The Reserve Bank of India has published on its website, a discussion paper on Banking Structure in India – The Way Forward which covers the following aspects:
- Consolidation of large-sized banks with a view to having a few global banks
- Desirability and practicality of having small and localised banks as preferred vehicles for financial inclusion
- The need for having investment and other specialised banks through ‘differentiated licensing’ regime for domestic and foreign banks instead of granting of universal banking license
- Policy regarding presence of foreign banks in India
- Feasibility of conversion of urban cooperative banks into commercial banks
- Periodicity of licensing the new banks – ‘ad hoc issue’ or ‘continuous licensing’
In this post, we refer specifically to the paper’s coverage of ‘small and localised banks’. The feasibility of such a proposition is looked at by pointing to learnings from US’s experience with small community banks.
In the US, there are about 7,000 small community banks with asset size ranging from less than US $10 million to US $10 billion or more. They account for about 46 per cent of all small loans to businesses and farms and in terms of the number, they constitute about 92 per cent of the all the FDIC insured institutions.
Notwithstanding India’s past attempt with Local Area Banks and Urban Cooperative Banks, it refers to similar recommendations of the Committee on Financial Inclusion (Rangarajan Committee, 2008) as well as the Committee on Financial Sector Reforms (Raghuram Rajan Committee, 2009), and puts forward the idea that such small localised banks have a pivotal role to play in financial inclusion and that this must be revisited as an important policy imperative. While specific questions need to be tackled, such as the nature of capital requirements and exposure norms and supervisory framework for such banks, the paper ends on a high note that in a deregulated interest rate regime and with technological advancements it is indeed possible today to make such banks viable from a cost perspective. This indicates a distinct shift in RBI’s previous stance on the subject (which we had analysed in a previous post).
We reflect on the recommendation of the Raghuram Rajan Committee report in this regard. The Committee recommends to:
Allow more entry to private well-governed deposit-taking small finance banks offsetting their higher risk from being geographically focused by requiring higher capital adequacy norms, a strict prohibition on related party transactions, and lower allowable concentration norms (loans as a share of capital that can be made to one party).
The small finance bank proposed emulates the Local Area Bank initiative by the RBI that was prematurely terminated, though the details of the Committee’s proposal differs somewhat. The intent is to bring local knowledge to bear on the products that are needed locally, and to have the locus of decision making close to the banker who is in touch with the client, so that decisions can be taken immediately. It would also offer an entry point into the banking system, which some entities can use to eventually grow into large banks.
With regard to the operational challenges with small banks, the Committee says,
This Committee recognizes that small banks have not distinguished themselves in India in the past, often because of poor governance structures, excessive government and political support as well as interference, and an unwillingness/inability of the regulator to undertake prompt corrective action. These are not the banks the Committee wants, and the Committee would call for substantial care in who is licensed, as well as greater regulatory oversight.
There is, however, no necessary link between size and honesty, as the recent experience with large banks suggests. Indeed, the larger number of potential applicants for small banks suggests the regulator can be far more selective in applying ‘fit and proper’ criteria. Moreover, technological solutions can bring down the costs of small banks substantially, even while increasing their transparency. Finally, the failure of even a few small banks will not have systemic consequences, unlike the failure of a single large bank. In sum, the Committee believes there has been sufficient change in the environment to warrant experimentation with licensing small banks.
We are in broad support of this proposed direction. For a country like India, large and diverse, there is a need for multiple approaches to financial inclusion and the localised financial institution is clearly one feasible approach. In addition, several game-changing trends such as the digitisation of cash, the roll-out of the Unique ID (Aadhaar) project and the blurring of lines between banking, insurance and capital market institutions, all make local institutions that much more feasible today.
We believe that high quality originators need to be local financial institutions characterised by the following:
- A branch based network that penetrates deep into the local geography so that every last individual and household can have access to financial services, and is staffed by well-trained local talent
- Availability of a complete suite of financial products to serve the multi-faceted needs of local households and enterprises
- The use of technology such as biometric identification, core banking systems and automated payment systems to drive down operating costs
However, the nature of such local institutions should be such that they are not allowed to take deposits and assume systemic risk given their inherently higher risk and local concentration features. They would be the innovators and risk takers that cushion banks from credit losses and costs arising from newer businesses, through their additional capital and their lower-cost delivery structure.