Financial Literacy - The Demand Side of Financial Inclusion

16 Pages Posted: 13 Nov 2011

Date Written: June 2, 2011

Abstract

Financial literacy has assumed greater importance in recent years especially from 2002 as financial markets have become increasingly complex and the common man finds it very difficult to make informed decisions. Financial literacy is considered an important adjunct for promoting financial inclusion, financial development and ultimately financial stability.

Financial development is widely recognized as an important determinant of economic growth (Levine, 2005). It can be argued that limited financial literacy serves as an important barrier to demand for services: if individuals are not familiar or comfortable with products, they will not demand them.

Financial Inclusion comes with potential dangers. Recent experiences in the microfinance arena have shown that poor people take loans that they have no capacity to service. Farmers have also taken loans that they have not been able to repay. Many have been driven to suicide because of debt problems. Unless financial literacy goes hand in hand with financial inclusion, instead of helping the poor, they will be put into more trouble. Another example is the mortgage crisis, in the U.S., which has lead to global crisis.

Financial Literacy can broadly be defined as the capacity to have familiarity with and understanding of financial market products, especially rewards and risks in order to make informed choices. It refers to the ability to make informed judgments and to take effective decisions regarding the use and management of money. It is regarded as an important requirement for functioning effectively in modern society. Trends in retirement income policies, work patterns and demography suggest its importance can only increase in the years ahead. Raising financial literacy supports social inclusion and enhances the wellbeing of the community.

There is need for financial literacy in both the developed and the developing countries alike. The increasing number and complexity of financial products, the continuing shift in responsibility for providing social security from governments and financial institutions to individuals, and the growing importance of individual retirement planning make it imperative that financial literacy be provided to all in the developed countries. In the developing countries financial literacy can be seen as the first step toward alleviation of poverty and development.

In India, the need for financial literacy is even greater considering the low levels of literacy and the large section of the population, which still remains out of the formal financial set-up especially in the rural areas.

India is among the world’s most efficient financial markets in terms of technology, regulation and systems. It also has one of the highest savings rate in the world. While savings are more in India, where the savings are invested is a cause for concern. It is also to be noted that most Indians do not have a regular savings habit also. Further only a minority of Indians is covered by mandated, and/or government financed social security schemes and social safety nets.

Wealth creation for the investor and the economy will remain a distant dream, unless the common man becomes a wiser investor and is protected from wrong doings. We need to convert a country of savers into a nation of investors.

Everyone saves money for future needs but the approach most of the time is to save surplus money without preparing household budgets, without prioritizing personal financial goals, without properly allocating investments in different asset classes and without understanding the real rate of return (after adjusting for inflation).

Investors tend to use thumb rules or seek advice from friends and relatives. Most of the time these are poor approximations compared to those that follow from a systematic process. These results often in poor outcomes and they lose faith in the financial sector.

Financial education primarily relates to personal finance, which enables individuals to take effective action to improve overall well-being and avoid distress in financial matters. Hence improvement of financial knowledge of households is necessary for them to participate continuously in financial markets. Financial literacy plays a vital role in the efficient allocation of household savings and the ability of individuals to meet their financial goals.

Financial literacy thus goes beyond the provision of financial information and advice. It is again a major issue for finance markets as it both drives and distorts investment behavior. It empowers the common person and thus reduces the burden of protecting the common person from the elements of market failure from a regulatory perspective.

Financial literacy can make a difference not only in the quality of life that individuals can afford, but also the integrity and quality of markets. It can provide individuals with basic tools for budgeting, help them to acquire the discipline to save and thus, ensure that they can enjoy a dignified life after retirement. Financially educated consumers, in turn, can benefit the economy by encouraging genuine competition, forcing the service providers to innovate and improve their levels of efficiency.

This paper would look into various aspects of financial literacy in both developing and developed countries and try to provide a suitable model that would be helpful for Indian conditions.

Suggested Citation

Ramachandran, Ramakrishnan, Financial Literacy - The Demand Side of Financial Inclusion (June 2, 2011). Available at SSRN: https://ssrn.com/abstract=1958417 or http://dx.doi.org/10.2139/ssrn.1958417

Ramakrishnan Ramachandran (Contact Author)

Vivin Consultants ( email )

J108 S&P Living Spaces, Kamarajar Street
Vanagaram-Ambattur Road, Aynambakam
Chennai, Tamilnadu 600095
India
+919952669656 (Phone)

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