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Pradeep Gaur/Mint
Pradeep Gaur/Mint

What to expect from small finance banks

Customised products, more competition in remittance, and further spread of financial instruments expected

On 16 September, the Reserve Bank of India (RBI) gave in-principle approval to 10 entities to set up small finance banks. The central bank has given them 18 months to comply with the requirements under the guidelines.

The 10 applicants who have received a nod are: Au Financiers (India) Ltd, Capital Local Area Bank Ltd, Disha Microfin Pvt. Ltd, Equitas Holdings Pvt. Ltd, ESAF Microfinance and Investments Pvt. Ltd, Janalakshmi Financial Services Pvt. Ltd, RGVN (North East) Microfinance Ltd, Suryoday Micro Finance Pvt. Ltd, Ujjivan Financial Services Pvt. Ltd and Utkarsh Micro Finance Pvt. Ltd.

Eight out of these 10 entities are micro-finance institutions (MFIs), one is a local area bank and one is a non-banking financial company.

This announcement comes a month after the central bank granted approval to 11 entities to become payments bank. Since majority of the entities are microfinance institutions, it seems the RBI considered MFIs to be a suitable vehicle to take banking services to those with little access to even basic banking services.

According to a World Bank paper—The Global Findex Database 2014-measuring financial inclusion around the World— India, China and Indonesia accounted for 38% of the world’s unbanked adults. “Both China and India saw strong growth in account ownership between 2011 and 2014—in China account penetration increased from 64% to 79%, and in India from 35% to 53%. Translated into absolute numbers, this growth means that 180 million adults in China and 175 million in India became account holders—with the two countries together accounting for about half (of) the 700 million new account holders globally," the report said.

Here is a look at the role that small finance banks are likely to play in the expanding banking landscape in India.

What is it?

The main purpose behind having small finance banks is to expand access to financial services in rural and semi-urban areas. These banks can do almost everything that a normal commercial bank can do, but at a much smaller scale. It will offer basic banking services, accept deposits and lend to underserved sections of customers, including small business units, small and marginal farmers, micro and small industries, and even entities in the unorganised sector.

While both payments banks and small finance banks may have some overlap in purpose—mostly in increasing access to banking facilities—there are many key differences.

One such difference is that a payments bank has a limit of 1 lakh on deposit per account; small finance banks do not have limit. Payments banks cannot lend, while small finance banks can give loans.

However, there are norms for giving credit. For instance, the central bank wants small finance banks to give 75% of their total credit to borrowers who qualify as priority sector as defined by the RBI. Priority sector includes those working in agriculture, and small enterprises and low-income earners. The 75% limit is higher as compared with commercial banks, which have to mandatorily lend 40% of their net bank credit to such sectors.

Small finance banks will also have to ensure that 50% of their loan portfolio constitutes advances of up to 25 lakh. These banks are also allowed to distribute third-party products such as mutual funds, insurance and pension products.

What to expect

Small finance banks will offer targeted deposit and lending products to low-income groups. The product proposition will be very focused keeping the target customer profile in mind. Hence, you can expect a roll out of smaller loans and loans targeted at low-income groups. “We would target mainly marginal farmers who own less than 2 acre of land or tenant farmers to provide loans for agriculture and animal husbandry. We would also consider providing housing finance loan to them, and business loans to shopkeepers," said Samit Ghosh, chief executive officer and managing director, Ujjivan, one of the MFIs that may become a small finance bank.

“Tailor-made lending products for small income categories will be launched," said Ratna Vishwanathan, chief operating officer, Microfinance Institutions Network, a self-regulatory organisation of non-banking MFIs.

While it may look like small finance banks will focus on the same kind of customers as MFIs, there is a difference in terms of lending practices. With micro-finance lenders, at present the interest rate is 24-26% per annum on loan products. With these institutions turning into banks, the lending rate may come down over a period of time, though not immediately.

“When you look at lending rates, you have to consider two things—cost of funds and rate of operations. There will be stress on resources in the beginning as MFIs have to put in place a newer framework. Only after the transition process is complete will they be able to leverage (the new customer base). So, the lending rates of MFIs that become small finance banks will come down only after 3-5 years," said Vishwanathan.

Small finance banks can take deposits. However, it is too early to say whether the interest rates will be higher than what universal banks offer.

Also, since the unbanked and underbanked population would be first-time users of formal financial services, it may be some time before they get familiarised with these. “The target customers for small finance banks are low-income households with certain degree of education. They are not used to brick and mortar system; and they prefer door-to-door services. So, it may not be easy to woo them," said Vishwanathan. Hence, the way services are provided may be different from what universal banks do.

Small finance banks can also provide remittance services, which will further increase the competition in the sector to which payments banks are also recent entrants. These two new entities are set to threaten existing money transfer services, especially those that offer expensive products.

“We don’t have plans to offer gold loans. We would compete with payment banks for remittances," said Ghosh.

Lastly, since the small finance banks can also distribute simple financial products, including insurance, mutual funds and pension products, one can expect further spread of these financial products.

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