Differentiated, branchless: how digital banks can make credit offtake better, cheaper, and fast

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Differentiated, branchless: how digital banks can make credit offtake better, cheaper, and grow fast?

New business models and deposit bases need to be created for the banking sector to expand. Some key issues that are hindering the expansion of banking in India can be fixed by digital banks. But these entities should not just compete with existing universal banks. They must get access to new markets which India should open as part of reforms.

By K Yatish Rajawat?

When the world around you changes, you cannot remain stuck to the old, self-perceived versions. Banking is one of the last vestiges of the licensing regime, with incumbents holding up sector reforms by preventing the entry of new players. Now, NITI Aayog has thrown its weight behind this crucial issue with a discussion paper on licensing for digital banks. This is a major reform measure, as entry of digital banks will change banking in India if it is allowed to.

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Every reform has its opponents, and banking has powerful entrenched incumbent interests. Thanks to intense lobbying by these incumbents, regulations for payment banks and small finance banks (SFBs) had been scuttled earlier. Hopefully digital-banking regulations will be allowed to come through, as it is important for India’s double-digit growth. ?

While SFBs came into being with a limitation on the size of their loan and deposit-taking capacity, payment banks were not even allowed to take deposits. The NITI Aayog paper mentioned above talks about a full stack or universal bank licence for digital players.

The universal banking bit needs to be revised, as its not necessary to create clones of private banks in the digital space. Fresh business models and new deposit bases need to be created for the banking sector to expand. To be sure, the US and other developed countries do not insist on a straitjacket universal banking model licensing. The one-size-fits all model of banking is only applied in India.

Bank with a click

NPA-laden public-sector banks are unable to expand their operations or services. While the push made by Jan Dhan accounts has made it possible to get 420 million new bank accounts opened, availability of financial services to these accounts is negligible. Opening a bank account cannot be called financial inclusion till such time these account holders do not get benefit of credit and other financial products, they are not really part of formal financial system. Private- or public-sector banks are not keen on expanding their services to rural areas or to MSMEs because of the high cost of delivery of services and legacy systems. Also, margins are low for small-ticket loans in the rural areas.

This lack of financial services keeps 40% of the rural population away from the growth in the formal economy. Moreover, legacy banks, due to their overloaded balance sheets and fixed costs, are not able to provide credit at the right rates to MSMEs. The collateral required and the high interest rate on loans make them unviable or unprofitable for MSME’s. This crucial component — cost of credit and access to new deposit base — which is hindering the expansion of banking or financial services in the country can be addressed with digital banking.?

Access to new deposit bases, by the virtue of it, means allowing new and different business models in banking to emerge. New digital banks should not just compete with existing universal banks for the same deposit base; new markets should also be opened up as part of reforms. Until such time that new deposits are not accessed, new borrowing models or business models cannot be created. It is not enough to merely “open up” digital banking. It is also important to allow differentiated banking models to evolve and emerge, based on digital technology.

A CIPP study shows that digital banking will benefit not just MSMEs but also the agricultural sector, custodian banking, and transportation and logistics services. These sectors are starved, and their growth engine hobbled due to lack of credit liquidity and margins affected adversely due to the high cost of credit.

The agricultural sector needs a digital bank, as the cost of branches and delivery in the hinterland needs to be reduced. With business correspondents now present in every village, a digital bank with one headquarter can deliver credit at a much lower cost to rural areas.?Moreover, as the mode of delivery is digital, with the last-mile documentation and authentication being done by low-cost business correspondents, the credit cost can be lower. Even deposit collection would be easier as it can bypass the chain of microfinance institutions (MFIs) or self-help groups and reach depositors directly an app.

Traditional banks, both public and private, still shy away from delivering banking services beyond opening accounts in the rural areas. They would rather subscribe to the Rural Infrastructure Development Fund (RIDF) maintained by NABARD (National Bank for Agriculture and Rural Development) than take credit risk in rural areas. They do not have the systems, credit records, or credit history to lend in these areas, whereas payment-transaction companies can easily slice this market segment and launch an agriculture or rural digital bank.

NABARD on the other hand does not lend to the retail customers or farmers in the rural sector — most of the RIDF funds go to states for infrastructure. In the name of agriculture, rural and priority-sector funds are diverted to state governments.

Leveraging FPI funds

Similarly, of the 18 custodian services providers in India, almost 90% of the FPI market is dominated by four-five foreign banks that are sitting on a USD7 billion deposit base of FPIs (foreign portfolio investments). This is a new deposit base that can be accessed and used for lending. If Indian custodian services are allowed to become digital banks, they will be able to compete against foreign banks for FPI deposits. They will also be able to direct these deposits into lending to Indian MSMEs and other sectors.

This is an important strategic change that has to be institutionalised as Indian custodian services are not able to access the FPI deposit base due to section 15 F5 of SEC (Securities and Exchange Commission) regulation that prevents a non-bank from servicing US-registered FPIs. This important reform will open up a new deposit base to be leveraged for Indian borrowers. This will release the excess liquidity of capital markets that is sloshing with FPI funds into lending. Hence, a custodian digital bank has to be a crucial part of this reform.

Other reforms

Also, an NBFC that specialises in lending to the transportation sector or logistics sector should be allowed to become a digital bank. If it can build a deposit base of drivers, fleet owners or others, it would be able to lower the cost of credit to this crucial sector. This will bring down the cost of capital for logistics services that will ultimately lower the cost of logistics services. This will help improve the overall competitiveness of the Indian companies globally.

It is important that digital banks are not asked to become universal banks or follow one particular business model. Differentiation in the business models is what will help expand the financial services base and reduce the cost of credit. NITI Aayog should incorporate this approach if it wants to make Indian businesses and banking competitive and sustainable from a global perspective.

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