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Long Term Implications of

Differentiated Banking on Indian Economy
Background:
In the month of April, the Reserve Bank of India issued long awaited bank licenses to two
new financial institutions. Earlier applications for new bank licenses had been invited by the
Indian Central Bank in February 2013 and these two were chosen from a pool of twenty-five
applicants by a committee headed by the former RBI Governor Dr. Bimal Jalan.
Bandhan Financial Services, the micro-lending company, and Infrastructure Development
Finance Company (IDFC), the infra lending company, were granted these licenses and are likely
to go operational and demonstrate compliances by October 2015. What comes as a major
surprise in this scenario is that among the other institutions that had applied but failed to secure
new licenses were some very big names such as Aditya Birla Nuvo, Reliance Capital, L&T
Finance, LIC Housing Finance, India-bulls Housing Finance, Edelweiss, IFCI, India Info-line,
J. M. Financial, Muthoot Finance, Religare, Shriram Capital, Bajaj Finserv and others.
Within a couple of days of the announcement, the RBI Governor spoke to the press and stated
that the RBI has opened up the possibility for those left out applicants who can apply once again
as they are put on-tap basis. Based on their expertise and specialization, some of the applicants
may be better off applying for a differentiated license rather than for the full license.
Unlike a universal banking license which is a blanket license that allows banks to offer a
range of services, a differentiated license from the RBI will allow a bank to offer specialized
services in select verticals, such as project financing, mortgage banking, industrial financing etc.
Currently in India, the RBI issues universal banking license to both domestic as well as foreign
banks. All banks in the country retain access to the central payments and settlement system and
are blanketed by the deposit insurance cover.
In a country like India, the presence of varied financial institutions that have developed niche
businesses has brought great variety to the finances sector. Each such institution has specialized
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in specific functions such as gold loans, infrastructure financing, auto loans, micro financing etc.
To bring them all under the RBI umbrella, currently they need to be issued a universal banking
license, forcing them to diversify into businesses they have no experience or expertise in. It is
claimed that issuing of differential banking licenses, however, is likely to promote better
utilization of financial resources, bring depth to core activities, and allow institutions to focus on
specific needs and customer segments.
Moreover, differentiated banking practices are in vogue in countries such as Singapore,
Indonesia, Australia, and the UK. Hong Kong also offers differentiated banking licenses. The
idea of getting to a differentiated banking environment was introduced by the RBI in its Annual
Policy Statement in 2007-08, but now the time for transition to a differentiated banking
environment seems to be close at hand. A number of foreign banks such as UBS and Barclays
Plc. have shown great interest in procuring such licenses. The question arises whether future
Indian Banks are ready for it.
Present Scenario:
Till now, India has been following the universal banking model where banks are holding
companies that operate different businesses like asset management, insurance, asset
reconstruction, stock broking, etc., through subsidiaries, joint ventures and affiliates. India issues
a single class of banking licence to both domestic as well as foreign banks and all of them enjoy
full and equal access to the payments and settlement system and the deposit insurance cover.
The thinking in Reserve Bank of India has changed and it is getting ready to open doors for
different types of banks even as the aspirants and banking consultants have been speculating on
their profile. If it chooses to have niche banks for different segments, we may end up having
mortgage banks, banks for lending only to infrastructure, lending only to agriculture, lending
only to small and medium enterprises and so on.
However, this is unlikely to happen for many reasons. First, there will be concentration risk
and a downturn in a particular sector can jeopardize the operations of a bank. Precisely for this
reason, Indias most project finance institutions had to reinvent them and become banks.
Secondly, the sector-specific banks also run the risk of asset-liability mismatches. For instance, a
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mortgage bank or a bank dedicated to infrastructure financing will have long-term assets, usually
backed by short- to medium-term deposits.
So the focus is more likely to be on banks with different structures. The Nachiketa Mor
panel on financial inclusion has spoken about at least two such categories: payments and
wholesale banks. The payments banks can be created by converting pre-paid payment issuers
(PPIs). There are more than two dozen PPIs that provide mobile wallets or cards that customers
can use to make payments with the money thats stored in them. They can gradually convert
themselves into banks and even others can join them. Over a period of time, they can start
offering other services as well.
The panel has also suggested setting up of wholesale banks to provide credit and deposit
products to other banks and financial institutions that subsequently lend to small businesses and
low-income customers. According to the panel, high quality NBFCs that are already engaged in
financial inclusion and the so-called priority sector lending activities can be converted into
specialized wholesale consumer and investment banks. As they are not envisaged to take retail
deposits, these wholesale banks will be able to deliver on financial inclusion goals immediately
without putting depositors at risk.
Again, the successful ones could be considered for graduating to full-service banks.
