insight Building a More Inclusive Financial System in India

The opportunity to provide rural unbanked communities with access to essential banking services. By Vinod Nair, Andrew Sofield, and Vijay Mulbagal

Despite recent economic progress and explicit socialist goals, India has amongst the world’s lowest GDP per capita ($763 USD) and lowest penetrated retail banking systems, with less than 20% of rural India having access to formal financial services. The reasons for this are complex, as is identifying potential solutions. A multi-pronged approach is required to make the Indian retail banking system more inclusive. This will require a concerted effort by several stakeholders, including the Government of India, the Reserve Bank of India, and the commercial banks. To bring about this transformation, public and private sector banks will need to play a key role in defining and implementing innovative business models and delivery channels using appropriate technology solutions.

The Current State of Rural Banking in India

The Indian Economy
India is the 12th largest economy in the world in terms of gross domestic product (GDP), and fourth in terms of purchasing power parity (PPP)1. The growth of the economy is equally impressive with an average of over 8.0% during the last three years2. However, in terms of GDP per capita, India ranks a lowly 160th among other nations3. Within the country, there is a stark divide in the incomes of urban and rural areas with the average monthly per capita consumption expenditure (MPCE) in urban India being almost double that of rural India. In addition, there are significant disparities in urban and rural consumption

expenditure between different states (Figure 1). Jharkhand and Orissa, for example, have an MPCE of approximately Rs. 900 in urban areas and Rs. 410 in rural areas4. In other states like Punjab and Haryana, the urban rural disparity is significantly lower. A fifth of the Indian population is below the poverty line (BPL) today with a MPCE below Rs 340 (Figure 2, see Page 3). In some states like Jharkhand and Orissa, the proportion of BPL is greater than 40%. Diamond believes that the segments that are not considered BPL should all be considered as “potentially bankable” with genuine financial needs that could be met by formal financial and banking systems.

Current State of the Indian Economy and the Urban/Rural Divide
Comparison with Other Countries
GDP/capita ($) — 2004–05

Economic Status — Rural vs Urban India
Average MPCE 1 (Rs.)
Urban India Rural India 565 1,060


Urban and Rural MPCE (Rs.)
1,692 763 Mexico Brazil China 688 Jharkand
High disparity

969 405 1,259 569 872 414 797 656 1,050 879 1,059 947


India Pakistan Bangladesh


table of contents
Current State of Rural Banking in India . 2 Key Drivers of Financial Exclusion in India Today . . . . . . . . . . The Way Forward Conclusion
. . .

GDP growth — 2004–05


Low disparity

Manipur 6.4% 6.3% 4.9% 4.4%


. . . . . . . . . .

10 16 18 18
China India


. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


About the Firm

About the Author

Pakistan Bangladesh Brazil


1. Monthly Per Capita Consumption Expenditure.

Urban Rural

For more information contact:

Source: World Bank; National Sample Survey Organisation (NSSO)—Household expenditure report 2004.

Vinod Nair Managing Partner—India 2

Figure 1

Current State of Indian Banking
An important metric to determine the level of financial outreach/inclusion is the ratio of the number of deposit accounts to population. Figure 3 gives a snapshot of the penetration of deposit accounts and credit accounts in India in comparison with a few select countries with similar socio-cultural and economic conditions. Even in comparison with other developing economies, India has a significant opportunity for increasing penetration of both deposit and credit accounts. Not only is there a large disparity between India and other countries in banking penetration but there is also a large variation in banking penetration within urban and rural India. While urban India seems to be over-banked with more than 100% penetration (many urban Indians have more than one bank account), rural India lags far behind with a 19% penetration. The variance in rural and urban deposit and credit account penetration is not restricted only to few states but is common across all states (Figure 4, see Page 4). In addition, the average value of a deposit account and a credit account is also quite low in rural areas as compared to urban areas (Figure 4). Diamond believes that the reasons for lower penetration levels are partly economic, as explained by the low GDP per capita in the rural areas of the country, and partly a result of “controllable” factors that are inherent in formal banking systems in India today. The low deposit and credit account penetration and low average values in deposit and credit accounts (Figure 4) demonstrate that banking outreach in rural India is sub-optimal. This low outreach can be explained by two key parameters: access and usage. Simply defined, access is the availability of financial

Segmentation of the Rural Market
Segmentation of the Rural Market 1
Below Poverty Line
1% 9% 4% 11% 43% 39% 30% 34% 45%

Average MPCE of States (Rural)


Banked & Potentially Bankable

29% 34% 51% 51% 25% 16% 3%


25% 5%

All India





Affluent states

Low income states
Monthly Per Capita Consumption Expenditure
>Rs. 775 Rs. 471–775 Rs. 340–470 <Rs. 340

Average MPCE (Rs.)
N.A. <500 501–600 601–750 >750

1. Based on Monthly Per Capita Consumption Expenditure (MPCE), segments are MPCE ranges of < Rs.340, Rs.341-470, Rs.471-775, >Rs.775. Below Poverty Line (BPL): Individuals with MPCE less than Rs. 340 Source: Diamond analysis; National Sample Survey Organisation (NSSO): Household Consumer Expenditure in India (2004).

