india unbanked

The latest data on India’s banking sector challenges the view that loans to disadvantaged sections of society are more risky.

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Conventional banking wisdom views government-directed lending to be of inferior credit quality. However, the recent performance of India’s banking sector challenges this view: disadvantaged sections of the economy repaid their loans on time, while banks are yet to recover the loans offered to the borrowers of their choice.

Imagine a life without access to formal sources of finance. Many people would struggle without savings, loans and transactions.

Governments in many developing countries have, of course, recognised the need for everyone to access banking services and have incorporated mechanisms to encourage financial inclusion.

As a large developing country, India recognised the need for affirmative action in bank lending in the 1970s. All banks – whether state-owned or private – are mandated to provide at least 40% of their credit to sectors neglected by the wider financial system, such as agriculture and small enterprises.  

All banks are mandated to provide at least 40% of their credit to sectors neglected by the wider financial system, such as agriculture and small enterprises

Over the years, Indian banks have tended to regard these government-directed ‘priority sector’ loans as an inconvenient but unavoidable cost to doing business.

Interest rates on priority sector loans are not regulated. But because of the disadvantaged background of many borrowers, the loans are expected to be inferior in credit quality. Therefore, free market loans to borrowers selected by the banks are intended to cross-subsidise the loss-making priority sector loans.

However, recent data on bad loans in the Indian banking system disproves the notion that loans to borrowers that are freely chosen by the banks are of superior quality.

Figure 1 shows the difference in the proportion of loans that were overdue for 90 days or more. The evidence is clear: priority sector loans have performed better. It is the disadvantaged sections of the society that repaid their loans in time, while the borrowers that were chosen by the banks defaulted on their obligations.

Hidden bad loans

The divergence in the credit quality of loans started in 2015 when Raghuram Rajan, then governor of the Reserve Bank of India, forced banks to disclose the bad loans that were hidden on their balance sheets – most of these hidden bad loans belonged to the borrowers that were chosen by the banks.

Figure 2 shows the make-up of the bad loans by segment. Individuals borrowers repaid their loans whether they were from the poorer sections of the society or not. Farmers paid despite near-drought conditions in parts of the country. Small enterprises also paid their loans on time. The defaults were mainly by large companies.

Once the truth about these hidden bad loans was revealed, conventional wisdom was turned on its head.

Priority sector borrowers clearly value access to bank lending and pay their debts despite many adversities. The real gross domestic product of India has quadrupled over the past 20 years. The growth in income of more disadvantaged sections of the society has enhanced their debt capacity; and lending to them has become a profitable option for banks.

Moreover, the prospects for India’s huge underbanked population may be set to significantly improve. India has more mobile phones than people (the latest estimates put the total population at 1.3 billion) and the cost of mobile telephony is among the lowest in the world. Mobile phones generate three quarters of total internet traffic in the country. Access to mobile phones is bringing fintech to the vast sections of society that were neglected by the traditional banking system. In light of their healthy credit history, they may soon be spoilt for options.

Pranav Singh is an assistant professor in finance and accounting at the Indian Institute of Management Ahmedabad.

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