The Lab Experiment

The latest addition to the banking sector reforms is the concept of local area banks (LABs).

Considering the fact that the banking industry is already characterised by a definite structure, positioning of the LABs in the hierarchy is what will determine how successfully the concept will actually take off.

The existing stucture in the sector begins with the private moneylenders in the unorganised sector. The local chit funds operate in a more informal and loose set up. The primary to co-operative societies are better organised . The regional rural banks and commercial banks jostle with the district level co-operative banks. The non banking finance companies have also acquired a strong retail presence in the rural areas. Of late, the financial institutions have also successfully played a role that shows a marked departure from convention by going retail through their bond issues.

 

The moot point, therefore, is this: where will the LABs position themselves in the market? This could decide their product features as well. There is a major constraint: since their area of operations is being defined in advance, LABs will have little choice in their target market segment. Product differentiation can, of course, be attempted by making available the services when the rural worker has time at his disposal - early mornings and late evenings. A labourer may not mind paying more interest if he could raise a gold loan without losing one days wages.

The pricing of the products will also be determined by their market positioning. The LABs will be engaged predominantly in an intermediation role for their profits. Their potential for fee based income will be very insignificant. So, if they choose to offer competitive returns for the depositors vis- a- vis the finance companies and unorganised set ups, they will have to look out for high yielding assets. This will translate into higher risks and will call for risk management systems of a higher order.

The asset size will also be determined by the quantum of capital employed. The threshold of a minimum net worth of Rs 5 crore loses relevance in the continuum of market structure. Their long term viability hinges exclusively on the capacity of the promoters to bring in incremental capital matching asset growth. But, the prevailing levels of return on assets in the banking industry (even in the ones with higher operating efficiency) does not leave much scope for incremental capital.

LABs will have to fall in line with commercial banks.The same constraints such as reserve requirements will be a drag on them in attracting talent for treasury functions. Access to money market instruments will also be curtailed in the absence of a settlement arrangement. These logistic bottlenecks will deprive the LABs of instant access to the Open Market Window (OMO) of the RBI. RBI's OMO window will assume more significance in the context of the ad-hoc treasury bills giving way to ways & means advances, which will result in the central bank holding securities at market- related interest rates. The limited access to the OMO window will put pressure on the net interest margins of LABs, which will, in turn, be reflected in the compensation package for the personnel.

It has already been stated that the need for higher returns on assets will translate into higher risks. It will be appropriate if the LABs have recourse to speedy and cost effective recovery machinery under the Revenue Recovery Act. The Deposit Insurance & Credit Guarantee Corporation (DICGC) should also make available insurance to depositors for their savings with LABs. The LABs should leverage on the corporations credit guarantee capabilities also, which has not found favour with many commercial banks in its present form.

With the area of operation already defined to three contiguous districts, not much is offered by way of flexibility in the marketing mix. However, the focus on technology for networking the branches could enhance the distribution of the products and also enable value addition.

The new private sector banks (NPSBs) will be under continuous pressure to meet priority sector lending targets and rural branch networks. They can set up LABs and bring about synergies. The NPSBs will be able to price their liability products differentially through the LABs and refinance the assets of LABs to the mutual benefit of both.

Commercial banks can attempt hiving off their branches in specific areas into LABs with a view to reducing their intermediation costs, notwithstanding the apprehensions expressed by the trade unionns in the banking industry.

The commercial banks are experiencing significant erosion in their market share in the metros with the entry of NPSBs. The LABs could set in a cancerous malignancy into their rural market share as well, which they have been complacently perceiving to be impregnable. Such a double ended squeeze could lead to a shake out and search for improved operating efficiency. That is where their actual importance would lie.

Ramesh Krishnan is dealer, money markets, State Bank of Travancore. The views expressed here are the authors own.