A recent innovation in the Indian banking structure has been the formation of a new banking institution—small finance banks (SFBs). These banks are expected to penetrate into financial inclusion by providing basic banking and credit services with a differentiated banking model to the larger population. In this context the new SFBs have multiple challenges in coming out with a new, differentiated business model. The challenges include building low cost liability portfolio, technology management, and balancing the regulatory compliances. This paper also presents the top of mind views of three senior executives of new small finance banks.
Academic literature on intermediation and growth (Cameron, 1967, Goldsmith, 1969, McKinnon, 1973, Patrick, 1966, Shaw, 1973) establishes that financial intermediation, both in the form of financial institutions such as banks and insurance companies as well as financial markets (equity, bond and derivative markets), exerts a powerful influence on economic development by reducing poverty and stabilising economies. More recent evidence also supports this (Bencivenga, Smith, 1991, Levine, 1997, World Bank, 1989).
In the Indian context, the banking sector plays a significant role in financial intermediation, more so since nationalisation which led to ownership and control by the Government of India of 14 major banks in 1969 and 6 more banks in 1980. One of the key objectives of such bank nationalisation was to spread banking activities by opening branches in un-banked areas. The post nationalisation decades witnessed rapid expansion of bank branches, especially in rural areas and so did banking scale and complexity (Gandhi, 2015). Public sector banks, holding substantial market share, contributed significantly by providing credit to finance agriculture and government designed credit-based poverty alleviation programmes. The existing banking structure (Table 1, Table 2) in India has evolved over several decades, is elaborate, and has helped to serve the credit and banking services needs of the economy. Further, there are multiple layers to cater to the specific and varied requirements of different customers and borrowers. Undoubtedly, India’s banks have played a major role in the mobilisation of savings and have promoted economic development (Reserve Bank of India, 2013a, Reserve Bank of India, 2013b). There has also been a substantial increase in banking business over the years, captured by the ratio of banking business (credit plus deposits) to GDP; commercial bank credit as per cent of GDP has steadily increased from 5.8% in 1951 to 56.5 % by 2012. The population per bank branch came down from 64,000 in 1969 to 12,300 in 2012 (Reserve Bank of India, 2013a, Reserve Bank of India, 2013b).
Table 1. Deposits, advances and branches of scheduled commercial banks in India as at end of March 2015.
|No of banks||Deposits (Rs in billions)||Advances and investments (Rs in billions)|
|State Bank of India (SBI) and associates||6||20179||21%||19198||21%|
|Private sector banks||20||19145||20%||18769||20%|
|Regional rural banks||56||2699||3%||2354||3%|
|State cooperative banks||17||811||1%||1271||1%|
|Urban cooperative banks||50||1661||2%||1484||2%|
Source: Basic Statistical Returns, RBI.
Table 2. Geographical presence of scheduled commercial banks—March 2009 (Number of bank branches).
|SBI and associates||5560||4835||3043||2624||16062|
|Regional rural banks||11626||2746||667||88||15127|
|Other scheduled commercial banks||1113||2638||2715||2411||8877|
Source: Branch Banking Statistics, Reserve Bank of India, September 1, 2010.
A key feature that distinguishes the Indian banking sector from banking sectors in many other countries is the fostering of different types of institutions that cater to the divergent banking needs of various sectors of the economy. Promotion and development of industrial finance institutions (such as Industrial Finance Corporation of India—IFCI, Industrial Development Bank of India—IDBI), finance for small industries (Small Industries Development Bank of India—SIDBI) and specialised sectors of infrastructure (Power Finance, Infrastructure Development Finance Company—IDFC, etc.) are classic examples. Similarly, urban cooperative banks (UCBs), regional rural banks (RRBs) and local area banks (LABs) are institutions encouraged by the Reserve Bank of India (RBI) for meeting banking requirements of small customers, especially located in rural and semi-urban areas. Further, there has been a parallel growth of non-banking finance companies (NBFCs) providing leasing and hire purchase services, vehicle finance, loans against gold, and micro-finance, etc. Although regulatory frameworks are different for these institutions, all serve the financing requirements of various customer segments.
Among these financial intermediaries, UCBs, RRBs and LABs are small size banks (see Table 3) established to cater to the financing requirements of small customers.
Table 3. Existing small banking structure
|Urban cooperative banks (UCBs)||Regional rural banks (RRB’s)||Local area banks (LABs)|
|Commencement and growth||Started in 1889 with the spirit of the cooperative movement||Started in 1976 following the recommendations of the Narasimham committee||Started in 1996|
|Ownership||Cooperative structure, mostly community dominated||Public sector banks, respective State Government and Government of India||Private individuals|
|Number of banksa||1574||56||3|
|Geographical area of operations||Higher concentration in a few districts and nominal||Restricted to a few districts of a state||Restricted to one or two districts|
|Regulatory reserve ratios||Applicable||Applicable||Applicable|
|Prudential norms of capital adequacy||Applicable||Applicable||Capital adequacy ratio of 15%|
|Advances to priority sector specified by the regulator||40%, similar to other commercial banks, out of which 25% should be for weaker sections|
|Market share in the banking sector||3.5% as on March 31, 2010||Insignificant portion|
|Customer clientele||Targetting specific communities
Mostly from semi-urban and urban areas
Middle and lower middle class customers
Middle and lower middle income groups
|Middle and lower middle income groups|
|Credit||Low amount for productive purpose
Small entrepreneurs (for example three wheeler rickshaw drivers)
Low amount for small entrepreneurs
|Systems, processes and controls||Moderate||Replication of public sector commercial banks||Customised systems and processes|
|Political interference||High level||Only through Government channel||No interference|
|Main problems||High non-performing assets (NPAs)||High NPAs||Moderate NPAs|
|Restructuring and consolidation||Many UCBs closed and merged with public sector banks due to capital erosion, frauds and poor quality of management||RBI initiated reforms and merged all the loss making RRBs in a phased manner||One bank closed due to irregularities and another merged with a public sector bank|
|Supervision||Reserve Bank of India (RBI)||National Bank for Agriculture and Rural Development
|Reserve Bank of India (RBI)|
Urban cooperative banks (UCBs)
Credit cooperatives were created to meet the financing, processing and marketing needs of small and marginal farmers. Cooperatives expanded in urban and semi-urban areas in the form of UCBs to meet banking and credit requirements of people with smaller means. Urban cooperative banks started as early as the 19th century after similar banking attempts became successful in England and Germany. Mutual help, democratic decision making and open membership form the core principles on which these societies work.1
The earliest known cooperative society was Anyonya Sahakari Mandali set up in Baroda (which was a princely state) in 1889. From the very beginning, these societies have continued to channelise savings from relatively more affluent sections of society and extended loans to other members who belong to poorer sections of society. The number of cooperatives grew rapidly after the Cooperative Credit Societies Act of 1904 was passed. With effect from 1966, in order to improve professionalism, banks with more than rupees one lakh2 paid up capital have been covered under the supervision of the RBI (Sinha, 2012). Although urban cooperative banks have shown growth on a year on year basis (as the share of UCBs constitutes just a small market share of 3.5% of the banking sector), such growth has not reflected the growth of the overall banking sector (Sinha, 2012). As cooperative banks work on their own equity funds contributed by members, as well as retained profits, these are inadequate to provide sufficient cushion for growth, resulting in resource constraints and lower growth. Further, due to bad loans and poor loan recovery, many cooperative banks have failed. For instance, in a period of two years (2011–2013), 31 co-operative banks failed and the Deposit Insurance and Credit Guarantee Corporation (DICGC) paid Rs 437.31 crore as compensation to deposit holders.3
The ownership and governance structure of UCBs is often bent to political influence and there are multiple instances where loans have been given on the basis of political influence.4 There are conflicting views on the suitability of the cooperative structure for banking activity as it is seen to favour big farmers and landlords who manage the societies, leaving small farmers aside (Nagarajapillai, 2008). Thus reaching target small customers has remained a distant goal of UCBs.
