of payments for a very long time. In the last decade with the advent of technology, banks have faced a challenge to their monopoly on payments by a clutch of technology and telecom companies, most notably; m-pesa, apple pay, google wallet and the like. India has been at the forefront of the payments revolution with systems like NEFT, RTGS and ECS which were promoted by the RBI and led to massive improvement in performance and customer services by banks. In the second version of this revolution companies like paytm and other digital wallets have garnered a lot of traction with technology savvy consumers. Payment services like m-pesa or airtel money however have not taken off like they did in sub-Saharan Africa.

Small finance banks are subject to most of the prudential norms that scheduled commercial banks. They need to maintain a cash reserve ratio (CRR), and statutory liquidity ratio (SLR). 75% of the credit advanced by small finance banks will need to go to sectors that are part of the priority sector, which includes agriculture, small enterprises and low-income earners. Commercial banks have to mandatorily lend “only” 40% of their net bank credit to such sectors. Small finance banks also have to ensure that 50% of their loan portfolio constitutes advances of up to Rs.25 lakh. Such a scenario would definitely put a pressure on the net-interest margin (NIM) of all small banks. They will need to go through this period of low profitability before they are allowed to convert to full service banks.

A study commissioned by the Bill and Melinda Gates Foundation found that part of the reason why m-pesa was able to reach a penetration that banks did not in Kenya were 1. The cost of transferring money to the villages from the cities was extremely high (sometimes going upto 20%) there was also a lack of safety in sending cash 2. Safaricom is a very trusted name and more so than Kenyan banks 3. Kenyan banks were restricted from utilizing banking correspondents beyond a certain distance 4. For nearly 5 years, safaricom enjoyed a monopoly where no banks or other companies were allowed to exist leading to the large scale adoption of m-pesa. The main reason in Kenya of why banks did not have branches in remote areas was that it was too expensive for banks to have branches there whereas Safaricom’s m-pesa could be accessed via the same vendors that provided mobile phone recharge and services.

India is very similar in this regard. Banks find it unprofitable to have branches in rural areas. However, cost of transferring money in India is very low. If bank accounts are opened once as the current push under PMJDY has been, operating bank accounts via mobile which include payments, savings and credit services is not very hard. The same amount of familiarity with a mobile as that required for operating m-pesa account would be required. One wonders if a mobile money system would not be tantamount to providing a substandard product to the consumer.

Brazil’s Correios is regarded as a world leader among postal providers for its innovative use of strategic partnerships with the government and private players. Banco Postal leverages its extensive network of retail outlets in the most remote locations for provision of consumer financial services to the poor and underserved. It operates a network of over 12,000 consumer outlets in more than 5,000 municipalities. It also operates ~4,000 community post offices and another 1,000 franchisee post offices. The post offices provide over 100 products and services like electronic voting, government applications and permits. By giving a payments bank license to India Post, the RBI has done a great disservice to it. Going by the Brazilian example it is amply clear that India Post can function as a full-fledged bank and not just another payment system.

If the goal is to provide payment and remittance services where none exist. To the poorest of the poor in the undeveloped parts of the country, it would be fair to presume that internet banking would not work. The African experience tells us that m-pesa was immensely successful in providing payment and remittance services where banks could not go via a network of merchants who could “recharge” m-pesa accounts.

What the RBI needs to consider is that there are not many companies more trusted that some of the big PSU banks in India. They have a reach and presence that is unmatched by anyone else anyone else apart from India Post. Would a relaxation of the BCs norms further financial inclusion more? A mobile wallet is a depreciating currency in the sense that every transaction incurs a transaction fee. Would the poor not prefer to transact via normal banks and not mobile money if a similar payment and banking services are provided by banks?

The only major difference between the current small banks and LABs is that the Small Banks may have a national footprint. With the LABs, there was an effort to open them in financially excluded regions. There is no such requirement with small banks. The path towards financial inclusion is going to be paved by technology. Mobile is surely a way to go, so are banking correspondents and India Post. Financial inclusion is just one side of the story. People should have faith in the system and adopt it and not just open bank accounts. DBT and payment services over a period of time will go a long way in building that trust.

From the companies that were given a payments bank license, it seems that RBI has chosen for itself the business model that may be most successful with 4 telecom companies and 3 companies with large retail distribution networks in terms of a future banking correspondent model. In its defense, the RBI also granted a license to paytm which is already in the space with a completely digital footprint.

India is not blessed with a very competitive banking sector and a few public and private sector banks dominate. In such a scenario, the RBI along with other regulators must ensure that the environment is conducive for the most efficient and customer friendly business to win. The RBI should provide for the most competitive banking environment. Regulation should not determine the winner in the payment or banking business.

PS: Since writing the update, Tech Mahindra too has returned its license. HAHAHAHA

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Peer to Peer Lending in India

In response to the financial crisis, banks improved their credit standards and one of the silver linings of the crisis has been an increase in financial creativity in how people raise money. Its not very clear if this is temporary or a structural change in the financial system, however, it has left certain profitable niches where smaller companies the so called “fintech” are trying to make their presence felt in the financial landscape.

