Stocktaking the fintech revolution

Business Standard, 19 February 2024

Fintechs can be important in India, given the weaknesses of the incumbent financial system. Finance is the business of serving the real economy, helping it do better in grappling with risk and time. Doing finance right requires risk taking and innovation on products and processes to fit the lives of the people across the geographical and class diversity in India. This runs afoul of the present arrangement of financial economic policy, where the government and its agencies run a central planning system with detailed control of products and processes. Limitations in the rule of law make financial firms cautious about innovating. Government-controlled monopoly systems, which are national champions, deepen state control. The future of Indian finance lies in reorienting financial economic policy.

The path towards serving India

Finance is the business of helping people surmount the problems of risk and time. Each of the 100 homogeneous regions of India, of about 14 million people, has its own rhyme and rhythm. There is much class diversity. The present financial system has not come to grips with this diversity. A process of innovation and risk taking is required to experiment with many new business models and process designs that can better serve the people.

The puzzles change when you go from Bombay to Thane to Pune. Nobody knows the correct answers. What is required is a process of discovery -- where clever firms experiment, innovate, take risks, and sometimes go bust. This process will find solutions on how to serve various subsets of India better. At present, however, financial economic policy is organised as a central planning system. Products, processes, and government-controlled monopolies are imposed from the top. The firms are further hamstrung by the uniquely Indian-style KYC and Prevention of Money Laundering Act.

The fintech possibility

When CPUs became cheap and internet connectivity spread, there was much optimism around `the fintech revolution'. This is the idea that many things that were done in banks can now be done by new kinds of technology-driven firms. They would be done better by these new firms, and the footprint of banking in the country would shrink. As an example, mobile phone companies and technology giants like Google can readily do payments, a business that was once the preserve of banking. Such a `fintech revolution' is a good thing from two points of view:

  1. Banking is a source of systemic risk in India, and a smaller banking system improves stability; and
  2. The incumbent banks are weak on innovating and serving users, so when more finance is done without banks in the loop, the financial system does better in serving the real economy.

This hasn't worked out

We are about 20 years into this story and so far things are not going well. Policymakers chose to defend banks. The levers of the central planning system were used to block competition from new kinds of firms. Policymakers want `fintech companies' to be service providers to banks; they want the main business and profit to be with banks. Banks in India are structurally unable to engage in a process of discovery, given the bureaucratic character of banking in India and state control of products and processes in banking. The terms `innovation', `risk taking', and `failure' do not sit well with bankers and their handlers.

Indian non-banking financial companies (NBFCs) have done better on solving problems of time and risk that are faced by households and firms. New fintech players could have arisen here. This process has faced three constraints:

  1. The limitations of the Indian bond market inhibit financing for NBFCs;
  2. Policymakers have generally used state power to protect banks at the expense of NBFCs; and
  3. The central planning system has crept into controlling the products and processes of NBFCs as it does with banks.

The hallmark of a successful market economy is that key persons in firms are primarily focused on customers, technology, and organisation building. The reforms of the 1990s were supposed to be about getting firms out of focusing on the government to learning how to be strong. Where we are in India today is that financial firms are primarily focused on the government. The government and its agencies specify much about the products, processes, and the obligatory national champions. In many aspects, prices are also controlled. The job of each financial firm is a bit like that of a division of a big public-sector system where the basic decisions come from above.

Innovation in the interstices?

There are chinks in the armour of the design supplied from above, where firms do have the space to think. Do these constitute opportunities to experiment, innovate, and come up with ideas on how to use technology better and serve users on the fundamental problems of risk and time? This runs into problems around the rule of law, and national champions.

Given the present working of regulators, a firm can be harmed when individuals inside government agencies decide to do so. Persons inside financial agencies have arbitrary power. The rule of law is a world where:

Most of these guard rails work poorly; agency personnel can harm or destroy firms at will. This makes firms deferential. When a new idea comes up, it is safer to first get permission from powerful people in the agencies.

After a firm navigates this territory successfully and does something new, a range of threats to the business model remain. The central planning system can disrupt a successful business model, or a national champion can come up and eject all private firms.

Conclusion

Finance is the most important of all industries. It is `the brain of the economy'. The fintech revolution can do a lot for India. But this requires changing the present arrangement of financial economic policy.

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