Regional rural banks (RRBs)5
With a view to create a parallel channel for co-operative credit societies, RRBs were established in 1975. The objective was to provide banking services in rural areas, help the rural economy in its development and extend credit to rural and agricultural sections of the economy. Regional rural banks are promoted by public sector banks in joint ownership with state and central governments. It is expected that the sponsor public sector bank will add professionalism and a large resource base to RRBs.
Regional rural banks have been restricted in terms of area of operations to certain districts in various states. They were created to bring together the positive feature of equity participation of cooperative institutions and professionalism of commercial banks to specifically address credit needs of backward sections in rural areas. Regional rural banks showed phenomenal growth in branch expansion, starting with 6 banks and 17 branches covering 12 districts to 196 RRBs with 14,446 branches in 518 districts across the country by the end of 1991.
Regional rural banks were unable to attract deposits from richer sections of society irrespective of the fact that these banks were as safe as other public sector banks; thus, gradually their funding position has weakened. In the race to expand their network, RRBs opened branches at places where commercial and co-operative banking facilities were already available, thus not serving the basic function of providing banking services to larger sections of society. Since the RRBs continued several old practices of public sector banks, customers were discouraged by the many formalities, which cost them a lot of time and delays in getting timely credit. Small borrowers continued with informal and indigenous sources of finance such as moneylenders. Regional rural banks failed to innovate any new business model to reach out to customers deprived of financial services.
Also, there is no effective link between farmers’ societies and RRBs, which could have promoted loans in rural areas. The want of local involvement from the staff has hindered their growth and failed to attract rural credit to these banks. Many RRBs have reported huge losses and capital erosion, leading to RBI intervention in 2006 and 2008 for closure and consolidation, thus reducing their number to 61.6
Local area banks (LABs)
LABs were introduced in 1996 and are similar to RRBs with a distinguishing feature of private ownership. Local area banks were given banking license with a view to bring the private sector’s efficiency and technology based banking services in rural areas. Initially the minimum startup capital was fixed at Rs 5 Cr7 and one single family’s ownership was restricted to 40% of equity. Local area banks are restricted from operating beyond a maximum of three geographically contiguous districts. The rationale behind this is to make banks more focussed on limited geographical areas and serve local customers who are living in the rural parts of the districts. It is intended to bring more financial inclusion.
Local area banks were directed to focus on financing agro-industrial activities, agriculture and allied activities and other similar non-farming sectors. Local area banks have to follow all the prudential norms regarding priority sector advances, capital adequacy, income recognition, asset classification and provisioning applicable to other mainstream banks.
Although an encouraging response was received from private individuals with 227 applications being filed, only 10 got the “in-principle” approval from RBI for the establishment of LAB and only six licenses8 were issued meeting the required criteria. Out of these, one bank was shut down by RBI in January 2002 due to major irregularities and another LAB was merged with a large public sector bank. Currently there are four LABs functioning.
In 2002, the Ramachandran Committee studied the performance of LABs and observed that the health of the existing LABs was weak. It recommended that no further LAB licenses should be issued. However, in the context of improving financial inclusion, the Rangarajan Committee9 observed that LABs have huge potential and along with local financial markets, can offer services like savings, credit, remittances, insurance, etc. It suggested that RBI should relook into the possibility of issuing new licenses for LABs, strengthening the view of the Raghuram Rajan Committee.10
At this juncture one more institution needs to be mentioned, i.e. microfinance institutions, although for a long time these have not been regulated by the RBI.
Overcoming the structural weaknesses of RRBs, cooperative societies and urban cooperative banks, the microfinance movement has a significant presence in the Indian credit market. Microfinance in India is a combination of two models; a contractual structure of joint liability group (JLG) or popularly, self-help group (SHG), and the second one is for-profit microfinance institutions (MFIs). Both these models have made significant progress in improving credit access to rural individuals. Microfinance has evolved as a people’s movement and has managed to exist outside of government schemes, banks and other interventions by entrepreneurs (Sriram, 2010).
Microfinance has made significant progress in the last two decades (1993–2012). For instance, in 2008–2009, the number of bank-linked SHGs stood at around 45 lakh (or about six crore households, if one assumes an average membership of about 12 households per SHG) and cumulative bank loans availed by SHGs stood at Rs 22,000 crore (Reserve Bank of India, 2009). Similarly, CRISIL (2009) shows that the top 50 MFIs together claimed an outreach of more than 1.2 crore clients and an outstanding portfolio worth Rs 7,650 crore in September 2008. The data also shows that the strategic focus of microfinance seems to have shifted from poor borrowers to profits. Transformation of MFIs towards such a commercial motive has been accompanied by changes in the structure of ownership, control and management, and nature of their stakeholder commitment (Nair, 2010).
Thankom and Hulme (2008) state that MFIs increase choices that millions of near-poor and poor people have to basic financial services i.e., loans. However, the loans provided have not always been for productive purposes. Being unregulated institutions, MFIs’ interest rates on loans are also too high. Further, most of the MFIs are concentrated around the same towns and rural hinterlands and often serve the same sets of households, encouraging multiple loans, leading to individuals being burdened with huge debt. Stringent performance indicators used by many MFIs exerted pressure on field staff to achieve financial targets by encouraging clients to take on large loans and on failure to make payment, the clients were disgraced in public which caused them psychological and physical distress, leading to some borrowers committing suicide (Hulme & Arun, 2011).
Thus, all existing banks and financing institutions, UCBs, RRBs, LABs and microfinance institutions have been suffering from structural weaknesses and there is a need for new small finance banks to extend financial services, especially to small customers.
Small banks: international presence
The concept of small finance banks is not totally new as such institutions have been in existence in developed and emerging markets as well. In the U.S., there are about 7,000 small community banks with an asset size ranging from less than U.S. $10 million to U.S. $10 billion or more. They account for about 46% of all small loans to businesses and farms and in terms of the number, they constitute about 92% of all the Federal Deposit Insurance Corporation (FDIC) insured institutions (FDIC, 2014). As quoted in the discussion paper on Banking Structure in India,11 Nigeria has set up over 1400 community banks in rural and urban areas. In Indonesia, the banking system is multifarious, with simultaneous existence of commercial banks in big cities and provincial banks (for example, Unit Desa of Bank Rakyat Indonesia (BRI)) in small towns to meet financing requirements of small customers.
