White Paper
Financial Inclusion and Digital Payments  Indicus Analytics[1] for IAMAI 
September 1, 2008 


 
Introduction
 In order to address the issues of financial inclusion, the Government of India constituted a “Committee on Financial Inclusion” under the Chairmanship of Dr. C. Rangarajan, that  submitted its final report to the Union Finance Minister in January 2008.  The Rangarajan Committee defined 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.”  As far as definitions go, the committee headed by the former RBI governor made a very significant departure from the past.[2]  Its definition and recommendations are more inclusive, deeper, and less constraining for policy makers.  
In line with the committees’ view of financial services for all, this paper looks at the role digital payments can play in ensuring such an outcome.  In the process it shows that there is one, and only one, way by which we can achieve the goals that we have set for ourselves, namely, “access to comprehensive financial services, including credit, to at least 50% (say 55.77 million) of the financially excluded rural cultivator/non-cultivator households, by 2012 …. The remaining households have to be covered by 2015.” 
It is well recognized that a large number of households and especially those in rural areas do not have bank accounts.  It is also well known that the formal sector has not been expanding rapidly enough where services to the masses are concerned.  In fact there is a relative stagnancy (See Box below). Data from the National Sample Survey Organisation shows that other formal sector modes of various financial services (e.g. via post offices) are also not growing rapidly enough where financial services are concerned.  Though the informal sector has been taking up some of this unmet demand, even that has been quite inadequate in reaching out to the large masses that require financial services, and later sections show this quite effectively. 

Undoubtedly the government has formulated policies, put in many rules and regulations, tried to mandate rural branches, lending to the underprivileged, controlled money-lenders, and each of these had had some success in reaching out to underprivileged, but never has it been enough.

Continued Failure of Conventional Financial System in Reaching to the Poor “In March 2005, commercial banks had 338 million savings and current accounts as against 290 million in 2000. Rural accounts went up from 172million to 200 million – representing an increase of 28 million, while urban accounts increased by20 million from 118 million to 138 million. The rate of growth annually was around 3 % just a little over the population growth- State wise data would show certain areas where there is hardly any increase. The number of loan accounts increased from 54 million in 2000 to 77 million in March 2005 (7.3 % CAGR). However the higher growth rate was on account of urban areas. In rural areas, the number of loan accounts went up from 40 million to 47 million (3.3%) whereas the urban areas showed a stronger growth from 14 million to 30 million loan account or growth rate of 16.5%. The growth in the number of small borrower accounts in rural areas was even lower at 2.5 % whereas the growth in the number for urban areas was 13.8 % between 2000 and 2005.There has been hardly any increase in outreach or scale in the last five years except for some growth in branches and loan accounts in urban areas. Number of bank offices in rural areas remained more or less the same - 47253 in 2000 to 47586 in 2005- while they rose from 19808to 22383 in urban areas. Current and savings accounts per branch in rural areas rose from 3650to 4202 and from 5965 to 6155 in urban areas. The number of loan accounts per branch rose from 844 in 2000 to 1003 in 2005 while in urban areas the number increased from 731 to 1335. These data bring out the spurt in urban retail lending in recent time –but this has not been matched by similar growth in savings accounts in both rural and urban areas or growth in loan accounts in rural areas. On the other hand, there are 93 million mobile users today –the CAGR since 1999 is 85 %. The number of mobile phones currently is more than the number of borrowers from the banking system. There is a clear need to increase the outreach and scale up operations at existing outlets. (emphasis ours)

