The banking licences granted by India’s central bank to entities such as telcos, e-commerce companies and microfinance firms are shaking up one of the most traditional banking sectors in the Asia-Pacific region, threatening the dominance of the full-service public sector banks.

New age of Indian banking

The Indian banking sector is witnessing unprecedented reform. A sector in which paradigm shifts have historically been few and far between will now host 23 new lenders, many of which began as anything but banks. Some of these new lenders are former microfinance firms, mobile network companies, e-commerce firms and even the Indian postal service.

The entrance onto the scene of these new players has been made possible by new licences granted by India’s central bank, the Reserve Bank of India (RBI), which began issuing them in April 2014.

This initiative seeks to achieve two things: to modernise a banking sector dominated by public sector banks and weighed down by a high level of non-performing loans (NPLs) and poor capitalisation and, second, to support the government’s policy efforts to bring more Indians into the formal financial sector.

New entrants

Among the new players are Infrastructure Development Finance Company (IDFC), microfinance firm Suryoday Microfinance and mobile commerce platform Paytm. IDFC has acquired a universal banking licence, Suryoday a small finance bank licence and Paytm a payments bank licence. Investment plans for their new bank subsidiaries suggest India’s banking sector is on course for its biggest shake-up since privately owned banks made their first foray into the sector in the 1990s.

However, India’s new banks will face challenges. Some aspects of banking regulation, including know your customer processes, still need to be standardised. Passing a bill that will back India’s national biometric identification system – the Aadhaar number – with a legal framework could also help banks acquire and authenticate customers.

Public sector banks dominate India’s banking sector with a market share of 75%. But despite their historical significance and strong links to India’s economic policy, they suffer from the weakest asset quality and poorest profitability in the industry.

The RBI has tried to revive the country’s struggling banking sector before by introducing privately owned banks in two waves, in the 1990s and in the mid-2000s. But neither the introduction of new players nor attempts at bank consolidation – which remains politically sensitive in India – has fully unlocked India’s banking potential. Indeed, the government is set to infuse Rs250bn ($3.73bn) in capital annually into public sector banks in fiscal years 2016 and 2017, and Rs100bn annually in fiscal years 2018 and 2019.

Specialist providers

The RBI’s latest attempt at reviving the local banking sector was aimed at bringing in new players from outside the industry. The 23 banking licences that the RBI has granted to non-bank entities have also introduced brand new bank categories in India. The aim is to stop the over-reliance on universal banks and open the way to more specialised forms of banking. “With the broadening and deepening of [the] financial sector… [there is] a need… for banks to move from [a] situation where all banks provide all services to a situation where banks find their specific realm and mainly provide services in their chosen areas,” says an RBI discussion paper.

The RBI also hopes that these new banks, which tend to be more tech-savvy and better capitalised than conventional lenders, will quicken modernisation among existing lenders. “They are bringing fresh thinking into the banking system,” says Raghuram Rajan, the governor of the RBI.

The new licences are also aimed at supporting the government’s financial inclusion drive, such as the recently launched Pradhan Mantri Jan-Dhan Yojana (the prime minister’s People Money Scheme) whereby banks are being urged to set up zero-balance accounts for every Indian citizen. 

These efforts are starting to bear fruit. The number of unbanked individuals in India had fallen to 233 million as of October 2015, from 557 million in 2011, according to PricewaterhouseCoopers. But only a meagre 7% of household savings are in India’s banking system. A significant portion of the population remains outside the formal financial sector.

The universal banks

In a move to diversify the Indian banking sector away from the universal bank model, of the 23 new permits granted by the central bank, only two were universal banking licences. These were given to Kolkata-based microfinance organisation Bandhan Bank and privately owned infrastructure financing company IDFC in Mumbai. “We presume some of [Bandhan’s and IDFC’s] DNA will reflect in the new business they do, which will be very interesting,” says Mr Rajan.

IDFC was set up in 1997 after the liberalisation of India’s economy to fund the country’s booming infrastructure development through the private sector. But as IDFC’s balance sheet grew, finding funding opportunities became a problem, according to Rajiv Lall, the managing director and chief executive of IDFC. “It was apparent to us and to the regulator that non-deposit-funded financial platforms like us that had grown beyond a certain size relative to the overall financial system could pose a systemic financial risk in times of liquidity crisis,” he says.

