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Differentiation in banking models is a must to drive competition

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Commercial banks perform three main financial functions — credit, deposits and payments, and they are the only institutions with the mandate to do all three on their balance sheets. Until a few years ago, banks were either the only or the biggest institutions offering these three functions in India. However, they now face considerable competition on all fronts due to the strong, near-universal wave of disintermediation seen spreading across these functions.

Payments banks and wallets are emerging as a threat to traditional banks on the payments and liquid deposits leg, while NBFCs and capital markets are eating into the share of banks on the credit leg. These functions are also being offered by many unregulated and real-sector companies, including e-commerce businesses, who enjoy competitive advantages from a cost- and/or information perspective. Online loan marketplaces and digital credit underwriting platforms use alternative data to generate leads on behalf of banks and NBFCs. Thus, any analysis of competition will have to consider the effects of such disintermediation.

We have 44 foreign banks, 22 public sector banks, 21 private sector banks, 6 small finance banks and 220 systemically-important non-deposit taking NBFCs, with a cumulative outstanding credit of Rs 90 lakh crore (DBIE & FSR, RBI). This is, however, inadequate for the needs of the economy. Consider tier-1 capital of India’s top 10 banks against the current levels of domestic-currency bank borrowings of the top 10 corporates by balance sheet size.

The RBI’s Large Exposures Framework limits banks’ exposure to a single counterparty to not more than 20 percent of their tier-1 capital. If such a constraint were to be applied to each of these banks and we disregard bank holdings of bonds issued by these corporates, these 10 banks would be able to cover bank borrowings for only the top 5 of these corporates. Since these banks make up 60 percent of banking sector assets, the rest of the banking system is unlikely to have the capacity to serve credit needs of the remaining corporate sector, and the whole of the MSME and household sectors.

Indeed, the bank credit to the private non-financial sector as a percent of GDP in 2017 was only 53 percent for India, while it was 156 percent for China, 63 percent for South Africa and 129 percent for Malaysia. This is despite India demonstrating similar numbers when it comes to bank branches per 100,000 population (15 for India, versus 9 for China, 10 for South Africa and Malaysia).

Even if we acknowledge SEBI’s latest push to make large corporates raise at least 25 percent of their borrowings from capital markets, we still need more banks and banks with larger balance sheets to service the remaining demand for credit. There is also little differentiation in business strategies followed by existing banks. A contributing factor for this could be the rigid nature of the Priority Sector Lending (PSL) targets and branch licensing norms. Banks are forced, to a substantial degree, to lend to similar sectors and geographies to the extent of the PSL requirements (40 percent of their adjusted net bank credit).

Several studies have found that the Indian banking sector, while having a large number of players, has monopolistic competition. This means that in the short run their revenues are inelastic to cost of inputs, and thus, they have little incentive to differentiate their services to gain greater revenue share. Indeed, there is a concern that public sector banks behave almost identical to each other due to their common owner, and the common pool from which their staff gets drawn.

Even if we might have better luck with NBFCs in the form of a good spread of asset classes and underwriting methodologies, their vulnerability to funding constraints was quite evident in the recent liquidity squeeze. NBFCs, though competing with banks in the credit market, are still substantially dependent on bank borrowings for their business and this is expected to continue for a while longer till debt capital markets build more depth.

The liquid deposits ecosystem today comprises commercial banks, payments banks and wallets/pre-paid instrument providers. While payments banks today have less than 0.01 percent of the overall bank deposits, e-wallets have their deposits held in escrow with commercial banks. With increasing usage of UPI and the recent move towards interoperability of wallets, payments banks and wallets will likely gain a greater share of the liquid demand deposits and payment transactions markets.

While the days of administered interest rates is well behind us, and we have a fair number of institutions to show, we still have some way to go in translating this to better competition and more choice for consumers. The key is to enable credit institutions to leverage their strengths and differentiate in business models as a matter of business strategy. Contrast this with specialised banks such as MSME-focused Planter’s Development Bank of Philippines (now merged with China Bank), or the Bank Rakyat (with its micro-branch model) of Indonesia. How can we have similar institutions?

As a first, this requires a more dynamic PSL regime where banks have freedoms to choose their sectors of specialisation, so that they can shift to achieving their overall PSL targets through a combination of direct branch-based origination, purchase of loans through the direct assignment route and the PTC route, and freedoms to build liquidity and tradability of the loan book.

The second area of reform would be in introducing differentiated banking for credit. This includes creating wholesale, deposit-taking institutions that large well-run NBFCs can choose to become, that have freedoms to originate a variety of assets, as well as banking aggregators who do not originate directly but who build and maintain a portfolio of well-diversified credits comprising rated loans, bonds and securitised PTCs.

This article first appeared in Moneycontrol.

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