Need for differentiated regulation for differentiated banks

Biswamohan MahapatraThe RBI in its discussion paper Banking Structure in India – The Way Forward, articulated the need for niche banking in India. Differentiated licensing could be a desirable step in this direction particularly for infrastructure financing, wholesale banking and retail banking. Estimates indicate that close to 90% of small businesses have no links with formal financial institutions and 60% of rural and urban population do not even have a functional bank account.The ostensible objective of allowing differentiated banks is to further enhance financial inclusion. These banks will be set up by small players to develop banking habits and to meet customer credit needs in the unbanked and under-banked regions. These banks must be clear about the regulatory requirements from the beginning in a way that is implementable by them, and not burdened with regulatory overdose. The overarching objectives of a regulatory regime are to ensure : (i) the bank’s risk is contained to the acceptable level, the so called prudential regulation; and (ii) the consumers of the bank’s services are not exposed unfair treatment by the banks, or the so called business conduct regulation.Even though RBI’s guidelines have addressed many of the differential regulatory aspects for differentiated banks, there are still several issues for which a conducive regulatory regime is required to nurture their growth. Some of the issues are discussed below:• Promoter’s ownershipThe RBI’s stated policy stance is that ownership in banks should be diversified. The maximum holding by the promoter, which was at 40% of the paid up capital in the 2001 bank licensing guidelines, was modified to 10% in RBI’s ownership and governance guidelines issued in February 2005. The RBI further modified its stance in its February 2013 guidelines for licensing of new banks in the private sector, raising the maximum shareholding by the promoter Non-Operating Financial Holding Company (NOFHC) in the bank to 15%. While articulating its preference for diversified shareholding in the guidelines for licensing small finance banks, the RBI has prescribed the maximum promoter shareholding at 26%. The RBI may take a comprehensive view, particularly in the light of the last amendments to the Banking Regulation Act, 1949 in December 2012, which enables it to raise the maximum voting rights of any shareholder in a private sector bank in phases to 26% from the current 10%.• GovernanceThe guidelines for licensing of small finance banks and payments banks do not cover the governance aspects in increased detail, except stating that the boards of the banks should have majority independent directors and the banks should comply with corporate governance guidelines including the “fit and proper” criteria for Directors. However, the RBI has been linking ownership with governance of banks. Given that the ownership pattern of these differentiated banks will be different from the universal banks, it is not clear whether RBI will insist on a new set of governance rules for these banks.• Pricing of servicesCurrently, keeping in trend with its liberalization stance, the RBI generally follows a benign attitude to pricing of products and services by scheduled commercial banks. In some areas, there could be potential conflict of perception between the RBI and these differentiated banks. One such area is interest rates on the loans and advances extended by small finance banks. Some NBFCs and /or MFIs may get the license to convert into small finance banks. Since their cost of funds will continue to remain high in the initial years of their operation as banks, and the cost of servicing small accounts are high, they will charge relatively high interest rates on their loans and advances. The RBI should not indulge in a knee-jerk reaction — with more low-cost deposits flowing into small finance banks, their cost of lending is expected to come down.Since payments banks will mostly depend on low-value, high-volume transactions, their service charges for remittances may be higher than those prescribed by the RBI. Till volumes pick up, payments banks’ service charges may look high. It may be desirable that the RBI not insist on the scale of service charges prescribed for scheduled commercial banks for payments banks.• Know Your Customer (KYC) regulations It is universally acknowledged that a very stringent KYC regulation has kept a majority of the population away from the formal banking system. While of late, the RBI has simplified the KYC regulations to a large extent, more is required to be done. With penetration of Aadhaar and on-line verification thereof, the KYC verification issue looks to be manageable. If telecommunication companies succeed in getting licenses to set up payments banks, they would have done the KYC requirements for their existing customers. However, the RBI’s insistence that a bank has to do its own KYC may lead to a lot of duplication of work and increased paper work for such payments banks. Mobile telephone has penetrated the country. The RBI may study the KYC drill currently undertaken by telecommunication companies and if found satisfactory, may not insist on another round of KYC for mobile phone holders who become the banks’ customers.Since KYC Rules are framed by the Government of India, the RBI needs to take up the matter with them before these banks become operational.• Branch bankingDifferentiated banks are supposed to be low-cost structures generally serving the bottom strata of the society. They are also required to make high use of technology for reducing transaction costs and bringing efficiency. They will be making extensive use of the services of business correspondents and other outlets such as ATMs, etc. The RBI recognizes these alternative forms of presence by payments banks in reckoning their requirement to have 25% of outlets in unbanked rural centres. However, in respect of small finance banks, similar dispensation has not been considered. Therefore, it is suggested that the RBI need not insist upon the condition that at least 25% of the branches opened should be in unbanked rural centres (population up to 9,999 according to the latest census); so long as the bank has other alternative delivery channels to meet the requirement.• Business conductIt is expected that a new class of entrepreneurs with expertise in diverse businesses will enter the field of banking and set up small finance banks and payments banks. They will bring new business practices from their experience in their respective fields. Some of these practices may be good for banking and customer service, but the fiduciary trust on which banks thrive needs to be maintained. The RBI should be watchful of the developments and act in a timely manner to encourage desirable practices and scuttle undesirable practices.The RBI’s regulatory regime should be more transparent and compliance requirements should be less cumbersome for the new generation of differentiated banks at least in their initial years so that the compliance cost for these banks will be low and they will be able to operate on a lean cost structure while concentrating on their core activities. They should be encouraged to experiment with innovative solutions to achieve the objectives for which these banks are being set up. Differentiated banks are required to maintain higher capitalization levels as compared with scheduled commercial banks. The RBI could consider that the stipulated capital requirements be gradually increased to the current prudential levels, so that the differentiated banks have more leeway in their initial years to manage their funds and improve their profitability. In due course, the RBI may review their working and its regulations.The RBI has been tightening its regulatory framework even for NBFCs. Taking a cue from the RBI’s revised regulatory framework for NBFCs in November 2014, the central bank is likely to expect the highest standards of corporate governance from differentiated banks. Increased regulatory compliance could be prescribed for differentiated banks and small finance banks with a size beyond a particular threshold, as they become systematically important to the financial system. It may be desirable for the RBI to come out with detailed operative instructions for differentiated banks so that the applicants are in a better position to plan their way forward.The differentiated banks should also prepare themselves to meet regulatory requirements. The stipulation that the banks should be set up by entities “owned and controlled” by residents has created difficulties for some applicants, particularly MFIs, PPI issuers and telecommunication companies. These applicants, if successful, will have to fulfil the requirement within eighteen months from the date of in-principle approval. The differentiated banks are expected to be high-tech organizations. They have to strike a balance between use of technology to reduce costs and the level of confidence and trust the typical unserved and under-served customers, who are usually illiterate, will have in the bank in the initial years of operations.Author is an independent consultant and former executive director of RBI