Separate banks for financing small firms: justification from academic research
Equilibrium credit rationing models state that the problems of moral hazard and adverse selection (Stiglitz & Weiss, 1981) are extremely high for small firms and that small firms may be particularly vulnerable to availability of credit. Due to this, large banks tend to provide fewer loans to small and medium enterprises (SMEs) (Berger & Udell, 1998). The relatively simple organisational structure of small banks is thought to play a key role; due to the simple organisational structure, there are fewer agency problems among small banks, and thus, small banks can produce and deliver qualitative information (Berger, Udell, 2002, Stein, 2002). Zhang (2002) indicates, based on the relational theory of organisation, that small banks have advantages in SME lending. A substantial body of empirical research shows that small banks are more willing to deliver bank loans to SMEs than large banks (Berger et al, 1995, Keeton, 1995). Lee (2002) determines that introducing small and medium-sized financial institutions will increase SME credit and increase the welfare of society as a whole as information superiority among small and medium-sized financial institutions is positively related to the total amount of financing that SMEs receive. Compared to large banks, loan officers in small banks have greater incentive to produce and use soft information on account of the simple organisational structure, and so small banks have an advantage in offering relationship lending (Stein, 2002).
Williamson (1967) proposed the theory of hierarchical control to explain operational differences between small and large banks. He notes that large banks suffer from an authority problem in the lending process and that to avoid distortions caused by their complex organisational structure, they need to standardise their lending process. Berger and Udell (2002) discover that relationship lending creates agency problems between companies and bank credit officers, between credit officers and upper managers, and between management teams and shareholders. As bank size increases and the organisational structure of the bank becomes more complex, more serious agency problems arise. Compared with large banks, small banks rely more heavily on soft information from borrowers based on their pre-existing relationships when deciding whether to approve SME loans (Cole, Goldberg, & White, 2004). Berger, Miller, Petersen, Rajan, and Stein (2005) have reached similar conclusions. Zhang (2002) has developed an organisational theory model that reflects the trade-off between information costs and agency costs in loan decision-making, proving the advantages of small banks in providing relationship loans.
Based on the financial institutions in Shimane, one of the most underdeveloped areas in Japan, Zhang (2007) finds that large banks tend to use less expensive loan technologies, including credit scoring and other transaction-based lending technologies, whereas small regional banks are committed to producing soft information about firms and thus providing substantial loan packages to customers. DeYoung et al, 2004a, DeYoung et al, 2004b demonstrate that the small bank competitive advantage, with regard to relationship lending technology, is due to the organisational structure and other factors, such as the information traits of relationship lending. The benefits of organisational and operational efficiencies support the small bank advantage hypothesis—small banks are able to lend to small businesses at a lower cost than large banks (and lend proportionately more to small businesses) (Jayaratne & Wolken, 1999).
Move towards new small finance banks
The High Level Committee on Financial Sector Reforms (Government of India, 2009) headed by Raghuram Rajan in its report, “A Hundred Small Steps”, emphasised the need for a paradigm shift in the strategy for financial inclusion. It said that emphasis should be shifted from the existing public sector dominated, large-banking structure to improved efficiency, innovation, and value for money. Motivated financiers with low cost structure who also have the capacity to make decisions quickly are to be encouraged to start banks. It therefore recommended that entry to private, well-governed, deposit-taking small finance banks be allowed.
The RBI discussion paper (Reserve Bank of India, 2013a, Reserve Bank of India, 2013b) focussed on “desirability and practicality of having small and localised banks as preferred vehicles for financial inclusion” among other aspects of banking structure. The paper emphasised that deepening the engagement of formal banking for low income households and providing access to the unbanked will require increasingly innovative approaches (including channels, products, interface, etc.). Such a framework will need to be localised, customised and contextualised to suit the differing needs of different localities and will need to address issues such as the development of an overarching macro policy environment, long-term financial sustainability of microfinance institutions, increasing outreach by capacity building and effective governance, and broad-based research and monitoring/evaluation.
Following this, the Reserve Bank’s report (2014) on Comprehensive Financial Services for Small Businesses and Low-Income Households popularly known as the Nachiket Mor Committee Report came up with two broad designs for the banking system in the country—the horizontally differentiated banking system (HDBS) and the vertically differentiated banking system (VDBS) based on the functional building blocks of payments, deposits and credit. In an HDBS design, the basic design element remains a full-service bank that combines all three building blocks of payments, deposits, and credit but is differentiated primarily on the dimension of size or geography or sectoral focus. This could also be referred to as the institutional design configuration. In a VDBS design, the full-service bank is replaced by banks that specialise in one or more of the building blocks of payments, deposits, and credit. This could also be referred to as the functional design configuration. In reality, most banking systems would have a mix of both designs (Reserve Bank of India, 2014).
Policy on small finance banks
The Reserve Bank has, accordingly, decided to licence differentiated banks and guidelines on licensing of small finance banks (SFBs) and payments banks were issued in November 2014. The objectives of licensing small finance banks were stated to be as follows: (a) provision of savings vehicles, and (b) supply of credit to small business units; small and marginal farmers; micro and small industries; and other unorganised sector entities, through high technology-low cost operations, where “small” refers to the kind of customer the bank deals with (Rajan, 2016). Small finance banks have the flexibility to operate all over India, against the earlier models of RRBs and LABs which had geographical restrictions.
Ownership and governance
The minimum paid-up capital for an SFB shall be Rs 100 crores and minimum capital adequacy ratio of 15% of its total risk weighted assets (RWA) on a continuous basis, with an emphasis on quality capital of Tier I capital which should be 7.5%. Small finance banks can be promoted by individuals who have at least 10 years of experience / expertise in financial or banking field or by private sector companies or societies with a good track record. The promoter’s minimum initial contribution to the paid-up equity capital shall at most be 40% and can be gradually brought down to 26% within 12 years from the date of commencement of business of the bank. The guidelines also facilitate foreign shareholding currently at 49%, which can go up to 74% with the permission of RBI. Also, SFBs with a net worth of more than Rs 500 Cr must get listed within three years while others may choose to go public voluntarily.
SFBs have to comply with all the prudential norms and regulations of RBI similar to commercial banks that include the fulfilment of requirements for statutory liquidity ratio (SLR) and cash reserve ratio (CRR). They need to extend 75% of Adjusted Net Bank Credit to the priority sector; while 40% should be as per standard priority sector norms, the other 35% can be in any of the priority sectors. Small finance banks will be small sized universal banks. Half of their credit portfolio will have to be of ticket size of less than Rs 25 lakh. The maximum loan size or investment limit to single or group obligator has to be restricted to 10% and 15% of its capital funds respectively.
The operations of the firm should be technology driven and a detailed technology plan has to be submitted to RBI.
Out of the 10 institutes (Table 4) who have obtained the in-principle license for small finance banks, eight are microfinance institutes whereas one is a LAB (Capital Local Area Bank) and one (Au Financiers) is an NBFC. While giving licenses to new private sector banks in April 2014, notwithstanding the introduction of small finance banks, RBI has favoured Bandhan, a microfinance company, to become a commercial bank. Bandhan has been working as an MFI for the past 15 years and will be the first such to be converted into a bank in this country. Bandhan Financial Services started full-fledged commercial banking operations from August 2015, a clear signal by RBI that there is need for more banks to meet small customers’ banking requirements.
Table 4. New small finance banks.
|Name of the institution||Nature of activity|
|Au Financiers India||Au Financiers is an asset finance company incorporated in 1996 as a non-banking finance company. The main asset portfolio includes vehicle loans, small secured business loans for MSMEs and housing finance.
