100 Small Steps: Will India’s Bank Licenses Bring Reform?

The Reserve Bank of India (RBI) has been steadily reforming India’s financial sector, in addition to achieving notable monetary policy successes. A few weeks back, the RBI granted licenses to 11 payments banks and followed that with licenses to 10 small finance banks.

The background for the broad and deep changes that the RBI’s actions can bring has been explained in two policy reports: Raghuram Rajan’s “A Hundred Small Steps” and Nachiket Mor’s recommendations.

The new licensing will enable mobile payments and a significantly expanded depositor base that will reshape India’s financial sector. The technological innovation and increased competition these measures will unleash may threaten the future of some of India’s listed banks. The new licensees are expected to broaden financial inclusion among India’s previously unbanked population, estimated at 50% of the total. Targeted subsidies that the banks can facilitate will likely prevent over $40 billion (2% of GDP) in leakages, whether through inefficiencies or corruption and otherwise help alleviate poverty. The last-mile connectivity that the payments banks are designed to provide, will remove one of the biggest handicaps hindering India’s unbanked poor.

The Poverty Link

Why are financial inclusion and poverty eradication important? How are they connected? India’s 7% average real annual GDP growth over the last two decades has brought considerable economic prosperity. But that prosperity has not been widely shared. India’s GINI index is lower (better) than comparable countries, but the absolute numbers are alarming. Most Indian metro areas have massive skyscrapers with their associated uber societies, replete with pools and saunas. These isolated pockets of wealth may become untenable if the seas of shanties surrounding them keep expanding. For growth to be sustainable, prosperity needs to be spread more broadly — and especially to those who now live hand-to-mouth.

India’s roughly 45,000 rural bank branches are severely constrained in serving the estimated 594,000 villages where many of the country’s poor live. A significant proportion of India’s small businesses — 60% (RBI, as of 2013) of the rural/urban population, do not have a functional bank account. Studies confirm an intuitive point: The poor are by necessity entrepreneurial, but cut off from most financial services, they lack a level playing field.

Payments and small savings banks are needed to bridge this service gap and provide banking to low-income households. The services offered by these banks will drive up India’s credit to GDP and total term life insurance sum assured to GDP ratios. For reference, India’s credit to GDP ratio is about 75% compared to 200% for high income countries and 100%-plus for middle income countries. India’s life insurance sum assured to GDP ratio is about 60%, compared to 150% plus for middle and high income countries. A projected 10% rise per year in credit to GDP can bring down poverty by 2.5%–3%. Assuming a base of 200-million unbanked poor, each year an estimated five million people who currently struggle to make ends meet would have increased access to food, shelter, and better health. Insurance products will complement the banking efforts and provide a crucial backstop to prevent people from slipping back into poverty.

Comparable Experiences

Payments and mobile banking concepts are not new. M-PESA in Kenya, branchless banking in Pakistan, and mobile banking in China have been among the most notable success stories. Compared to these examples, India’s payments bank licensees are notable for their collective size and potential impact. Seven of the 11 licensees are associated with $5-billion plus market-cap companies. Experienced multinational names like Alipay and Vodafone are among their investor lists. Assuming 300 million of India’s partially banked or unbanked population become users, the marginal sector revenue for a pure payments solution could be more than $6 billion, compared to M-PESA’s revenue of about $313 million for roughly 14 million customers. As the poor move out of poverty, the increased prosperity will create a need for broader services. It is worth noting how fast technology and smart entrepreneurship changed the contours of China’s asset management market. 

Competitive Changes

India’s financial sector has advanced and changed significantly over the last 10 years. From 11% of total market capitalization, the sector has grown to about 18% — a significant advance, but still well below the 25% level in the developed world. In terms of key players, the State Bank of India, a public sector bank, was the biggest financial company in India by market capitalization 10 years ago. Today, however, that position is held by HDFC Bank a private sector bank. Public sector banks face governance inefficiencies and have been struggling with their nonperforming asset problem. Many of the new payments and small bank licensees are private entities. Over time, with fewer impediments compared to their public sector counterparts, the new players may significantly alter market shares in India’s banking space.

The Takeaways

Poverty is a multidimensional phenomenon and India’s society is enormously diverse. But persistent and coordinated government intervention to remove barriers is a positive development. A well-connected fiber optic and wireless world can increase opportunities, while competitive private sector participation will help weed out many inefficiencies. The inherent market discipline that the private sector offers can bring significantly better and broader financial services to all India.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©AP Photo/Rajesh Kumar Singh