Governor, Reserve Bank of India
 As of today, as per the government’s own admission, barely 27% of rural households are able to access a financial institution (see Economic Survey 2007-08). Recent initiatives, though promising, will need to be made even more cost-effective and accessible for the poor. Take, for instance, micro-finance.  Despite more than three decades of microfinance institutions operating in South Asia, their household penetration has not increased beyond 3 percent.[3] Or consider Bank Correspondents who reduce cost of delivery and increase access as they do not require the setting up of a bank branch and are also located close to the user.  India has taken a few steps towards the creation of such ‘correspondents’, an initiative borrowed from Latin America where retail vendors, lottery outlets and post offices double as bank branches for customers.  However, it is also well known that even in Brazil where they are considered to be most successful, users tend to be those who receive welfare payments, or use it for utility bill payments etc. Only a minority of the users use services such as savings deposits etc.  
There is a serious and critical constraint with financial inclusion. The poor have irregular and small value transactions, their credit requirements and deposits also tend to be low value, they have few assets and poor records of those that they do possess, and they are time constrained.  The formal financial service organizations however are just not cost efficient enough to profitably service such requirements. 
This paper makes the point, that it is possible to profitably service the poor, rapidly reduce servicing costs, and cover large numbers rapidly.  And this is only possible through a digital payments ecosystem that is characterized by open entry and inclusiveness.  Such an ecosystem needs to be based on the following three principles.
Principal One:  Financial inclusion deals with overall financial services and not just banking.
The Rangarajan Committee has already taken this conceptual leap by broadening the notion of financial inclusion from banking services to financial services.  Even within the banking system there is some agreement on this move to widen the range of options that will be needed to reach out to the masses.[4]  Later discussions will show how ‘financial services for all’ is the critical element in universal financial inclusion.
Principal Two: Focus towards transactions and not just lending or borrowing.   
Within the ambit of overall financial services, are also services that enable transactions. The poorest segments do not have significant experience or wherewithal in formal lending or borrowing.  If one were to rank the various requirements of the poorest segments, it is the transaction that will come out on top.  Hence to bring the poor into the system, it would be best to first start with the transaction.  Moreover, borrowing and lending are activities that are the outcome of financial health of the consumer.  Transaction history is the only credible means of analyzing financial health or financial requirement in the future.  A system that can credibly capture details of transactions would be much better able to service the requirements of the masses.  
Principal Three: Cost effective delivery of the financial and transactional services is the only constraint.   
Universal financial inclusion would be an automatic outcome if delivery costs of financial/transactional services are low enough.  In other words, if it were possible to dramatically reduce costs of transactions, and costs of access by the poor, then the profit motive combined with an open entry ecosystem would automatically lead various players to provide services for the masses.
The three points above naturally point towards various forms of digital payments as the only way by which it would be possible to achieve in six years what we have not been able to in the sixty since independence.  Digital payments (or electronic payments) exchange money electronically. This typically requires an electronic end node (internet point, mobile, telephone instrument); a form of electronic communication (wireless or wireline); and a computer; combined with a digital stored value system.  There may also be one or more bank accounts at the core of the system.  Electronic funds transfer, credit card, prepaid card, mobile banking, prepaid cards, debit cards, etc. are only some forms of electronic money that are used for digital payments. There tends to be little need for a human interface in digital payments.  This is because the need to safely keep the physical store of value, automatic recordkeeping and collating, no requirement for physical meeting of the provider and the receiver, 24 by 7 availability at the fingertips, independence from the constraints imposed by geography, etc.  This ensures that the cost of transactions is extremely low – both for the provider as well as user.   And in turn this implies that transactions that are of lowest value can be undertaken profitably. Therefore even minimal of transaction fees has the potential to generate surpluses for the service provider, given of course that the scale is large enough.
This white paper on digital payments and financial inclusion calls for a consensus among policymakers on the criticality of the emerging digital payments ecosystem in India.  The paper argues that universal financial inclusion rests on the wide spread use of digital payments.  Moreover, it also argues that a good digital payment ecosystem is one that ensures that the poorest and those at the bottom of the pyramid are not left out, as they have been from the banking sector.  That is, the criteria for developing the various institutions around a new digital payments regime in India should primarily be India’s objective of universal financial inclusion. Since there are various regulatory issues that can be instrumental in determining the course that digital payments regime takes in India, the paper argues that the most important metric to judge the potential impact of such mechanisms, needs to be financial inclusion.  Success will imply that those at the bottom of the pyramid are finally mainstreamed into the financial sector.  Failure will only lead to greater hurdles in India’s objective of sustainable and equitable growth.
The paper proposes the following as the key elements of a digital payments ecosystem aimed at true financial inclusion.
1.       Ensure entry of various players to ensure a highly competitive regime
·         Inclusiveness: Both banking and non-banking entities should be encouraged to enter the industry.
·         Level playing field: The close links between the service provider (e.g telecom company, ISP) and the consumer should not provide inordinate advantages to those companies at the cost of other players.
·         Large and small: The digital transaction eco system should involve, and not keep out, small firms. Large firms should not derive undue advantage from regulatory prescriptions.
2.       Ensure low cost access for the masses that is integrated with the economy
·         KYC Norms: KYC practices that have contributed to financial exclusion of the large masses need not be replicated in the case of low value digital payments.
·         Integration: Facilitate a variety of services that are easy to integrate with all sectors of the economy.
3.       Ensure that the system can serve heterogeneous requirements
·         Inherent flexibility: A one size fit all approach that is currently the practice in banking regulation needs to change to become more flexible and adapt to the different needs of the consumers at the bottom of the pyramid, who are a highly heterogeneous group.
In the following sections, the paper examines the large unmet demand for financial services at the bottom of the pyramid and give various examples of groups of people whose needs are going unfulfilled by the formal financial sector. International examples of financial inclusion through digital payments are presented to show their relevance and utility in the Indian context. This is followed by a sketch of the characteristics of a good digital payment ecosystem. This section also includes recommendations to policy makers and regulators that are necessary to ensure an enabling environment that will bring about true financial inclusion.
Meeting the needs of the bottom of the pyramid
 This section shows that there is a large unmet demand for financial services at the bottom of the pyramid and the current problem of exclusion has risen from a market failure of mismatch of needs of the banks and low income consumers. Innovative solutions to address this issue need to move away from a purely bank-based model to one where greater range of services – from purely bank based, to bank to non-bank integration, to purely non-banked ones are possible to provide.  This will also be possible if we embrace modern technology through a convergence of digital and payment systems. 
It is well understood that the flow of money through the economy in a seamless fashion is a key driver of high growth. The introduction of currency enabled economies to move away from the constraints of a barter system in the past; from there cheques were the next step ahead as a speedy, secure and convenient facilitator of transactions. With advances in technology, electronic payments removed the need for physical exchange of instruments of payment and settlement, making for substantial savings in cost and time. Electronic clearing systems, credit and debit cards are just some of the ways in which banks and their customers can settle transactions more efficiently. However, in a country like India where a significant share of the population has no bank account, the vast majority remain outside the scope of these technological advances in banking.
For both the government and the Reserve Bank of India, financial inclusion is a policy objective. According to the RBI, financial exclusion can be interpreted in two ways[5] – first is exclusion from the payment systems and second is from the formal credit markets. However, in both cases, this is defined with reference to direct access with the banking sector. Measures of financial inclusion therefore are per capita bank account ratio and the number of loan accounts, adjusted for adult population.  The RBI understands that the present low level of access to the formal settlement system is a case of market failure and sees its role as trying to “create enabling conditions such that markets become more open, more competitive, affordable and inclusive.” (Thorat, 2007). Yet, the model sought to address the problem continues to be emphasis on a bank-based model.
Migrant remittances – the Bihar story

