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Differentiated Banks: Design Challenges (Sri V Narayanan Memorial Lecture” delivered by Shri R. Gandhi, Deputy Governor at Sastra University, Campus Kumbakonam on April 18, 2015)

Dated:- 20-4-2015 - In a dynamic growth-oriented economy, the financial sector needs to keep pace with the demands of the real sector. It is crucial that the financial system is flexible and competitive to cope with multiple objectives and demands made on it by various constituents of the economy. The financial sector comes of age when it has diverse institutions, catering to different segments, ranging from retail to wholesale, micro-finance to project finance, nurturing specific sectors and of .....

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rve Bank has completely liberalised and has put it at the banks end the decision about their geographical expansion and coverage; banks are effectively free to decide how many branches and other channel outlets they should open, when and where these touch points should be located, etc. Consequently, as on 31st March 2014, there were 1,16,415 branches of scheduled commercial banks, 19,082 branches of the RRBs, and 9,526 branches of UCBs. As on 31st March 2013, there were also 93,488 PACS in the c .....

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0 per cent of the adults have formal bank accounts. Reserve Bank is aware of this aspect and is committed to financial inclusion and is exploring various possibilities to foster inclusion of the unserved and under-served population and areas and facilitate provision of affordable financial services by increasing competition among the banks and encourage innovative approaches (including channels, products, interface, etc.). 5. The Government of India and the Reserve Bank are clear that financial .....

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t is, branches, BCs or other modes such as ATMs and satellite branches, etc. All these unbanked villages have been covered by opening banking outlets comprising 2,493 branches, 69,589 BCs and 2,332 through other modes. 6. In Phase II, under the roadmap for provision of banking outlets in unbanked villages with population less than 2,000, about 4,90,000 unbanked villages have been identified and allotted to banks for coverage in a time bound manner by March 31, 2016. As per the progress reports r .....

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IPs was implemented over 2010-13. The Reserve Bank has used FIPs to gauge the performance of banks under their FI initiatives. With the completion of the first phase, a large banking network has been created and a large number of bank accounts have also been opened. However, it has been observed that the accounts opened and the banking infrastructure created has not seen substantial operations in terms of transactions. In order to continue with the process of ensuring meaningful access to bankin .....

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up to March 31, 2014 is: The number of banking outlets has gone up to nearly 3,84,000. Out of these, 1,15,350 banking outlets were opened during 2013-14. Nearly 5,300 rural branches were opened during 2013-14. Out of these, nearly 4,600 branches were opened in unbanked rural centres (Tier V and Tier VI centres). Nearly 33,500 BC outlets were opened in urban locations during 2013-14 taking the total number of BC outlets in urban locations to 60,730 as at the end of March 2014. More than 60 m .....

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o 250 million transactions during 2012-13. 8. As you all know, greater impetus to the Financial Inclusion plans has since been received through the Prime Minister s Jan Dhan Yojana. Under this programme, in a short span of seven and a half months, a world record breaking achievement in the form of opening JDY Accounts for 14.71 crore persons as at end March 2015 has been accomplished. Need for more Banks & Differentiated Banks 9. While thus the Financial Inclusion efforts through the existin .....

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d from large-bank-led, public-sector-dominated, mandate-ridden, branch-expansion-focussed strategy. It said the poor need efficiency, innovation, and value for money which can come from motivated financiers who have low cost structure and thus see poor as profitable, but who also have the capacity to make decisions quickly, and with minimum paperwork. It therefore recommended that entry to private, well-governed, deposit-taking small finance banks be allowed. 10. The available options for the Re .....

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mber 2013, we came out with our policy for allowing the foreign banks through Wholly Owned Subsidiary (WOS) model. The scheme is yet to take off, though two foreign banks have since approached us formally in this regard. 11. The licensing policy for the private sector banks has been to grant universal bank licences as a stop and go licensing system. In the above background, in 2010, Reserve Bank brought out a Discussion Paper for licensing of new banks in the private sector, which was followed b .....

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the time was not yet opportune for such banks. Thereafter, the concept was once again discussed in a Paper Banking Structure in India - The Way Forward , brought out by the Reserve Bank in August 2013. The Paper looked into various aspects of the banking structure, licensing of banks, banking models and suggested a transition path for some banks. 13. Another initiative taken by the Reserve Bank was setting up of a Committee headed by Shri Nachiket Mor, on Comprehensive Financial Services for Sma .....

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ts, and credit but is differentiated primarily on the dimension of size or geography or sectoral focus. In a VDBS design, the full-service bank is replaced by banks that specialise in one or more of the building blocks of payments, deposits, and credit. Among others, the Committee suggested licensing of Payments Bank and wholesale banks as differentiated banks. 15. The Nachiket Mor committee opined that in the Indian context it would be important to have the regulatory flexibility to approach pa .....

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segment. The differentiation could be on account of capital requirement, scope of activities or area of operations. As such, they offer a limited range of services / products or function under a different regulatory dispensation. The concept is not entirely new. In fact, and in a sense, the UCBs, the PACS, the RRBs and LABs could be considered as differentiated banks as they operate in localized areas. 17. Some countries, for example, USA, Australia, Singapore, Hong Kong, Brazil, and Indonesia, .....

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gnificant macro-economic growth potential could be utilized by niche banking by facilitating specialization thereby enhancing optimal use of resources. Each of the niches has the potential to be individually large to sustain significant balance sheets and specialized entities can play a major role in all of them. Currently, while the banking sector is evolving depending on the needs of the economy, it is felt that given a choice, some banks and non-bank financial companies may choose to operate .....

