Licensing “small finance banks”

The Reserve Bank of India today released the final regulations for setting up “Small Finance Banks” in India.  The Reserve Bank of India has taken this step with the objective of furthering financial inclusion by (i) providing savings vehicles (ii) providing credit to small business units; small and marginal farmers; micro and small industries; and other unorganised sector entities, through high technology-low cost operations.

With this move, the Reserve Bank of India is making a significant shift in the landscape of financial inclusion in India. While on the one hand the step indicates the commitment that the central bank is making to the issue of lip service, the step is likely to have other ripples in the sector.

Priority Sector Assets

The circular requires Small Finance Banks to ensure that at least 75% of their portfolio qualifies as Priority Sector. With the two new banking licenses that were provisionally given earlier this year, this creates a huge demand for Priority Sector Assets. There is an immediate need for banker’s training colleges to begin thinking about, and developing deep expertise in underwriting these asset classes. In the absence of this expertise, credit will continue to flow to a select few resulting in either an under-utilisation of the PSL target, or over-lending to a select few.

Impact on the NBFC-MFI sector

The circular outlines that existing NBFCs or MFIs can opt for conversion into small finance banks. For the microfinance sector that has faced a slew of regulations in the past two years, this offers a clear pathway to the next stage of growth. There are, two options that are available to most MFIs as a result of this circular. They can either opt to be Business Correspondents (BCs) of existing banks, or they can choose to transform themselves into small finance banks. Further, with great foresight, the RBI has also stated that a small finance bank cannot be the BC of any other bank, but can appoint other BCs themselves. Effectively, this implies several small MFIs that are high quality originators in a limited geography, who were hitherto unable to raise debt themselves to act as BCs of banks, allowing for geographical diversification at the level of the bank. Seldom does one see policy that has been thought out in such a systematic fashion, especially with respect to ensuring risk aggregation.

Location of small finance banks

The RBI has categorically stated that there will be no restriction in the area of operations of small finance banks. However, they will have to follow similar branch licensing norms of setting up 25% of their branches in unbanked districts. Unlike a half baked Jan Dhan Yojana, this is a systematic means of ensuring that households even in rural India have access to a complete suite of financial products.

Challenges and opportunities

Contenders for the small finance bank licenses will need strong technology and data analytics at their disposal to ensure that their business model works. One of the key challenges that these banks will face is requisite infrastructure in unbanked locations, whether it is electricity or access to technology. It is high time that investments were made by these banks to understand households in these areas and their needs and requirements, before developing relevant products. As these banks set up branches in remote, rural locations, it is possibly also time to begin thinking about true inclusion: is the branch equipped with facilities that can cater to customers who have physical challenges, the aged, people who need wheel chair access? How can these banks develop GUIs that are accessible by all?

These contenders will also do well to begin by identifying metrics that would truly impact the market segment they ought to be reaching. This cannot be limited to superficial measures like number of accounts opened, or number of insurance policies provided. Instead, banks need to start thinking about metrics like reduced vulnerability or improved wealth of their customers. While such metrics seem harder to achieve, following these would help them succeed. The other factor that would greatly aid better underwriting is getting credit bureaus to share databases with each other.

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