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THE COST OF FINANCIAL INCLUSION

Young Bites. Dated: 7/17/2019 11:05:55 AM

MOIN QAZI In 1919, Charles (Carlo) Ponzi, a dishwasher from Parma, Italy, who immigrated to the United States (US) in 1903 and worked as a clerk in Boston, duped the Americans with a scheme that now bears his name. Ponzi was a financial con artist who did not invent this eponymous scheme but he lent star power to one of the oldest scams known to us and pioneered its subtle variation on a huge scale. India has always been a fertile ground for swindles that have bilked mostly low-income households of millions of rupees. The financially illiterate are usually the easy picks. Financial illiteracy leads people to make systematic and costly mistakes. Investors have been periodically gulled by nefarious characters into dubious schemes. The poor have now become wary of investing money even in credible organisations. These mercenary agents use enticing traps to net gullible investors like sharks preying on small gold fish in the big bad financial ocean. Ponzi sponsors are authors of the dreamers’ landscape: Get-rich-quick schemes and rags-to -riches stories; they have an unerring gift of charming and beguiling investors, fuelling their avarice. The ruse actually juggles investors’ money and works in this manner: Perpetrators typically promise gullible clients moon-stratospheric returns on investments. The scheme relies on a constant stream of new investors to fund guaranteed payouts to existing savers. These schemes can snowball but eventually collapse when the potential pool of new savers runs dry. This happens when the scheme hits the natural limits of its strategy for recruiting investors. Ponzi and pyramid schemes: A Ponzi scheme is a classic swindle, similar to a pyramid scheme in the sense that both are based on using new investors’ funds to pay earlier investors. The promoters tout phenomenal returns for investors. One difference between the two schemes is that the Ponzi originator gathers funds from new investors and then distributes them. Pyramid schemes, on the other hand, allow each investor to directly benefit in proportion to the number of new investors recruited. Older members are allowed to withdraw money after a certain period of time and receive bonuses for encouraging new entrants to sign up. In this case, the person on the top of the pyramid does not, at any point, have access to all the money in the system. Instead of investing funds or doing legitimate business, the uncouth Ponzi operator just recycles money, uses the commitments to pay off earlier investors and takes a cut for himself. Gullible investors are normally illiterate and do not understand the nuances of finance. They don’t realise that existing investors are paid money not from genuine business profit. They believe that their funds are a sound and legitimate business. The scam establishes a façade of credibility by paying the promised returns to early-stage backers, as long as new savers keep adding to the fold. The liabilities actually exceed assets and the firm is permanently insolvent. The scheme moves seamlessly, delivering steady returns and without raising a faintest hint of suspicion, until a point when it is no longer able to attract new investors. The promoters even pay the fanciful returns, perhaps even higher than the promised dividend, out of their personal funds, thus confirming the promoter’s credibility. They plough ahead until the whole structure collapses like a house of cards when the flow of fresh money dwindles and the perpetrator can’t honour the redemptions because the outflow of cash exceeds the inflow. This model, where the responsibility sits on the consumers for choosing the right product, is based on the twin pillars of full disclosure by firms and of literate consumers, who are considered capable of decoding these disclosures. Since low-income communities face multiple risks, small businesses need to be insured to prevent their slide back into poverty. Micro-insurance softens the impact of economic shocks, which frequent within this segment. Offering micro-credit without micro-insurance is self-defeating; it must be an integral component of financial inclusion when offered in conjunction with micro savings. Micro- insurance can keep this segment away from the poverty trap. Offering microcredit without micro-insurance is fraught with risk. Therefore the need is to emphasise the linking of microcredit with micro-insurance. It will also enhance the sustainability of micro-insurance as it is not viable as a standalone product. Many micro-entrepreneurs still prefer other informal sources of finance, like the moneylenders because of their flexible methods of repayment. If they are prepared to pawn their jewels, local informal lenders will advance at high interest. The (interest) rate may be sky-high, but one can pay back whenever he/she has the money. It’s less stressful and one can invest all the loans without keeping anything for initial instalments. Many of these borrowers are moving to other sources for their financial needs after experiencing too many close calls when they find themselves short of money to make their microfinance repayment. Robust consumer protection rules are critical to safeguard people from fraud and abuse and the pervasive menace of illegal money pooling by companies. We need an overhaul of the customer protection regime. The new regime must be one that can hold all entities to a common standard of institutional conduct in how they deal with the individual customer, including how they sell products. A misalignment of incentives between the provider and the customer leaves the customer worse-off. Therefore, we need to enforce a system that keeps the customer’s interests above everything else. The good news is that there are now several channels of information and resources to help the public build financial stability. To safeguard the hard-earned money of investors and curb the pervasive menace of illegal money pooling by companies, the Reserve Bank of India has set up a portal — sachet.rbi.org.in — to enable the public to obtain information about registered entities, who accept deposits, get information regarding illegal acceptance of deposits and lodge complaints. The portal also facilitates filing and tracking of complaints. THE VIEWS EXPRESSED IN THIS COLUMN ARE THE INDIVIDUAL'S AND DON'T REPRESENT THOSE OF THE PAPER.