Let’s stop kicking the can down the road: Highlighting important and unaddressed gaps in microcredit regulations
By Deepti George, IFMR Finance Foundation
The Reserve Bank of India has published on its website, a discussion paper on Banking Structure in India – The Way Forward which covers the following aspects:
- Consolidation of large-sized banks with a view to having a few global banks
- Desirability and practicality of having small and localised banks as preferred vehicles for financial inclusion
- The need for having investment and other specialised banks through ‘differentiated licensing’ regime for domestic and foreign banks instead of granting of universal banking license
- Policy regarding presence of foreign banks in India
- Feasibility of conversion of urban cooperative banks into commercial banks
- Periodicity of licensing the new banks – ‘ad hoc issue’ or ‘continuous licensing’
In this post, we refer specifically to the paper’s coverage of ‘small and localised banks’. The feasibility of such a proposition is looked at by pointing to learnings from US’s experience with small community banks.
In the US, there are about 7,000 small community banks with asset size ranging from less than US $10 million to US $10 billion or more. They account for about 46 per cent of all small loans to businesses and farms and in terms of the number, they constitute about 92 per cent of the all the FDIC insured institutions.
Notwithstanding India’s past attempt with Local Area Banks and Urban Cooperative Banks, it refers to similar recommendations of the Committee on Financial Inclusion (Rangarajan Committee, 2008) as well as the Committee on Financial Sector Reforms (Raghuram Rajan Committee, 2009), and puts forward the idea that such small localised banks have a pivotal role to play in financial inclusion and that this must be revisited as an important policy imperative. While specific questions need to be tackled, such as the nature of capital requirements and exposure norms and supervisory framework for such banks, the paper ends on a high note that in a deregulated interest rate regime and with technological advancements it is indeed possible today to make such banks viable from a cost perspective. This indicates a distinct shift in RBI’s previous stance on the subject (which we had analysed in a previous post).
We reflect on the recommendation of the Raghuram Rajan Committee report in this regard. The Committee recommends to:
Allow more entry to private well-governed deposit-taking small finance banks offsetting their higher risk from being geographically focused by requiring higher capital adequacy norms, a strict prohibition on related party transactions, and lower allowable concentration norms (loans as a share of capital that can be made to one party).
The small finance bank proposed emulates the Local Area Bank initiative by the RBI that was prematurely terminated, though the details of the Committee’s proposal differs somewhat. The intent is to bring local knowledge to bear on the products that are needed locally, and to have the locus of decision making close to the banker who is in touch with the client, so that decisions can be taken immediately. It would also offer an entry point into the banking system, which some entities can use to eventually grow into large banks.
With regard to the operational challenges with small banks, the Committee says,
This Committee recognizes that small banks have not distinguished themselves in India in the past, often because of poor governance structures, excessive government and political support as well as interference, and an unwillingness/inability of the regulator to undertake prompt corrective action. These are not the banks the Committee wants, and the Committee would call for substantial care in who is licensed, as well as greater regulatory oversight.
There is, however, no necessary link between size and honesty, as the recent experience with large banks suggests. Indeed, the larger number of potential applicants for small banks suggests the regulator can be far more selective in applying ‘fit and proper’ criteria. Moreover, technological solutions can bring down the costs of small banks substantially, even while increasing their transparency. Finally, the failure of even a few small banks will not have systemic consequences, unlike the failure of a single large bank. In sum, the Committee believes there has been sufficient change in the environment to warrant experimentation with licensing small banks.
We are in broad support of this proposed direction. For a country like India, large and diverse, there is a need for multiple approaches to financial inclusion and the localised financial institution is clearly one feasible approach. In addition, several game-changing trends such as the digitisation of cash, the roll-out of the Unique ID (Aadhaar) project and the blurring of lines between banking, insurance and capital market institutions, all make local institutions that much more feasible today.
We believe that high quality originators need to be local financial institutions characterised by the following:
- A branch based network that penetrates deep into the local geography so that every last individual and household can have access to financial services, and is staffed by well-trained local talent
- Availability of a complete suite of financial products to serve the multi-faceted needs of local households and enterprises
- The use of technology such as biometric identification, core banking systems and automated payment systems to drive down operating costs
However, the nature of such local institutions should be such that they are not allowed to take deposits and assume systemic risk given their inherently higher risk and local concentration features. They would be the innovators and risk takers that cushion banks from credit losses and costs arising from newer businesses, through their additional capital and their lower-cost delivery structure.
Completely agree with the aspects of promoting localized banks to capture local knowledge in enhancing credit decisions and making small loans portfolio better quality. This is the aspect that makes the SHGs microfinance institutions successful. Bringing in “external” talent to a location either makes lending too conservative or ill-informed (likely, not always).