Motilal Oswal Private Equity Advisors, ChrysCapital, Kedaara Capital, Warburg Pincus, and International Finance Corporation have substantial ownership in the company and have geographical presence across 10 states in northern India.
|Capital Local Area Bank||Capital LAB is the largest among the surviving local area banks. Set up in January 2000, the bank has been operating in five contiguous districts in Punjab. As of March 2015, Capital LAB has Rs 1506 Cr of deposits and Rs 926 Cr of advances on its balance sheet; it has 39 branches and has been consistently profitable.|
|Disha Microfinance||Disha Microfinance started in 2009 offers financial services to rural and semi-urban areas of Gujarat, Rajasthan, Madhya Pradesh and Karnataka. Along with microfinance loans, it offers credit linked insurance and retirement solutions. It has more than Rs 200 Cr of assets under management as of 2014. The company is backed by equity investors like India Value Fund. As of March 2015, Disha Microfinance covers close to 8600 villages with 71 branches across 39 districts. A unique feature of this company is it offers credit to only women borrowers.|
|Equitas Microfinance||Based out of Chennai, Equitas was formed in 2007 as a microfinance institution. Since then, it has diversified its businesses through a holding company into different verticals like housing finance and used commercial vehicle financing. Equitas has operations in 124 districts across seven states with 361 branches, but its main business still comes from Tamil Nadu.|
|Evangelical Social Action Forum (ESAF) Microfinance||ESAF society started as an NGO in 1992 in Kerala. Its objectives were to deal with unemployment and poverty. ESAF started its microfinance business in 1995. In 2006, the society acquired Pinnai Finance and Investments. It currently offers products like micro loans, social security services like insurance and pension and money transfer. ESAF has operations in Tamil Nadu, Kerala, Madhya Pradesh, Maharashtra, Chattisgarh, and Jharkhand. ESAF predominantly offers loans to women borrowers under the joint liability group model of lending.|
|Janalakshmi Financial Services||Janalakshmi Financial Services is the third largest urban MFI of India with more than Rs 3800 Cr. It has 23 lakh customers served through 233 branches with a presence across 17 states and in 151 cities. Janalakshmi is backed by investors such as Michael and Susan Dell Foundation, Lok Capital and Bellwether Microfinance Fund.|
|Rashtriya Gramin Vikas Nidhi (RGVN) (North East) Microfinance||RGVN is a society strated in 1990 and converted into a micro finance institution in 2010. The society was founded to develop and support NGOs and community based organisations in the north-eastern part of the country. The company is headquartered in Guwahati and has presence in five states—Assam, Arunachal Pradesh, Meghalaya, Nagaland, and Sikkim. The company has more than 2.2 lakh borrowers who are served through 104 branches.|
|Suryoday Microfinance||Suryoday received license as a microfinance institution in 2009. It has presence in seven states though its primary business (up to 65%) comes from the states of Maharashtra and Tamil Nadu. The focus of the firm is on the women borrowers from the weaker sections of society. As of March 2015, Suryoday has 164 branches through which it is serving 6.05 lakh customers.|
|Ujjivan Microfinance||Having started operations in 2005, Ujjivan Microfinance is the fourth largest MFI in the country. It has Rs 3270 Cr of assets under management and serves over 20 lakh clients through 463 branches. The company was started to provide financial solutions to the urban poor and is backed by investors such as the CDC Group, Sequoia Capital, Lok Capital, and International Finance Corporation among others.|
|Utkarsh Microfinance||Utkarsh Microfinance, started in 2009, has a presence in the central and northern areas of the country. Headquartered in Varanasi, Utkarsh is backed by investors such as Lok Capital, Norwegian Microfinance initiative, Aavishkaar Goodwell, International Finance Corporation and Commonwealth Development Corporation. In a short span of six years, Utkarsh has built a customer base of 600,000 with a network of 271 branches.|
Need for discussion
In this context the current round table discussion assumes significance for widening the ambit of banking services to small businesses and raises the following questions
What is the spirit of differentiation and source of business opportunity recognised by prospective small finance banks?
How are these new banks leveraging technology?
How are these new banks building up their liability portfolios?
What are their capital management strategies?
What strategies do these banks envision to face the challenges of a competitive banking landscape?
Spirit of differentiation
Question: RBI has performed a similar experiment earlier by introducing regional rural banks or local area banks. What exactly is the spirit of differentiation as you understand, with the introduction of small finance banks?
Rajat Singh (Ujjivan Financial Services): Three things. First, allowing small finance banks to operate pan-India. I would say that is a big differentiator because given the kind of business we are in, we are always prone to some political mandate or natural calamity. Having concentrated your business in one geographical area makes your business very risky. Both local area banks and regional rural banks are geographically constrained, and when the small finance bank discussion paper came up, the authorities came up with the same thought process that SFBs have to be geographically contiguous, and they cannot be pan-India. As an MFI, we tried to explain to them why it does not make sense to have a geographically concentrated institution. It has its own challenges and risks, and it has been tried earlier as well with LABs. When the final guidelines came up, they removed this clause. In the final paper, they did not put a constraint on geography but on the loan size. Fifty per cent of our loans have to be below Rs 25 lakhs. To that extent, it is a big difference for us. Secondly, from day one they have made it very clear that all the regulatory guidelines (prudential norms) will be applicable to small finance banks. Take capital adequacy ratio (CAR) —it is higher than the requirement for commercial banks and similar to NBFCs. The RBI also said that all the CRR and SLR requirements will apply in the same spirit which makes investors or people who are putting money with the license holders very comfortable. To that extent, I feel that this initiative—SFB—is a bit different from what RBI has done earlier with LAB and RRBs. Further, here we are under direct supervision of the RBI, while RRBs were not as they had their sponsor banks. The RBI cannot go wrong with us in terms of not supervising very closely, so that lends us a lot of credibility in the market. And thirdly, there is an inflection point in terms of technology so we do not have a lot of the legacy and baggage that traditional banks have. We have the opportunity to start from scratch, and it is a big advantage. We may not be able to compete with the HDFCs of the world, but there are many banks which have a healthy respect for us because they feel that we can disrupt the market merely because of our ability to use a very agile technology platform. There are technology platforms which are 10 to 15 years old, from which we can learn and thus make a platform which is more robust and at the same time cost effective. Thanks to Aadhaar, thanks to National Payments Corporation of India (NPCI) and thanks to the mobile revolution, we can do banking much more differently from what is being done today. These are the three points which will help us in being successful in this experiment.
Sarvjit Samra (Capital): We are a local area bank, and we have been operating as a LAB for the last 16 years. The difference between us and other banks is that we can open branches in the local areas that we have been assigned. According to the RBI guidelines, we could work in three contiguous districts as the area of operations. For the first 13 years, we worked in the three districts of Jalandhar, Kapoorthala, and Hoshiarpur and in January 2013 we got permission for expansion into two more districts—Amritsar and Ludhiana. In terms of small finance banks, there will be no restriction on the area of operations. We can keep on expanding. Presently we are not a scheduled bank; once we start working as a small finance bank, we will be a scheduled bank. A scheduled bank has a number of other advantages. We will be eligible for certain subsidies which the government provides to scheduled banks, and we can pass them on to marginal farmers and others.
HKN Raghavan (Equitas): We always wanted to become a bank. Our vision, from the time we started in 2007, was to become a bank. Our mission is to improve the quality of life of our clients in a fair and transparent way and getting the bank license is a way forward towards it.
