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The basis of investor education must be evaluation of risk in a formal financial set-up

The cries for investor education have become shriller in the past few weeks. Without an understanding of the context in which we expect people to learn finance, we may not go too far. The first lesson to teach is about risk. We have to do this with empathy for the cultural context in which we have lent and borrowed money. We continue to shift the blame when a crisis hits us because we are not trained to deal with risk.

The formal and informal markets for finance work on completely different principles. When we lend to a friend, he loses his face if he defaults. There are various informal groups for financial activities, and they work very well when the amounts are small, the borrowing and lending is on reasonable terms, and the pressure to keep the promise is high as a collective social responsibility. The risk in these informal arrangements is contained when social costs are high. Defaulters are shunned by friends and the community, and it is tough for them to
borrow again. Micro-finance arrangements work on the same principle.

These informal markets become formal when money has to be lent and borrowed on a larger scale, and between strangers. A bank stands between borrowers and lenders who do not know one another. It screens borrowers and ensures that only the sound ones get credit. The loans that the bank offers are its assets, which will earn interest income. On the basis of the quality of its assets, the bank raises deposits. The ability of a bank to keep its promise to its depositors depends on the quality of loans it offers. This is why investing in banks that don't follow sound lending practices is risky.

The formal financial systems in our country have been unfortunately dominated by the government. Even today, the banking system is dominated by PSU banks. These systems have hurt the ability of the investing public to understand how formal markets work. They don't understand that formal systems would actively avoid offering bad loans because there were bailouts of failing institutions; they failed to see that bad borrowers may find it difficult to get money because the good and the bad were not differentiated by indifferent public lenders. Even today, depositors do not care much for the quality of a bank's assets; they believe that if it is owned by the government it won't fail. Publicly owned entities have two more problems: they face political interference and turn to red tape to protect themselves from bad decisions.

Investors did not learn the difference between formal and informal finance. If a finance company offered 15% interest, while a bank offered 8%, they thought the bank was not as enterprising as the private player. If they did not know anything about whom the finance company lent to, they did not see it as a problem. They had been used to opacity, not having asked the government agencies what they did with the money. If the finance company gave a loan or took a deposit without a KYC or PAN, they saw it as efficient compared with the sloppy agency that took too much time with paperwork.

What has still not been learnt by the ordinary investor is that money can be returned only on the basis of the strength of the borrower's balance sheet. Investors look for promises and guarantees, and continue to think that there has to be some way for borrowers to make a promise and keep it. The small informal group-based lending was always based on the quality of the unbroken promise.

Therefore, they expect that large, formal financial mechanisms should also find a way to make and keep promises. They fail to see that formal mechanisms cannot be risk-free. When money is lent to unknown borrowers, whether they repay or not depends on how they use the money, what asset they create, and how these assets generate income.
If money can be raised on the basis of empty promises, we will continue to see rampant misuse and failures. In a formal structure, the amount a person can borrow is limited by the risk associated with assets. When we take a gold loan, the lender tells us that he can lend us only up to 60% of the value of gold. The lender is limiting the loan, because he knows that the value of the gold may fluctuate. Stock market transactions are guaranteed based on the same principle. The estimated rise or fall of the price is collected upfront as margin. A bank's ability to pay all its depositors, even if some of the loans default is similarly based on its capital. The fundamental principle in ensuring a stable banking system is capital adequacy. This means that the bank brings in its own equity capital of at least 12 for every 100 of loans, so that deposits do not default.

The primary objective in investor education is to demonstrate how the quality of promises made between strangers has to be evaluated for the inherent risk. Bailouts are as dangerous as guarantees.

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