But, with a banking licence, IDFC will now be able to raise funds through deposits, making its liabilities base more stable. The lender will also launch a retail business, which will diversify the business away from focusing purely on infrastructure financing.

Rural expansion

IDFC Bank’s new retail business will involve building a presence in the cities, where the bulk of India’s savings are deposited. But the bank’s key objective is to crack the rural market, which has been ignored by conventional banks, according to Mr Lall. “Most banks have been forced by the regulator to do business in rural India. It was never truly profitable for them. Only in the past six to eight years have one or two banks thought of this as a business opportunity,” he says.

Now, the cost of acquiring and authenticating customers has dropped thanks to technological advances, increased mobile connectivity and the Aadhaar number – India’s national identification system. According to the Telecom Regulatory Authority of India, mobile phone subscribers in India reached a record 1.03 billion in October 2015. “A bank of the future can use technology and authentication infrastructure to build scale in an unprecedented manner. If you can do low-cost transactions on a humongous scale, then you can crack the mass market,” says Mr Lall.

When it was set up in October 2015, IDFC Bank had 300 corporate customers. But Mr Lall aims to have retail clients in the millions, mainly from rural areas. To do so, IDFC Bank will initially collaborate with entities that originate customers and business on its behalf. “We cannot afford to have a parochial mentality. We are happy to share customers at first,” says Mr Lall. Leveraging technology will also help acquire customers. This will be easier for a new player such as IDFC Bank that does not have to upgrade a legacy platform as in the case of conventional banks, says Mr Lall.

In order to build up a presence in rural areas, IDFC Bank will minimise but not eliminate brick-and-mortar branches. “India lives in several centuries at the same time. We need to straddle those time warps in our business model. Physical branches will become more of a marketing or confidence-enhancing mechanism than a place of transacting business. The future is mobile-first,” says Mr Lall.

RBI grants new banking licences

The microfinance model

Historically, only microfinance firms or non-governmental organisations focused on servicing India’s poor rural areas. But micro-loans’ small ticket sizes and short tenors forced microfinance firms to charge very high rates to stay profitable.

IDFC Bank does not have this problem, however. Its fundamentals tower over those of many Indian banks. IDFC’s total income has grown ninefold in the past 10 years. IDFC also boasts a Tier 1 capital ratio of more than 20%. By comparison, only two Indian state banks have Tier 1 capital ratios of more than 10%. IDFC’s high capitalisation means it can go without raising capital from the market for three years despite big future investment plans. IDFC Bank has already increased staff eightfold to 2800 in the past 18 months.

If IDFC Bank reaches scale, it will be able to charge lower micro-loan interest rates. Indian microfinance firms commonly charge up to 25% to 26% interest. IDFC Bank is aiming to charge 18% to 19% rates and still produce return on assets of 2.5% to 3%. “If you can do that in a banking construct, that is a 20% to 25% return on equity business, which is much higher than many other banks,” says Mr Lall.

If IDFC Bank succeeds, it could solve the microfinance conundrum of having to charge high rates to the poorest of the poor due to limited resources and scale. IDFC Bank would become one of the first Indian banks to be a well-capitalised lender running a profitable microfinance business that can lower micro interest rates. “If as a new-age bank we don’t attempt this, then, frankly, what are we doing?” says Mr Lall.

Suryoday's transformation

In a further effort to bring more low-income individuals into the formal banking sector, the RBI has granted banking licences to 10 microfinance firms, which are now called small finance banks. “The idea is that small finance banks should lend to small entities, so [firms receiving these licences] should have a culture of lending to the small guy. Now they will also get easy access to deposits and be able to lend,” says RBI’s Mr Rajan.

Suryoday Microfinance is one of the 10 firms to have been granted a small finance bank licence. Set up in 2009, it operates in seven Indian states: Maharashtra, Tamil Nadu, Gujarat, Odisha, Madhya Pradesh, Karnataka and Rajasthan. It will take up to two years for Suryoday to fully transform into a bank.

Acquiring this new licence was a watershed moment for Suryoday. Being able to take deposits means it will have a stronger asset base. This will allow it to develop new financial products, cut lending rates, improve risk management and hire more staff, says Baskar Babu, chief executive at Suryoday. Deposits will also become a key new source of funding. “The long-term bank loans we used to get as a microfinance firm will no longer be available to us. Funding will have to come from retail deposits and savings accounts from our existing customer base,” says Mr Babu. If conventional banks offer 4% rates on a savings account, small finance banks such as Suryoday are willing to offer 8% to encourage customers to save.

