Policy Talk | Growth of Payment industry is a risk : Nachiket Mor

After six years, last week, the RBI gave out a new banking license to the acquirers of a distressed cooperative bank. Banking remains one of the few sectors of the Indian economy where license raj is well and truly alive. The claim, a well-justified one, is that licensing controls the risk of systemic failure, but it has resulted in an environment where several sectors are credit-starved; the credit to GDP ratio at 50% is among the lowest and across-the-board cost of capital is among the highest among the world’s major economies. In an increasingly growth-challenged economic scenario brought into sharp focus by Covid-19, reforms in bank licensing assume critical significance.

Today in Policy Talk, K Yatish Rajawat, CEO CIPP, speaks to Nachiket Mor, an important voice on this issue. Mr Mor’s various simultaneous interests include banking, technology and non-profits. In this discussion, he weighs in as the banker who headed the committee that recommended licenses for differentiated banking and small finance banks.  

Question:  I would like to welcome all of you for an interesting discussion with Nachiket Mor who has been a banker, non-profit head, and now a researcher. You rarely get that combination of working in the non-profit sector and the profit sector. Mr Mor has, among his many professional achievements, been a director at ICICI and headed the ICICI Foundation. Welcome to Policy Talks, Mr. Mor.

 Nachiket Mor: Thank you, I am pleased to be here.​

 Question: Mr Mor, ever since the RBI appointed the new committee under the chairmanship of Shyamala Gopinath for new bank licenses, there is a renewed debate on differentiated banking licenses. In today’s context when we still haven’t been able to meet our priority sector lending targets or even properly provide credit to several sectors, what do you think is the role for differentiated banking licenses?

Nachiket Mor: I do not work in banking and finance anymore, so my information would be somewhat dated, and I may not be as fully informed as you would like, but the problem you outlined, particularly as we look ahead to pandemic recovery, credit is an important part of the recovery fuel, people’s access to financial resources, their savings, money transfer, and so on. Credit has become an important part of the government’s response. The problematic areas are that, the sectors and regions are starved of credit. I believe sectors are a subset of the region. Depending on the competitive capability of a region, the region must decide where credit should go, but the region must get access to credit. Unfortunately, the overall Indian banking system is underpowered relative to this need. India’s credit-to-GDP ratio should be 200-220% for a rapidly growing economy. In many regions, many states, that number is low-- 20%-25%. 

Question: What is the best way to bridge this gap? What can the regular banks do? Is there a role a differentiated approach could help us provide? 

Nachiket Mor: The idea of differentiation is not necessarily new to India. We have always had cooperative banks, regional rural banks; the RBI had experimented with a local area bank earlier. The committee that I happened to chair explored not so much differentiation per se, but differentiation along different lines. A lot of the earlier differentiation was around size, around ownership, around focus of business, but you did not see differentiation around dimensions. 

Question: Differentiation along what lines? As of now, the debate seems to start and end with ownership. 

Nachiket Mor: I know that there is a lot of debate on the corporate ownership of banks--  should they be allowed, should they not be allowed. There's a clear temptation to bring them in, because they bring a lot of beneficial capability and deep presence on the ground.  If I look at a fertilizer company, a mobile phone company, or a pharmacy chain, they bring such presence. And they also bring a fixed cost base, the sunk cost that has already been paid for by their other existing businesses.

Question: Domain expertise also. 

Nachiket Mor: They bring an understanding of what we call the “real” sector. But the challenge of course with corporate ownership is this whole issue of self interest. There is a concern that when a crisis hits, corporate-owned financial institutions tend to lend money at preferential terms to other parts of the businesses they own. In particular, to protect retail depositor, as the wholesale depositor is a smarter, more intelligent depositor and can  handle the risks.

An example of differentiated thinking is the way many African countries had taken a lead in payments and wallets a decade back. They had become very large. There was a concern that they would threaten systemic stability, that if you started to build non-bank players that were very large, and they were connected to small banks on the ground, you would increase the risk. Hence, it was better to bring them into the system.

Question: But now that environment has changed substantially. We’ve seen the fact that payment itself has become a very large segment; transactions particularly have moved away from banks, payment banks have of course collapsed but digital wallets have become large, have raised billions of dollars in risk capital, and are doing IPOs. The regulator does not want to take any risk and wants its players also to take zero risks. Now, that we have reached a stage of at least some maturity in our regulatory environment, should we start thinking differently in terms of banking and deposits and the risk that institutions or banks should be able to carry?

