Interest free establishments as an alternative way for financial inclusion in Kerala

Abstract of the paper prepared to present in international conference on Innovation & Inclusion in Banking: Issues,Strategies and Options on February 2011 atschool of development studies, department of applied economics Kannur university Thalasseri campus. by

Dr. K V Pavithran Research Guide in economics Department of economics and research centre Govt. Brennan College Thalasseri. & Muhammed K Research scholar in economics Department of economics and research centre Govt. Brennan College, Thalasseri. mohdpalath@gmail.com 09539142919 Karandoli House Palath Post, Kakkodi via Calicut, Kerala, 673611

What is financial inclusion?

Dr. C Rangarajan defines financial inclusion as the process of ensuring access to financial services and timely and adequate credit where needed by vulnerable groups such as weaker sections and low income groups at an affordable cost. It includes access to financial products and services like, Bank accounts check in account, Immediate Credit , Savings products, Remittances & Payment services, Insurance Healthcare, Mortgage, Financial advisory services and Entrepreneurial credit. The categories of people who are underprivileged section in rural and urban areas like, farmers, small vendors, etc agricultural and industrial laborers, People engaged in unorganized sectors, Unemployed Women & children, Old people, Physically challenged people are generally financially excluded in India.

Financial exclusion in India

Shri V.Leeladhar, (2005)14 Deputy Governor of Reserve bank of India in a speech points out that the banking industry has shown tremendous growth in volume and complexity during the last few decades. Despite making significant improvements in all the areas relating to financial viability, profitability and competitiveness, there are concerns that banks have not been able to include vast segment of the population, especially the underprivileged sections of the society, into the fold of basic banking services. NSSO data reveal that 45.9 million farmer households in the country (51.4%), out of a total of 89.3 million households do not access credit, either from institutional or non institutional sources. Further, despite the vast network of bank branches, only 27% of total farm households are indebted to formal sources (of which one-third also borrow from informal sources). Farmer households not accessing credit from formal sources as a proportion to total farm households is especially high at 95.91%, 81.26% and 77.59% in the North Eastern, Eastern and Central Regions respectively. Thus, apart from the fact that exclusion in general is large, it also varies widely across regions, social groups and asset holdings. The poorer the group, the greater is the exclusion.

Raghuram Rajan (2008) observes Indias poor, many of who work as agricultural and unskilled/semi-skilled wage laborers, micro-entrepreneurs and low-salaried worker, are largely excluded from the formal financial system. Over 40 per cent of Indias working population earn but have no savings. Even accounting for those with financial savings, too large a proportion of the poor lie outside the formal banking system. For example, only 34.3 per cent of the lowest income quartile has savings, and only 17.7 per cent have a bank account. By contrast, in the highest income quartile, 92.4 percent have savings and 86.0 per cent have bank accounts. Similarly, 29.8 per cent of the lowest income quartile had taken a loan in the last two years, but only 2.9 per cent had loans from banks (about one tenth of all loans), while 16.3 per cent of the highest income quartile had loans and 7.5 per cent had loans from banks. Sources of Loan by Income Group Percentage of persons in income quartile who have taken loan from sources in last two years. Loan sources
Percentage of persons in income quartile who have taken

Loan sources

Lowest income Second income Third income Highest income quartile quartile quartile quartile Relatives/friends 39.2 34.4 33.2 32.0 Money lenders Banks Self Help groups Co op societies Chit funds/NBFC Microfinance others 39.8 9.6 9.7 5.4 1.6 1.1 1.0 33.2 20.7 8.4 4.9 1.9 1.4 0.9 25.8 33.3 3.3 6.5 1.5 1.2 0.8 14.8 45.8 3.4 7.4 1.2 0.9 1.4

Source: Raghuram Rajan report 2008, p54

Various studies and Market Surveys are estimated that Check in accounts in banks have 40%, Life Insurance have only to 10%, Non-Life Insurance -0.6% and ATM + Debit