Before acquiring the licence, Suryoday mainly offered loans. “We used to operate on very thin margins. We did not have the resources to do sufficient customer research,” says Mr Babu.

Microfinance customer service

Concentrating on loans also stopped Suryoday from building strong relationships with its customers – an essential aspect of microfinance, since clients are often poor and financially illiterate. “We never had true stickiness with our customers. It was only a transactional relationship and we interacted [with them] only right before the loan disbursement. Was the customer really looking forward to those interactions?” says Mr Babu.

Focusing on lending without being able to take deposits also made for an unsustainable business model, especially since for a microfinance firm, overall outstanding loans often outweigh total savings. “This is not a business thesis on which you can build a bank,” says Mr Babu.

Suryoday will start rolling out new products including deposits, term life insurance and savings accounts, which will help the unbanked build a stronger credit history and the lender become more familiar with its clients and increase fee-based income. “We might even consider offering pension fund services and mutual funds in the future,” says Mr Babu.

Having a banking licence also means Suryoday’s funding costs will drop by 200 to 300 basis points. This will in turn make it easier to cut lending rates. As a microfinance firm, Suryoday could previously offer loans at 18% or more – almost twice the base rate of 9.3% – and with three-year tenors at most. “As a bank we can probably offer about 15%,” says Mr Babu.

If fee income rises and funding costs drop, Suryoday will have bigger scope for investment. New hires are one of Mr Babu’s investment priorities, especially in the financial education department. The lender aims to have one staff member per branch teaching customers about financial literacy. “We used to have staff doing everything, including financial literacy. But that was spreading resources thin and the exercise became more of an obligation than anything else,” says Mr Babu.

A stronger asset base will also help Suryoday build its presence in Odisha and Madhya Pradesh – two of the poorest states in the country – and set up operations in the state of Chhattisgarh. The new bank will increase the number of microfinance branches and also set up about 140 new fully fledged bank branches in its first 12 months as a bank.

Mr Babu is also confident about this investment plan because of Suryoday’s capital base, which is far stronger than that of many Indian microfinance firms and conventional banks. Suryoday’s bank will start off with a 30% to 35% capital adequacy ratio, which is up to five times higher than some Indian public sector banks.

Mobile payments

The RBI’s third type of banking licence is the payments bank. In August 2015, 11 applicants including mobile networks, payments companies and India’s national postal service were given the approval to set up payments banks in 18 months’ time.

“The payments banks are intended to reach every part of the country, give people cash-in and cash-out services wherever they are, as well as bringing the mobile payment ecosystem into existence… you may have a cell phone kiosk [in remote Indian villages] but you might not have a bank branch within 10 miles,” says Mr Rajan.

Payments banks will also quicken the pace of modernisation among conventional lenders, according to Mr Rajan. “Before [issuing these licences], we tried to get [conventional] banks to co-operate with the mobile [network] companies and it simply was not happening. The moment we allowed mobile companies in [to the banking sector], suddenly a whole set of alliances formed between banks and mobile companies,” he says.

Among the payments banks is mobile commerce platform Paytm. Its range of services has grown from mobile top-ups to a mobile application, an e-commerce platform, electronic bill payments and a mobile wallet, among others, in just six years.

The company is growing fast. In the retail market, Paytm is used to cash in and cash out at convenience-type stores, where retail agents act as a human version of an ATM and facilitate transactions carried out on users’ mobile wallet app. As Paytm’s bank expands in rural areas, it will set up a network of up to 1 million retail agents who will also work in Paytm’s branches, where staff will work only with a mobile phone. Paytm founder and chief executive Vijay Sharma expects Paytm wallet users to total 500 million in 2018 from today’s 120 million.

In the commercial world, Paytm set up an e-commerce platform linking merchants directly to their clients. The firm also offers payments services for online applications and websites. Indeed, Uber launched in India with Paytm’s wallet as its only digital payments service. At the other end of the spectrum, Paytm links offline merchants to its mobile wallet app. Users can pay any merchant who has a sticker with a unique bar code by scanning it with their smartphones. Even rickshaw drivers in New Delhi are now accepting payment via Paytm’s wallet.