Figure 2

Current Status of Banking in India
Comparison with Other Developing Countries
Deposit Accounts1 (%)

Penetration of Banking Services
Deposit Accounts1 (%)
Urban India Rural India National Average 19 45 114 2

63 45 19 23

Pakistan Bangladesh




Credit Accounts (%)

Credit Accounts (%)
Urban India Rural India National Average 4 7 17

5 2 Pakistan Brazil



1. Deposit accounts include both savings and current accounts, 2. 114% because some individuals or firms have more than one account.




Source: Census India 2001; BSR 2005—Reserve Bank of India; World Bank—Sept 2005.

Figure 3


Banking in India — Rural vs Urban Divide
Deposit Accounts in India
Penetration (% of Population)
288 1 9 169 38 117 25 87 19 83 18 80 12 15 18 31 2 13 41 3 10 48 13 39 5 7 26 128 25 46 6 16 30 149 17 36 4 28 42 130

Credit Accounts in India
Average Value (Rs. 000s)
28 3 12 120 138

Penetration (% of Population)

Average Value (Rs. 000s)
91 33 245

Affluent States Low Income States





Madhya Pradesh

1. Percentages above 100 are because some individuals or firms have more than one account.

Urban Rural

Source: Census India 2001; BSR 2005—Reserve Bank of India; World Bank— Sept 2005, Diamond analysis.

Figure 4

services, and usage is the actual use of those services. Access is influenced by issues such as the basic economic state of rural India, lack of physical infrastructure facilities, regulatory constraints, and the

economics of rural banking. Usage is constrained by social issues such as illiteracy, incomplete service offerings by banks, and high transaction costs in the formal banking system. Access and usage

are not synonymous, as people may have access to financial services, but decide not to use them, either for socio-cultural reasons or because opportunity costs are too high.


Key Drivers of Financial Exclusion in India Today

According to Diamond estimates, approximately 245 million adults in rural India do not have a bank account today. As depicted in Figure 5, this reflects 24% of the total population. While 60 million out of 245 million may not need banking services because they are below the poverty line, Diamond believes that approximately 185 million “potentially bankable” people do not use formal banking services because of reasons like poor access or usage.

access to financial services, with 23% of villages going without electricity, 67% without a Post Office, and an average rural literacy rate of 59% and secondary school penetration of 12%. This lack of physical and social infrastructure in rural India is a key issue impacting access to formal financial services. The average distance to a branch in India is approximately 3.8 Kms (Figure 7, see Page 6). While this compares favourably to the average distance to a branch in a developed market like the U.S. (which is 6 Kms6), there are significant additional challenges in India in the form of unpaved roads and limited access to modern transportation. Most rural customers are likely to sacrifice an entire day’s wage to travel to a bank branch which is open between 10:00am and 5:00pm. While some banking transactions could be done over phone, this is rarely an option in a country with such low rural tele-density.

Access Issues for Rural Customers
Access is explained in terms of infrastructure, physical distance, limited delivery capabilities, regulatory constraints and the economics of rural banking. The banking infrastructure in rural India is not encouraging, with just 7% of villages housing a bank branch5. What’s more, the poor physical and social infrastructure (Figure 6, see Page 6) also impacts the

Size of Potentially Bankable Market in Rural India


185 million people are potentially bankable but unbanked because of access and usage constraints Demand limitation: People below poverty line1 53% 16% 37% 13% 24% 6% 18% Potentially Bankable


Total Population

Non-adult Population2

Adult Population

Urban Adult Rural Adult Population Population

Banked Population

Unbanked Financially Population Constrained

1. Poverty Line: The cost of average basket of consumption of 2400 calories per capita per day (Rs 328/month as of 2001). 2. Population up to 18 years of age. Source: Census India 2001;BSR 2005—Reserve Bank of India; World Bank & NCAER (2004).

Figure 5


Current Status of Rural Infrastructure
Physical and Social Infrastructure
Population per Branch
38,000 31,970 4,840 2,490 2,160 1,850 1,590 1,130 970 340 7,500 23,200 27,200 20,900 Primary School Karnataka
Rural Regions Only

Banking Infrastructure

Number of Branches
Urban India Rural India Uttar Pradesh Bihar

Percentage of Villages Having Listed Facilities
Post Offices Irrigation Electricity Community TV Centre 23% 76% 77% 7% 72% 12% 64%

16,100 24,000 19,700 14,200 21,600

Secondary School Self Help Groups

Limited delivery capability is a significant challenge. Much of rural India is serviced through branches because ATM penetration is low and other channels such as Phone and Internet Banking are non-existent. Intermediaries like Non-Governmental Organizations (NGOs), Self-Help Groups, and Micro Finance Institutions (MFIs) are being used by banks to improve access to credit and savings. However, these channels, in their current form, offer limited services (Figure 8 and 9, see Page 7). There are some regulatory constraints imposed by the Reserve Bank of India (RBI) which may inadvertently contribute further to the lack of formal banking services in rural areas. For example, the RBI does not allow banks to post any person other than a security guard at ATMs.Hence, banks cannot deploy many ATMs in rural areas as many rural customers require in-person support. A second regulatory inhibitor is that new banks planning to establish a branch in a rural area have to receive approval from the Lead Bank and District Collector of that district. Hence, banks choose not to open new branches in certain areas even when it is profitable to do so because there is no certainty of getting approvals. Many banks view the rural market as a regulatory requirement rather than an economic opportunity. Banks have from time to time borne the social cost of lending to the rural economy at rates below their costs. They have also faced capital erosion because of the writeoff of loans, particularly agriculture loans. Banks are required via regulatory requirements to open branches in rural areas to provide loans to agriculture and other priority sectors. These branches are often unprofitable because of low ticket size, high cost to serve, higher risk of credit, information asymmetry, and high proportion of non-performing loans (NPLs):