Card holders are only 13% . Only 5.2% villages have a bank branch and it has wide Geographical disparities across country. In order to get an aggregate picture of banking activities in different dimensions, we need to design an index of financial inclusion. This is because from individual dimensions we get only partial information on banking activities. The position of a country may be quite good in one dimension but not in another. For instance, in 2004 in India the number of bank accounts (per 1000 adults), number of bank branches (per 100,000 adults), domestic credit (as percentage of GDP) and domestic deposit (as percentage of GDP) were respectively 627.1, 9.4, 36.9 and 54.9 ( Sarma, 2008). Thus we note here that although India had a low density of bank branches at that time, the performance in the last two dimensions seems to be reasonably good. Analyzing data from 1981 to 2007, Pal and Vaidya (2010) find that the patterns of changes in different dimensions of banking services over time are quite diverse. Given this diversified picture of Indias banking performance along different dimensions, it becomes necessary to get a comprehensive picture of the situation. This in turn necessitates the construction of an overall index of financial inclusion. This indicator is a measure of the extent of banking performance. A higher value of the index will indicate a better performance since an improvement in the banking activity in a dimension will represent a higher value. Such an index may be referred to as a functioning achievement index. Measures taken for financial inclusion The need for rural credit in India had been recognized even before independence by the erstwhile British Government as early as 1793 when it issued regulations for Taccavi loans to farmers and subordinate tenants for various purposes. The Cooperative Societies Act which was passed in 1904 to provide necessary legislative support to the financing of agriculture and regulating credit in the interest of cultivators then signalled the entry of credit for agriculture from the institutional sector. Since then, and till the late Fifties, cooperatives have been the major institutional source for all agricultural loans. The last four decades witnessed a rapid growth of banking network in India under the guidance and initiative of the Reserve Bank of India (RBI). A

vast cooperative branch banking network was developed in the Fifties and Sixties for purveying agricultural credit. The nationalisation of the Imperial Bank of India in 1955, 14 major commercial banks in 1969 and another 6 commercial banks in 1980, the setting up of the Farmers Service Societies (FSS) in 1973 and Regional Rural Banks (RRBs) in 1975 have enabled the creation of an extensive financial infrastructure for taking banking to the far-flung rural areas. A multi-agency approach has been adopted for rural credit delivery, involving commercial banks, RRBs and cooperatives. A vigorous rural branch expansion programme by commercial banks and RRBs was undertaken to increase the rural credit flow. The main emphasis in the spread of the banking network and introduction of new instruments, credit packages and programmes, and sectoral and institutional 'benchmarks' was to make the financial system responsive to the needs of the weaker sections in the society comprising small and marginal farmers, rural artisans, landless agricultural and nonagricultural labourers and other small borrowers falling below the poverty line. As a result, the rural and semi urban areas of the country are served today by more than 1,50,000 retail credit outlets comprising over 92,000 cooperative societies, 12,128 branches of DCCBs, 14,142 branches of RRBs, and 20571 rural and 12,283 semi urban branches of commercial banks. In other words, there is at least one retail credit outlet for a rural population of 4,700 (based on 1991 Census). This should normally be regarded as an extensive network and should be capable of meeting the financial needs of the entire rural population. Reaching out to the far-flung rural areas to provide credit and other banking services to the hitherto neglected sections of the society is an unparalleled achievement of the Indian banking system. It is very often said that credit 'per se' is not a sufficient factor for economic development, but assumes significance when preceded by or accompanied with sustained economic and social activities. In a study commissioned by Asia Technical Department of the World Bank (1995), it was observed that the priority across different types of financial services among the rural poor was consumption credit, savings, production credit and insurance. Not only consumption constituted two-thirds of credit usage, but even within consumption credit, almost three fourths of the demand was for short periods for meeting emergent needs such as illness and household expenses

