MUDRA: Old Ideas, New Name?

Similar efforts like SIDBI, NABARD, NHB, etc have failed. The idea of financial inclusion merits more innovative thinking.

On Wednesday last week, the government launched the Micro Units Development and Refinance Agency, popularly known as MUDRA Bank, in a bid to help about 5.8 crore small business units secure cheap financing. According to the government estimates, about 96 per cent of these units do not have access to an institutional channel of financing. The bank, therefore, serves to fill the gap. It would have an initial corpus of Rs 20,000 crore in addition to Rs 3,000 crore credit guarantee fund.

The event largely garnered positive responses from most quarters of the industry as well as the media. One only has to perform a quick search on Google, most links would throw up some or the other argument as to why the government’s decision to create a public bank that would seek to complement domestic commercial banks by providing refinancing and credit guarantee to micro finance institutions besides also performing a host of other regulatory functions, is a wise move.

First announced in the Union Budget 2015, the plan to create this bank is seen as the Modi government’s second most significant development (after the Jan Dhan Yojana) aimed at furthering financial inclusion and equal opportunities. The huge magnitude of positive perspectives about MUDRA bank are overwhelming, except for the fact that there is nothing unconventional about this idea of targeted development.

Beginning with Indira Gandhi’s dreaded nationalisation of the country’s banking system in the late 1960s, virtually every subsequent creation or continued existence of inefficient public sector banks in India carried the typical socialist justification that the State must intervene to create “a level playing field”.  If one intervention failed to create this field, the State continued to find (as it did in every other socialist country) preposterous reasons to expand itself by just a little more.

In the pursuit of this utopian concept of equality, we eventually ended up stifling our banking system, misallocating the country’s financial resources, and squeezing ourselves of opportunities that could have catapulted India’s economy to match the level of China’s.  Thanks to the liberalisation of 1990s, India has seen a slew of privatisation measures in the past two decades. Today, we have a fair number of successful private banks delivering state-of-the-art service to urban customers.

The rural customers, however, continue to be underserved and financially excluded. Budding entrepreneurs within the marginalised sections, particularly the Scheduled Castes and Scheduled Tribes (SC/ST) are discriminated against by local financiers — not just socially, but also when it comes to loaning them funds to pursue their entrepreneurial paths. Then, there is also the challenge of viability. Commercial banks do not lend them owing to the high-risk nature of the funding. SCs/STs neither have the required financial history nor a desirable background that could enable them to qualify for credit. In addition, they also lack access to influential networks that, understandably, could make doing business in India an easier task.

These challenges are real, and it would therefore make sense why one would favour active government involvement to correct them — except that that approach does not quite stand up with what India’s history suggests. It is not that the country has not had banks or institutions specifically created for “funding the unfunded” (to borrow the famous phrase from India’s finance minister Arun Jaitley).

We have had Small Industries Development Bank of India (SIDBI) for more than two decades now. It attempts to grow and develop micro, small, and medium-scale enterprises in India. There is the National Housing Bank (NHB), which aims at making housing credit more affordable; the National Bank of Agriculture and Rural Development (NABARD), which is a development bank encouraging financial inclusion through carrying out various credit-related activities in rural areas. There are also the mandatory priority sector lending required of commercial banks. These institutions have not been particularly successful. Part of the reason, of course being the lack of awareness among entrepreneurs of the schemes provided by them.

One could argue that MUDRA bank, by virtue of its large size and backed by political will, would ensure necessary awareness. But that still leaves open the question about due diligence and transparency. A chief criticism of Brazil’s national development bank, BNDES, for example, concerns the opaqueness with respect to how it chooses to disburse loans to companies. Excessive regulations prevent the bank from sharing the details of these loans.

Will the BJP government ensure transparency in MUDRA Bank’s operations, especially in terms of its policies governing loan disbursements? As a general rule, we should be sceptical, if not outright cynical, about a State-owned banks’ ability to maintain accountability in this area. They simply do not have the necessary incentives or competitive pressure to do so.