With the lowest per capita income in the country, the state of Bihar lags behind on all social and development goals, leaving the people with little choice but to migrate to other states seeking employment and better livelihoods. Migrants are usually single men, with women and children left behind in the villages. While there is no formal data on the quantum of remittances, Post Office records show that money orders to the tune of Rs. 450 crores were sent to Bihar from other parts of India in 2005-06. This is just a fraction of the money that is moved usually through self, friends, relatives, private agents and in some cases through bank drafts. Here again, the poorest hand carry their money while those who can afford transfer charges use informal and formal agents.

According to one survey in north Bihar, remittances accounted for one-third the income of the households and are used mainly for consumption needs and medical expenses. Other surveys have shown the use of remittances to raise assets through land leasing, home improvements etc. There is however no doubt that remittances play a crucial role in improving livelihoods in the poorest of regions of the country.

Migrants need safe and cheap ways to transmit small amounts of money. The use of digital methods of transactions to remit this money will not only be faster, less expensive and more secure, it will also allow for more diverse transactions. For instance, payment of school fees or doctors bills in the villages can be done directly from the migrant’s e-wallet. Source: Deshingkar et al,. ODI 2006.
Consequently, while the RBI recognizes that there are strong issues on both the demand and supply sides, on demand concerns, it sees geographical barriers, low awareness, low incomes, illiteracy etc as constraints and on the supply side, branch timings, distance, unfriendly staff, documentation hassles etc. are problems to circumvent, as these result in high transaction cost. So the RBI has been now looking at solutions such as no-frills account, banking correspondents, use of intermediaries in NGOs, branchless banking etc.  However, what is often overlooked is the main reason behind the slow progress in financial inclusion through a bank based model - the banking sector has not extended its presence in the rural regions and amongst the poor of the country precisely because of a fundamental mismatch between the needs of the banks and of the consumers.
It is here that the market has failed. Around 40% of Indian households have income less than Rs. 75,000 per year[6], that is there are more than 90 million households across India depending on cash for their transactions. These include diverse groups such as marginal farmers, landless labourers, urban slum dwellers, unorganized sector employees and entrepreneurs, migrants, socially excluded groups etc. 
What all these groups have in common are what can be termed the “economic environment of the poor”[7] with two essential characteristics. To begin with, all the typical transactions of the poor occur in very small amounts. As such the cost of transaction tends to be high and standard administrative bank charges are unaffordable by the poor. The second is that cash flows of income and expenditure are usually irregular with a high level of insecurity and risk. Employment may be uncertain, contracts may be unenforceable, sickness can affect income as well as expenditure etc.
Banks with their formal systems of assessing credit worthiness find such groups unattractive.  To deliver service to the poor therefore the first step is to understand their peculiar needs, that distinguish them from the average bank customer. Not just in India, studies across the developing world have shown that given the low and uncertain levels of income and saving, ‘cash is king’ for the poor (Wright et. al. (2006)).[8] What the poor require is the facility to move money in small amounts quickly and securely with minimum transaction cost. Clearly the costs of providing such services through the traditional bank model of branch service are large. 
One view is that if a payment system is to meet the needs of the poor, providers must determine which of the transactions have low transaction cost for the poor e.g. making a purchase of groceries, and which have a high transaction cost e.g remittances to the village, visit to the bank branch to access cash. Focusing on transactions where cash is inconvenient is the best way to bring people into the fold of the modern financial system and raise efficiencies through savings in cost and time.  Cash on delivery payments, payments related to business requirements of the masses (about half of all Indians are self employed, a percentage that is much higher among the poor), insurance payments, salary payments for schemes such as NREGA, small wage payments by private entities such as construction contractors, etc. In 2005-06, there were more than 500 million people whose consumption expenditure averaged less than Rs. 580 per month. The majority are in the rural areas, where the reach of the banking sector has been reducing over the recent years (See Graph).