Question: The RBI guidelines clearly say that the SFB should be a technology driven bank. What are your thoughts on devising technology driven business models? Also, would banks need differentiated technology to do risk assessment and credit assessment of such a varied customer base?
HKN Raghavan: We were the first MFI to invest heavily in technology. Equitas’ first disbursement was with a centralised back office. We invested in core banking software back in 2007. Technology is very important. We believe in technology on two fronts. One, from the customer perspective, technology enables ease of operations, and we want to make it user-friendly and easily accessible. The other is from the perspective of internal control—technology enables fraud detection, process management, and risk mitigation. Technology and process are interwoven today. Today, we collect cash from 1.5 lakh clients every day without any fraud. If it were not for the technology, it would be impossible. You build technology in such a fashion that your risk is mitigated. Coming back to banking—we will be hi-tech and hi-touch.
Rajat Singh: We take pride in saying that we have one of the best technology solutions in the industry. Such technology could be common for banks but in microfinance, no one has invested so much in technology. Many MFIs that have opened after Ujjivan have learnt about the technology; however, we were the first to begin using technology in this industry on a larger level. Group lending is our bread and butter, where we use Craft Silicon, a Kenyan software. In India, back in 2005, there was no software service provider who was looking at this space actively. It was not a key business area. When we started, we wondered what we should do. We could not start a business without software. Prior to us, there were microfinance institutions who started their business, but they came from an NGO background. They had a different mindset and their outlook was very different. They did not focus on risk management, operational efficiency and so on. It was more in the nature of doing a good thing. Our management came from a banking background. These things were ingrained in their DNA. Microfinance was well developed in African countries, so we brought the Kenyan software to India. Today they have many MFIs as customers. For individual lending which is an emerging or growing portfolio, we have a software called SysArc which is provided by Lend Perfect, a Chennai based company. Most of the PSU banks are using it as their loan map origination system; it is also a software for individual lending. Third is our mobility solution. Today all our individual loans are app based. We have developed a software with the help of a startup where financial analysis, credit bureau linkage, customer acquisition, etc. happens over the tab and that makes the overall process efficient and faster. But that is done only for individual loans, which are 12% of our portfolio. For the remaining group loans, we have not automatised the front end process. We are in the process of doing it, and will convert the front end of group lending process into a paperless process. One of the processes is customer onboarding; another is collecting repayment from our customers which we are doing on a door to door basis. Once a month, we have to go to our customers and collect money from them. Initially, this whole process was paper driven. Now we have automatised it. We have a solution called true cell where field staff can update repayment. It reflects in real time in our system. This reduces a lot of paper work because when paper comes into the picture, the process of reconciliation and report generation has to be carried out, only after which you come to realise that there is some payment that is overdue. Now these things are gone, and you have a very fast, agile and efficient system. So these are some of the efficient actions we have taken. We have outsourced the database in Mumbai to the people who can manage it best. The whole data centre is managed by IBM. These are some of the highlights of our technology.
Coming back to our backend technology, for group loan which is not fully automated, it is done on paper; the customer acquisition or loan forms are filled up, and those forms come to the general bank for approval. The process thereafter is paperless. When the loan paper comes to us, we scan the document and everyone, operations department or cash department, works using that image. When forms come here, they get digitised. So when you go to our operations department, you will see that it is like any bank. No papers or documents are lying around. Everything is fully automated. When the processes of my section (operations section) are completed, the form will automatically progress to the outsourced level. When the outsourced person is done with it, it goes to the credit queue. When credit is done, it goes to cash. So it is an automated and highly integrated system. When we started, our vision was to integrate the front end of Grameen 12 to a retail bank. Grameen is good for the front end; it will cut down your front end cost, get the right customer, and so on, and retail back end ensures that you have efficiency. So from day one we were very focussed on that. Over a period of 10 years, it has turned out to be one of the most efficient processes. For example, our operating cost is one of the lowest.
Sarvjit Samra: At present we are a very technology savvy bank. We will be adopting all the channels. We were the first bank to post an ATM in a rural area over 15 years back in Punjab. Now we have all those technological channels, and we will be strengthening them. We will be going ahead with digital banking.
Question: Except Capital Local Area Bank, all the license holders are NBFCs or microfinance institutions which have asset portfolios funded by bank loans and borrowings but not low cost deposits. What are your thoughts on building a liability portfolio and offering a wide range of liability products?
Rajat Singh: It is a big challenge. It will also require a mindset change on our end. Today the only question we ask is, “Can I trust you?” but we now have to answer this same question from the borrower. At the level of field officer it requires a change of mindset. There could be two opportunities; if you look at the RBI guidelines carefully, on the asset side, they have put a lot of restrictions such as 50% of credit under Rs 25 lakh, 75% priority sector lending (PSL), that decide where you need to look for the liabilities. But there are no restrictions on the liabilities side. This makes the whole game very different. So depending on the DNA of the organisation, different organisations are taking it differently. For example Bandhan has got the full banking license, but they were originally an MFI. What they have done is to create two banks in one bank. They are targetting all customers from high net worth individuals (HNIs) to people at the bottom of the pyramid. They have two sets of branches. One set of branches is targetting urban, affluent and HNI and other branches are looking after the rest of the people. This also means two different sets of teams. They believe that with this approach they will have access to liabilities, current and savings account (CASA), and so on, and they will be able to build liability portfolio very quickly.
The second approach could be to look at the customer side. These are the customers whom we know very well. We have served these customers for the last 10 years. Our approach could be to focus on this set of customers so that we can leverage our existing distribution network, branch network, technology and people. Once you build this base, incrementally you can go to the next set of customers such as micro and small and medium enterprises (MSMEs), and poorly served bank customers from old public and private sector banks. So the idea is to first go with your customer and then with those who are either underserved or poorly served. The challenge in this strategy is that your market will be smaller, and people’s ability to save is very small. Nobody has profitably served this set of customers from the banking point of view. The core customer segment is the untested market. They all have Prime Minister Jan Dhan Yojana (PMJDY) account, but the accounts are not regularly used. The advantage of this strategy is there is no competition from formal financial service providers whereas in the Bandhan strategy you have to really fight tooth and nail with established players such as the HDFCs, ICICIs, and AXISes of the world. Our strategy is, not to compete when we are setting up our operations initially with those who have invested the last 20 years in establishing their network and technology. We will focus on our own customer base. A closer look at the savings habit of our customers reveals that it is not that they are not saving. They are saving with different informal segments of society such as chit funds, companies like Sahara, Saradha, Rose Valley and so on. When we go to different parts of the country there are different methodologies. Chit funds have a larger presence in south India. The amount of money being transacted through chit funds is very large. As per our estimate, if we collate this market, there is a Rs 4 lakh crore liabilities-side market known in these kinds of institutes. We are not considering the unknown here. If we include Post Office accounts and money in PMJDY accounts as well, the size is reasonable, and we are initially targetting 5% of this market in five years. This is similar to the kind of situation we were in when we started the microfinance business. If we can provide technology and access to our customers and we can provide customers courteous service, we can tap the market. However, such customers are not comfortable doing CASA with us. The way to go in this market is to start with products such as fixed deposit (FD) and recurring deposit (RD). It will increase your cost of funds, but that’s the only way to actually educate and bring this customer into your fold. The other companies in the informal segment do not do CASA with these customers. They have educated this customer about FD and RD. We can build on that. Once your channels are in place—ATMs, business correspondent, network, and so on, we can educate them to have CASA. We can also digitise their income to a certain extent. As far as people like us are concerned, 90–95% of our transactions are cashless. The only reason it is cashless is because our income is cashless. If we are able to create an ecosystem for our set of customers, if we can digitise their income and put in ATMs and business correspondents (BCs) close by so that they have access to their income, I think we can win this game. That’s our strategy on the liabilities side.
