Banking on diversification

Small finance banks should help financial inclusion

With the Reserve Bank of India announcing the issuance of licences for setting up 10 small finance banks, the first phase of diversification and expansion of the banking system appears to be complete. First, two licences for commercial banks were issued in early 2014, one of which has formally begun operations and the other is expected to do so soon. A month ago, 11 licences were issued for setting up payments banks (PBs). Both payments banks and small finance banks were key recommendations of the committee on financial inclusion chaired by Nachiket Mor and reflect the need to address the huge problem of delivery of meaningful products and services to a new class of consumers through the creation of new organisational structures and business models. Unlike the payments banks, which can take deposits but not provide credit except to the government, the small finance banks are essentially scaled down versions of commercial banks, with both deposit-taking and loan-making functions. They are required to provide at least 75 per cent of their loans to borrowers classified as priority sector and at least 50 per cent of their loans must be below Rs 75 lakh.

Unlike the licensees for the payments banks, which was quite a heterogeneous group comprising telecom companies and prepaid instrument providers among others, this group is relatively homogeneous, mostly comprising non-banking financial companies in the microfinance sector. Going by the basic motivations for setting up these new categories of organisations, this is an entirely logical distinction. Payments banks are really in uncharted territory and the greater the variety of organisational legacies that they come from, the better the prospects of finding a successful mode. On the other hand, microfinance institutions are already in the lending space and the successful ones have presumably developed the capacity to effectively monitor borrowers and assess risks. To the extent that their borrower constituency will be a natural target for their deposit-related services, the efforts required to scale up this new part of their business should not be too onerous. In this category, the real constraint is scale and this requires geographic focus. The selection process has taken care to ensure that the 10 licensees are spread broadly across all parts of the country.

As welcome a development as this institutional diversification is, some caution is advisable in assessing the prospects for success. In the case of the payments banks, the success of the Prime Minister's Jan Dhan Yojana in achieving virtually full penetration of no-frills accounts may prove to be a constraint in their pursuit of deposit accounts. For the small finance banks, this will also be a challenge; both groups will have to persuade a large number of potential customers to either switch from commercial banks or open up a second account. Beyond this, on the loan side of the business, as they seek to grow their lending volumes, they will be in direct competition with the priority sector mandates of commercial banks. For these new categories to be given a fair chance of success, there is a need for some re-alignment of roles and responsibilities between different categories of banks in relation to no-frills accounts and priority sector loans. Notwithstanding these concerns, however, the setting up of both payments banks and small finance banks represents a significant leap forward.