Nachiket Mor: You are quite right--things have changed. Certainly, as an outsider now, I would be very concerned about the growth of the payment industry, without the banking regulation being applied to them. In fact that is the very issue we were trying to protect against. A large wallet emerging which does not have a capital requirement, doesn’t have a reserve requirement, is now depositing money with a subsidiary small bank. This is exactly what we were concerned about for Africa, some years back. What if some of these players fail? The shock through the system could be enormous. For a variety of reasons--I do not know the details of it. When you say lighter regulation, somehow the word ‘bank’ seems a heavy word. What we had tried in the committee was to lighten the word itself. What does lighter regulation mean? Should I not conduct regulation? Should I not have capital requirements? Should I not have some reserve understanding? Well, if all it means is that we call it a bank, then why not call it a bank? Why not pretend it’s not a bank when it is performing those exact functions. As you correctly pointed out things have changed and I don’t know the details of that line of thinking, but as an outsider I would certainly be concerned about it. Allow corporate entry in an unfettered way into that segment: Why not a Hindustan Lever, why not a Big Bazaar, these are entities that deal with cash, deal with customers, so long as they cannot lend money?

Question: And they don’t take deposits?

Nachiket Mor: No, deposits they can still take. At the end of the day, a deposit is value transferred, for consumption later, and value withdrawn. That’s a deposit. That’s a wallet. Just because we called it a wallet, doesn’t mean it didn’t become a deposit. It’s a matter of how you want to think of systemic regulation independent of words.What are the underlying principles you’re trying to work with? 

It is the notion of banks and ‘non-banks’. Unfortunately, these non-banks are referred to as ‘shadow banks’ but actually, the shadow banks are used more like insurance companies and mutual funds because they’re actually performing the deposit taking function. In shadow banking, it means you perform a bank-like function which in India is defined as deposit taking.  That’s what the act says. We have chosen, for a variety of reasons, to think in the banking frame and try to get everybody, either as a bank or in some ways, to gradually wither away. Now the point you make is that if I have got a deposit taking institution, do I really want to build a high risk business from it? If a bank is not lending to a remote area in the northeast, well, it is performing the function it was designed to perform which is to make sure the safety of deposits. Banks have a very high leverage rate. If I look into the debt equity ratio of a bank, it can be as high as 1:20.

So such a high leverage, from finance 101, cannot have a lot of revenue volatility because then, it immediately translates into default. So now the question is: Are we inadvertently creating safer non-banks and riskier banks, by putting massive capital regulations on the non-banks finance companies, that we define “systemically important?”

We have a huge threshold for what is systemically important for a bank. I am certainly concerned, that this is driven more by competitive concerns than by prudential concerns and the desire to make the non-banks less competitive relative to banks. 

The non-bank is not a bank-like entity, it’s a corporate-like entity. It does not actually need to be regulated except as you would regulate a corporate. And a bank, as a lender, is de facto an internal regulator of corporate sector. In the remoter parts of the country, in the high risk business of the country, to encourage the non-banks to go out there. If they fail, they fail. You know obviously you cannot allow them to get Rs 50,000 crore or Rs 100,000 crore. There is clearly another problem that we have, we have very large non-banks which are systemically truly important--more than 100,000 crore that are now being gradually nudged into banking.

Question: They are being nudged into banking. The fear of corporate ownership is still true in the current neo-liberal paradigm.

Nachiket Mor: It’s a real threat. We have seen worldwide this is a problem. But at that point, we had felt that the wholesale bank model route-offered a nice route for many of these entities:to come into the banking fold yet without retail deposit taking and taking large deposits. In fact, India is one of the few regulatory environments that is not doing this. If you open a bank in the USA, you’re not allowed to take retail deposits until you are able to convince the regulator that you know about banking.

Ensure that a corporate entity that is running a non-bank finance company is not doing retail deposit taking. If they are, give them a banking license but only to take wholesale deposits now. You can only borrow from other banks. That allows you to bring these larger systemically important institutions into the regulatory fold, allows you to take away the concerns about corporate ownership because now there are no retail deposits. We made a distinction between wholesale investment banks and wholesale consumer banks. A Bajaj Finance, for example, will become a wholesale consumer bank. A JP Morgan would become a wholesale investment bank because it could not only borrow only wholesale but it would do only investment banking type assistance. So, it is a relatively easy matter for a payment bank to be told that if you want to lend money, fine.  They don’t need any other process because licensed you at the bank. It’s a simple letter to move forward and backward. It seems to us a consistent, single strategy dealing with multiple sectors.

Question: This pancaking issue or this conversion of a non-bank into a bank and the subsequent securing of deposits has a larger systemic impact, in terms of the cost of lending or the cost at which an NBFC or an SFB can lend. This, in the long term, also impacts the competitiveness of certain sectors. Now when you look at the cost of credit and competitiveness of a country, where do you see these balances, “relaxations” happening in our “over-regulated” banking environment?

Nachiket Mor: If you look at the risk-free interest rate, it has actually been trending downwards, it’s not necessarily as high as one would imagine it to be. The issue is that the risk-free rate might be low but what about the rate at which an entity can get money? We need to think, can they get money? So there’s an accessibility issue that arises. 

