The Indian economy might have been “liberalized” since the early 1990s, yet a sector–banking–still exists where a license is given and the business model defined by the regulator. The Reserve Bank of India (RBI) defines the kind of bank you can be based on your license. This is hopefully expected to go with the Prime Minister making a forceful case for digital banks in a recent address. The national think tank NITI Aayog has also put its weight behind digital banks by releasing a discussion paper. I had explained its role as a structural reform here.
CIPP published a paper on digital banking in July this year. The need for regulation for digital banks arises as traditional universal banks like Kotak are already offering digital banking through their 811 service. There are several fintechs, payment wallets and lending apps offering different aspects of digital banking services, without being a bank or a digital bank. Sometime back, Equitas SFB teamed up with Google Pay to invite digital deposits; this caused a furore among the traditional banks who screamed murder and objected to the entry of ‘Tech Titan’ Google into their hallowed and protected turf.
India has witnessed a proliferation of lending apps, including by Chinese companies, offering all kinds of credit and muscling their view into the market. Credit is important–many sectors, businesses and people are so starved of credit that they are willing to avail usurious digital offerings. Some of these sectors are well-known, for instance, agriculture and MSME. The Niti Aayog paper talks about the need for digital banking for fulfilling the needs and requirements of the MSME sector. But a digital expansion should not be limited to a sector; it is important to expand both its expanse and its range. Giving up control or letting go of one-size-fits-all mindset will not be easy.
Traditional Banks, Old Lobby
This is not going to be easy as the entrenched incumbents do not want competition from new nimble players. While the entry of Big Tech into digital banking can be thought through, there is no reason to delay the regulations on digital banking because it will bring competition. The NPA-laden public sector banks cannot be pushed to enhance credit to MSME, agriculture or other sectors. Private sector banks are not interested in a low margin, high volume business. This is threatening the survival of these sectors and preventing the country from achieving double digit growth. India is a bank-led financing model and several businesses are unable to scale up to any economic size due to the high cost of bank finance or no access to finance. Actually the high cost itself makes it difficult for small businesses to use bank finance, as their business would become unviable and unprofitable with such high cost of capital.
Cost of credit and absorption of credit are interlinked; banks cannot offer credit at 12-14 per cent to MSMEs, agriculture, and logistics. Such high rates, along with the huge collateral requirements, will make most small businesses unsustainable. Working capital loans that are the lifeline of small businesses are not easy to procure. Most small entrepreneurs have to use their homes as collateral for their businesses. Public sector banks are particularly insistent on homes as collateral as they feel it reduces the risk of default. The decline or stagnation in property rates has further hit the ability of small businesses to raise bank finance. Moreover, anecdotal evidence says that service-oriented businesses like restaurants that suffered during the COVID era lost their collateral.
In a growing business that needs working capital, increasing the collateral, like a home, is difficult. While ideally banks should be able to do receivables financing, few want to take that risk. To make receivables financing work, banks need to have a deeper understanding of the risks and payments structure of the sector and businesses. For such due diligence, traditional banks do not invest in manpower at the branch level, as they are anyway overburdened with branch rentals and other legacy investments. Indian banks still follow the SBI model of due diligence, which really means that whatever appraiser at SBI says about the risk profile, other banks just copy and paste it. Few banks have built expertise at a branch level to appraise and study the businesses of their potential borrowers.
NBFC Ambitions Curbed
Non-banking financial companies or NBFCs which have invested in this space have grown substantially but as they are not banks they do not have access to low-cost deposits. Hence their cost of lending is bank finance plus margins, raising the cost for ultimate borrowers.
The entrenched banking lobby has scuttled the ambitions of the NBFCs for a long time. A few have held to ransom not just the reforms in the banking sector but also the economic growth of the country. It’s sad that these banking leaders who raise the fear of Big Tech also indulged in fear-mongering about corporates entering banking, or NBFCs destabilizing the banking sector in the 2000s. While protecting their turf, they have caused enormous damage to credit growth and competitiveness of the Indian economy.
Fear works wonders with regulators because bureaucracy in a regulator is risk averse by design. Hence to prevent any kind of reforms, change or expansion in the regulations, the best way is to create fear among bureaucrats and regulators. This would ensure that they will slow down the decision-making process and the reform process will be delayed and soon forgotten. Bureaucratic inertia is the biggest challenge the Narendra Modi government is tackling and entrenched businesses are using it effectively to protect their turf. Banking, electric vehicles, power distribution, agriculture are all sectors where reforms have been stymied by entrenched players.
Need Regulations, Not Risk Aversion
If delay is one strategy, dilution of norms to prevent digital banks from competing fully is another. While traditional banks cannot easily change their business model, a new digital bank starts with the advantage of not having the fixed cost of a traditional bank. They cannot be clones of traditional banks and they need to be allowed a differentiated banking model.
These banks can leverage a new deposit base like custodian digital banks, which can access the pool of capital existing in capital markets for lending. There are custodian service providers sitting on thousands of crores of deposits that can be channelized into lending. Currently, foreign banks charge high conversion rates and do not channelize FPI (foreign portfolio investment) funds that they control into the domestic credit market. If Indian custodian services companies are allowed to become digital banks not only will they be able to expand the deposit base but also level the playing field with foreign bank.
Similarly, a kisan digital bank is the order of the day. The cost of delivering financial services through a branch network is just too high. Hence the penetration of financial services is still poor in the rural areas. Financial inclusion has to be about financial services, not just bank accounts. A bank account used for only direct beneficiary transfer from the government to the citizen is a transaction. Important for getting into the right account, but not sufficient enough to classify as financial inclusion. The user will be included in the formal financial system if s/he has access to the same financial services as a salaried middle class person in an urban area.
Custodian digital banks will be able to offer capital market financial services to the last mile and help in overall penetration of the capital markets. But if the entrenched lobby gets its way, differentiated digital banks will not happen. Instead we can expect something similar to what happened in the case of payment banks where the regulations were so tight that they could never prosper. Even in the case of SFB, by restricting their loan and deposit size, their growth and profitability have been restricted severely.
To ensure that digital banking licenses are not restricted by business model or delayed beyond redemption, it is important that RBI takes the lead. The role of regulator does not have to be so risk averse that it prevents the growth in its sector. RBI has to shed its fear of new players. If it does not come out with pragmatic norms for differentiated digital banks, the market will just evolve and leave the regulator behind. There are already several digital lending models in the market serving customers that cannot be regulated.
Moreover, RBI is allowing the payment banks to become schedule-1 banks that allow them to participate in government-to-citizen transactions but still do not allow them to lend. Deposits in the wallet are also capped at Rs 2 lakh. RBI is being careful because it does not want any failure. But in spite of being cautious, we have had failures like Yes Bank and Global Trust Bank. It’s not the rules that will create safe banks, it is the system that has to build regulatory capacity to ensure banks are safe. Starving the economy of credit in the name of risk management harms growth.
K Yatish Rajawat is a policy analyst and works with Center for Innovation in Public Policy. He tweets @yatishrajawat. The views expressed in the article are those of the author and do not represent the stand of this publication.
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