Madhya Pradesh Orissa Punjab Jharkhand Kerala

Percentage of Population Covered
Tele-density 2% 59%



Source: Census India 2001; BSR 2005—Reserve Bank of India; National Sample Survey Organisation (NSSO) report on village facilities—2003.

Figure 6

Current Status of Access to Rural Banking
Average Distance to a Bank Branch Distance to a Bank Branch — Rural India




Adult Population: 541,031,553 Area: 3,287,590 Sq. Kms. Branches: 69,969


Within Village

<2 kms

2–5 kms 5–10 kms

>10 kms

81% of villages don’t have a bank branch within a 2 km radius Population per branch: 7,732 Area Covered/Branch: 46 Sq. kms Average distance to a branch: 3.8 kms
Source: Census India 2001; BSR 2005—Reserve Bank of India; Diamond analysis, National Sample Survey Organisation (NSSO) report on village facilities‚2003.

Figure 7


Current Rural Banking Channels
• Full fledged Branches and Extension Counters of — Scheduled Commercial Banks including Regional Rural Banks — Cooperative Banks • NGOs, SHGs, MFIs and Cooperatives who act as intermediaries to take financial services to the rural areas

Services Provided
• • • • • Deposit Accounts Credit Accounts Remittances Cards Third-Party Products

• 96% of total deposit and 95% of total loans are with scheduled commercial banks with cooperative banks holding the difference • Has a high cost-to-serve • This channel delivers limited services in its current form



• MFIs directly lend to the poor and also act as agents for the banks • SHGs borrow from banks and are beneficiaries of loans themselves • • • • • • • • • • Cash Withdrawal Cash Deposit Money Transfer Cheque Book Request Bill Payments Cash Withdrawal Cash Deposit Money Transfer Cheque Book Request Bill Payments


• Onsite — ATM installed at a branch • Offsite — ATM installed at a remote location • Phone Banking — Manual — Interactive Voice Response (IVR) • Internet Banking • Kisan Credit Card — Provide short-term credit

• Negligible presence of this channel in rural areas

High Non-performing Loans (NPL): Banks have higher non-performing loans in rural areas because rural households have irregular income and expenditure patterns. The issue is compounded by the dependence of the rural economy on monsoons, and loan waivers driven by political agendas. NPLs from the agriculture sector are 7.7%, compared to 3.5% across non-agriculture sectors8. In order for banks to view rural India as a growth opportunity, rather than a regulatory requirement, a combination of these issues must be addressed. Increasing financial access to rural areas is contingent upon basic conditions such as proper infrastructure and an enabling regulatory framework, as well as innovative thinking on the part of commercial banks. Access issues, however, explain only one part of the problem. Usage is an equally important issue for rural customers.
Cost Per Transaction in Indian Banks
Cost Per Transaction (Rs)1


• Almost non-existent in rural India because of low: — Tele-density — Internet-penetration — Credit appetite of banks

Source: Reserve Bank of India; Diamond analysis.

Figure 8

Low Ticket Size: The average ticket size of both a deposit transaction and a credit transaction in rural areas is small (Figure 4). This means that banks need more customers per branch or channel to break even. Considering the small catchment area of a branch in rural areas, generating a customer base with critical mass is challenging. High cost to serve: Branches are the most used channel in rural areas. This is because many rural people are not literate and are not comfortable using technology-driven channels such as ATMs, phone banking or internet banking. On the other hand, a branch is an expensive channel for banks (Figure 9). In addition, rural people, whenever they have access to banks, have frequent low ticket and cash-based transactions, which increase the overall transaction cost for their bank. Higher risk of credit: Rural households may have highly irregular and volatile income streams. Irregular wage labor and the sale of agricultural products are the two main sources of income

for rural households. The poor rural households (landless and marginal farmers) are particularly dependent on irregular wage employment. Rural households also have irregular expenditure patterns. The typical expenditure profile of rural households is small, with daily or irregular expenses incurred through the month. Furthermore, a majority of households incur at least one unscheduled expenditure per year, with the most frequent reasons being medical or social emergency 7. In short, the rural customer is generally considered to be a risky one. Information Asymmetry: Since many rural people do not have bank accounts, there is a lack of information on customer behaviour in rural India. Absence of a Credit Information Bureau also complicates the problem as banks have to rely on informal sources to learn the credit history of rural customers. A lack of reliable information can result in either missed opportunities in not approving otherwise eligible loan candidates, or nonperforming loans.

25 18 8 4 Branch Phone ATM (Call Centre) Phone Internet (IVR)

1. Cost per transaction refers to the operating cost that a bank incurs per customer transaction on a particular channel. Source: Reserve Bank of India; CGAP, World Bank.

