Why banking in India will never be the same again

India needs more banks of different shapes, sizes and business models. The banking regulator is responding to this need

Last week, the focus was on the change in the Reserve Bank of India (RBI)’s stance on liquidity and the cut in its benchmark policy rate and many of us overlooked the structural changes in the banking industry architecture that the Indian central bank had hinted in its first bi-monthly monetary policy for fiscal 2017. If RBI is serious about it, banking in India will never be the same again.

After giving licences to two full-service or so-called universal banks, 11 payments banks and 10 small finance banks, RBI is ready to release norms for bank licensing on tap soon. It is even exploring the possibility of licensing other differentiated banks. A discussion paper on that is expected in the next few months and they could include wholesale banks, custodian banks and investment banks.

The two new universal banks, Bandhan Bank Ltd and IDFC Bank Ltd, started operations last year. While Bandhan continues to focus primarily on small loans, the mainstay of its earlier microfinance avatar, IDFC is a corporate bank with a consumer banking wing. By April 2018, we could see 20 more—10 payments banks and an equal number of small finance banks. Of the 11 entities RBI had given conditional payments bank licences to, Cholamandalam Distribution Services Ltd has withdrawn from the race, citing competition and long gestation period. A couple more could follow. Meanwhile, Jalandhar-based Capital Local Area Bank will kick off operations as the first of the small finance banks this week as Capital Small Finance Bank Ltd.

Payments banks can collect deposits of up to Rs.1 lakh, provide payments and remittance services and distribute third-party financial products. They won’t be able to give loans and issue credit cards, but can provide debit cards and Internet banking services. Essentially, they will mobilize deposits on behalf of other banks, acting as a business correspondent. Small banks, on the other hand, will offer loans. They have to give 75% of their loans to the so-called priority sector, and 50% of the loan portfolio should constitute small loans of up to Rs.25 lakh, even as they will be subject to all prudential norms like any other commercial bank. While payments banks will stick to their niche and try to take away other banks’ fee income and look for opportunities in the remittance space, successful small banks can graduate to universal banks after a few years.

By the time these new entities settle down, we will probably see a few wholesale banks, custodian banks and even investment banks to focus on new niches and lend depth and sophistication to India’s banking landscape, where the bond market is still not deep enough to meet the needs of long-term funding.

The bulk of Indian banks’ bad assets is in the infrastructure sector. Many had rushed to lend, often under pressure from the government, without understanding the risks associated with infrastructure financing. Besides, they didn’t have the long-term resources to support such loans. Wholesale banks can fill in this gap. They will be able to generate long-term funds and probably won’t be subjected to the reserve requirements such as cash reserve ratio (CRR) and statutory liquidity ratio (SLR).

CRR, currently 4%, is the portion of deposits that banks need to keep with RBI on which they don’t earn any interest. SLR refers to the compulsory bond buying by banks, currently 21.25% of deposits. Such banks will also be exempted from priority sector lending—loans to agriculture, low-cost housing and small businesses. Currently, 40% of a bank’s loan must flow into these segments.

Some of the large non-banking financial companies that raise funds from the wholesale market and lend to corporations can become wholesale banks. A few foreign banks, too, will be happy to enter this space, even though they have reservations about local incorporation, which RBI has been pushing for.

Custodian banks don’t dabble in commercial and retail lending; they safeguard a firm’s or individual’s financial assets such as stocks, bonds, currency, commodities, metals and money market instruments like commercial papers. They arrange settlements of sales and purchases, ensure delivery of securities and offer accounting, legal, compliance and tax support services to customers such as commercial banks, insurance firms, mutual funds and pension funds in multiple jurisdictions around the world.

Unlike commercial banks, which offer loans using cash deposited with them, custodian banks can lend securities. Currently, Clearing Corp. of India Ltd provides guaranteed clearing and settlement functions for transactions in government securities, foreign exchange and derivatives as well as money markets, while there are two depositories—National Securities Depository Ltd and Central Depository Service (India) Ltd. Once RBI issues the guidelines for custodian banks, clarity will emerge on the future of these entities.

Almost two decades ago, in the late 1990s, RBI pulled down the barriers between development financial institutions and commercial banks and encouraged universal banking—a model that makes a bank a one-stop shop for all banking products. The experiment has not succeeded. Government-owned banks, with close to 70% market share of banking assets, have piled up bad loans due to their lack of expertise in project financing even as the share of foreign banks has been shrinking due to their failure to face the challenges in the Indian market and troubles overseas. A handful of new private banks cannot meet the diverse needs of Asia’s third largest economy. And anyway, they have mostly focused on retail business.

India needs more banks of different shapes, sizes and business models. The banking regulator is responding to this need. At the same time, it is also trying to de-risk the balance sheets of state-run banks. The consolidation move, if it succeeds, will lead to larger but fewer universal banks. Many more, relatively smaller banks offering specialized services will complete the landscape.