Peer-to-Peer finance has been getting increased attention in the past few years. Its potential impact may be similar to what Napster did to the music industry. P2P platforms provide a web-based system which brings lenders and borrowers together in a market place. P2P lending is a form of crowd-funding unsecured loans which are paid back with interest.  One of the major reasons for their popularity is that they are able to provide lower rates than those offered by moneylenders and offer higher returns to investors than what is available via conventional investment opportunities.

P2P platforms enjoy three advantages over traditional banks: (1) absence of legacy operating costs like branches (2) no need for access to payments infrastructure and (3) no capital requirements or charges for deposit guarantees.

Though it has not yet become a huge market in India, the cumulative lending via P2P networks touched GBP 5.1bn globally in March 2016 [P2PFA] (some estimates put it at a couple of orders of magnitudes higher than this as in essence chit funds are technically P2P lending). Key factors that may facilitate crowdfunding are: (1) Regulatory framework that leverages the transparency, speed and scale of the internet (2) Online marketplace that facilitates capital formation while providing prudent investor protection and (3) Collaboration with other entrepreneurs, events and hubs that creates trust in the marketplace.

The Reserve Bank of India recently released a consultation paper to regulate the nascent peer-to-peer (P2P) lending business in India. Overall the recommendations of the RBI are well thought-out. However, they also show a lack of understanding of the business. Firstly, since the lending is from an individual/group of individuals to another individual/company, the concept of leverage should not arise. The platforms only operate as facilitators or as a marketplace and do not invest their own capital. Flowing from this, the minimum capital requirement of INR 2cr sounds prudent but in an unnecessary requirement and will raise the cost of starting a P2P lending service and hamper its development. If the capital is used to create capital buffers or some form of investor guarantee/insurance it would improve trust in the platform. Secondly, the proposal that the money should not be held in an escrow account but be directly transferred to the borrower takes the benefits of a platform away and makes it more burdensome for borrowers to monitor and repay. This recommendation should be repealed.

P2P lenders currently use CIBIL scores and their own proprietary methodologies to assess the creditworthiness of borrowers. The lenders on the other hand are made aware of the risks in investing in such products. Since transactions happen via bank accounts, RBI deems that the KYC has been done by the bank. In such a scenario, the recovery process and investor protections needs to be looked into. This could be a source of pain during an economic downturn and we would risk throwing the baby with the bathwater like it happened with microfinance.

The interesting thing about P2P is that it shows that it is possible to separate the business of deposit taking, payments and credit (this is not really a surprise because that is how banking originated). While banks and P2P lending are fungible from a borrower’s perspective, on the lending side, the investors are fully exposed to the credit risk of the borrowers. The threat to banks from P2P lending platforms is hence limited to the extent to which these platforms can mitigate credit risk and create capital buffers for investor protection.

In theory P2P lenders should be able to poach safe retail borrowers from banks due to their operational and regulatory cost advantages and thus generate superior risk adjusted returns. For startups crowdfunding has had moderate success while, for institutions with greater capital requirement, P2P lenders will not be able to match the quantum or quality of service.

As P2P networks grow in size, they will have a non-zero effect on financial systemic risk and monetary policy. The effect on economic cycles of this distributed financial network will need to be studied in the near future. Central Banks and other regulators will need to be prepared for a shock and whether adequate buffers exist in the financial system. This would also bring into focus the relation of the non-bank credit sector better known as “shadow banking” to systemic stability. In general, P2P lending would introduce more equity in the financial system, bring down the gross leverage which would be a good thing and should be encouraged. In essence, P2P lenders are like a 100% equity funded bank.

From a credit and regulatory perspective, if the assumption of credit risk by individuals turns out to be desirable, peer-to-peer lenders will have a structural advantage over banks and continue their explosive growth. In such a scenario, P2P loans can be considered an alternative to high yield bonds and could constitute a new asset class. The current low interest rate environment would contribute to the attractiveness of these platforms from an investor perspective.

If lenders on P2P platforms prefer the additional returns but are not pricing the risk correctly, the growth of P2P networks may be halted once the lenders become aware of the risks or face an economic down-cycle with increasing defaults. If they deem this risk as non-desirable, P2P lenders would have to build out their risk management capabilities or provide some form of credit guarantee/insurance. On the other hand, financial institutions may start issuing loans on P2P platforms since they may have better mitigation and recovery mechanisms. This is already being observed in the case of the biggest platforms in the US and UK where financial institutions have become among the biggest lenders (40% of the lending on Lending Club and Prosper is from institutions). Financial institutions have the option of cooperating with and these networks to mitigate risk and simplify loan origination. In essence, these platforms may become the front-end interface for the asset side of the financial system.

This blog first appeared on: Pahle India Foundation

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