Designed to Fail – Payments Banks

This was written about 6 months ago but it became appropriate to bring it out from the cold storage given recent events. Updated a bit…

After Cholamandalam, Dilip Sanghvi along with IDFC Bank and Telenor Financial Services have decided to give up the in principal approval to start a payment bank. The entities that were granted an in-principle approval for starting a payments bank were given a year to launch the bank and in turn gain a payment bank license. After eight months, a JV between a group with deep pockets, a bank and a telecom player have decided that it makes no economic sense to start a payments license.

The Reserve Bank of India had granted 11 licenses to companies for starting so called “payments banks” in India which are licensed to provide payment services in the country. Following which, the RBI granted 10 licenses for starting small banks which are allowed to provide a whole suite of banking products like deposits, credit but in a limited area of operation. The stated objective for these licenses is to promote financial inclusion in the country and provide banking services to areas and people where they do not exist.

Considering the stringent regulations and restrictions on operations, it seems very likely that more players will drop out of starting small and payments banks in the near future. The RBI had engineered a similar fiasco with the Local Area Banks in 1997. Of the 10 licensees, only 4 are in existence at present. The LABs were similarly constrained by regulations requiring them to remain in unprofitable rural markets and allowed to open only 1 branch in an urban area per district (maximum of 3).

Payment banks by regulation are not allowed to lend so their classification as banks is incorrect and they may be more appropriately governed under the Payments and Settlements Act 2007. These payments banks have been mandated to hold 75% of their liabilities in SLR securities (yielding ~6.5%) and the remaining 25% as deposits with other banks (yielding ~7.25%). This means that payment banks have no risk on the asset side of the balance sheet. Assuming that the cost of funds for these payments banks will be comparable to current private sector banks (we are stretching our imagination here), that leaves absolutely no margin for these banks to cover their operating costs. The assumption is that payments banks will leverage technology and have minimal operating costs.

The cost of funds for payment/small banks will definitely be higher than full service banks which have better credit as well as access to inter-bank and RBI for overnight liquidity requirements. To counter this, the balances held with these banks will yield less than balances held with SCBs. There will be no incentive for customers to hold deposits in these accounts.

This leaves charges for payments as the only possible source of revenue for payments banks. Almost all banks in India have implemented a core banking solution and are able to provide payment services for free via internet banking. There is zero transaction cost for a consumer (on most platforms) on transfer of money to anyone else in the country be it a business or another individual via NEFT or RTGS. Debit cards and ATM machines are also available in most places now. This begs the question why would anyone keep any float in a payments or small bank account which presumably would not pay any interest (paytm wallet, m-pesa or airtel money earn no interest currently). There is also a matter of a transaction cost however small that a payments bank may charge whereas bank payment services are free.

It was obvious from the start that payment banks under the restrictions of the RBI have no business model. Of all the payment and small banks set up, only telecom companies and IT players and retail chains have a different cost and technological platform than regular banks. These players were already in the payments business via wallets and mobile money applications. In the end if only these companies had to remain, the RBI need not have gone through the whole licensing charade but could have legitimized their operations.

Payments business is different from banking. It enables the transfer of funds from a payer to a beneficiary. Banks, payments networks like Visa, Mastercard and cash were the only mode of payments for a very long time. In the last decade with the advent of technology, banks have faced a challenge to their monopoly on payments by a clutch of technology and telecom companies, most notably; m-pesa, apple pay, google wallet and the like. India has been at the forefront of the payments revolution with systems like NEFT, RTGS and ECS which were promoted by the RBI and led to massive improvement in performance and customer services by banks. In the second version of this revolution companies like paytm and other digital wallets have garnered a lot of traction with technology savvy consumers. Payment services like m-pesa or airtel money however have not taken off like they did in sub-Saharan Africa.