Figure 9


Usage Issues for Rural Customers
Even if access to formal banking is provided to rural customers, there is no guarantee that these services will be used. According to a study conducted by the World Bank, many households, even in developed countries, choose not to have a bank account as they do not engage in many financial transactions—they collect wages in cash, spend in cash and do not wish to be burdened by a bank account9. To compound the situation many customers in rural India, who have access to and would otherwise choose to use formal financial services, do not do so because the product and service mix do not meet their needs. The financial service needs of rural customers are not confined to just savings and credit, as is usually assumed. Their financial needs are linked to their life cycle needs, ranging from savings to credit to insurance to remittances (Figure 10). In fact, even the savings and credit products currently offered to rural customers do not entirely meet their needs. Access to savings and investment facilities is critical for the poor. The two critical needs for the rural poor are micro-savings and frequent withdrawals. These needs facilitate a customer in building capital over the long term, as well as coping with income shocks in the near term.10. However, banks do not offer adequate services to address these needs. The lack of services, therefore, leaves the rural poor with little option than to transact with the informal banking market. A study conducted by MicroSave also concludes that the poor transact with the informal sector because it will accept small amounts, provide doorstep service, and ensure ease of enrolment11. Rural customers need loans not only for productive purposes but also for consumption needs (Figure 11). As shown in Figure 10, apart from agricultural support, rural customers need microcredit for consumption, education and 8

Financial Needs and Service Requirements
Current Availablity Via Formal Banking

Critical Needs

Frequent and daily surplus savings To meet contingencies, social functions and working capital For consumption, education and emergency purposes Working capital or small capital investments requirements Asset Protection, Health, Life and Savings Protection To Access funds remitted by relatives

Banks do not offer daily small savings deposit schemes Branch channel is costineffective for rural customers Rural banks generally do not give loans for consumption & emergency purposes Banks provide seasonal and long-term agriculture loans but there are delays and excess documentation Banks have not targeted the rural poor for insurance Rural branches are not computerized and usually remittances take more than 2 weeks to reach the beneficiary

Frequent withdrawals


Micro-enterprise Loans

Insurance & Remittance


Remittance & Transfers

Source: Diamond analysis.




Figure 10

Purpose of Borrowings
Rural Household Borrowing Bank Lending to Rural Households

Other Business Expenditure 14% Household Expenditure 48%

Personal Loans 12% Other Business Loans 52%

Agriculture Expenditure 38%

Agriculture Loans 36%

A significant percentage of borrowing is toward consumption and other household expenditure, whereas formal financial institutions in rural India provide loans primarily for productive purposes.
Source: AIDIS—2003, National Sample Survey Organisation (NSSO); Diamond analysis.

Figure 11

emergencies. Though banks offer purposefree loans (personal loans and credit cards) in urban areas quite liberally, in rural areas sanction of such loans is significantly restricted. Therefore, the poor raise these loans through the informal financial system (it is worth noting that these loans taken

from the informal system are almost always repaid or renewed12). In addition, larger households need occasional high value micro-enterprise loans for small capital investment. Though banks offer these loans, they require excessive documentation and time-

consuming processes which discourage customer applications. Insurance reduces the vulnerability of poor households by replacing the uncertain prospect of large losses with the certainty of payout against small, regular premium payments. It is integral to a comprehensive risk management strategy for poor households. This includes life, health, accident and asset (dwelling, crop, and livestock) insurance. Banks and insurance firms do not offer these services in many rural areas, leading the poor to rely on the informal financial system. There are many rural households which depend on weekly or monthly remittances from their family members who have moved to urban areas. At present, they depend on informal channels to remit the money and consequently either risk the loss of money or pay high transaction fees. Banks do not offer seamless remittance facilities between urban and rural branches as many of the rural branches are not computerized and connected to the main bank’s computer systems. This often results in the beneficiary receiving the amount two weeks after it has being transferred. This represents yet another key service which is not provided. The transaction cost for a rural customer to receive credit primarily constitutes four attributes: the interest rate, loan amount received as a percentage of amount applied, bribes paid, and the lead time to process the loan. Though the formal banking system offers loans at interest rates lower than informal banking systems, the time taken for a loan to be sanctioned (Figure 12) is high which increases uncertainty and opportunity cost. In addition, the customer needs to pay almost 10% of the loan amount in bribes and eventually receives an amount that is less than what was applied for. Therefore, while the interest rates are usurious in the informal financing system, rural customers still resort to this channel because the waiting time to

Aspects of Credit and Deposit in Rural India

Aspects of Banking Transactions
Interest rate (median) % p.a. Loan amount received as % of amount applied Bribe as % of amount approved Time taken to process a loan application Cost of opening & operating a deposit account

Cost of Formal Financing
9.5% 92% 10% 33 Weeks 10% 3.5% Low

Cost of Informal Financing
24%–120% (Varies from state to state) 100% 0% –1 Week 0–2% 0–10% Medium to High (In extreme cases, deposit facility provider may abscond)



Interest earned Associated risk

Source: State Bank of India; World Bank.

