RBI needs to allow small banks to think big if it wants them to succeed

In the next few weeks, the Reserve Bank of India (RBI) will finalize the norms for the entry of smaller banks-something that can change the way people perceives banking in rural India. These entities are conceptualized to cater to low-income borrowers and small business units.

Several companies are planning to apply to become smaller banks, including some among those, which failed to win a banking licence in April. In April, from a list of 25 applicants, the RBI gave licences to only two - Bandhan Financial Services and IDFC Ltd.

RBI issued draft norms on small and payments banks in July 2014. Going by the definition of the RBI, smaller banks have a lower entry capital of Rs 100 crore compared with the commercial banks, but will not be very different from commercial banks, when it comes to operational mandate.

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Payments banks, on the other hand, would facilitate fund transfers and accept small deposits but wouldn’t offer credit.

However, geographical restrictions proposed on smaller banks are likely to act as a huge turn off for potential aspirants, who are concerned that operating in a few districts wouldn’t be a safe proposition for them.

If indeed the RBI sticks to its draft rules and restrict the operations of smaller banks to only a few adjacent districts, there may not be too many takers for the plan since a majority of the aspirants are likely to be non-banking finance companies with operations across the country.

The operations of smaller banks will “normally” be restricted to contiguous districts to give a “local feel” and culture, and any possibility of expanding comes after an initial period of five years that is a stabilization period.

And, that’s where the whole problem begins.

Restricting smaller banks to a few contagious districts would mean that RBI is giving birth to yet another set of Local Area Banks (LABs), something the country tried in 1996-97 and failed. The mandate given to LABs was almost same as that for smaller banks now.

Out of the six LABs given license, two met with an untimely death. The four remaining ones aren’t doing too well.

The reasons for failure of these banks can be attributed to high concentration risks typical to adjacent districts in the form of natural calamities and political risks, which can result in large scale defaults.

“Certainly we don’t want to be one of such company (LAB),” said Samit Ghosh, Founder of Ujjivan Financial Services. Ghosh’s firm, which had earlier planned to apply for smaller bank license, is now having second thoughts due to the geographical restrictions proposed on such firms.

According to Ghosh, Ujjivan has written to the Reserve Bank of India (RBI) seeking changes in the proposed regulations for small banks.

Financial inclusion

About half of the total population doesn’t have access to formal financial services and most of them rely on money lenders for their banking needs. These include illegal chit funds and private individuals running illegal banking businesses.

The government and the RBI have been trying to push financial inclusion in Asia’s third largest economy through various plans over the years. In 2010, the RBI launched a phase-wise financial inclusion programme through commercial banks that included a business correspondent model and opening of zero-balance accounts.

While such efforts have resulted in an increase number of people covered under formal banking services, a large section still remains excluded from the formal financial system.

Last month, Prime Minister, Narendra Modi, launched a massive bank account opening programme under Jan Dhan Yojana, which required banks open 7.5 crore accounts in five months.

Small banks can bring the rural poor and unbanked to the world of formal finance in a steady, sustainable manner as compared to the instant-financial inclusion models currently being tried out by the Modi government.

If RBI’s intention is to limit the scope of smaller banks as banks for the poor and low-income groups, there is no need to limit such entities to a few districts. It could instead cap the amount that can be transacted in such banks (in the form of loans and deposits) which will take care of the issue of scope.

Rather than creating tiny banks limited in few districts and prone to failures, building banks for small customers with a national presence makes more sense. RBI can, thus, avert committing the mistake of creating another set of LABs and co-operative banks.