Small finance banks are subject to most of the prudential norms that scheduled commercial banks. They need to maintain a cash reserve ratio (CRR), and statutory liquidity ratio (SLR). 75% of the credit advanced by small finance banks will need to go to sectors that are part of the priority sector, which includes agriculture, small enterprises and low-income earners. Commercial banks have to mandatorily lend “only” 40% of their net bank credit to such sectors. Small finance banks also have to ensure that 50% of their loan portfolio constitutes advances of up to Rs.25 lakh. Such a scenario would definitely put a pressure on the net-interest margin (NIM) of all small banks. They will need to go through this period of low profitability before they are allowed to convert to full service banks.

A study commissioned by the Bill and Melinda Gates Foundation found that part of the reason why m-pesa was able to reach a penetration that banks did not in Kenya were 1. The cost of transferring money to the villages from the cities was extremely high (sometimes going upto 20%) there was also a lack of safety in sending cash 2. Safaricom is a very trusted name and more so than Kenyan banks 3. Kenyan banks were restricted from utilizing banking correspondents beyond a certain distance 4. For nearly 5 years, safaricom enjoyed a monopoly where no banks or other companies were allowed to exist leading to the large scale adoption of m-pesa. The main reason in Kenya of why banks did not have branches in remote areas was that it was too expensive for banks to have branches there whereas Safaricom’s m-pesa could be accessed via the same vendors that provided mobile phone recharge and services.

India is very similar in this regard. Banks find it unprofitable to have branches in rural areas. However, cost of transferring money in India is very low. If bank accounts are opened once as the current push under PMJDY has been, operating bank accounts via mobile which include payments, savings and credit services is not very hard. The same amount of familiarity with a mobile as that required for operating m-pesa account would be required. One wonders if a mobile money system would not be tantamount to providing a substandard product to the consumer.

Brazil’s Correios is regarded as a world leader among postal providers for its innovative use of strategic partnerships with the government and private players. Banco Postal leverages its extensive network of retail outlets in the most remote locations for provision of consumer financial services to the poor and underserved. It operates a network of over 12,000 consumer outlets in more than 5,000 municipalities. It also operates ~4,000 community post offices and another 1,000 franchisee post offices. The post offices provide over 100 products and services like electronic voting, government applications and permits. By giving a payments bank license to India Post, the RBI has done a great disservice to it. Going by the Brazilian example it is amply clear that India Post can function as a full-fledged bank and not just another payment system.

If the goal is to provide payment and remittance services where none exist. To the poorest of the poor in the undeveloped parts of the country, it would be fair to presume that internet banking would not work. The African experience tells us that m-pesa was immensely successful in providing payment and remittance services where banks could not go via a network of merchants who could “recharge” m-pesa accounts.

What the RBI needs to consider is that there are not many companies more trusted that some of the big PSU banks in India. They have a reach and presence that is unmatched by anyone else anyone else apart from India Post. Would a relaxation of the BCs norms further financial inclusion more? A mobile wallet is a depreciating currency in the sense that every transaction incurs a transaction fee. Would the poor not prefer to transact via normal banks and not mobile money if a similar payment and banking services are provided by banks?

The only major difference between the current small banks and LABs is that the Small Banks may have a national footprint. With the LABs, there was an effort to open them in financially excluded regions. There is no such requirement with small banks. The path towards financial inclusion is going to be paved by technology. Mobile is surely a way to go, so are banking correspondents and India Post. Financial inclusion is just one side of the story. People should have faith in the system and adopt it and not just open bank accounts. DBT and payment services over a period of time will go a long way in building that trust.

From the companies that were given a payments bank license, it seems that RBI has chosen for itself the business model that may be most successful with 4 telecom companies and 3 companies with large retail distribution networks in terms of a future banking correspondent model. In its defense, the RBI also granted a license to paytm which is already in the space with a completely digital footprint.

India is not blessed with a very competitive banking sector and a few public and private sector banks dominate. In such a scenario, the RBI along with other regulators must ensure that the environment is conducive for the most efficient and customer friendly business to win. The RBI should provide for the most competitive banking environment. Regulation should not determine the winner in the payment or banking business.

PS: Since writing the update, Tech Mahindra too has returned its license. HAHAHAHA


About Roy

Ce n'est pas moi
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