Currently, many banks buy assets from others to fulfill their priority sector obligation under
which a bank needs to give loan to agriculture and small businesses to the extent of 40% of total
loans. Such asset buying happens through the securitization route. The wholesale banks will be
aggregator of both deposits and loans, allowing smaller and more specialized banks and financial
institutions to transfer their own systematic exposures to them.
Customers may not like the idea of differentiated banks as they would need to approach
different banks for different financial needs but since the idea is to cover the vast tract of
unbanked geography, this will not be an issue as access to any kind of bank will be welcome in
rural India, unlike the urban pockets where most banks are one-stop shops, catering to every
financial need of a customer.
Research output from SBI:
A recent SBI research report suggests that India may not be ready yet for a differentiated
banking system. They feel that it would be bit early to introduce such a model in the domestic
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context. There is also the very real fear that agriculture and small and medium enterprises may
be neglected in such an environment. Currently the stipulation of priority sector norms ensure
that commercial banks allocate 40% of the net credit lending to agriculture and small and
medium enterprises. The report suggests that it could become untenable for differentiated banks
to survive on one or two products alone. The report also suggests the differentiated licensing
model could first be tried out in the case of credit cards, remittances and such payment as well as
settlement business.
Another panel constituted by the Reserve Bank of India has recommended that a special
category of banks, called payments banks, be set up to widen the spread of payment services and
deposit products to small businesses and low-income households in Asias third-largest
economy, where about 40% of the population still do not have access to formal financial
services. Such banks will have a minimum entry capital requirement of Rs.50 crore, which is
only one-tenth of what a full-service bank requires, since they will have a near-zero risk of
default. Payments banks will be required to comply with all the RBI guidelines as usual relevant
for ordinary commercial banks.
Existing banks should be permitted to create a payments bank as a subsidiary, the panel has
said. The Mor panel recommendations for dedicated banks for financial inclusion has come at a
time when the central bank is in the process of giving entry to a third set of private banks in
Indias Rs.81 trillion banking sector.
The panel has also recommended the creation of a set of banks called wholesale banks to
provide liquidity to other banks and financial institutions thus creating assets in the so-called
priority sectors. Such banks, given that their primary role is to give loans, will only be permitted
to accept deposits of more than Rs.5 crore. They too will have a minimum entry capital
requirement of Rs.50 crore.
Some experts say that existing institutions such as grameen banks can be used effectively to
expand access to financial services to the poor. Because the present system has failed to use the
existing network of small banks such as grameen banks, which were ideally placed for the
purpose of financial inclusion. Then question arises that why does the country need to open new
banks for differential purpose.

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Mor Panel Report:
The present governor of RBI announced the setting up of the Mor panel in September 2013 to
study various aspects of financial inclusion, including institutional frameworks and regulations
and a comprehensive monitoring framework to track the progress of the financial inclusion of
small businesses and low-income households in India.
The Mor panel has also proposed the creation of a universal electronic bank account
(UEBA) for all adult Indian citizens and access to formal credit for low-income households and
small businesses by January 2016 and major changes in priority sector lending norms, among
other things. The country should have enough number and distribution of electronic payment
access points so that every single resident would be within a 15 minute walking distance from
such a point anywhere in the country by January 2016.
On UEBAs, the panel said every resident should be issued a UEBA automatically at the
time of receiving their Aadhaar number by a high quality, national, full-service bank. An
instruction to open the bank account should be initiated by Unique Identification Authority of
India upon the issuance of an Aadhaar number to an individual over the age of 18. To open such
an account the customers will not be charged an account opening fee but the banks will be free to
charge for all transactions, including balance enquiry.
Indeed, RBI introduced a three-year financial inclusion programme in April 2010 that saw
banks opening outlets in 200,000 villages. The banking regulator has asked banks to draw up a
financial inclusion plan for 2013-2016 to broaden access. According to the panel, by 1 January
2016, each low-income household and small business would have convenient access to
providers that have the ability to offer them suitable investment and deposit products, and pay
reasonable charges for their services.
Focus on Priority Sector:
In order to encourage banks to actively manage their exposures to various sectors, including
priority sector, the panel has proposed to make it mandatory for banks to disclose their
concentration levels to each segment in their financial statements. Under the priority sector
lending, banks are required to lend 40% of their loans to agriculture and economically weaker
sections of the society. The panel has also proposed to do away with the requirement of prior
approvals from RBI to create dedicated subsidiaries for financial inclusion.
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Even though banks are already permitted to set up specialized subsidiaries after getting
specific approvals from RBI, no approvals have been granted potentially due to concerns around
circumvention of branch licensing guidelines for initiating differentiated banking.
