RBI's draft norms for smaller banks: Raghuram Rajan is repeating a mistake

It is an old story.

In 1996-997, the then union finance minister, P Chidambaram, announced the creation of Local Area Banks (LABs) in a bid to push banking services to rural areas of the country, where the waves of economic liberalisation hadn’t reached as yet.

The mandate of these banks was to operate in a few adjacent districts and provide banking services in that limited geography, in a small scale. The Reserve Bank of India (RBI) duly followed the process and issued licences to six LABs.

The experiment was, arguably, a failure.

Out of the six, two met an untimely death. The remaining four aren’t doing too well. The core issue with LABs was their concentration risk itself. If something goes wrong in those few districts they operate, that impacts repayment and credit culture, the whole business suffers, threatening the survival of the entity.

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To be sure, the RBI corrected its mistake by deciding not to grant any further LAB licences.

Seventeen years later, the central bank is close to committing the same mistake by the creation of the proposed smaller banks.

Going by the draft guidelines of the RBI, the smaller banks will not be very different in mandate and operational scope compared with that of LABs.

The operations of smaller banks will “normally” be restricted to contiguous districts to give a “local feel” and culture. Any possibility of expanding the presence comes after a period of initial five years of stabilisation period. For initial three years, the smaller banks would require prior approval of the RBI.

There is not much difference from LAB rules, except the fact that smaller banks can expand to districts in the adjoining states “if necessary”. But that’s a scenario one has to wait and watch to see whether it happens in reality.

Now, the problem is that such a caution in the initial years curtails the chances of many aspiring companies in lending business, such as several microfinance companies and non-banking finance companies (NBFC), which would probably want to become smaller banks and regulated by the RBI as a bank.

The reason is many of these companies already have operations nationwide and limiting their operations to a few districts doesn’t make real economic sense. From a stability perspective, a commercial bank, big or smaller, commands much more public faith than an NBFC and are safer institutions due to the nature of their regulations.

Several companies FirstBiz spoke to said they are planning to approach the RBI to make a request to widen the scope of smaller banks. The central bank has given time until 28 August to accept comments on small and payments banks. Once the comments are received, the RBI is expected to come with final guidelines soon.

“What is the point of becoming another LAB?” asked Samit Ghosh, founder and managing director of microfinance firm, Ujjivan Financial Services, which has operations in 24 states. Ghosh’s firm is planning to approach the RBI to make a request to become a smaller bank operating in multiple districts.

Ghosh’s question makes sense. The RBI has been maintaining that MFIs cannot accept deposits and if they want to, they can become banks and comply with the regulations. In that sense, becoming a smaller bank is an opportunity for MFIs to become a bank and operate in a larger scale.

Besides Ghosh’s firm, there are several other firms, which are keen to apply for the smaller banks licence, including some of the firms, who couldn’t make it to the final list for the new bank licence. In April, from a list of 25 applicants, the RBI gave licences to only two-Bandhan and IDFC Ltd.

Most of the firms are not keen to apply for the payment bank licence since it doesn’t make sense for companies that are in lending business already to become a mere payment agency.

In fact, if the scope of the smaller banks is widened to operate in multiple states for small customers, instead of limiting to few districts, the payment function can be undertaken in the smaller banks itself.

On the contrary, if the central bank sticks to its idea of smaller banks and restricts these new set of lenders to a few districts as outlined in the draft guidelines, the RBI will be, in effect creating a new set of LABs, which too could eventually meet the same fate.

Those who forget the past, says the old proverb, are condemned to repeat it.