Typically transaction amounts are small, for instance, under the National Rural Employment Guarantee Scheme, wages around Rs. 100 per day are guaranteed for labour for 100 days in a year. In 2007-08 under the scheme, more than 30 million households across India received wages amounting to around Rs. 3000 per household. Even though the amount per household is small, the programme has been successful in reducing distress migration from rural areas and raising household incomes. To increase transparency and eliminate leakages, the government is now using the post office network to disburse wages to workers in rural areas. This year more than 23 million accounts were created in post offices and banks under this scheme[9].  It must be noted that these measures are taken by government diktat, and are not market induced. Consequently, while the need of the poorest is being fulfilled, the cost of service delivery is being borne by the public institutions, even as there is a larger demand there waiting to be met. On the credit side, while recent initiatives in microfinance have been attempting to address the problem, even such attempts are failing at the last mile, for reasons similar to the failure of the bank model – high transaction costs. 
Again, the non-farm unorganized sector is an important part of the economy, it accounts for more than a quarter of the GDP in India. However, a very small percentage of these firms have access to formal sector bank credit. The Third Census of Small Scale industries conducted in 2001-02 showed that while 14 percent of the registered units enjoyed bank credit, just 3 percent of the unregistered units had bank loans. Credit to the small sector has not kept pace with other sectors and the Report on Financing the Unorganised Sector by NCEUS 2008 has this to say, “Had the SSI sector received the same percentage of gross bank credit as it got between 1994-95 and 1999- 2000 i.e. 15 per cent of the net bank credit, the actual credit to this sector would have been Rs 203,190 crores instead of Rs. 101385 crores in 2006. The addition of about Rs. 1,02,000 crores would have doubled the employment, output and export. On the basis of current statistics of production, employment and exports, we find that the nation lost about 30 million of mandays employment, about Rs. 5,00,000 crores of production and about Rs. 1,50,000 crores of exports. A sector which has the potential to grow at a much higher rate than 9 to 10 per cent and create large employment was denied this opportunity … (emphasis ours).” It is therefore quite apparent that alternatives to the bank based model must be sought urgently to bring the bottom of the pyramid into the growth trajectory of the rest of the economy.  
A look at the comparative costs of provision of services through various channels shows that removing the physical presence of the bank is by far the cheapest method of transacting (See Graph).   So even banking business in general will profit through technological advances and convergence with digital systems of payment.  In fact, the goal of financial inclusion is best met through the convergence of digital and payment systems in a manner that will bring in the small low income cash-dependent customer. This is because true financial inclusion is one that will allow each citizen to enjoy the fruits of the modern payment and settlement system. How do the poor currently meet their needs?  Though comprehensive studies do not exist, data on indebtedness gathered from a large representatively sampled set of households by the NSS provides some indications.    The households in lowest asset classes in both urban and rural areas, tend to be most poorly served by the conventional institutional sources (including banks, various government agencies, cooperatives, insurance companies, etc.).  The non-institutional sources however tend to be much more even in their credit disbursals.  The same survey also shows that the institutional sector has not improved upon its performance in this regard in more than a decade after reforms.  In rural areas, it has in fact become worse. Though the non-institutional creditor has been less biased against the poor, even it has not been able to fill the gap.  Consequently less than a third of the households obtain credit – perhaps the most important component of financial inclusion.  The key reason is the same - high cost.
Box: Network Externalities in the Financial Space With new technology there are significant positive externalities from being connected to others on the same network. Whether this is through the internet on computers, television cables or mobile phones, as the number of devices increase and connectivity increases, there will be an exponential rise in the benefits to new users on the digital payment landscape. “As more people become connected to the network, the value to each individual of acquiring a mobile phone increases, as there are more people who can be called. A similar effect is to be expected in terms of m-transactions and if so, it is at the point where network effects are triggered that we will see truly transformational impacts. Before any such point is reached, the role of financial and telecoms regulators will be key.” Nick Hughes, Head of International Mobile Payment Services, Vodafone in “The Transformational Potential of M-transactions”, Policy Paper Series, No. 6. July 2007.