There is another problem. Several reports have shown that development banks across the world often use the country’s financial resources to bargain political support — to win votes during election periods. Given that the SCs/STs form a significant enough vote bank, what if MUDRA Bank becomes just another instrument for politicians to exploit them for political gains? After all, most state-owned institutions eventually become puppets of the ruling establishment anyway. Even if we assume that the leadership of Modi will ensure efficiency to an extent, there is no guarantee that the bank will not face the same fate as most public sector entities once he is no longer at the helm.

Apart from a host of already existing banks (as I have stated above) intended to provide credit support to rural entrepreneurs and consumers, Jaitley had announced, in the Union Budget of 2014, a Rs 10,000 crore fund to facilitate fund flows to start-ups and small and medium enterprises. He had also announced a Rs 100 crore fund for “Technology Development Fund.” In the Union Budget of 2012-13, a similar fund of Rs 5,000 crore was also announced by then finance minister Pranab Mukherjee, with not much to show in terms of results. Incidentally, this fund (most of which remained unused) was managed by SIDBI, an institution under which the MUDRA Bank will be housed, too (for the time being) until a separate law is created for it. Given the muted success of SIDBI, the prospect of the successful implementation of MUDRA’s objectives remains clouded with doubts.

The deeper, yet most fundamental, reason why a state-owned and operated development bank such as MUDRA is a bad idea is its focus on providing credit at cheaper than market rates. This objective runs against the most basic of financial principles: capitalists (those who own the capital) should be compensated for their funding in proportion to the risk they take. In other words, higher risk should entail higher return. Else, they would rather invest their funds elsewhere!

In the case of MUDRA, we could say that the role of the ‘capitalist’ is performed by the State — since it is the government which would fund cheaper credit. Even more accurately, we could say the taxpayers are the real capitalists. The government has no funds except that which it earns through taxes. It is this money that would ultimately be directed to MUDRA through budgetary allocations or from the priority sector lending requirements of commercial banks.

The reason why most private, commercial banks do not venture into rural areas is because they do not find it financially viable to lend to high-risk sections having weak backgrounds. Private banks simply cannot afford to take such risk with other people’s money. But the State operates by a different set of standards. Taking risks with other people’s money (read taxpayers’) is a routine operation for the government. That is why it ventures into creating another such bank in the first place.

In saying this, I am, in no uncertain terms, discouraging the idea of funding the entrepreneurial dreams of the marginalised sections of society. Just that that funding could be performed much better through private capital. For instance, we could make the environment for starting and operating a small finance bank (SFB) as less restrictive as possible. Regulation should be encouraged, but in a minimal capacity such that it does not thwart their risk-taking abilities.

Fortunately, many microfinance institutions as well as non-banking finance companies are already on their way to becoming SFBs, thanks to the Reserve Bank of India that has decided to issue new licenses. These institutions have rich local area expertise in terms of demographics, culture, financial strength, requirements, and other variables of the population and hence are better equipped to carry out lending and refinancing activities.

Nirvikar Singh, a professor of economics at the University of California, suggests taking a more structured approach. He recommends making right infrastructure investments in regional towns. This would take “the pressure off the big metropolitan areas, which are often the political capitals as well.” He also suggests taking bolder calls with respect to labour law reforms to boost employment opportunities “as well as other changes in government regulation and taxation of small and medium enterprises.” Lastly, he says that “the government must speed up the Schumpeterian process of creative destruction, which can sweep aside inefficient social systems as well as outmoded techniques of production and firms.”

These solutions may take time to fructify owing to their structural nature, but they are far better than pursuing the Fabian way of gradually expanding government programmes and hence the size of the State through new public sector banks. The concept of MUDRA may sound path-breaking, but as American economist Henry Hazlitt belonging to the Austrian School noted in his 1946 book, Economics in One Lesson, “The ideas which now pass for brilliant innovations and advances are in fact mere revivals of ancient errors, and a further proof of the dictum that those who are ignorant of the past are condemned to repeat it.”