during the lean season. While almost 75% of the production credit (which accounted for about one-third of the total credit availed of by the rural masses) was met by the formal sector, mainly banks and cooperatives, almost entire demand for consumption credit was met by the informal sources at high to exploitative interest rates that varied from 30 % to 90 % p.a. Due to the inability of the poor borrowers to offer any security for their small consumption loans, they were unable to take short term consumption loans from the formal banking system even though RBI guidelines did provide for granting of consumption credit by banks. Consequently, a large number of the rural poor continued to remain outside the fold of the formal banking system. After the institution of social control in banks and their nationalisation, a big thrust was given on provision of credit to the weaker sections by commercial banks while RRBs were established to provide credit exclusively to the poor. The policies concerning rural credit through the banking system were hitherto pursued on certain assumptions such as, (i) the rural poor have no capacity to save, (ii) could only be developed through subsidy linked poverty alleviation credit programmes, and (iii) interest rates of credit from informal sources were exploitative, etc. These assumptions led to the policy orientation focusing on capital subsidies and low rates of interest on loans, target oriented poverty alleviation programmes, credit guarantee for small loans, fixing up of sectoral targets for disbursement of credit, soft lending terms including nil or very low down payment, long loan maturities and grace periods, relegation of savings as a source of funds, increasing reliance of the rural credit system on concessional refinance from higher financial institutions, etc.

Micro Finance Institutions (MFIs) could play a significant role in facilitating inclusion, as they are uniquely positioned in reaching out to the rural poor. Many of them operate in a limited geographical area, have a greater understanding of the issues specific to the rural poor, enjoy greater acceptability amongst the rural poor and have flexibility in operations providing a level of comfort to their clientele. The Committee has, therefore, recommended that greater legitimacy, accountability and transparency will not only enable MFIs to source adequate debt and equity funds, but also eventually

enable them to take and use savings as a low cost source for on-lending. There is a need to recognize a separate category of Micro finance Non Banking Finance Companies (MFNBFCs), without any relaxation on start-up capital and subject to the regulatory prescriptions applicable for NBFCs. Such MF-NBFCs could provide thrift, credit, micro-insurance, remittances and other financial services up to a specified amount to the poor in rural, semi-urban and urban areas. Such MF-NBFCs may also be recognized as Business Correspondents of banks for providing only savings and remittance services and also act as micro insurance agents. In the midst of the apparent inadequacies of the formal financial system to cater to the needs of the rural poor despite its phenomenal physical outreach, and with the active support and patronage of some NGOs, an informal segment comprising small, indigenous self help groups (SHGs) has started mobilising thrift and savings of their members and lending these resources among their members on a micro scale. The amounts involved are small, the processes followed are simple, but the operations seem to be successfully and effectively meeting at least the immediate needs of the poor. The potential of these SHGs to develop as local financial intermediaries to reach the poor has eventually gained wide recognition in many developing countries, especially in the Asia-Pacific Region. Many NGOs have played an active role in fostering the growth of SHGs in furtherance of their basic objectives. As the concept of informal self help groups was relatively new, the National Bank for Agriculture and Rural Development (NABARD), the apex development institution with exclusive focus on integrated rural development, supported and funded in 1986-87, a MYRADA-sponsored action research project on Savings and Credit Management of Self-Help Groups for assessing its efficacy to help the target groups. Thereafter, in collaboration with some of the other member institutions of Asia Pacific Rural and Agricultural Credit Association (APRACA), NABARD undertook a survey of 43 NGOs spread over 11 States in India to study the functioning of SHGs and possibilities of collaboration between banks and SHGs in mobilisation of rural savings and improving the delivery of credit to the poor. Further, 10 other initiatives in the NGO and formal banking sector which specifically aimed at improving the access of the poor to banking

were studied and analysed in great detail under a Government of Germany (BMZ) funded research programme. Encouraged by the results of these studies on SHGs and other initiatives, NABARD launched in 1991-92 a Pilot Project on Linking SHGs with Banks. Steady progress of the pilot project led to the mainstreaming of the SHG-Bank Linkage Programme in 1996 as a normal lending activity of the banks with widespread acceptance Not achieved yet because Problem of interest It is now already recognized that implementation of microfinance is a powerful tool for financial inclusion and poverty alleviation. Raghuram Rajan continues Microfinance is the fastest growing non institutional channel for financial inclusion in India. A key factor that influenced the success of microfinance was its ability to fill the void left by mainstream banks that found the poor largely uncredit worthy, and were unable (or unwilling) to design products that could meet the needs of this segment in a commercially viable manner. Using group-based lending and local employees, microfinance provides financial services (largely credit) using processes that work, and in close proximity to the client. These qualities facilitated the proliferation of microfinance from a virtually non-existent activity in 1990 to a small, but increasingly important, source of finance for Indias poor. (Raghuram Rajan 2008)6. In order to address the issues of financial inclusion, the Government of India constituted a Committee on Financial Inclusion under the Chairmanship of C. Rangarajan. The Committee submitted its final report to Hon'ble Union Finance Minister on 04 January 2008. This report also suggests opening specialized microfinance branches / cells. (Rangarajan 2008)7