Noting that banks may choose to focus their priority sector strategies on different customer
segments and asset classes, the panel has recommended that RBI should provide specific
guidance on differential provisioning norms at the level of each asset class. Also, the panel has
proposed that all loans given to landless labourers and small and marginal farmers be counted as
a part of direct agriculture and not merely the wages component of a loan given to a farmer for
financing the agricultural production.
Focus on Non-Banking Finance Companies:
To enable non-banking financial companies (NBFCs) to become more active in spreading
financial inclusion, the Mor panel has recommended a partial convergence of norms for NBFC
and banks with regard to bad loan norms.
Presently, if a loan is not repaid for 90 days, banks can qualify this as non-performing assets
(NPAs), while for NBFCs, this period is 180 days. Also, if the account remains as an NPA for 12
months, banks have to classify this as a sub-standard asset, while for NBFCs, the period is 18
months. There is a case for convergence in norms on these areas for both types of institutions,
provided risk-based approaches are followed, the panel said. Besides, the panel has proposed to
restore the permission of non-deposit taking NBFCs to act as business correspondents of a bank.
According to the panel, the apex bank must represent to the ministry of finance to restore the tax-
free status of securitization deals conducted through pass-through vehicles for tax treatment,
pointing out the role it would play in ensuring efficient risk transmission.
Also, banks must be permitted to purchase portfolio-level protection against all forms of rainfall
and commodity price risks, through the use of financial futures and options bought either within
India or globally.
Soon after granting the licence to IDFC and micro-lender Bandhan Financial Services,
Reserve Bank of India Governor conveyed that the industry is on the cusp of a transformation in
the form of differentiated and 'on-tap' banking licences.
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Going by the two signposts of India's current financial system, the country could soon have, at
least theoretically, 10 different types of banks, serving various constituencies from retail to
infrastructure.
Does that mean that scores of new banks are a panacea to all the economic ills faced by the
Indian Economy? India is a vast market and we need different approaches to different regions
and segments, but we have to guard against regulatory arbitrage between differentiated banks,"
says the chief executive of Axis Bank. Indeed, different rules for different entities could be
disruptive.
To be sure, differentiated banks will not be new to India. Financial intermediation in India
happens at least through eight different institutions, from the likes of State Bank of India and
HDFC Bank to SKS Microfinance and Janalakshmi Financial Services, which lend to small
businesses. India is also home to commercial banks, non-banking financial companies, co-
operative banks, regional rural banks, and investment banks. It also has the National Bank for
Agriculture and Rural Development (NABARD), Small Industries Development Bank of India
(SIDBI), National Housing Bank and many more.
Given that there is no dearth in the varieties of financial institutions, what could be the
agenda of the Governor of RBI? Will it just be a change in nomenclature and a move towards the
French way where anyone who lends is a bank, irrespective o f the source of funding? On the
basis of wishful thinking of the RBI panel and having frozen new licences for commencing non-
banking financial company, India may call Shriram Transport Finance as Shriram Transport
Bank and SREI Infrastructure as SREI Infrastructure Bank.
Fortunately, in India, there are already many of the elements and there is experience with
multiple kinds of banking system design, which RBI says in his report on how to achieve
financial inclusion, based on the significant experience of both the national bank as well as the
regional bank design being implemented in India.
So the question arises about the hullabaloo on differentiated bank licences? Even finance
companies or cooperative societies do not worry about what they are called as long as their costs
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of funds are as low as that of banks. But there lies the catch. Finance firms, unlike banks, are
banned from accessing deposits. That essentially marks the difference between the two.
Of course, being a bank has its costs in the form of mandatory government bond holdings
and keeping a proportion of deposits as cash reserves with the RBI. But someone like the
Chairman of IDFC should know it better as to which one is beneficial. And there is history in the
form of ICICI and IDBI Bank, which also junked their term lending status to become banks.
It would be bit early to introduce differentiated banks' model in the domestic context. While
universal banking model remains the dominant and preferred model across the globe, there are
countries, for example the US, Australia, Singapore, Hong Kong and Indonesia that offers
differentiated banking licence. We however, feel it would be bit early to introduce such a model
in the domestic context. SBI Research said in a report that time is not ripe for such a system and
40 per cent of India's population falls into the financially excluded category, and highlighted not
so encouraging experiences with the local area and regional rural banks in this regard.
The differential banking activity licences issued to RRBs and local area banks (LABs) could
achieve limited success which prompted authorities to call for large size banks to go for rapid
financial inclusion in a time bound manner. It would be very difficult for a differentiated bank to
survive by selling only one or two products, and only the foreign lenders, which undertake niche
business activities even though they have a universal banking licence could be possibly
interested in differentiated licensing. Additionally, the differentiated licensing model can be tried
for fee-based business areas like credit card, remittances, payment and settlement business.