Figure 12

receive the loan is negligible and there are no indirect costs or commission. Banks also insist on collateral security which many rural poor cannot afford. As far as savings are concerned, though the formal banking system provides financial security, the cost of opening and operating an account is high. The overall cost of transacting with the formal financial system increases for a rural person because of additional costs such as expenses incurred to reach a branch and the opportunity cost of lost wages. Since rural banks are generally not within an accessible area and do not operate at convenient times, the rural customer must forgo a day’s wage to reach a branch. Informal systems, on the other hand, involve a lower transaction cost, but they are risky and in some cases result in the loss of one’s entire capital. In short, this leaves the rural customer to choose between two unfavourable options. In summary, the services being offered by the formal banking system do not seem to meet the needs of the rural poor. A World Bank study suggests that the poor apply a set of criteria to judge the services

being offered by any financial service provider, including: • Products—Are financial services available and tailored to my needs? • Cost—What is the total cost of the service (including opportunity cost)? • Convenience—How easy is it to access and use? • Eligibility—Am I eligible for financial services and can they be accessed repeatedly? As explained earlier, the savings products offered in the current format do not qualify as a flexible, convenient and cost-efficient service. Similarly, loan products do not meet product and eligibility criteria. In addition, insurance and remittance services are not even available. The cost of services, despite lower interest rates, is high because of other indirect costs which make the banking services cost-inefficient. The access and usage issues need to be addressed to improve financial inclusion. The next segment of the paper looks at some changes that the government, RBI and banks need to make. 9

The Way Forward

In building an inclusive financial system, each of the three key stakeholders—the government, RBI and commercial banks— has a role to play. The following chapter briefly examines the desired actions to be taken by the government and RBI, and then provides more in-depth recommendations for banks. We focus on the actions to be taken by banks because they are able to more rapidly implement change than the government or RBI, even within the current regulatory environment.

has an additional responsibility to improve social infrastructure by improving literacy rates and education facilities. In addition, the government should educate rural people about the negative effects of debt-trap and the benefits of using formal banking channels. Finally, to regulate the informal credit market, the government can not only enact laws such as the Moneylenders Act, but also needs to successfully implement them. Reserve Bank of India: The Reserve Bank of India, as the regulator of the formal banking system, has a critical role in improving rural access and usage. Changes in technology, banking systems, and market conditions may require that the RBI revisit some of its guidelines governing the licensing of new branches, operations of ATMs, and use of technology. The following are a few suggestions to address each of these three issues. First, with improvements in banking technology, it may not be essential to have a bank branch to reach rural customers. The RBI need not require banks to open a branch in rural areas as a requirement to grant licenses for urban branches. Instead, banks should be allowed to explore alternative, more economical channels to reach the rural customers.

The Government: As noted, weak infrastructure is an important factor limiting access to rural branches even in areas where it would seem that customers are within a reasonable distance of a bank branch. The government has initiated the Bharat Nirman plan13 to improve infrastructural conditions in rural India, but there is a need to ensure rapid implementation. The two critical elements of rural infrastructure which have a direct impact on the accessibility of banking channels are road and transportation infrastructure and electricity and power infrastructure. Similarly, high levels of illiteracy deter rural customers from actively engaging in formal financial channels. Hence, the government

Stakeholders Involved in Improving Access and Usage
Issues Stakeholder Involvement
Government Access RBI Banks

Role Description
• Government to play an important role in building basic infrastructure • RBI to bring necessary changes in regulation • Banks to innovate and use technology to improve the banking outlets • RBI to relax guidelines to permit banks improve services & operations • Banks to introduce new products, improve processes, establish new partnerships and manage pricing to improve usage of banking services
High Medium Low Negligible


Source: Diamond analysis.

Figure 13


Second, ATMs are an effective channel to deliver many services at significantly lower cost than a branch. However, ATMs are not effective in rural areas if they are unattended, as required by the current RBI guidelines. The RBI should consider the option of allowing banks to appoint customer service agents in rural ATM kiosks subject to some stringent rules to prevent fraud. Last, the RBI should examine the potential impact of allowing bank business correspondents to use point-of-sale technologies such as Palmtops to deliver financial services in rural areas. While there are additional regulatory reforms which would enhance banking access and usage for rural customers, Diamond believes that addressing these three points would be a significant start. Banks: Even within the sub-optimal infrastructure and regulatory framework laid out by the government and RBI, there is an opportunity for banks to improve the rural customers’ access and usage. Access can be enhanced through new and innovative channels which the RBI already permits, and by leveraging cost-effective technology in existing channels. Usage can also be improved if banks revise their product and service offerings to meet the needs of the rural customer.

Rural India has a Large Untapped Credit and Deposit Market
Current Coverage of Scheduled Commercial Banks

Total Market
1. Consumption or Working Capital Rs. 6,000 per household for all Households



2. Capital Investment Rs. 30,000 per household for 10% of Households


Total Credit Market = ~ Rs. 1,330 Billion Savings Per Household Rs. 7,800

Untapped Market Size = Rs. 1,204 Billion


Financial Savings Per Household Rs. 2,800

Non-Financial Savings Per Household Rs. 5,000



Total Deposit Market = ~ Rs. 400 Billion
Note: No. of Rural Households—148 Million
Source: BSR 2005—Reserve Bank of India, RBI; World Bank 2003.