In India, though there have been many initiatives to move away from a branch-based model of financial inclusion, progress has been slow on the regulatory and legal front to allow the evolution of the payment and settlements system into the next phase of transactions through the mobile phone. Not only is there caution in allowing banks to participate in mobile payments, there is even more reluctance to expand the scope of non-banking institutions. Despite the RBI’s stated commitment to creating an enabling environment for more open, competitive, affordable and inclusive markets, action on this front is very tentative. Being a new technology whose processes and implications are yet to be fully understood, this conservative approach may seem natural. Yet there is much to learn from the experiences of other countries and the sooner the government and regulators get their act together, the closer the country will come to achieving true financial inclusion.  Experiments on financial inclusion through digital payments have been successful in many parts of the world and the great impact such models could have on financial inclusion objectives is well understood. There are various models e.g  PayPal, Paymate, M-PESA, G-Cash, ITZ  Cash etc. that work through the internet, through mobile phones, through agents or POS terminals and allow consumers to make retail transactions in a secure and convenient environment. Another trend for the future is the use of digital interactive television to make transactions. This has taken off in developed countries of the West and can be seen as a potential access point for financial services in developing countries too.  It is important for retailers to connect with these payment systems in a way that allows the spread of the service amongst low income unbanked consumers. For instance, the Indian Railways allows purchase of the tickets through kiosks or through the internet using a variety of methods. Latest data[10] showed that while credit cards accounted for 41 percent of successful transactions, net banking 31 percent and cash cards 26 percent of the online business of more than Rs. 450 crores in August 2008. What is more interesting is that net banking was the least successful transaction method with a 65 percent success rate while cash card transactions had the highest success rate of more than 80 percent. The average amount transacted was less than Rs. 1000 (Rs. 877.95 for cash cards). The typical customers for cash cards are those who do not have credit, debit cards, or net banking facilities, in other words are not seen as attractive customers for banks. They can however use point of sales terminals to purchase cards and make retail transactions in amounts as small as Rs. 100. It is for users like these that digital payments can prove to be a boon.   As of now, no one single model has been found internationally that can service all the requirements of the poor. However, there are many ongoing experiments, and the greatest successes are likely to come from some model that has digital payments at the core.  While mobile density is rising at an unprecedented pace in India, with more than 8 million subscribers added every month, broadband connectivity is also going up, the subscriber base has crossed 4.5 million. Meanwhile, under the government’s national e-governance plan to set up one common service center amongst every six villages in the country, more than 70,000 centers have been set up in 14 states by July 2008[11]. Payment systems that use this growing network will be in a position to reach the masses that have so far been excluded from the formal banking system. For this to become an actuality, it is important to create an environment that will enable greater numbers of such service providers and greater range of services for digital payments.
A Good Digital Payment Ecosystem: Characteristics and Recommendations
This section brings together the key characteristics of a good digital payment ecosystem, that enables financial inclusion, an ecosystem that allows all citizens to participate in the growth and development trajectory of the economy.   The key stakeholders in the digital payment scenario are numerous – internet service providers, payment system operators, technology providers, mobile network operators, banks and retailers form the actual players in the market. The digital transaction system allows banks to increase their customer base with lower costs and risks. According to Booz Allen estimates, banks can reduce cash logistics by 10% through use of cashless payment transactions[12]. Telecom and internet service providers gain by increasing customer retention, higher revenues through value added services etc. Retailers and service providers benefit through fast access to a larger base of customers, better payment collections etc. There is a synergy between the digital world and the financial world that needs to be exploited successfully to give the final benefit to the consumer. However, at the same time the government and regulators of banking, telecommunications, payment systems, competition issues, anti-money laundering, all form the environment in which the digital payments business model functions. 
Given that the business of digital transactions is new and unfamiliar, governments and regulators tend to be cautious about allowing innovations that may disrupt financial stability of the economy. As has been emphasized in the previous sections of this paper, while on one hand financial inclusion is the stated objective of governments, and new technology has been widely accepted as a tool for financial inclusion, regulatory and supervisory concerns have inhibited the development of digital payments in many countries, including India. For a new product market to develop, it is important that the enabling environment be one which blends legal and regulatory openness and certainty – openness will allow innovation to flourish while certainty will give confidence to entrepreneurs to make investments. Thus the markets which develop fastest are those which are in environments that are moving towards greater openness and greater certainty.  The most crucial issue here is to ensure that the market remains open and competitive for entrepreneurs to take up new business models. The key characteristics have been mentioned and discussed at various points in the preceding sections.  These are:
1.       Ensure entry by ensuring a high degree of inclusiveness in types of service providers, ensuring a level playing field, and also ensure that both large and small players can enter the industry. Inclusiveness: Both banking and non-banking entities should be encouraged to enter the industry.   The basic concerns of regulators in the financial sphere revolve around  (i) maintaining financial stability, (ii) raising economic efficiency, (iii) increasing access to financial services, (iv) ensuring financial integrity, and (v) ensuring consumer protection, and (vi) ensure rapid accessibility of such services for the masses with heterogeneous requirements.  
Given the focus of financial regulators to ensure financial stability, it is but natural for them to have a bank focus.  Take, for instance, electronic money. The Reserve Bank of India has been aware of the developments in the technological sphere and had set up a working group to make recommendations on electronic money way back in 2002. This committee which was largely made up by bankers had advised the issuance of open multipurpose cards by banks alone. This was to be done in the interests of ensuring central bank control over monetary policy objectives.[13]  It needs to be recognized that the disruption to financial stability deals with systemically important payment systems, and not retail payment systems, especially of micro-magnitude. This distinctiveness of retail and micro-amounts should be well understood to avoid stifling innovation that has the potential to help the masses of the country. Consequently there is no need to limit this industry only to the banks.
According to the Bank of International Settlements, one of the main objectives of payment regulation is to address those legal and regulatory barriers to market development and innovation. It is for the RBI and other regulators to work towards this end, so that the potential of technology can be exploited to the full in meeting the goal of financial inclusion. International experience shows that the future will see the growth of non-bank payment institutions within the digital transactions market space. Financial regulators should set their policies within this emerging reality. While such firms have stepped in easily in developing countries where the banking sector is not well developed, this model is also coming into play in the European market. From 2009 the European Commission’s new payment-services directive will allow such firms to operate, with no banking licenses and restricted activities, but which will come under money-laundering controls. 
Level playing field: The close links between the network service providers and the consumer should not provide inordinate advantages to those companies at the cost of other players. For instance, currently the mobile phone is considered the most potent tool of financial inclusion.  However the mobile industry is characterized by only a handful of operators both in India and abroad.  Given the close links between the consumer and the mobile service provider and the tie-in of the consumer to the service provider, a monopolistic digital transaction industry would be a likely outcome if a level playing field is not created. A digital-payment platform set up by the service provider should be open to other account holders within a specific agreed time period, and new entrants should be allowed to use existing payment infrastructures.  Just as landline users can choose between different long distance providers, so too must regulation ensure that various financial service providers can access the user.
Large and small: The digital transaction eco system should involve, and not keep out, small firms.  Large firms should not derive undue advantage from regulatory prescriptions.  This is important for many reasons.  Take for example Micro-finance initiatives and how they can leverage the intra-communities ties for lowering cost of credit.  Whether we have MFIs or bank correspondents, or private money-lenders, or NGOs, or for that matter other entities operating in small distinct communities, such entities need not be debarred from providing their services to their users through digital means. Though certain prudential norms would be essential, they should not follow a one size fits all approach and, depending upon scale and scope of their operations, their regulatory requirements also need to be appropriately structured.
2.       Ensure low cost access for the masses that is integrated with the economy.
KYC Norms: KYC practices that have contributed to financial exclusion of the large masses need not be replicated in the case of low value digital payments. If  digital transactions are to be truly transformational, it is important to bring unbanked customers into the fold of payment systems. KYC regulations put in to ensure financial integrity can hamper the growth of this market and hence affect the aim of financial inclusion.  Even in the draft guidelines released in June 2008, which are at the time of writing of this report still pending finalization, mobile payment services to be offered by banks are not only restricted only to their customers, but also to those customers who are KYC/AML compliant. Since subscription to a mobile phone also involves identity checks, this is a duplication of effort and can given rise to inconsistencies in norms. Standardizing the system of compliance across digital and financial worlds will also help sharing of data and information. These may seem as small glitches now, but can appear as roadblocks later on retarding the goal of integrating the latest digital technology with financial services. Discussion on evolving systems is important to keep abreast of technological and market developments. 
Integration: Facilitate a variety of services that are easy to integrate with all sectors of the economy.   In the digital transaction market, there is a significant coordination problem that arises due to the overlapping role of multiple regulators of banking, telecom and payment system supervisors, competition and agencies involved in monitoring activities of money laundering and fraud. The problem is compounded because of the dynamic nature of the industry and continuously evolving technology. This means that the regulators have to be flexible, be quick on the uptake to change when needed and deliver appropriate regulatory orders in a coordinated and consistent fashion.