Liability is a long term game while in assets in one year you can build a huge portfolio because it is all about giving away the money. Later you can worry about your credit cost. With liabilities—it is very difficult. Liabilities take time to build. If you look at banks, it has generally taken 7–10 years to build liabilities and CASA. Everybody has started as a corporate bank and then shifted to being a commercial bank. I agree with your point that it will take time to build the liabilities side, say three years. In the transition phase, we have to look for alternate sources of funding. Term loans will go away. We have to rely on short-term interbank lending which will mean asset-liability mismatch (ALM). Further, interbank will be only 10–15% of the liabilities. Second source could be long-term loans from financial institutions such as SIDBI, National Housing Bank (NHB), National Bank for Agriculture and Rural Development (NABARD), and Micro Units Development and Refinance Agency (MUDRA). We have already established a relationship with them, and we have to see how much we can leverage the relationship. The third one could be securitisation. According to RBI, 75% of our portfolio should be PSL. Today 100% of the portfolio is PSL, so practically speaking I can securitise some of it. The fourth source is commercial paper (CP) and also, certificate of deposit (CD). So these are some of the sources through which we will try to manage our transition.
HKN Raghavan: It will take time for us to build the low-cost liability side. The existing client base is not going to help much. They will contribute close to 15–20% of the liabilities. Rest, we have to fight with the “biggies”. Irrespective of whether we enter into small finance banks or not, one constant endeavour has been to reduce the cost of funds. There are many choices available now—commercial papers and non-convertible debentures (NCDs) are two. We have also reduced the interest rates to 22.5% in the last six months from the earlier 23.5%. With the reputation of MFIs having improved since the Andhra crisis, raising money from the market is not as difficult as it was before. We also have a credit bureau where we can get information about individuals who have taken loans from multiple MFIs. We have put systems and processes in place to make sure that the client is not overleveraged. This has helped us to take a leading decision today.
The institutions NABARD and SIDBI have been helping MFIs already and with MUDRA, special focus has been on loans in the range of Rs 50,000 – Rs 5,00,000. This is the same range in which SFBs will be working. Hence, refinancing is going to be important and will give us some breathing space. The RBI is also supportive of us in delivering objectives expected of an SFB. I expect the proportion of lending by NABARD, MUDRA, and SIDBI to increase once SFB operations start in comparison to what is being provided to MFIs. However, there might be internal caps on these institutions.
Sarvjit Samra: On the liability side our risk is well spread. From the deposit point of view also, we do not have any bulk deposit. On CASA, which we have developed, we are paying only 4% unlike leading private commercial banks like Kotak and Yes. You can have the required quality of loan portfolio when you pay less on deposits and charge less on loans.
Management of statutory liquidity ratio (SLR) and cash reserve ratio (CRR)
Question: With RBI being strict on not relaxing the CRR and SLR norms for SFBs, how difficult will it be for SFBs to maintain a good Net Interest Margin (NIM) or lower the cost of funds? Is regulatory cost too big a burden on SFBs?
HKN Raghavan: It is a process. We have to live with it. It is in the interest of RBI as well, as it wants SFBs to be successful. The RBI has been very sympathetic to the operational issue. They have formed a committee only to solve the operational problems of setting up a bank. You cannot have two sets of guidelines for banks.
Sarvjit Samra: At present, we are regulated by the same benchmarks as full scheduled banks so the regulatory cost will definitely not increase.
Rajat Singh: Yes it will be very costly. It is the cost of being a bank. It will bring pressure on our bottom line. Being a bank, you also need to bring down your net interest margin. Today we enjoy net interest margin of 12% or so. We have to bring it down to 4% which is a desirable level which our kind of operation cannot do. When we made five year plans, we realised that 4% is not a possibility at all. So we came to the mid-way point. We have small transactions and not door step services, which adds to our cost. Our operating cost itself is 7%. In taking the middle way we envisaged that 12% would go down to 8% over a period of five years. As we increase our operational efficiency, we will gradually reduce the net interest margin and fortunately, RBI has also understood this fact, and they are fine with it. They have given the license and realised that to bring NIM down to 4% is a long term process and cannot be done in the short term. And if it forces us to do so, probably this experiment will not succeed. We will reduce it further because our funding cost is coming down. Also, the spread is coming down. Average yield is close to 23%. Over a long period, we will be able to reduce it to 18.5%. Over the last few years, whenever we have gained operational efficiency or our cost of funds has come down, we have passed those benefits to our customers. In this way, Ujjivan is a unique organisation; we take the stakeholder approach and pass the benefit to all the stakeholders, including customers.
Regulatory credit exposure to priority sector
Question: Though Equitas has been lending to the priority sectors, how easy or difficult would it be for Equitas to meet prudential norms, i.e. 75% of banking credit to priority sectors?
HKN Raghavan: Asset side is not a worry. We have been lending to priority sectors, so almost 100% of credit is to the priority sector.
Capital management and foreign holding
Question: What are your thoughts on reaching the target capital requirement of Rs 500 crore?
HKN Raghavan: Initially, Indian investors did not buy the MFI story. Hence the low equity from domestic investors, and most of the MFIs have more than 70% of foreign holdings. These foreign investors over the world have seen the growth of microfinance, and they know what they are investing in. So, there are only two options—initial public offerings (IPOs) or some foreign investors selling their stakes to Indian investors. Initial public offerings will bring down the foreign holding below 49%, and we will see from there what the future holds.
Rajat Singh: Our main reason for going for listing is to bring down the foreign holding to 49%. Today we are comfortable because we have capital adequacy ratio of above 20%. From that point of view, we don’t need capital, we can still manage capital. Since we need domestic capital, we are going for listing. The listing cost will be on the higher side, but at the same time if you look at it, it is the adjusted premium that you will see on our balance sheet.
Question: Will listing on the new SME exchange help you or will you go for mainframe?
Rajat Singh: A lot of investors have their own policy of not investing in SMEs. So, our strategy is to go for mainframe listing.
Sarvjit Samra: We have done a rights issue in December 2015, which was around Rs 17.29 Cr. So as on date, our networth is Rs 118 Cr. This was the only thing regarding which we were non-compliant with RBI guidelines. We are compliant with all the rest. Domestic holdings for us are around 66–67%. We are not planning an IPO. In the next financial year, we are targetting some equity infusion via private placements; the IPO plan may be after four or five years; we made our projection that we do not need additional capital for the next four to five years.
Question: With customers having the option of choosing from multiple e-wallets—be it HDFC PayZapp, ICICI Pockets, SBI Buddy or any other, Equitas might need to produce its own if it wants to compete with these biggies?
HKN Raghavan: Yes, absolutely. Wallets are a kind of financial product and the more products you are able to offer to your customers, the more likely they are to stick with you. We will also explore the possibility of wallets and other financial products.
Question: There are payments banks as well which are coming up. Are they going to be a competitive segment for you because RBI has identified a separate set of players for payments banks altogether?