Untapped Market Size = Rs. 215 Billion

Figure 14

Market Opportunity
At present, a rapidly growing urban India is the focus of the banking sector; however, as the deposit penetration numbers suggest (Figure 3 & 4), the market is highly competitive and overbanked. Despite this, most banks are still not shifting their focus to the rural opportunity, as they are apprehensive about the total market potential of the rural market and the profitability of rural banking channels.

Contrary to the widely held notion, however, the rural market is attractive from both a credit and deposit perspective. The credit demand in rural areas is approximately Rs 1,330 billion (based on an estimate by World Bank). There are other studies by the Planning Commission and ICICI Bank which put the figure even higher at Rs 1,440 billion and Rs 1,500 billion respectively. Similarly, on the deposit side, a large segment of the rural population does not save with formal banking channels because banks are not accessible and do not provide the appropriate products and service, leaving a significant opportunity to grow the deposit base. At present, the penetration of banking in rural areas is sub-optimal with a large market remaining untapped in both the liability (~ Rs 215 billion) and asset (~ Rs 1,204 billion) sides of the business (Figure 14). These estimates clearly suggest that there is sufficient demand in the rural market to encourage banks to think seriously about rural areas as an alternative growth opportunity.

As we identified earlier, access and usage are two broad concerns which explain why the potentially bankable are unbanked. With regard to access, the challenge for banks is to identify profitable channels that meet the needs of rural customers. With regard to usage, banks need to understand the requirements of the rural customer and customize products and services accordingly (Figure 15).
Proposed Approach to Tap Potentially Bankable Population
Address Access Needs of Rural Customers

Improve Access for Rural Customers

Ensure Channel Profitability

Convert Potentially Bankable

Encourage Usage of Services

Address Usage Needs of Rural Customers Bank Initiatives to Improve Usage

Source: Diamond analysis

Figure 15


Improving Access
Today, branches are the primary delivery channel in rural areas. Though there are 32,000 commercial bank branches in India, they cover less than 7% of total villages14. Opening more branches is not necessarily profitable as many pockets of rural areas do not have business enough to justify an expensive branch channel. Therefore, to improve access in rural areas, banks need to modify existing channels, introduce new channels and identify innovative ways to integrate the two. Modify Existing Channels Fortunately there are a variety of options available for banks looking to modify their existing channels. To reduce the costs imposed by branches, banks should consider the option of sharing their branch infrastructure. This would not be too dissimilar to the example of the telecom industry sharing network infrastructure or the fast food industry sharing food courts in urban areas. Though infrastructure sharing may raise concerns over client confidentiality and data leakage, in the long run banks will only benefit from such collaboration. ATMs are an effective channel which can deliver many of the services frequently used by a branch customer. However, ATMs, in their current form, are not suitable for rural areas as the literacy level and transaction ticket amount is too l ow. ATMs can, however, be designed to meet the needs of rural customers. For example, ICICI Bank is working with IIT Chennai to develop an ATM that has a biometric fingerprint login, accepts soiled notes, and lower value denominations. In addition to modifying the design of the machines, banks should also hold discussions with the RBI to allow an attendant to be posted at ATMs. This will enhance the usability of ATMs. 12

Though phone banking and internet banking are cost-effective channels, given very low tele-density and low internet penetration in rural areas, the ability to use these channels to reach the rural customer is low. However, phone and internet banking should be considered once infrastructure and literacy levels improve in rural India. A business correspondent could then run an e-kiosk to assist customers to transact over these channels. For example, Centenary Bank in Uganda uses internet and phone banking to provide bill payments, money transfers and loan repayments. Business correspondents can be provided with point-of-sale (POS) functionality to allow customers to deposit and withdraw cash from their accounts. Combining POS with a smart card is one way to improve access. Brazil has successfully used banking correspondents who use POS and card readers to provide current accounts, loans, and insurance, accept bill payments, and perform other transactions. Introduce New Channels The RBI allows banks to appoint business correspondents and facilitators to be used as intermediaries in providing banking services. NGOs, MFIs, Societies, Section 25 companies, registered NBFCs not accepting public deposits, and Post Offices can be appointed as Business Correspondents. Business Correspondents can provide several services which are not currently offered by SHGs and MFIs, including: (i) identification of borrowers and fitment of activities; (ii) collection and preliminary processing of loan applications including verification of primary information/data; (iii) creating awareness about savings and other products and education and advice on managing money and debt counseling; (iv) processing and submission of applications to banks; (v) promotion and nurturing Self Help Groups/Joint Liability

Groups; (vi) post-sanction monitoring; (vii) monitoring and handholding of Self Help Groups/Joint Liability Groups/Credit Groups/others; and (viii) follow-up for recovery; (ix) disbursal of small value credit, (x) recovery of principal/collection of interest (xi) collection of small value deposits (xii) sale of micro-insurance/ mutual fund products/ pension products/ other third-party products and (xiii) receipt and delivery of small value remittances/ other payment instruments. The introduction of Business Correspondents may face some challenges from labour unions. However, Diamond believes that there may be some options to address the concerns of the current workforce while using Business Correspondents to capture more value from rural customers. Caixa Economica, a state-owned bank in Brazil, manages the country’s lottery network and distributes government benefits. To increase the access of its services, Caixa extensively utilizes the Banking Correspondent channel, with 14,000 banking correspondents covering all of Brazil’s 5,500 municipalities. In less than 2 years, Caixa opened about 2.8 million new accounts and estimates that 40% of its banking transactions are handled through the banking correspondent channel. Satellite offices are a cost-effective alternative to branches. These offices can be established at fixed premises in villages and are controlled and operated from a base branch located at a block headquarters. All types of banking transactions may be conducted at these offices. Banks have, however, not used this channel actively, despite the argument that this channel is relatively less expensive, as it can draw personnel from the main branch and can remain open for just two days a week. This channel, therefore, is appropriate in blocks and districts which are densely populated. In the urban areas, most Indian banks opt for an

