Thursday, January 21, 2010

Financial engineering for the poor

The last two decades have seen a proliferation of financial instruments that have had a dramatic impact on the global financial markets. While many of these instruments of financial engineering have played critical contributory roles to the current crisis, it cannot be denied that they have had considerable beneficial effects.

In the circumstances, it may be appropriate to borrow atleast some of the more obviously beneficial initiatives and instruments of financial engineering and use them to help the poor and lower middle class save more and efficiently and control their expenditures. Unlike the profit-driven nature of conventional financial market interventions, financial innovation for poor people should draw in on insights from behavioral psychology that point to numerous cognitive biases that forces them into sub-optimal spending and saving decisions.

Instead of providing inefficient direct assistance through revolving funds, interest subsidies and plain vanilla bank loans, it may be more effective to take a leaf out of behavioural economics and design instruments that incentivize savings, optimize consumption expenditures, and more effectively manage income flows for poor people.

In view of the large number of competing immediate consumption needs and their limited income, poor people experience very high opportunity costs on their savings. They also face self-control problems with managing their incomes and expenditures due to their dynamically inconsistent inter-temporal preferences. Recent research in behavioural economics have shown numerous examples of the aforementioned problems and offered suggestions on overcoming them.

In this context, in a classic paper, Shlomo Benartzi and Richard Thaler have advocated the use of instruments like "Save More Tomorrow", that commit savers in advance to allocate a portion of their future salary increases toward retirement savings.

In the present arrangement, the SHGs leave their thrift savings in the group savings bank account, which yields meager returns. Savings accounts, similar to the Corporate Liquid Term Deposit (CLTD) accounts offered to corporate clients, that automatically sweeps all the balances in the account into short term (say, money market) instruments and gives higher returns can optimize returns on their savings.

Apart from the issue of large numbers of competing needs, it is also commonly observed that a large share of the savings get dissipated in expenditures during festival seasons on "temptation goods". In order to overcome the self-control problem and disincentivize wasteful consumption expenditures, restrictions can be imposed on the periodicity and amounts (minimum balance requirements etc) that can be withdrawn at any time from an account.

Any exception to this should require an elaborate application process, including possibly multiple visits to the bank. Higher premiums (interest rate discounts or flat penalties) can be placed on withdrawls during a specific period, timed to coincide with, say festival season, or higher interest rate return for savings during that particular period ("festival offer" of higher rates for specified periods, complements nicely with the demand-supply dynamics, given that people tend to withdraw their savings in larger quantities during such times).

Savings instruments that combine features of a lottery (which are manifestly attractive for low income people) can be used to incentivize people to both save and keep their savings locked in for longer periods. Peter Tufano of HBS has designed premium savings bonds, that come with a lottery option, in which the buyer can particiapte only if he remains invested for a certain period of time. The Irish government has a unique form of tax and risk-free, state guaranteed savings instrument, Prize Bonds, offering people the chance to win big cash prizes in a weekly lottery.

There is also evidence to suggest that use-directed accounts, that are designed based on people's mental accounting choices, are effective at promoting savings. Accounts designed with pre-defined and use-directed escrows, can therefore be a very effective instrument in nudging people to both making savings for specific needs and limiting withdrawls from specific escrows. Further, sub-accounts like "education accounts" or "bike accounts" can be used to channel specific subsidies like student scholarships or even be linked up with commercial EMI based schemes for consumer durables.

Simple savings instruments that make annuity payments for children's educational purposes are effective means of chanelling savings for specific purposes. Besides, public policy can promote them by making matching or some pre-defined contributions to such accounts. The periodic (monthly/quarterly) contribution can be transferred by default from the savings bank account. Like Save More Tomorrow, the contributions can even be increased every year, in small increments, as a default option.

Appropriately customized (varying subsidies, depending on the size of house to be constructed), easy to access home loan products for the poor, can be designed and offered through private banks at varying commercial terms (tenor, rates and so on). The subsidies - direct cash, interest rate subsidy, etc - can be directly transferred into the account of the individuals.

Similarly, specific business investment products can funnel savings and government subsidies (like those under various self-employment schemes) to make capital investments in starting new or expanding existing businesses. Government support can be made conditional on achieving certain levels of savings, and can also be used to leverage further private bank loans.

In view of the volatile nature of inflation in developing countries, inflation-indexed savings products, especially those with longer tenor, can help mitigate inflation-induced erosion of the value of savings.

Agricultural income comes as harvest-time windfall inflows, which, given the self-control problems that afflict human beings, are liable to be inefficiently frittered away. It is therefore only appropriate that this one time inflow be converted into a stable revenue stream so that the farmers have access to an assured income every month. So how about a "harvest plan" annuity product offering by banks to attract these amounts as term deposits with gradual draw down? Such annuity plans can be offered to farmers groups, so that the banks can attract large deposits from the incomes of a group of farmers.

A share of these deposits can then be channeled into some of the various other savings products, including as default options. Payments on procurements by the FCI can be funneled into these accounts by default, including into a "fertilizer account", which can in turn be drawn down to make payments for fertilizer purchases for the next season. Such instruments can be used to make more efficient use of the proposed nutrient-based direct cash transfer fertilizer subsidy regime.

Or the subsidy can be given as dated vouchers which expire within specific period, timed to coincide with the mid-season, when application of fertilizers is most optimal.

Apart from promoting savings and containing excessive and even wasteful expenditures on "temptation goods" and immediate gratification, such financial instruments also help to more optimally and efficiently target beneficiaries with various direct and indirect subsidies. It also creates signalling platforms that simultaneously enables private companies to tap into the "fortunes at the bottom of the pyramid" and those consumers to access the products of this market.

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