Need more competition
Small finance banks have a clear path
The Reserve Bank of India last week issued rules outlining the glide path for existing “small finance banks”, or SFBS, that wish to transition to regular “universal” banks. While it is unclear if any of the current SFBS will take advantage of the process immediately, it is welcome that a clear set of policies has been introduced for what has been a long-stated goal. SFBS that transition will gain certain advantages — for example, they will then have lower capital requirements and can reduce their level of priority-sector lending. This will bring down their capital intensity and allow them to become more profitable. The RBI’S requirements are relatively stringent, and so most SFBS will not qualify. Small banks should be listed and functioning for five years, as well as pass the regular due diligence exercise by the regulator. But they should also have reported a net profit the previous two years and have at least ~1,000 crore as their net worth. All existing SFBS other than AU SFB have a net worth below ~1,000 crore. But AU SFB is also going through a merger, first announced in October 2023, with Fincare SFB, which may open up new geographies in South India.
The broader process, however, is good news. The eventual goal must be greater competition in the banking sector alongside clear regulatory goalposts. Most SFBS — a category announced in 2014 — were created from non-banking financial companies, or NBFCS. They now have a path to universal banking. There is thus a clear ladder of safety, reliability, and regulatory oversight that the financial products sector can follow up to become a regular bank. For the banking regulator, it must be a priority to increase competition in the sector. Research has shown that, in the era of bank consolidation in India, which began in 1998, the efficiency of monetary-policy transmission declined significantly. This is natural, as greater market power increases individual banks’ alternative financing sources.
The SFB category was originally developed to increase financial inclusion. A worthy locus for further research is whether they have served that purpose. However, theoretically it seems clear that banks that have emerged from the regulatory environment that defines SFBS will help expand the scope of universal banking as well, given that they have specific know-how about increasing bank deposits from the underbanked. The growth of deposits in the banking sector will likely be a major priority, going forward. Recent research by Standard & Poor’s has shown that loan growth in banks is 2-3 percentage points higher than deposit growth. Some in the banking sector argue this is a natural corollary of other trends. Household financial savings, for example, are under pressure and the performance of alternative investment sources — such as mutual funds — has been attractive.
Returns on deposits in banks in recent times, meanwhile, have been too low in real terms. However, demand for credit continues apace. Thus, in the aggregate, according to S&P, loan growth is 1.5 times the growth in nominal gross domestic product (GDP), while deposit growth is just keeping pace with nominal GDP. As a consequence, unless deposit growth is juiced up, loan growth may have to fall, with unintended effects on the macro-economy and overall investment and growth. Greater bank competition with a focus on expanding the banking base is one way to mobilise deposits.