3.       Ensure that the system can serve heterogeneous requirements 
Inherent flexibility: A one size fit all approach that is currently the practice in banking regulation needs to change to become more flexible and adapt to the different needs of the consumers at the bottom of the pyramid, who are a highly heterogeneous group. The terms ‘masses’ and ‘under-privileged’ are a highly heterogeneous segment.  They include self-employed and unemployed, cultivators and land-less laborers, literate and illiterate, nuclear households and joint families, indeed the range is large.  And so are the requirements.  
To sum up the key points of action need to be on the following lines:[14]. 
1.       There should be sufficient legal certainty about the status of electronic contracting. Suitable policy/regulation/legislation is needed to address issues such as legality of electronic signatures etc.
2.       Customers should be adequately protected against fraud and abuse. This can involve appropriate disclosure requirements on part of the service providers, limits to liability of the customers in case of unauthorized transactions and a fair dispute resolution system. A common standard must be worked out in consultation with the industry stakeholders before legislation.
3.       Regulators should encourage inter-operability by ensuring that providers have access to payment systems and that consumers are able to switch between operators and providers. A digital-payment platform set up by the mobile or web service provider should be open to other account holders within a specific agreed time period and new entrants should be allowed to use existing payment infrastructures. Cell number portability should also be required within a reasonable time frame.
4.       Account opening procedures should be risk-based and not unduly prejudice remote account openings by small customers. Either there should be exemption from the rules for small accounts or suitable guidance should be developed that will allow small accounts to be opened.
5.       Customers should be able to make deposits and withdraw cash from agents and remote points outside branches. This is the banking correspondent model being adopted in India now and is supplementary to (and not competing with) digital transactions.  There are some other associated issues such as management of cash reserves at the agent level, apart from the financial risks involved here, there are also issues of liability that need to be addressed in the legislation.
6.       Adequate provision must be made for the issuance of e-money by appropriately capitalized and supervised entities, which are not necessarily banks. E-money is an evolving concept and regulation should allow non-bank players to issue such money on terms which limit the volume and risk per customer and also monitor the transaction volumes and outstanding balances.
Conclusion
 Despite decades of progress in the financial systems and markets in India, the masses continue to depend on cash for their transactions and remain outside the scope of the formal financial sector. There is a vast and diverse group of people whose financial needs are going unmet – marginal farmers, agricultural labourers, migrants, employees and entrepreneurs in the unorganized sector, socially excluded groups etc. Their cash flows of income, savings and consumption are of low levels and often of uncertain, irregular nature, making them unattractive clients for the formal financial sector. Yet, bringing the poor and poorest into the system has large savings in the present transaction costs of dealing with cash and has the potential of boosting economic growth. Thus financial inclusion is recognized as a goal by all policy makers as the economic growth and development story will remain incomplete without participation by the poorest of the poor. However policy makers in the government and at the RBI continue to emphasize the role of the banks, even as it is clear that market failure has arisen in meeting the goal of financial inclusion precisely because of a mismatch of the needs of the formal financial sector and the low income consumer.  It is time to look for new non-bank based models that can fill in the gaps. Evolving technology has changed the landscape of the financial world as digital payments bring with them significant efficiencies. Further, with the fast adoption of mobile phones and spread of the networks, costs of making transactions have been significantly reduced. Experiences in other countries and modern technology shows that the future lies in involving non-bank institutions as intermediaries. While vigilance is justified when confronted with new, unfamiliar systems, stifling innovations and market developments through extreme caution will only retard the growth trajectory of the economy. The policy makers should therefore work towards providing an environment where all stakeholders can perform the functions they do best. An added problem in the digital payment space is that the overlapping roles of multiple regulators leads to coordination failure and this should be well understood by all policy makers. The need of the hour therefore is to work with clarity and consistency and speed up the process of moving towards greater openness and greater certainty in the digital payment sphere. 
 “In new market areas, regulators have a delicate task: neither over-reacting and stifling market development, nor under-reacting to potential large scale risks until it is too late. While delicate, the task is not impossible. Managing possible trade-off between innovation and stability is at the heart of good policy and regulation. If policy makers develop a clear market development strategy, this will not only brings greater certainty but also enable regulators to take a sequenced, proportionate response to the risks involved”. David Porteus (2006, p 37).
 


