The Hindu Business Line : No-frills account — Instrument to combat credit rationing

Credit rationing denotes a situation where a large section of loan applicants do not get the loans they seek. This has serious implications for a developing economy like India. The proposed no-frills account is a win-win opportunity for banks to cater to such a segment and attract profitable customers as part of their unsecured campaign.

IN A recent move, the RBI has urged the banking community to introduce the no-frills account to bring a large section of under-privileged people into the banking net. The idea has been propelled by the realisation that even with 70,000 bank branches in the country, a large section of the population continues to remain credit-starved.

The no-frills bank accounts will, therefore, be an innovative instrument to introduce the concept of banking to the under-privileged and reduce credit rationing for this section of people. As the individual bank would have the privilege to design these no-frills accounts, the basic characteristic would involve zero or a very low balance with limited transaction facilities.

Despite concerns about the servicing costs, many financial economists believe that it could be an effective instrument to combat credit rationing and provide the much-needed credit to a large section of the under-privileged population in the country.

So, what is a credit rationing and how does it happen in the first place? As Baltensperger (1978) puts it, credit rationing denotes "the situations where prices persistently stay at a level implying an excess demand over supply can be consistent with rational lender behaviour".

In simple words, credit rationing captures the situation where the interest rate is different from the market clearing rates and at this rate, the demand for loan is greater than the supply of loan, implying that a large section of loan applicants do not get the loan. This has a serious implication for a developing economy like India, as credit is essential in poor rural economies for the subsistence. Credit rationing forces a large section of poor people to approach informal credit market and accept a usury rate.

There are several approaches that attempt to explain credit rationing. Though differing in specific dynamics proposed, they share a common general theme, that the credit market is characterised by the "asymmetry of information". In a market, information asymmetry occurs when one party to a transaction has more or better information than the other.

Typically, in an unsecured credit market, the borrower will have better information than the lender and, therefore, the latter cannot distinguish between borrowers of different degrees of risk. One of the perverse fallout of asymmetry of information is the "adverse selection". On the most abstract level, it refers to a market process in which bad results occur due to information asymmetries between buyers and sellers: The `bad' products or customers are more likely to be selected.

George Akerlof, in his 1970 work, explained the concept of adverse selection through a real life example, which he called the ``market for lemons''. He argued that the people buying used cars without knowing whether they are `lemons' (bad cars) or `cherries' (good ones), would be willing to pay an average price that lies in between the price for lemons and cherries, where the willingness is based on the probability that a given car is a lemon or cherry.

If buyers had perfect information, they would know the value of a car for certain, and would simply pay an amount equal to the value of the car. Therefore, in a market with asymmetry of information, the sellers will sell fewer good cars since they think the price is too low, but they will sell more bad cars because they get a very good price for them.

As the buyers would realise this, they will no longer want to pay the old price for a used car. The price will fall and even fewer cherries, and even more lemons, will be put up for sale. In the extreme, the good car sellers will have been driven, as it were, out of business. Therefore, the price mechanism fails to keep the lemons off the market, even in a competitive market. Instead, they dominate the market.

In a seminal paper, Stiglitz and Weiss (1981) extend the concept of adverse selection to the credit market to provide a plausible explanation for credit rationing. They argued that a credit market with asymmetry of information along with limited liability imparts preferences for risk among borrowers and a corresponding aversion to risk among lenders.

Raising interest rate may not be an option (in fact, can turn out to be counter-productive), as the high interest rate leads to an adverse selection. At a high level of interest, lenders would end up attracting only the extremely high-risk applicants. Knowing this, lenders may prefer to hold the interest at a level below the market clearing rating, leaving a vast pool of applicants credit starved. Contrary to this, the informal credit market, based on its private information about the borrower, can charge an appropriate interest rate, often an usurious one, to meet this unsatisfied demand.

Therefore, the only way to combat credit rationing by banks is to improve the informational asymmetry by bringing in more accurate information about the borrowers in the market place. And no-frills bank accounts can be a highly effective instrument to generate this information.

As the no-frills accounts are expected to introduce the concept of banking to a large section of underprivileged, it will also help the banks create a database of these customers. The banks, therefore, can prudently use this information to target the honest customers in their databases to cross-sell various unsecured products.

Given the experience of the industry, and with a certain degree of creativity, this set of customers can turn out to be the most lucrative segment of the unsecured market. The 80/20 rule governing the credit industry usually demonstrates that only 20 per cent of the database generates 80 per cent of the revenue.

The no-frills account, therefore, is a win-win opportunity for India where the banks attract the profitable customer as a part of their unsecured campaign, and a large segment of under-privileged customers gets access to the formal credit market, without falling prey to the village money-lender. For now, how the banking community strategises the no-frill account as an effective channel to acquire a profitable (potential) customer, and prudently manages him as a part of its active CRM strategy, remains to be seen.

(The author is an Associate Professor with the Madras School of Economics.)