But now Micro Finance institutions started in India for filling the gap created by banks becomes most exploitative institutions. In rural areas many MFIs were charging high interest rates. Y. S. Rajasekhara Reddy, (2008) former chief minister of the
Andhra Pradesh, complained that some MFIs were "worse than moneylenders" because they charged interest rates over 20 percent. The poor people normally pay interest to money

lenders as bank is beyond their reach. In the case of MFIs or SHGs also people

pay interest. According to India's National Crime Records Bureau, more than 87,000
farmers committed suicide between 2002 and 2006 because of failing harvests and huge debts. A 2004 article in The Lancet, a renowned British medical journal, found that young women in South India had the highest suicide rate in the world. Sudhirendar Sharma, a former World Bank analyst and now director of the Delhi-based Ecological Foundation, thinks that microfinance is part of the problem. The rural suicides, he wrote, "cast a dark shadow on the fledging microfinance sector." (Thilo Kunzemann 2008)26 For the last couple of months microfinance is a hot discussion for the medias especially in Andhra Pradesh, there state govt. now introduced a separate registration for regulation of microfinance institutions. The media and various official agencies find that more than 50 persons were committed suicide within one year because of the harassment of microfinance officials. Sharma complains that usurious interest rates of up to 40 percent and forced loan recovery practices were intimidating the poor. This and other incidents have led to mounting criticism of microcredit as a debt trap for the poor.

A comprehensive study of 13 micro credit schemes in Asia, Africa and South America indicates unanimously that the benefits of the micro credit schemes under study were not scale neutral the upper and middle income poor tended to benefit more than the poorest of the poor (Hulme and Mosley 1996)27. The rigid design of traditional microcredit programmes and the limited range of financial services offered have made the arena of the micro credit project a difficult terrain to negotiate for poorer sections. The World Development Report (2000-06) acknowledges that the reach of micro finance has been limited to moderately poor sections rather than the poorest and recommends

greater flexibility in loan size and repayment schedules to reach poorer sections in any region. The interest rates on loans charged by traditional NGOs including Grameen Bank are high by any standard (20-35%), and reports of poor borrowers having to dispose of whatever assets they have to pay the usurious interest are not uncommon (Rahman, 1999)28. It is also alleged that micro-lending initiatives of Interest based MFIs have a self-perpetuating character and the borrower is seldom rid of his/her indebtedness. In this consequence, it is crystal clear that financial sustainability of MFIs plays a vital role to provide less costeffective lending/investment. Interest free microfinance in Kerala As a way of escape from the above issues of traditional (interest based) MFIs, a handful of Interest-free MFIs have come forward very recently to provide interest free financial services. Many of the countries of the world studied the evils of interest and introduced interest free banks and microfinance institutions. Asian Development Bank in its 2006 report points out that the special characteristics of interest free finance can provide alternative means to reach undeserved groups in small rural areas and agriculture producers29. In India main factor which inhibits these institutions to enter in to real banking business is the prohibition from the RBI. Even then non banking financial companies and interest free micro credit institutions are doing interest free banking activities so as to benefit thousands of people of the country. Guiding principle of the said microfinance institution is to become sustainable, side by side with promoting entrepreneurship amongst financially disadvantaged segment of the population with the sole objective of creating enabling environments for them to fully participate in the economic process and build up assets of their own. Many studies in different parts of