Rajat Singh: To some extent they will be our competitors because they are doing liability overlay but they have a certain restriction on liability so they can only do CASA; they cannot do term products or loans. Of course, they can tie up with banks and come to some arrangement. Second thing, unlike SFBs, their focus will be across the spectrum; if you look at it, 8 out of 10 SFBs are actually microfinance institutions. So by orientation or DNA, they try to focus on the segment of customers who are unserved. Payments banks have many such restrictions. Most of them are either technology or telecom companies. They will be serving both the top end as well as the bottom end customers. What we have seen is that if you have such a huge customer base, you end up serving profitable customers, at least initially. To that extent, they will serve the segment they are most comfortable with. I don’t know what priority customers with say, less than 500 rupees, will have for them. If some of them choose to serve and actively pursue this segment, they would be our competitors, because they have to reach out and they are expected to provide very agile and fast service to their customers. To that extent, there will be a fight on CASA. But only if they are actively pursuing this segment of customers. The natural possibility is that they will start with the middle and affluent classes. Probably later they will come here.
Competition and business model
Question: How do you see the competition from other players like payment banks and regional rural banks and urban cooperative banks?
Sarvjit Samra: When we started in 2000, we had the advantage of being early starters. At that point of time, the presence of private players in rural areas and semi-urban areas was very small but today every other bank is present where we are opening our branches. When we compare the growth of our new branches with that of the new private sector banks, we are growing at a much better rate. We find that nationalised banks which open branches in our area of operation, are not doing well. Let me share with you how we are planning to continue this growth story. We want to maintain contiguity in our growth story. We don’t want to grow in a haphazard way. If you study the models of a few of the post-liberalisation private banks, one such bank, for example, is concentrated mainly in south India and focussed on Tamil Nadu. Now they have opened branches in Ludhiana and Jalandhar. But for them, they will always be strong in Tamil Nadu. So when we grow, we will remain clear cut market leaders in the area in which we are operating presently and the adjoining area. We will not face competition from anyone because of the brand equity which we have developed over the years. Now we want to carry it forward. If contiguity is maintained, you can very well carry it forward. This is what we experienced when we expanded from three districts to five districts.
Question: With expansion into new geographies, will the model of Suvidha centres (brick and mortar BC outlets) continue?
Sarvjit Samra: Suvidha centres will not continue. Suvidha centres were opened in unbanked rural areas, about six or seven years ago. Now RBI is saying that you open brick and mortar branches. So with the opening of branches in unbanked areas, Suvidha centre will not work. In fact, the business correspondent (BC) model, used by many banks has not succeeded.
Question: Do you think people will come to branches or should branches go to people via BCs?
Sarvjit Samra: People in the rural areas love to come to branches. It has been our experience, and that is why our Suvidha centre was that successful. Other banks which used BCs are going to doorsteps of people and opening their accounts; they have not been very successful in comparison to our Suvidha centres.
Question: Overall, what are the challenges you see once you convert yourselves into a SFB?
Sarvjit Samra: In the immediate future, I do not see any challenge. In fact, instead of challenges, there are a lot of opportunities. But, in the longer run, maintaining a higher capital adequacy of 15% will be a challenge. Today my balance sheet size is Rs 2000 Cr but in five years’ time, it is going to cross Rs 8000 Cr and in business terms from Rs 3000 Cr of business to 12000 Cr in five years’ time. At that level, maintaining a 15% CAR will be a bit challenging. But we expect that after a couple of years of successful operations, RBI may relax this. For others, CAR is very low, it is around 9%. Same with priority sector lending. At present, we do not see any challenge but as size grows, maintaining 75% PSL is also going to be a challenge. The RBI is very open and we expect that after the banks stabilise, RBI will definitely relax these norms.
Question: Then there is an opportunity to convert yourself into a full commercial bank as well…
Sarvjit Samra: Yes, of course. According to the business plan which we have made for ourselves, we plan to cross around Rs 400 Cr of net worth in five years. Then we are thinking of going for an IPO, so we bring in another Rs 300 Cr to Rs 400 Cr of additional capital to our net worth. Then we can think of becoming a universal bank.
Question: Will you be using your own ATMs?
Rajat Singh: We have two options. We are saying that on day one, we will have on-premise ATMs. So we will have ATMs only where our branches are. We will not go for the off-premise model because it is an expensive proposition. We do not have the luxury to go for that kind of model. We will consider it over a period of time. At the same time, we will provide a debit card to all our customers. So wherever we find that the use of debit card is very high, and there are a lot of transactions and people are using debit cards to withdraw money from other ATMs, we will analyse that data and see whether we need to put an ATM there or not. Depending upon the breakeven cost, if transaction cost goes beyond the limit, we will put an ATM there. We do not have to invest in these things from day one. We have to take a call on required basis and then go for it. So ATM will be part of our channel if the customer sees it as an important channel. It also helps in moving a customer from assisted to self-service mode. But it is a kind of journey. It will start at some point and move later. From day one, it may not be all across, but it will be in our branches, and later we will go to off-premise ATMs as well. Our most important channel apart from branches will be the business correspondent, and we are bullish on the BC. Our surveys suggest that customers do not want to move beyond one and a half kilometres to do a transaction. That is their comfort zone. We too do not want to move beyond one km to enable an ATM transaction. So we will be establishing our BC network, and that will be probably with the help of corporate BC. There are several players who already have their BC network. We will ride on one of them and will see how we can provide transaction points to our customers in their neighbourhood. The BC is our key channel in the foreseeable future.
Question: Regarding the business correspondent or BC network, as the customers are rural in nature, will the technology be friendly for them? Second, will BCs be collecting savings or giving loans to the customer? Will the customers trust them or not?
Rajat Singh: For the kind of BC services we are thinking of, the customer does not have to be a tech savvy person to avail those services. We are talking about leveraging Aadhaar, OTP, card or SIM where there is a neighbourhood shop, you go there and say you want to withdraw Rs 500. You use your thumb for biometric authentication, and you will get your money. We are not talking about moving them to a self-service mode where you use your own wallet to withdraw or lend or transfer money. That is not under our framework for the next two years. Our theory is to move customers from assisted to self-service mode. We see it as a journey. From day one, we are not asking them to do things on their own because of the reason you just stated.
