Monday, January 10, 2011

Budgeting and savings bank accounts

All private firms and government organizations, small and big, today manage their finances using modern budgeting principles. Accordingly, cash inflows and outflows from and to different sources are escrowed into seprate heads of accounts. This separation of revenues and expenditures into multiple and clearly-defined sub-heads is at the heart of budgeting and is central to modern day firms and organizations. It contributes to financial discipline and helps in effective management of their incomes and expenditures. All firms have separate accounting wings to manage their finances based on these principles.

People and families too face the same broad spending and savings choices and dilemmas as firms and organizations. Their problems are amplified by powerful cognitive biases like self-control problems and hyperbolic discounting (much higher preference for the immediate as opposed to the latter). Further, for poor families, effective management of their incomes determines whether they go to bed hungry or not.

A myriad government-run poverty alleviation and welfare programs seek to increase the incomes of poor people. However, very little or no attention is paid to help people manage their finances more effectively. In recent times, there have been initiatives on financial inclusion and providing a savings bank account for every individual. However, this does not help people with budgeting nor address the aforementioned behavioural problems. How do we therefore empower people to manage their finances more efficiently?

It is obviously both impractical and expensive for individuals to employ accountants. Effective management of finances depends on the manner in which people handle money. Ordinarily this is done through their savings bank account. However, a single tier, savings bank account cannot address the aforementioned problems. In the circumstances, as I have blogged earlier, a multi-tier bank account with use-directed tiers, can be an effective instrument in optimizing financial management for individuals.

The psychology behind multi-tier accounts is mental accounting - the division of income into separate, end-use based mental accounts. It helps people manage their finances more effectively in two ways. One, people are inclined to save if they are aware of what they are saving for. For example, a "car account" is a strong nudge to get people to save for purchasing a car. Two, separation of expenditure heads with pre-defined allocations help in effective management of expenditures. It is easier to fritter away Rs 1000 on an evening out from the total monthly salary of Rs 10000, than from a leisure account allocation of only Rs 2000.

The science behind such accounts is that it has an inherent budgeting dimension. The tiers are classified into broad spending pockets, with pre-defined income allocation ratios. The savings account could come with a default allocation ratio, which could be changed by the account holders, depending on their specific requirements. An appropriately designed multi-tier account can therefore address both the behavioural and budgeting challenges.

For example, people could classify their incomes into say, five broad heads - pension and insurance, child education, house loan repayment, recurring household expenditure, and leisure goods. An individual could customize such a five-tier savings account offered by banks into five specific heads - pension, child education, car-purchase, household expenditures, and lesiure. Modern information, communication and data management technologies makes administration of such accounts very simple.

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