India post payments bank

I’d once written about India Post Payments Bank, after a visit to a post office, and wondered if it will actually help foster financial inclusion. Now that the bank is about to launch, it seems to be doing some interesting thing, and mostly in terms of the intermediary it will be.

Being a payments bank, IPPB can only take deposits, and not give loans. It is trying to build a platform where it will simply act as a distributor for loans, and different lenders can make use of its customer transaction data and lend to its customers.

Also, since payments banks can only invest their deposits in government securities, the “float” is limited by the difference between the yield on such securities and the interest offered to depositors. Competitive pressures mean that the latter needs to be high, resulting in a thin float. Consequently, a payment bank needs to make money on payments and selling third party products such as investments insurance.

A recent interview with IPPB CEO Ashok Pal Singh gives some interesting pointers about how the bank might go about this. Firstly, the bank will dispense with the investment+insurance products, and will sell pure unbundled life insurance. The logic is that since the clientele is likely to be the hitherto unbanked, they will not be able to understand complicated products, and there is a high chance of misselling. By restricting product choice to those that are highly unlikely to be missold, the bank can ensure customer protection.

Similarly, in case of mutual funds, distributors have an incentive to recommend funds with high fees since they also tend to offer higher distributor commissions. Again, given IPPB’s clientele, the chances of mis-sale are high, and so the bank has decided to sell only index funds!

This is remarkable since index funds have hitherto been non-starters in India. Benchmark Mutual Fund had managed to establish a market, but a series of acquisitions has meant that the market hasn’t really taken off. Most financial advisors in India swear by actively managed funds. So a bank, however small, announcing that it will only sell index funds can give a massive boost to that market!

Apart from selling “simple” products such as term life insurance and index funds, the way the bank is going about the process is also interesting. Rather than tying up with a single provider of these products (as most other banks have done), IPPB plans to take the “broker” route and distribute products from different asset managers and insurers. This ensures that the rates remain competitive, though it is natural that the end salesperson might choose to sell products with the highest commissions/incentives. Nevertheless, with the products being inherently simple, the rates to the end customers are still likely to be competitive.

After over a decade of slumber, the RBI licensed a few (limited) banks last year. It is interesting to see the kind of diversity this new set of licensing has unleashed. Again goes to show that removal of barriers to entry can result in significantly better markets!

During his last few speeches, former RBI Governor Raghuram Rajan kept mentioning how full-service bank licenses will be soon “put on tap”. The sooner that happens, the better it is for Indian banking customers.

Extremes and equilibria

Not long ago, I was chiding an elderly aunt who lives alone about the lack of protein in her diet (she was mostly subsisting on rice and thin rasam). She hit back citing some research she’d seen on TV which showed that too much protein can result in uric acid related complications, so it’s ok she isn’t eating much protein.

Over the last couple of years, efforts to encourage non-cash payments in India have been redoubled. The Unified Payments Interface (UPI) has come in, payments banks are being set up, and financial inclusion is being pursued. And you already have people writing about the privacy and other perils of a completely cashless economy.

Then you have index funds. This is a category of funds that is 40 years old now, but has gained so much currency (pun intended) in the recent past that the traditional asset management industry is shitting bricks. And so you have articles that compare indexing to being “worse than Marxism” and dystopian fiction about a future where there is only one active investor left.

All these are cases of people reacting to suggestions with the perils of the suggestion taken to the extreme. My aunt needs more protein in her diet, but I’m not telling her to eat steak for every meal (which she anyway won’t since she’s a strict vegetarian). The current level of usage of cash is too high, and there might be more efficiencies by moving more transactions to electronic media. That doesn’t imply that cash in itself needs to be banned.

And as I mentioned in another blogpost recently, we probably need more indexing, but assuming that everyone will index is a stupid idea. As I wrote then,

In that sense, there is an optimal “mixed strategy” that the universe of investors can play between indexing and active management (depending upon each person’s beliefs and risk preferences). As more and more investors move to indexing, the returns from active management improve, and this “negative feedback” keeps the market in equilibrium!

In other words, what more people moving to indexing means is that the current mixed strategy is not optimal, and we need more indexing. To construct scary scenarios of where everyone is indexing in response is silly.

Effectively, what we need is thinking at the margin – analysing situations in terms of what will happen if there is a small change in the prevailing situation. Constructing scare scenarios around what will happen if this small change is taken to the extreme is as silly as trying to find the position of a curve by indefinitely extending its tangent from the current point!

Indexing, Communism, Capitalism and Equilibrium

Leading global research and brokerage firm Sanford Bernstein, in a recent analyst report, described Index Funds (which celebrated their 40th birthday yesterday) as being “worse than Marxism“. This comes on the back of some recent research which have accused index funds of fostering “anticompetitive practices“.

According to an article that says that indexing is “capitalism at its best“, Sanford Bernstein’s contention is that indexers “free ride” on the investment and asset allocation decisions made by active investors who spend considerable time, money and effort in analysing the companies in order to pick the best stocks.

Sanford Bernstein, in their report, raise the spectre of all investors abandoning active stock picking and moving towards index funds. In this world, they argue, allocations to different assets will not change (since all funds will converge on a particular allocation), and there will be nobody to perform the function of actually allocating capital to companies that deserve them. This situation, they claim, is “worse than Marxism”.

The point, however, is that as long as there is no regulation that requires everyone to move to index funds, this kind of an equilibrium can never be reached. The simple fact of the matter is that as more and more people move to indexing, the value that can be gained from fairly basic analysis and stock picking will increase. So there will always be a non-negative flow (even if it’s a trickle) in the opposite direction.

In that sense, there is an optimal “mixed strategy” that the universe of investors can play between indexing and active management (depending upon each person’s beliefs and risk preferences). As more and more investors move to indexing, the returns from active management improve, and this “negative feedback” keeps the market in equilibrium!

 

So in that sense, it doesn’t matter if indexing is capitalist or communist or whateverist. The negative feedback and varying investor preferences means that there will always be takers for both indexing and active management. Whether we are already at equilibrium is another question!