Posted in Finance Articles, Total Reads: 1308
, Published on 17 October 2014
The Indian financial sector reform process which began in the early 1990s has resulted in the creation of a healthy and competitive financial system in the country. With further deepening of the financial sector in the Indian economy, banks are seen shifting their role from being an all service provider to a provider of niche services in areas of their choice. Considering the fact that banks catering to retail customers essentially have different risk profiles and skill sets from those catering to corporate clients, this kind of a shift makes a lot of sense. Keeping these in mind, RBI has come out with guidelines for the issue of differentiated bank licenses. A differentiated bank license, unlike the universal bank license, will provide banks the flexibility to offer services in some selected verticals like mortgage banking, project finance etc. As per the current practice in India, universal bank licenses are provided by RBI to both domestic and foreign banks.
Existing Banking and Financial Services structure in India
Full-fledged commercial banks: Around 75% of the assets are under the control of the public sector, the private sector handles 18% and the rest is under the control of foreign banks.
Regional rural banks: They are supported by the public sector banks. They basically focus on providing banking services in the rural sectors where there is not much presence of the large commercial banks.
NBFCs: They act as supplements to the big commercial banking firms and provide services similar to them. They are not subjected to regulations from RBI.
As per the latest RBI draft guidelines, it has proposed issue of bank licenses for two categories of banks i.e. small banks and payment banks. Both these categories have been established keeping in mind the common goal of promoting financial inclusion. Small banks will provide the entire range of services including loans and deposits while functioning in a limited operational area. Payment banks will offer services like accepting demand deposits and fund remittance while operating in a wide network with focus on remote areas. They will extensively use technology to add value while lowering costs.
However, both these categories have some common features which include requirement of minimum paid up capital of Rs.100 crore, initial contribution of the promoter to be at least 40% with a lock-in period of five years which has to be brought down to 30% in 10 years and 26% in 12 years from bank’s commencement date. In order to be eligible for the license, the promoters need to have a good track record of running their business for at least five years.
As per RBI’s draft guidelines, NBFCs, mobile telephone operators, non-bank prepaid instrument issuers, co-operatives and super market stores are among the entities which are eligible for starting Payment banks. Small banks can be started by individuals with an experience of 10 years in the field of banking and finance, non-banking finance companies, local area banks and microfinance institutions.
Differences between existing Financial Institutions and Differentiated Banks
India has many financial institutions apart from banks which include NBFCs, investment banks, NABARD etc. In spite of that RBI is planning to roll out differentiated bank licenses. The major differences between the financial institutions and differentiated banks are:
- Differentiated banks can access public deposits whereas finance firms are banned from doing so.
- Differentiated banks, like other banking entities are subjected to regulations like CRR, SLR etc. from the RBI whereas other financial firms are not.
- Differentiated banks have access to unlimited low-cost funding from the central bank while other financial firms don’t have that facility.
Why the Differentiated Banking Sector is Attractive to the Applicants?
India is one of the largest and fastest growing economies of the world. The banking sector has a huge growth potential and is projected to become the fifth largest sector by 2020. Banking credit is projected to grow at the rate of 17% CAGR which would lead to an increase in the credit availability. All these are positive indicators of potential business opportunities for the applicants.
Required Approach from the Applicants
As of now the applicants have been diverse entities comprising mostly NBFCs which are ambitious to transform into banks. Their successful transformation will require strong management and development of the ability to handle unforeseen risks. They have to shed the image of being mirror images of the established commercial banks and learn to harness their esoteric knowledge in the niche segments they handle. They have to develop good customer service practices. They have to focus on filling up the gaps which the big commercial banks have neglected and create different operating models which have more customer focus.
The differentiated banks have to develop cost-effective operating models and have to develop ties with financial institutions which have good local knowledge and governance control.
Role of regulator
The success of differentiated licensing will also depend on how efficiently RBI can overcome the challenges faced in the implementation of this model. It will have to ensure that systemic stability is maintained despite the presence of different banks and that there is no scope of indulging in regulatory arbitrage by any bank. This is particularly important since the existing norms cannot be uniformly applied once different kinds of banks come into existence.
Advantages of differentiated licensing
- The flexibility to provide specialized services will help in identification of core competencies which when harnessed would lead to enhancement of productivity. This includes a reduction in intermediation cost and achieving better price discovery.
- It will help in addressing issues related to conflict of interest which normally arise when multiple functions are being performed by the bank.
- It will lead to better utilization of scarce resources and specific expertise in areas like risk assessment and infrastructure financing.
Issues with differentiated licensing
- Due to the adoption of a narrow business model, the specialized banks may be liable to suffer from concentration risk.
- A universal bank has an option of cross subsidizing across the different sectors in which it operates which leads to optimum resource utilization and provides better profitability to banks. On the other hand, the specialized banks do not have this advantage.
International experience with differentiating licensing
The differentiated licensing model is being globally practiced by few of the countries like Australia, Hong Kong, USA, Singapore, Indonesia and London. Some countries even issue different licenses for savings bank, commercial banking, rural banks and credit unions.
Introduction of differentiated banking might not be as effective as projected because almost 40% of India’s population is still financially excluded. The payment banks would not achieve the targeted financial inclusion as they would not be providing credit facilities. Like any other commercial bank, they will also have to meet the reserve requirements and their returns may not look attractive since they are mandated to park their deposits in government securities. Looking at the business model of payment banks they may not be able to attract many serious promoters. They might also face stiff competition from the existing regular banks. Small banks, on the other hand, bear a close resemblance to existing local area banks which were first launched in 1996 but did not attract many applicants.
The multitude of banking and other financial institutions existing in the Indian context have specialized in dealing with niche segments’ financial requirements. They are present in almost all the verticals of businesses. So the differentiated banking sector might not provide a new dimension for financial activities. All these possibilities point towards the roadblocks and cautions in implanting differentiated banking services.
The differentiated banks though are a way to enhance availability of financial services to niche segments and the financially excluded section, face a number of challenges in terms of proper administration, complex regulations and norms to be set by the RBI and competition from the existing financial firms which have a deep understanding of the niche segments. It might even confuse the borrowers and increase complication as different institutions have to be approached for different needs. It also entails the risk of giving access to unlimited low cost funds to the niche players who might not use them judiciously. Thus, a completely differentiated bank format might not provide a rosy picture which encompasses the required levels of financial inclusion, as it does not allow them to lend credit, or an effective risk management system. Therefore, it might be prudent to roll out a system wherein all the differentiated banks provide few common and minimum services, till a robust system has been established.
This article has been authored by Ashmita Nagpal and Ramakrishna Matli from IIM Udaipur