The BC is an assisted model where customers will be assisted by the BC during the transaction. So knowing technology is not an important parameter, even when they are dealing with the BC. The element of trust is there. Business correspondents are of two types: static and mobile. We are talking about static BC, which will be located at some place. They will probably use a combination of technology and supervision methodology to make sure the customer gets a seamless experience. I am not saying it will happen on day one. It is a human channel and is expected to have a lot of problems. But it will happen with the help of technology and strong customer education on financial literacy, on what is right and what is not so right; and third, by putting a supervisory structure in place. Our idea is to make sure these things minimise trust related issues. Today because of facilities such as Aadhaar, the telephone, OTP, and messages, people get updates. So to a great extent, fraud can be avoided. Ten years back, in such a situation, it was very difficult to prevent a fraud; today you can do it. You get an SMS on a mobile phone after every transaction. A little bit of customer education will also help us in preventing all these things. As of now, BCs are hungry for business and they have established themselves. They try to squeeze the transactions that come their way. Once they realise that a customer is coming in regularly, say twice in a month, they will know that they have to conduct themselves professionally with the customer, because either he will complain or he will go to some other BC. The BC will also change as will his income over a period of time. His urge to do wrong things will decrease. The number of the transactions in this customer segment may increase. Business correspondents will earn more than what they earn today. Plus, today BCs are largely being used for fund transfer and not for transactions. Once in a quarter, customers may go to withdraw their NREGA payment, or transfer money to somebody else and the transactions are not so frequent. Now even if the charge is 40 rupees per transaction, the customer will think that it is better than going to a remote bank and standing there for hours to get money. When you have to do it more frequently, you will also become more concerned. These are the hypotheses on which we feel that we will be able to prevent or avoid some of the trust issues. Technology should play an important role. Our supervisory action should be able to help us to do that. The BC model is not the easy way to go forward, but that’s the cheapest way. If you have to serve this segment profitably, then you have to do that. The ATM transaction costs you 15–18 rupees, BC may cost you 5 rupees. If you start putting ATMs everywhere, then your transaction cost and maintenance cost will be very high. You cannot really afford it. To serve this segment, you have to serve through the BC route knowing fully well that there can be certain pressure points, and you have to deal with it as you can.
Since you talked about customers’ ability to use technology, I would recommend to you a report from China about a financial service which is an arm of Alibaba. They have published their one-year transaction history and details that are very insightful. Regions that are most backward, are most using mobile technology. In areas like Tibet and so on 80% of the transactions are done through mobile. It is lower for people living in Shanghai as they use multiple avenues for transaction.
Question: Talking about RRBs, they want customers to come to their premises. Don’t you think that with static BCs, the problem will remain the same?
Rajat Singh: Static BCs are nevertheless in their neighbourhood. Best is to provide them door step service. The question is, Can you afford it? If you can afford to provide door step service, that’s great. But some balance has to be created and our survey suggests that customers are comfortable with a 1 or 1.5 km walk; that is, a 15 minute walk is not an issue for them. We are talking about BC here. It is completely different from RRB which is 5–10 km away from the customer’s home. We are talking about the same village having a BC presence. You can also have a mobile BC, but it comes with many other side effects. It restricts you, in my opinion. Mobile BC has fixed timings. They may not meet your requirement all the time. So it is not that flexible. The risk and trust issue is also more than with static BCs.
Bandhan is doing what you are suggesting, not through BC but through their staff. Once in a week at a specified time, he comes, and you can withdraw money. According to me, it’s an inflexible way of doing things.
Question: SFBs can also deliver other services like mutual funds, etc. How do you see this opportunity?
Rajat Singh: It is a big opportunity. However, not all customers are ready for it. We have to do this with a lot of customer education. To start with we will go with remittances and insurance. A mutual fund is not in our framework for the next five years. Basic insurance is in our framework because we feel that there is a need for such a kind of product as well in our customer segment. We will tie-up with insurance providers.
Question: How can SFBs innovate on the technology front or how can they increase the usage of technology among clients? The question becomes more relevant since the clients who are currently dealing with MFIs belong to the low-income group and fear e-banking.
HKN Raghavan: I agree with you that it will take time for them to adopt technology. The current generation will adopt with time but the generation which is 40–50 years of age will need assistance. One more important development which has taken place is payments banks. They will ensure that people adopt technology. License holders of payments banks are technology and communication companies which will ensure that their customers adopt and accept the technological changes. If we take into account the JAM revolution—The Jan Dhan Yojana, Aadhaar, and Mobile—we are looking towards an economy which will be completely cash-free in 10 years. Further, with mobile wallets removing the cash required in individual wallets, this is an exciting time for our country. We are all fortunate to be a part of this financial revolution.
Subsequent to the Round Table, two important changes worth discussing in the context of small finance banks are capital funds raised by the two small finance banks (incidentally, they are participants of the round table) and the event of demonetisation announced by the Government of India. A brief note on these two is presented here.
Subsequent to the discussion, the two licensees Equitas and Ujjivan have gone for IPO to raise capital funds and have raised Rs 2170 crore and Rs 885 crore, respectively. Both the companies’ post issue stock prices are significantly higher than issue prices, indicating the stock market welcomed the idea of small finance banks.
On 8th November 2016 the Prime Minister of India made an announcement, nullifying the legal currency (or demonetisation) with an aim to clean out the cash supply in black market (black money), corruption, terror funding and to declare a war on counterfeit or fake currency. This demonetisation move completely disrupted the social, political, and economic spheres of India for approximately two months. With the announcement of cancellation of legal money, all Rs 500 and Rs 1,000 rupee notes were instantaneously voided, and a 50 day window period (November 10th to December 30th, 2016) ensued where the people were given the option to redeem their cancelled cash for newly designed 500 and 2000 rupee notes or deposit the cancelled currency in bank accounts.
The financial and business press in India has widely discussed and debated the long term and short term implications of demonetisation for the society, the economy in general and the banking sector in particular. Although small finance banks are new players, the demonetisation event has ramifications on the business of these entities. These are:
Low cost of funds: With a large part of the cash moving through the banking channels, the banking sector is flooded with funds, with liquidity, and this partly helps banks to reduce cost of funds. Banks started getting a lot of low cost CASA deposits coming at a huge spread to them. This will benefit the SFBs as well, as initially the SFBs are dependent on bank borrowings. The cost of borrowing for SFBs is likely to come down.
Improved credit to retail sectors: The prospect of large size banks flush with liquidity, in a falling interest rate scenario, is a catalyst for lending activity. But as the Indian corporates are highly leveraged and with banks having stressed credit exposures, there may not be any demand for improved credit in the near future. This gives an opportunity to SFBs to give retail and small business loans. The increased usage of credit card, and improved digital connectivity with retail and micro business segments provide new business avenues for SFBs to improve the credit outflow.
Cash-less transaction system: Demonetisation has pushed individuals to go for more cash less transactions among other things. This has provided an opportunity to obtain information about individuals, consumption habits and history of financial transactions. The SFBs can make use of this information to design innovative credit products for these new customers.
Strengthening of systems, processes and control: During the demonetisation (November 10th to December 30th 2016) period the banking system experienced a lot of stress, some stress points being customers standing in serpentine queues to exchange old currency for new one and to deposit old currency, non-functioning ATMs, calibration of ATMs to facilitate withdrawal of new currency notes, restricted withdrawals from ATMs and so on. Apart from liquidity problems of customers, the event thoroughly exposed the weak control systems and processes of both government and private sector banks. The demonetisation event made banks cautious about strengthening of audit and other control systems, and also ethical aspects of banking staff. The SFBs can learn from the experiences of other banks and start their business by designing robust systems and processes.
The new small finance banks are likely to redefine the banking sector in India with more number of players competing in the rural financial services landscape. The immediate challenges for these banks are building the liability product portfolio, meeting the mandatory norms on statutory norms of cash reserve ratio, improving the digital connectivity with the large scale rural customer base, and designing cost effective banking solutions. These new banks are yet to come out with an innovative banking business model to chart a path for differentiated banking.
We thank Mr. Sarvjit Samra, CEO Capital Local Area Bank, Jalandhar, Mr. Rajat Singh, Head of Strategy and Planning, Ujjivan Financial Services and Mr. HKN Raghavan, CEO, Equitas Microfinance for participating in the discussion. We also thank the anonymous reviewers and the journal editorial team for useful comments and suggestions.