However, a few aspects may be worth considering in the context of things in India:
i) Why shouldn’t these banks take deposits? Even small ones. (the last para suggests you don’t think this should be allowed). Getting people into the banking system is the biggest bottleneck for millions small enterepreneurs (think of the thela food seller) who have steady income but no record of it.
ii) “Concentration” of loans defined in geography is counterproductive, especially in relatively low growth areas. For example, a rural area would be a “small bank” because of the size of monetized economy amenable to banking – not population or geography. Its likely that initially there may be only 2 or 3 significant enterprise level borrowers. The banking ratios don’t account for quantum of loan just proportion. Integrating these “small banks” into a larger system or bank, is the spreading of risk on the area (not the borrower only). Not different from insurance. Would an insurance company say “no” to the 1st 2 or 3 insurers as it’d be geographically concentrating it.
iii) Adequacy Ratio enhancement. The total volume of loans (small loans) won’t add up to much in an entire system. What’s the point of localising as a cost reduction measure, also, and then hiking up the fundamental cost of lending through CAR? Cost of lending is the biggest single component I’d guess even for “small loans”. Even if it isn’t its still significant.
iv) How about looking at co-option of local financial stakes as a bundled part of credit evaluation? Let me explain: Suppose a local savings group agrees to put in 10% of its saved funds – 20 local people have Rs 10,000 saved and agree they’ll lend directly Rs 1,000 from it (treated as a CAR equivalent) for which they’ll get higher than bank deposit savings rates. This ensures the “credit” decision doesn’t translate into a buddy network through real stakes couple with real benefits (how the SHGs etc de facto function). The idea can be refined, but you get the general idea.
v) How about a tier 2 of deposit accounts that enables a person to place his/her cash without onerous requirements of opening a bank account? This can be upgraded to a normal Tier 1 account holder when Aadhar or some such happens. Meanwhile, the person’s credit history is developed. So say, a vendor with steady income of Rs 1500-2000 a month (reflected in bank deposits) could become eligible for say 50% of annual deposit as loan after 1 year…based on his/her record. Its a way to expand reach of the system given our constraints. Or else much of the focus would remain on
a. staffing small branches – no ambitious officer wants that job anyway a big glitch with the banks
b. investing in IT infra – that tech depts love for bigger budgets and “feel good” aspect of catering to weaker sections
c. banks PR to say they’re hiring local talent
d. its become cost-effective
while the real glitches remain:
e. how to find a way to get more people into the system
f. how to beat rules on lending without sacrificing the loan quality etc
g. actually kickstart the local economy as it becomes better business sense for the bank, albeit in a longer time frame than a nice city.
@expraso:disqus
Sir, thanks for the detailed comment. You raise many valid points on the subject. I agree that the business of the (small) bank would depend on a host of factors perhaps the most important being the level of economic activity in the region which would dictate the extent of credit absorption and therefore the case for large banks that can move deposits from one region to deploy in another. But with large banks, the last mile problem remains to be addressed and this can be done only with localized institutions with sound systems in place, with the ability to offer a whole host of financial services that then tie back to product manufacturers through real-time transactions. Other than making them BCs, permitting this thin-front end to take deposits on its own books and fund their portfolio with it, would result in massive systemic risk concerns irrespective of the levels of regulatory capital allocated. A local external shock affecting the credit quality of its assets would coincide with the withdrawal of savings by its depositors. Deposit insurance in this regard would only cost higher for such institutions.
Regarding developing credit history for customers, rather than placing the onus on the customer to maintain deposit accounts and build a history of deposits (as a proxy) as you suggest, notwithstanding the long time lag in accessing credit, wouldn’t it be more prudent to require credit reporting not just by commercial banks and NBFC-MFIs as is currently is, but also by all other institutions such as UCBs, RRBs, and the rural cooperative credit institutions, and to collate this in a manner that is not institution-specific? It is a known fact that many of the target customers have long standing relationships with the PACS (some that date back 30-40 years), cooperative banks and SHGs.
Thanks for making the time for the detailed response above. Your points are relevant, no disputes with that. I think finding a way to gather credit history from all sources is a brilliant one – rather that wait for the customer to push it to the system (the normal way I’ve been thinking too) through just one account. Also gives the local branch officers scope to do more at work (that should be enriching) than just efficiency and operations!
My suggestions weren’t intended as an “either or” situation. Managing how capital costs/ risk compliance/ insulation from shocks etc works can be defined by redeployment of gathered deposits in larger pools defined by “class of assets” investments. Insurance companies have to invest their corpus available in similar regulations (less than 20% in equities etc, not sure of these numbers, but you’ll know them better!). That way local deposits are at risk close to sovereign risk, which may be acceptable.
My suggestions were more about seeking creative ways (I may be completely wrong on whatever I’ve listed) of making the credit risk evaluations robust by adding even token stakes to decisions – this last bit is what makes the SHGs pretty good on this count (NPAs etc). Else its always just a matter of time when the big thrust to expand will result in poorer quality decisions.
If I can think of anything else that may contribute to your thoughts processes, I’ll do so!!
The recent decision of NABARD to reposition PACS as BCs of CCBs/StCBs has all the characteristics mentioned as summary of the note of IFMR, except the use of technology, PACS have local presence and their network penetrates deep into the local geography. The also offer both credit and savings products which are critical for any rural client. Of course, in the new dispensation proposed by NABARD, PACS can mobilise deposits only on behalf of CCBs/ StCBs while they can insulate themselves from the risk of non-repayment of loans issued. But, they should become tech savvy so that they can run their operations with greater ease with increased productivity and transparency. Can a call the move of NABARD a very very bold one, a Masterstroke!, If and when implemented, this will be a game changer in the banking scenario with CCBs/StCBs providing keen competition to the smaller Commercial banks.
Sir, PACS have been the local credit provider for very long, for a large proportion of Indian farmers. Inspite of their poor financial performance, their rural presence is unquestionable. We look forward to a scenario where the CCBs with robust systems in place, can become successful banks with their PACS serving as effective BCs.