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e banking and financial landscape reflecting significant macro-economic growth potential in India and differentiated licensing could enable unlocking potential of these opportunities as it encourages niche banking by facilitating specialisation thereby reducing potential non-optimal use of resources. Very large ticket, long term infrastructure lending requires risk management expertise that goes beyond traditional credit appraisals at banks. There is significant space for specialized entities i .....

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licenses are issued. Risk management systems and structure for regulatory compliance could be customized according to the banking type. Customized application of supervisory resources according to the banking type could result in greater optimization of such scarce resources. Core competency could be better harnessed leading to enhanced productivity in terms of reduced intermediation cost, better price discovery and improved allocative efficiency. The Policy on Differentiated Banks 20. After .....

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d in November 2014. Objectives 21. The objectives of licensing small finance banks are furthering financial inclusion by (a) provision of savings vehicles, and (b) supply of credit to small business units; small and marginal farmers; micro and small industries; and other unorganised sector entities, through high technology-low cost operations. We hope to achieve the stated objectives by stipulating target segments where the credit should be directed and by indicating the ticket size of the advan .....

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be deployed. Promoters 23. The Small Finance Banks can be promoted by individuals who have at least 10 years of experience / expertise in financial or banking field or by private sector companies or societies with good track record. Existing MFIs, NBFCs or LABs can opt for conversion. The promoters will have to be resident Indians or owned and controlled by resident Indians. They will have to conform to stringent fit and proper criteria. The promoter's minimum initial contribution to the pa .....

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s will have to be resident Indians or owned and controlled by resident Indians. They will have to conform to stringent fit and proper criteria. There can be strategic partnership with other banks. The promoters can retain 100% ownership. Responsibilities and permissible activities 25. The Small Finance Banks will be small sized universal banks. They have to finance priority sector to the extent of 75% of their NDTL; while 40% should be as per standard priority sector norms, the other 35% can be .....

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Both the Small Finance Banks and the Payments Banks can operate all over India. Challenges of designing the differentiated banking structure 28. Given our objective of furthering financial inclusion, it was relatively easy to determine what type of differentiated banks that can subserve this objective. It was amply clear that the Small Finance Banks and Payments Banks are such entities. However, designing their structures was not that easy. We encountered several competing options, dilemmas and .....

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ich is a potential source of risk and vulnerability. Therefore, we decided that at least to begin with, the niche-banking should not be exposed to such liquidity risk. That is why we decided to design Small Finance Bank and Payments Bank which will not have such liquidity risk. 30. While encouraging the presence of different kinds of banks, the regulator has to ensure that risk management is robust as niche banks are susceptible to risks such as concentration risk which needs to be mitigated thr .....

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or the Small Finance Banks. Likewise, these risk management considerations determined in prescribing that Payments Banks cannot extend loans and advances and not less than 75% of their assets to be in Government securities only. Managing public perception 31. Another challenge is to build trust in the minds of depositors and public in general. Considering that in India we have been only licensing universal banks which engage in all types of financial activities, it may be a challenge to manage t .....

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tor banks and RRBs), which are established under specific enactments. Every bank in India, i.e., domestic and foreign, apart from banking business, can carry out all the activities permitted under Section 6 of the Banking Regulation Act. However, the Act also provides for Reserve Bank specifying the terms and conditions and other requirements, along with the licences. We have to employ these provisions for licensing of differentiated banks. Viability of the models 33. Concentration risk: The dif .....

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function by engaging in cross-subsidizing loss making business in one segment with earnings from another which will not be possible for specialized banks thereby, impacting their revenues. The localized operations or restriction on the banks to engage in a particular activity could lead to non-availability of cross-subsidization impacting the viability of such models. 36. Avenues for income generation: Providing avenues for income generation for the differentiated banks is a challenge. To begin .....

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venue. Ownership of differentiated banks and corporate governance issues 38. The question of what kind of promoters should be allowed access to banking system is also relevant in the context of the high standards of corporate governance needed for the banking industry. There are existing non-bank financial sector entities, micro finance entities, Local Area Banks and Urban Cooperative Banks who would like to convert themselves into Small Finance Banks; telecom companies who would like to set up .....

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except that of UCBs. UCBs we are awaiting enabling statutory amendments. As regards individuals, we prescribed 10 years of experience in banking and finance as a precondition. In the case of real sector companies and societies, we prescribed track record of five years. 40. Since there are separate guidelines for foreign ownership of banks, we prescribed that the promoters of these Small Finance Banks and Payments Banks will have to be resident individuals or resident owned and controlled entiti .....

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of over a period of 12 years. Since in the Payments Banks case there is no conflict of interest as they are prohibited from lending activities, there are no such limitations on higher promoter s holdings. Challenges to regulation and supervision 42. Providing a level playing field in development obligations: Introducing differentiated banks would take away the level playing field which is now available to all banks uniformly where the banks are required to contribute to the priority sector oblig .....

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nks, as they will not have lending activities, we have ensured their participation in development by prescribing 75% investment in Government securities. Elimination of regulatory arbitrage 44. As universal banks are permitted to do all or any of the activities mentioned in Section 6 of Banking Regulation Act, 1949, regulating the universal banks is easier for the regulator as the regulations could be principle based and common to these banks. However, once the differentiated banks are licenced, .....

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