the world especially in Bangladesh shows that in a short span of time, interest free MFIs have been performing better than the traditional MFIs in the field of resource mobilization and poverty alleviation (Chowdhury, 2007)30. Interest free microfinance is the part of interest free banks rises in the financial world from 1970s. Interest free banks are mainly promoted from the Muslim world because Islam strictly prohibiting interest. The Banker, famous finance journal published from UK explains the growth of Islamic finance sector in the following words. Todays Islamic finance industry is rapidly evolving from niche to mainstream, with growth of Islamic banking assets now estimated at $750bn and growing at a rate of 15% to 20% a year. The Gulf Co-operation Council (GCC) proportion of total Islamic banking assets has reached 30% and is projected to rise to 40% in the next three years. In Malaysia, the Islamic share is currently 12% and the government is committed to boosting this to 20% by 2010. In Islamic countries such as the United Arab Emirates (UAE), where less than 30% of the local populations are Arabs, sharia-compliant banks are gaining market share at the expense of conventional banks. The spectacular acceptance and demand for Islamic finance means that within the next decade, the industry is likely to capture half the savings of the 1.6 billion-strong Muslim world. It is tempting to assume that the growth is being fuelled by an older generation of Muslims keen to take advantage of an offering that complies with their traditional way of life. Not so: the vast majority of the uptake comes from the under-30 segment of the Islamic world, and it is this segment that holds the key to success for the more than 250 Islamic banks that now operate in more than 75 countries worldwide. The popularity of Islamic finance among these young

Muslims responds to a resurgence of interest in their cultural and religious identity. This baby boom of customers makes up the backbone of the industry. (The Banker)31

Though there is no permission to start interest free banks hundreds of interest free micro credit institutions are working in the country. These institutions are financing micro level and not charging interest. They are providing loans from Rs 500 to Rs 25000 to needy persons. This institutions help to reduce debt burden and debt trap of poor people. So it is a way to reduce poverty (Shariq Nisar 2009)33. According to the available statistics (Rahmathulla, 1999) there are at
least 159 such institutions functioning in the country (Table). It shows that the highest number of such institutions is in Kerala, followed by Uttar pradesh, Andra Pradesh, Maharastra and Karnataka. But no study has taken place till now how far it benefits

the poor people.

Number of interest free financial institutions in India
State No.of institutions 23 5 2 7 14 46 3 21 1 3 9 24 1 Per cent 14 3 1 4 9 29 2 13 1 2 6 15 1

Andra Pradesh Bihar Delhi Gujarat Karnataka Kerala Madhyapradesh Maharastra Panjab Rajasthan Tamilnadu Uttar pradesh West Bengal

Total

159

100

(Source:Rahmathullah 1999)

Different from above data it is assumed that in Kerala more than 500 interest free institutions are working in organized and unorganized sector. Few are registered as finance company and co operative society. Some nidhis are registered under charitable trust or societies act, associations of persons, self help groups, or NGOs. INFECC is the single largest body which coordinating interest free

establishments working in Kerala. 360 local nidhis which doing interest free transactions are registered under this organisation. The organization gives directions for allowing loans, and giving necessary training for the office bearers. Some information available from its office about the functioning is briefing in table 1.9 above. Out of 360 nidhis the information of around 250 are included in it because others not submitted its annual report in time.

District

No. of Ndhis

Kasargod Calicut Wayanad Malappuram Palakkad Thrissur

3 47 3 136 6 10

Ernakulam Alappuzha Kollam Patthanamthitta Total

36 4 6 1 252

Source: INFECC working report 2007-08 (unpublished) A study conducted myself in five of these institutions shows the financial exclusion of the beneficiaries of this nidhis. Study about Different Sources of loan from which the beneficiaries usually avail loans is the following. Of the 50 respondents; 28 (56%) availed loan only from interest free institutions. 10 (20%) persons have loans from co operative banks, 5 have from commercial banks and one person have loan from a private bank. Four (8%) beneficiaries also have loans from money lenders and two persons (4%) have loans from kudumbasree unit. Here reveals the rate of interest charged by different institutions. Money lenders are charging usually 60% as interest. Other sources are charging 8.5% to 12% as interest. But interest free ventures are not charging any extra. It is the main attraction of interest free institutions. Table 5.12 Sources of other loans of beneficiaries. Name of the source Cooperative bank Commercial Bank Private bank Money lenders No. of persons 10 5 1 4 % of interest 12 8.5 11 60 percentage 20 10 2 8

SHG/ Kudumbasree No other loans

2 28

10 0

4 56

Aplicablity