According to a paper my colleague and 1 had written in 2004, there is a policy-induced uncertainty that thus produces credit risk volatility that has to be priced in by any lender. There’s no way we can move aside from pancaking and all these issues.

 Let’s look at these infrastructural finance, for example. Why are the interest rates so high for long-term infrastructure projects, even when the risk has been taken care of? Because there’s a great deal of policy-induced uncertainty related to the associated capital.

 Question: How does it come together? For instance, can you have domain specialization in segments like logistics, MSME or even agriculture? Do you think that we need domain specialist banks in these segments? Nobody is actually able to lend to a farmer. NABARD, for example, says that it lends to the farmers but, actually, it lends to state governments, who in turn, say that they are lending to infrastructure, which is going to be used for farmers. There are MFIs that have understood the risks or the credit business of farmers. Therefore, domain expertise is really very important if you want to reach out to the unbanked, whether they are in the MSME sector, logistics sector, custodian segment or in the agricultural sector. What can be done there to make it happen?

 Nachiket Mor: Again, we go back to the differentiated issue. Why do we not want the non-banks to have domain capability? They already have it and it’s not just domain, so why do we need to attach the word ‘bank’ to it? Entities already exist there; we need to look at why they are not more competitive. They are not more competitive because you don’t want them to be competitive, you want them to either disappear or convert to a bank.

 Question: Is that because of the fact that RBI doesn’t want people who are not regulated by it to be managed by them?

 Nachiket Mor: They are regulated. At the end of the day, will I say that since corporates are using money, RBI should regulate them. It does regulate them, via the bank. Why not the same approach here?

 What is the intent of regulation? Good behavior. They are systemically not important. Why would you not allow an entity with Rs 300, Rs 500 or even RS 1000 crore in the balance sheet to go out there and use their domain capability? What if they fail tomorrow, or if there’s a large risk that they fail? Well, if the bank that lent to them had built a portfolio that could absorb that failure, the other fellows will come.

 Question: Should they then be allowed to take deposits to reduce their cost of capital?

 Nachiket Mor: No, see the cost of capital is rising because of pancaking. Otherwise, why would somebody require it? If I borrow money from a large bank, which has the cost of money at 3%, what they will lend to me is decided by the regulation on how much capital everybody needs to keep.

 Question:  So a kind of differential model for non-banks who are borrowing from the banks?

 Nachiket Mor: No, treat the non-banks as corporates and not as bank-like entities. They’re not bank-like entities. Let the banks worry about it. If they cross a certain size, say Rs 50,000 crores, then nudge them towards a banking license.

 Many of them are owned by corporates; many differentiated choices can be used to accommodate corporate ownership, without losing domain capability. But do not allow them to continue as non-banks beyond Rs 50,000 crore, else they can become systematically problematic. Here, Rs 50,000 crore is a number that has been randomly taken to signify a very large number. In general, that is comparable to what you would associate with a bank. The bank number should be lower and the NBFC number should be higher as the banks take deposits and you’d worry a lot more about it. 

 Currently, it’s completely the opposite. The bank is systemically important at a very high ceiling and the NBFC is systemically important at a tiny number. As I said earlier, I think this is dictated by competitive concerns and not prudential norms. The worry is that NBFC is more nimble at a much higher cost of money. It is still able to compete with the bank. Why not bring them into a certain fold once they cross a certain threshold, but below that, remove capital regulation.  

 Question: It is desirable, but is it also cyclical?

 Nachiket Mor: It could be cyclical. You then have to have a bank that is able to understand the risks. You can’t tell me that a bank understands steel risks but doesn’t understand the risk of an NBFC because an NBFC is similar in terms of skill sets to what a bank itself does. If anything, banks are very competent to be internal regulators of NBFCs and much less competent to be internal regulators of infrastructural projects.

 Question: So, to sum it up, the aspect of treating non-banks as corporates and allowing them to lend as a corporate instead of burdening the banks with so many requirements that the cost of capital to them automatically becomes too high.

 Nachiket Mor: Yes, the banks and the NBFCs. The NBFCs are required to keep even more capital as compared to the banks.

 Question: So, essentially, it means to free them up. Where do you see this freedom coming from? 

Nachiket Mor: Any decision making of such an important nature would need consensus between the Ministry of Finance, Reserve Bank, Reserve Bank Board, Reserve Bank staff. Consensus is important in this. Banking is not a business where you turn on a tap and do things. You have to go carefully. I don’t know what happened but it’s possible that consensus was not reached and there was some issue. On the other hand, on allowing a lot of  wallet-type players to emerge without capital controls, maybe there was consensus.

 Question: You made that point earlier that having such a large wallet, the transaction industry which is unregulated essentially, is a systematic risk.

 Nachiket Mor: The idea of the payment banking was designed, not as a separate idea, but actually to take the same wallet and give it a slightly better, systemically-consistent regulatory structure. In my understanding, it was not intended to be a new entity. It’s the same wallet, with better regulation, called a payment bank.