Though the RBI constituted Nachiket Mor Committee for financial inclusion, but it has first
mooted the idea of having differentiated banks in the country. The panel's suggestions include
specialized payment banks, retail banks, wholesale banks, infrastructure banks etc. In this
context, while RBI granted universal banking license to two applicants, Bandhan and IDFC,
added that some of the nearly two dozen aspirants were more suited for differentiated banking
licence.


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Arguments in favour of adopting a Differentiated bank licensing policy:
With the broadening and deepening of financial sector, it is observed that banks are slowly
migrating from a situation in the past where the number of banking services offered by the banks
was limited and all banks provided all the services to a situation where banks are finding their
niche areas and mainly providing services in their chosen areas. Many banks keep the plain
vanilla banking as a small necessary adjunct. It is widely recognized that banks providing
services to retail customers have different skill sets and risk profiles as compared to banks which
mainly deal with large corporate clients.
The present situation where every bank can carry out every activity permissible under Section 6
of Banking Regulation Act, 1949 has the following implications, relevant to the subject under
consideration:
For a wholesale bank dealing with corporate clients only, it becomes a costly adjunct to
maintain a skeleton retail banking presence. Moreover it becomes difficult for such a
bank to meet priority sector obligations and obligations for doing inclusive banking.
Retail banks may have to create risk management and regulatory compliance structures
which are more appropriate to wholesale banks, thus resulting in non-optimal use of its
scarce resources.
Similar supervisory resources are devoted to banks with different business profiles. This
may also result in non-optimal use of supervisory resources.
The priority sector lending regime for foreign banks has been causing some discomfort
for some of the foreign banks. For example, some of the foreign banks find it difficult to
fulfill even the less rigorous target of 32 per cent in respect of priority sector advances.
Some banks find it difficult to provide ' no frills' facility to economically disadvantaged
people. For them more liberal licensing regime causes a different set of problems.
It appears that given an opportunity, some of the banks may like to follow a niche strategy rather
than competing as full service all purpose banks.

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Arguments against adopting a Differentiated bank licensing policy:
On the other hand, there are some factors which point towards desirability of continuing with
the existing system of universal banking:
In India, the penetration of banking services is very low. Less than 59 % of adult
population has access to a bank account and less than 14 % of adult population has a loan
account with a bank. Under such circumstances, it would be incorrect to create a regime
where banks are allowed to choose a path away from carrying banking to masses.
Priority sector lending is important for banks. The revised guidelines on priority sector
lending have rationalized the components of priority sector. For the first time,
investments by banks in securitized assets, representing loans to various categories of
priority sector, shall be eligible for classification under respective categories of priority
sector both direct and indirect, depending on the underlying assets, provided the
securitized assets are originated by banks and financial institutions and fulfill the Reserve
Bank of India guidelines on securitization. This would mean that the banks' investments
in the above categories of securitized assets shall be eligible for classification under the
respective categories of priority sector only if the securitized advances were eligible to be
classified as priority sector advances before their securitization. These measures would
make it easier to comply with the priority sector lending requirements by those banks
which had faced some difficulties in this regard.
The business model adopted by such niche banks depends heavily on ample inter-bank
liquidity. Any shock leading to liquidity crunch can translate into a run on the bank. This
situation has been clearly illustrated recently in UK in the case of Northern Rock Bank.
Concluding Remarks:
It may be seen that one of the major objectives of banking sector reforms has been to enhance the
efficiency and productivity of the banking system through competition. It is also aim of
authorities to provide banking services to maximum number of people. To enable the banking
system to operate at optimum efficiency, and in the interest of financial inclusion, it is necessary
that all banks should offer certain minimum services to all customers, while they may be allowed
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sufficient freedom to function according to their own business models. Thus, it will be prudent to
continue the existing system for the time being. The situation may be reviewed after a certain
degree of success in financial inclusion is achieved and Reserve Bank is more satisfied with the
quality and robustness of the risk management systems of the entire banking sector.
References:
15
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May 2014, Foreign Banks Keen on Differentiated Licences, The Business
Standard,
15
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May 2014, New Bank Licences: Some Applicants may be better at Differentiated
Banking, Financial Express.
24
th
April 2014, Differentiated Bank Idea Premature: State Bank of Indias Report,
Times of India.
21
st
April 2014, India not yet ready for Differentiated Banks: State Bank of Indias
Research, Press Trust of India.
21
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April 2014, India not yet Prepared for Differentiated Banks Model, Press Trust of
India.
9
th
April 2014, Differentiated Bank Licence: Will they be Old Wine in a New Bottle?
Times of India.
5
th
April 2014, RBI Governor Pitched for Differentiated Licences, on-tap Approvals,
Economic Times.
5
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April 2014, Some Applicants can Apply for Differentiated Licences, Financial
Express.
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