 
Select References

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Medianama, September 8th 2008: http://www.medianama.com/2008/09/223-irctc-does-102-million-in-online-transactions-in-august-payment-trends-hdfc-icici-cash-cards-significant/http://www.medianama.com/wp-content/uploads/2008/09/irctc-july-august-average-transactions.jpg

Ministry of Rural Development www.nrega.nic.in

Ministry of Rural Development, Government of India, press release

Morowczynski Olga, 2007, Innovations in Mobile banking, the case of M-PESA, presentation at the First National Consultative Forum on Microfinance, Sudan.

NCEUS, 2007, Reports on the Financing of enterprises in the unorganized sector and the creation of a national fund for the unorganized sector. www.nceus.gov.in

NCEUS, 2008, Contribution of the unorganized sector to GDP: Report of the Subcommittee of a NCEUS Task force, Working Paper No. 2.

Porteus David 2006 The enabling environment for mobile banking in Africa

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The New Wallet 2008, http://dqindia.ciol.com/content/wifi/2008/108030801.asp

Thorat Usha, 2007, “Financial Inclusion – the Indian experience”, speech on June 19th 2007.Williams Howard and M. Torma 2008 “ Trust and Fidelity: from under the mattress to the mobile phone”, The Policy Paper Series No. 6. Wright Graham, Nick Hughes, Brian Richardson and David Cracknell, 2006 Mobile Phone-based e-banking – the customer value proposition, Microsave Briefing Note No. 47.
[1] A paper by Laveesh Bhandari and Sumita Kale, Indicus Analytics, New Delhi, 2008, for IAMAI.  The authors would like to thank IAMAI and the in-depth discussions with their members and secretariat.  All errors are ours.  Contact at laveesh@indicus.net and sumita@indicus.net.
[2] The international definition tends to be similar to this, “Financial Inclusion is the delivery of banking services at affordable costs to vast sections of disadvantaged and low income groups” (http://en.wikipedia.org/wiki/Financial_inclusion).  However, rightfully, Indian policymakers have suitably modified it for Indian conditions.
[3] Gonzalez  and Rosenberg , 2006, “The State of Microfinance – Outreach, Profitability, and Poverty: Findings from a database of 2600 microfinance institutions”, mimeo., CGAP, World Bank. (http://info.worldbank.org/etools/docs/library/232702/Rosenberg_OutreachEfficiencyProfitability.doc)
[4] “Financial inclusion is aimed at providing banking / financial services to all people in a fair, transparent and equitable manner at affordable cost” - Financial Inclusion-Reaching the Unreached (2007), Indian Bank (http://www.indian-bank.com/Agri_FinancialInclusion.pdf).
[5] Financial Inclusion – The Indian Experience, speech by Smt. Usha Thorat, Deputy Governor RBI on June 19,2007.
[6] Market Skyline of India 2008, Indicus Analytics estimates, using NSSO data
[7] Martin et al.
[8] Wright et al. 2006 Mobile Phone-based e-banking – the customer value proposition, Microsave Briefing Note No. 47.
[9] PIB Ministry of Rural Development Press Release August 1st 2008 http://pib.nic.in/release/release.asp?relid=40946
[10] Medianama September 8th 2008.
[11] http://www.mit.gov.in/images/cscstatus140708_large.jpg
[12] The New Wallet, 2008, http://dqindia.ciol.com/content/wifi/2008/108030801.asp
[13] However, the committee did put in a caveat that non-banks should not issue multipurpose electronic money unless they are subject to certain prudential norms.
[14] This draws heavily from Porteus (2006).