How Paytm works

These transactions are free of charge for both the buyer and the merchant. This is Paytm’s competitive advantage over credit card systems that are costlier to operate for the merchant, according to Mr Sharma. “Visa or MasterCard do not acquire customers directly like us. They acquire partners. The more parties involved in the network, the costlier it gets,” says Mr Sharma. “In today’s mobile world, Visa or MasterCard and the networks they have created, which are their biggest asset, are at risk.”

So, if Paytm does not charge for transactions, how does it make money? Paytm charges a 2% fee when merchants transfer money out of their Paytm wallet and into banks, and when individuals cash out from their mobile wallet. This covers the cost of the retail agent (1% per transaction) and encourages users to keep and use digital money within the Paytm network.

Encouraging transactions within the network is crucial because it generates unique customer data that can be used for credit scoring and for developing targeted financial products, says Mr Sharma. This illustrates the ability of digital companies to sell financial products through a strong understanding and connection to their customer base. “[With our data] I know that I can give you insurance for my e-commerce platform for less than a normal bank because I have such good visibility on your spending patterns,” he adds.

The lending gap

Payments bank licences, however, do not allow these banks to lend – an indication perhaps of RBI’s reformist yet paced approach. But Mr Sharma is confident the regulation will change. And when it does, Paytm Payment Bank will target customer segments so far ignored by conventional banks.

For instance, Uber currently struggles to get its drivers in India auto loans because many of them are retired army professionals who do not have a history in commercial driving. “But we are best placed to give them loans since we are already integrated in the Uber payments system. We have a perfect loan business model,” says Mr Sharma.

However, some analysts feel that without the ability to lend, payments banks are doomed to lose money. Significantly, payments banks have to invest 75% of their demand deposits in government bonds or treasury bills with tenors of up to one year, which tend to be low-yielding. “Payments banks will take time to achieve profitability given their small spreads and scale,” according to Standard & Poor’s.

Paytm Payment Bank’s investment returns will indeed be about 4% short of what conventional banks make through lending. But the cost of acquiring a new customer for Paytm is nearly zero and the new bank will not compete for clients with conventional banks, says Mr Sharma. “We can do away with this 4% gap,” he adds.

“Comparing the cost and revenue structure of a payments bank to a conventional bank does not make sense. What [conventional] banks are missing is revenue from the payments business. But we have a $3bn transaction business that makes a profit. Banks think money can be made only through lending,” says Narendra Yadav, deputy general manager at Paytm.

Symbolically, Paytm Payment Bank will launch in Meerut, a city in the state of Uttar Pradesh, where the freedom movement against British colonial rule originated and where poverty levels are high. “This will signify freedom from poverty and freedom from the financial inclusion gap,” says Mr Sharma.

Structural challenges

While the new banking licences granted by the RBI will change a banking sector that has gone without new entrants for decades at a time, there still are structural issues that could slow the rise of these new lenders.

According to S&P, it will take at least two to three years for small finance banks and payments banks to build market share. So far, private banks set up in the 1990s and 2000s still only have 25% market share, with public sector banks taking the balance.

Other market participants remain frustrated by how political calculations are limiting the role of the Aadhaar number in increasing financial inclusion. In February, the government introduced a bill to give Aadhaar statutory status as the means to disburse government subsidies to low-income individuals. But India’s Supreme Court is still stopping Aadhaar numbers from being used as proof of identity by banks, the stock markets and phone companies. India’s opposition – including the same party that launched the Aadhaar system in the first place, the centre-left United Progressive Alliance (UPA) – is against the idea on the basis of security and privacy concerns. The Aadhaar number is still not mandatory nationwide. “This is a perfect case of crazy politics,” says one market participant.

If these legal reforms materialise, the Aadhaar number could simplify and standardise banks’ know your customer procedures. “Insurance claims still get stuck if someone has changed their name in one document and not in another set of documents. It is a big bureaucratic hurdle,” says Suryoday’s Mr Babu.

Although India’s new banks will not eradicate state lenders’ high NPLs and poor capitalisation overnight and although structural hurdles still burden lenders, RBI’s new licences are one of the boldest banking sector reforms India has seen in a generation. They are setting the foundations for brand new types of banks to shake one of Asia’s most stagnant and traditional banking sectors to its core. Bankers in New Delhi and Mumbai go as far as terming this moment “the new age of Indian banking”.


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