extension counter where the business does not justify a full-fledged branch. Similarly, satellite branches can cater to rural areas which do not justify a large branch. Where banks do not find it economical to open full-fledged branches of satellite offices, mobile offices may be more appropriate. Mobile offices extend banking facilities through a well-protected truck or van. The mobile unit visits villages on specified days/ hours. The mobile office would be affiliated with a branch of the bank, and serve areas which have a large concentration of villages. This will not be dissimilar to the mobile ATMs implemented by some of the Indian banks in the urban areas. Determine the Combination of Channels There is no one right channel or solution to improve access in rural areas. Banks have to evaluate the trade-offs between those channels that are most convenient to customers and those that are the most profitable. Banks are not comfortable opening new rural branches

because many of those that already exist are unprofitable. Therefore, determining the right combination of channels is critical to improving access in profitable ways. An innovative approach to improving access will consider a combination of these channels. For example: • Branches and Satellite Branches— In addition to providing regular banking operations, providing backend support to manage and audit the operations of business correspondents. • A low-cost, custom-made ATM— Managed by a business correspondent to bring down the operating cost and scale the channel. • An e-kiosk—Managed by a business correspondent with internet banking, ATM and POS terminal in relatively large rural areas. • A business correspondent—Using manual ledgers or POS/Palmtop to act as deposit collector and remitting agent in smaller rural areas.

While this list is not exhaustive, it highlights the need for creative solutions that apply the right channel to the right market and transaction. In South Africa, Capitec has combined convenient branches along transportation routes (for example, train and bus stations, and taxi stops). In addition, it has rolled-out debit cards and automatic teller machines across 200 of these branches to stimulate savings among low-income earners. Between February and August 2004, the number of customers jumped from around 18,000 to more than 60,000.

Encouraging Usage
The presence of a banking channel does not guarantee that the rural customer will actually use that channel. In addition to access issues there are usage issues. To stimulate usage, banks need to improve their product mix, reduce total transaction cost, provide convenience, and clearly outline the eligibility criteria for products and services (Figure 17, see Page 14).

Multi-Channel Approach to Meet Customer Needs and Ensure Channel Profitability
Busines Satllite/ Facilitators Correspondents Mobile Office Internet Banking/Phone Banking/POS



Address Access Needs of Rural Customers Improve Access for Rural Customers

Access Cost

Ease of Access

Ensure Channel Profitability

Cost to Serve

Revenue Potential

Very High





Source: Diamond analysis.

Figure 16


With regard to products, rural customers have some critical needs, such as micro-savings, micro-credit, remittances and others which will require banks to develop some innovative offerings. For micro-savings, banks could develop a flexible savings product with daily deposit collection and withdrawal facilities. A business correspondent carrying a manual ledger or POS can facilitate such a product. For micro-credit needs, consumption loans need to be designed. This is not entirely different from giving purpose-free personal loans and credit cards in urban areas. Rather than not offering these loans at all, banks should focus on managing credit risk. For instance, banks may give such loans only under the Joint Liability Groups (JLGs) format. Similarly, for remittances, banks need to accelerate the remittances between various channels by improving technology and connectivity. SafeSave in Bangladesh is an example of how well-designed financial services products can quickly become popular amongst rural populations. SafeSave has designed savings products which allow the poor to save on a daily basis, withdraw as needed at their doorstep, and access credit products with flexible repayment options. Rural customers are concerned not only about the interest rate, but also about indirect costs (bribes, commissions, etc.) and expenses associated with banking transactions. While interest rates of the formal banking system are not high, the total transaction cost for a rural customer is. The government and RBI can relax rules around interest rates for loans less than Rs 200,00015 to allow banks to manage the cost of credit risk. To reduce indirect costs to the customer, banks have to adopt simpler processes and documentation, and transparent and clearly defined norms. By allowing rural borrowers to use their approved 14

credit limits through credit cards, banks can reduce their visits to branches and intervention by a bank officer. This will not only reduce the cost of bank operations but also reduce the burden of commissions/ bribery at every stage of the process. In South Africa, cell phone companies are developing low-cost, cell phone-based banking services using short message service technology, often connected to mobile banking. Transactions, which are being used mainly by poor customers, include balance inquiries, bill payments, money transfer, transaction alerts, and account servicing. The primary convenience needs of rural customers are bank operating hours, ease of transaction, and customer service. Operating hours need to be tailored to better meet the needs of rural customers. In agricultural communities, for example, opening the branch in the morning and evening would allow farmers and daily wage earners to bank without losing a day’s work or wage. Alternative operating hours have, in fact, already

been implemented in urban areas where banks are open from 8:00am to 8:00pm or four hours in the morning and four hours in the evening. To improve the ease of operating an account, banks can print signature-ready pay-in slips and withdrawal slips, wherein the illiterate rural customer is required only to tick the amount of deposit or withdrawal and place a thumb impression. Finally, to improve customer service, banks can recruit staff locally. Banking correspondent channels have been successful in some countries because they recruit local staff who better understand the local customer. Prodem in Bolivia is a successful example of how banks can increase customer usage by improving convenience. Prodem installed ATMs that incorporate biometric fingerprint readers and voice instructions in three languages. These ATMs, along with smart cards, can support many banking transactions and given their convenience, have been popular with customers.

