For someone unfamiliar with the field, how would you describe financial engineering, and to what extent do you see financial engineering being applied by retail providers serving low-income households today?
In the Foreword to the book, Dr. Nachiket Mor, a mentor to us at IFMR Trust, observes that the retail finance industry the world over has gone in the direction of standardized products and transferring the burden of decision-making away from bankers and to the consumer. This is also true of providers serving low-income households. This, we think, misses the power of finance. The motivation of this book is to systematically compile principles from finance and economics theory and apply them to the context of design and delivery of financial services for low-income households. We use the term financial engineering in this context.
Do you think that this framework addresses any misapprehensions, gaps, or problems in the way that financial products are currently designed for low-income households?
I think it is safe to say that there is negligible design today – largely because so much of the energy and focus has been on sheer distribution. Just getting a small loan delivered in a remote context is hard enough, leave alone worrying about whether the loan is structured well to suit the customer. This book lays out an approach for a new generation of providers, who are concerned about distributing well-designed products to meet client needs, not just any product.
One of the goals of your book is to provide an understanding of the risk-reward trade-offs facing low-income households. In your experience, what is the most widespread risk barrier, perceived or actual, preventing greater financial services adoption in India?
I think one of the big challenges that we worry a lot about is that so much of the portfolio of low-income households is dominated by physical assets (land, house, and livestock). These are typically low return, high risk, and highly correlated with their human capital. The opportunities to do better than that are therefore infinite.
How can we shift this particular risk-reward trade-off in favor of financial services? What area of financial services design and delivery presents the biggest opportunity for improvement?
The biggest opportunity is in going away from standardized products delivered “over the counter” to customized delivery. It is indeed possible to do this at scale through effective human and software interactions. Financial engineering is essential to this customization. In theory, each person can have a uniquely designed portfolio of financial services that reflect her growth and risk management needs. Financial engineering provides us the algorithms/rules for this customization.
Does financial capability play into financial engineering product design or marketing? Some studies have shown that even extremely well-designed products can have very low adoption among low-income households if they don’t understand the features of the products or the intended benefits.
Agreed, this is where the role of the provider is so crucial. In Chapter 1, we argue that instead of passing the buck to the client in the name of literacy and capability, there must be a greater onus on the provider to assess and provide suitable financial services. In fact, we wrote the book keeping in mind the staff of financial institutions like cooperative banks, microfinance institutions, rural banks. If staff in these institutions understand these ideas better, they can impact adoption rates among clients.
As you are at the helm of KGFS, a growing rural financial services company, you have had the chance to apply financial engineering first-hand. Can you talk more about what that has been like and any particularly successful products?
It has been amazing to execute this first-hand at KGFS jointly with my talented colleagues over the last five years. We did two things in particular that helped. One, we created a specialist team that is very highly trained in product design, drawing on both financial engineering as well as client understanding. Second, we developed an operating model where the front-line salesperson is incentivized to acquire an in-depth understanding of the customer profile and provide the financial services that are suitable to them. The KGFS branch is not rewarded on the basis of product sale in-aggregate, but on suitable sale. This reinforces the concept on a daily basis. One of our biggest successes has been in insurance. Linking insurance sale to human capital values and premium linked to age of the customer has enabled us to have much better success than a standardized insurance sale approach.
What up-and-coming financial services innovations are you most excited about at KGFS or market-wide?
We are making a big shift at KGFS from product-based credit under-writing to household-based credit under-writing. Instead of relying on collateral like gold or group guarantees to decide credit eligibility, a new process that we are testing will underwrite the household on first principles and then take collateral as a deterrent against strategic default. This is an important innovation and will allow us to make sure that clients can exploit growth opportunities much better without getting stymied by product-specific criteria. For example, if a client wants a loan for higher education of his daughter and has enough cash-flows to support the same, we can provide the same with recourse to collateral of some type (house, shop, land) without having to call it or structure it as an “education loan.”