Niche banks — Small Finance Banks and Payments Banks — are finally coming with the Reserve Bank of India (RBI) releasing in late November detailed but separate rules for setting up these banks. The draft guidelines were issued on July 17. In formulating the final rules, the RBI has taken into account the suggestions and feedback. The last date for receiving applications for opening these banks has recently been extended to February 2. Scrutiny and vetting will take some more time before the successful candidates are announced.

These are still early days but one noticeable feature so far is the subdued excitement that is defining the prospective applicants. This is in sharp contrast to the enthusiasm that prevailed in the run-up to the new full bank licences. In April last, the RBI issued in-principle bank licences to two — infrastructure company IDFC and microfinance lender Bandhan Financial Services. There were other strong eligible contenders, and an elaborate process of vetting the applications from out of a final list of 25 candidates yielded just these two names. Some of those who did not make it might possibly start one or other of these niche banks or wait for the RBI to starts issuing full bank licences on tap.

The final rules for setting up these Payments Banks and Small Finance Banks differ only marginally from the draft guidelines. The common objective of these niche or differentiated banks remains the same — furtherance of financial inclusion, which has become a key objective of public policy. Conceptually, Small Banks will provide a whole range of banking products — deposits and loans — but were initially confined to relatively small geographical areas. Importantly, they will focus on smaller businesses and accept relatively small deposits.

Payments Banks will offer a limited range of products and services such as acceptance of demand deposits and remittances of funds, but will have a wide network of access points, especially in rural areas. They will supplement their own network with business correspondents and may even depend on the network provided by others. Technology will be extensively used to add value. It is likely that many prospective applicants will wait out until a few pioneers establish the business viability and operational effectiveness of these new categories of banks.

The point is while the format and prospects of a new full (or universal) bank are understood, it has been far more difficult to visualise a new Payment Bank or a Small Bank. Not that these are entirely alien ideas — a Payment Bank borrows freely from the vast volume of literature governing narrow banking. A narrow bank is allowed to take demand deposits (savings and current account), but can only invest in gilt-edged securities. This model was first suggested for the troubled Indian Bank in the 1990s, but was quickly abandoned on the ground of being unviable.

A Small Bank, as is visualised now, has an uncanny resemblance to the Local Area Banks (LABs), which came on the scene in 1996. Despite the enthusiasm shown by the government, LABs were not a success. By 2003, the RBI stopped issuing new licences for this category. It is not clear how the RBI and the government are plugging this idea now. Perhaps, the enormous step up in technology in the financial sector, in recent years, is seen to be a decisive factor enhancing their viability. Certainly for Payment Banks, technology is going to be a great enabler.

On its part, the RBI has sought to extend the appeal of these banks to wider sections. The category of Payment Banks, it is expected, will interest telephone companies (that run electronic wallets) or other pre-paid instruments, supermarket chains and non-banking finance companies. A tie-up with an established bank will also be possible. There can no relaxation, however, on the fitness criteria applicable to promoters, who are expected to have a sound track record of professional experience or of running their businesses for a minimum period of five years. The paid-up capital will be Rs.100 crore with the promoters contributing a minimum of 40 per cent.

There are restrictions on the businesses these banks can do. Individual customers can keep no more than Rs.1 lakh as deposits. These banks are allowed to do remittance businesses and offer payment facilities, but many transactions that are routine for a full-fledged bank are out of bounds for now.

It is this and the strict guidelines, which regulate the deployment of funds, will make the Payments Banks idea quite unattractive. The RBI seems to have realised this. The final guidelines allow these banks to invest 25 per cent of the funds deployed in term deposits with commercial banks, the balance largely in SLR (Statutory Liquidity Ratio) securities.

Small Banks will be allowed to operate without any restrictions on geographical areas (as was visualised by the draft guidelines). But the restrictions on lending norms — the distinct bias towards priority sector lending and loans to small businesses. Their paid-up capital requirements are the same as for Payment Banks, except that the promoters are expected to dilute their shareholding to 26 per cent within 12 years.

One has to wait to see whether the idea of niche or differentiated banks is going to catch on. The regulatory features of both these categories look forbidding, but who knows the banks may still be a commercial success.

In the final analysis, it is the motivation of profits that will drive these new banks, which one should not fail to note that these will be entirely in the private sector. The success of the differentiated bank idea will herald a major change in the ownership pattern of banks with public sector’s dominant share getting whittled down.

(This article first appeared in The Hindu dated January 5)

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