Improving Usage — Desired Initiatives from Banks
Eligibility Criteria
• Eligibility for account opening, loans, and other services

Address Usage Needs of Rural Customers Encourage Usage of Services • Flexible savings account • Bancassurance • E-remittances • Credit Cards and personal loans • Joint Liability Group based loans • • • • Micro-savings Micro-credit Micro-insurance Remittances

• Interest Rates • Indirect costs — Bribes — Commissions — Documentation expenses

• Banking Hours • Ease of deposit and withdrawal • Friendly bank officials

Bank Initiatives to Improve Usage

• Differential interest • Flexible working rate based on hours • Simpler pay-in credit history slips and • Minimal documentation withdrawal forms • Loan delivery • Employees through credit sensitive to local cards culture • Usage of palmtops and POS for deposits and withdrawals

• Define eligibility clearly in vernacular • New credit scoring models to suit rural customers • New methods for sharing credit information

Note: Usage Needs are Not Exhaustive
Source: Diamond analysis.

Figure 17

Uncertain eligibility criteria traditionally have been a barrier to usage. The process and guidelines to apply for loans are neither clear nor concrete. Rural customers are never certain what is required to apply for a loan or whether they qualify for a certain product. In order to encourage consumption banks need to clearly define the loan qualification criteria in the local language. In addition, banks should ensure that otherwise qualified candidates

are not denied credit. This can be achieved through proper credit scoring systems that assess credit risk of farmers and others who have irregular cash flows, and processes and systems which allow banks to share information. Most importantly, developing and enforcing clearly defined rules and educating the customers will help them to see the merits of the formal banking system.

CECAM in Madagascar and Prizma in Bosnia present two examples where innovative methods in developing credit products and credit methods helped to include the poor in their clientele. CECAM developed credit products where the repayment of loans matches the cash flows of the borrower, and Prizma developed customized credit score models which help it keep track of customers’ credit histories.



There are 185 million bankable adults in rural India who are unbanked because of access and usage issues. This presents a significant opportunity for commercial banks. However, to reach this market and subsequently build an inclusive financial system, there must be a coordinated and concerted effort by the three key stakeholders: the Government of India, the

Reserve Bank of India and the commercial banks. In addition, partnerships between banks and business correspondents, and collaboration amongst banks is critical. Furthermore, banks should tailor their product and service mix to meet rural needs, and adapt their delivery models to ensure commercial viabiility of their rural banking operations.


End Notes
1. World Bank 2005 2. Reserve Bank of India 2005 3. 4. National Sample Survey Organization (NSSO), Household Consumer Expenditure in India (2004) 5. Census 2001 6. Access to and Usage of Financial Services, World Bank 2003 7. RFAS, 2003, World Bank & NCAER 8. Reserve Bank of India, 9. Access to Financial Services by Stijin Claessens, World Bank 2005 10. Rutherford Stuart, “The Poor and their Money,” January 2000 11. 12. RFAS 2003, World Bank 13. Bharat Nirman is a four year business plan of the Government of India to improve rural infrastructure 14. National Sample Survey Organization (NSSO) 2003 15. At present interest rates on loans less than Rs 200,000 are regulated.


About the Firm

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About the Authors

Vinod Nair is a Partner at Diamond and leads the firm’s India practice. He has worked with clients in India, Europe, the Middle East, U.S. and South Africa on a range of strategic and operational issues. Vinod has focused on issues such as successful market entry strategies, proposition development and marketing planning, analytical marketing techniques to improve customer lifetime values, and operational improvement efforts to reduce costs and streamline processes. His clients include leading corporations in the telecommunications, financial services, media, automotive and manufacturing sectors. In financial services, he has worked with retail banks and credit card issuers on defining new payment solutions and exploring partnerships between retail banks and mobile operators. He has also advised leading private equity houses on potential transactions in Europe and in India. Andrew Sofield is a Manager in Diamond’s Financial Services practice. Andy has experience in retail financial services’ organization, product, marketing and communication strategy, process and policy reengineering, competitive analysis, and operations management. He has also worked as a strategy, operations, and change management consultant in the telecommunications, health care and product sectors. Throughout his consulting career Andy has gained extensive international experience, having lived, worked, or travelled in more than 50 countries on six continents. His most recent international initiative has been helping open Diamond’s office in Mumbai, India. Vijay Mulbagal is a Senior Associate in Diamond’s Financial Services practice. Vijay has nine years of experience working in commercial banking in India. He has worked across multiple segments, including retail banking, operations, trade services, microfinance and corporate banking, in both domestic and multinational banks. He has significant experience in client relationship management, due diligence, structured problems analysis, and project management.


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