Small banks: lessons from local area banks

There are four LABs in the country. They have been performing satisfactorily on most banking parameters, and have achieved deeper penetration without posing systemic risk. Two LABs failed in their early days but that instance was handled effectively.

RBI would greatly benefit by reviewing its handling of LABs. Three major aspects need attention: ownership, capital and stability; systemic issues and concentration risks; operational issues of business model, freedom and autonomy.

On the issue of capital, the guidelines specify an initial capital of Rs100 crore. For LABs this was Rs5 crore to start with, and revised upwards to a target of Rs25 crore. Only one of the four LABs could achieve this target within the timeframe of 5-7 years that was provided. None of these LABs have Rs100 crore net owned funds even today. This requirement may come with an offer of greater geographical coverage. Even then, Rs100 crore for a small bank is steep, when the capital requirement for a universal bank is Rs500 crore. RBI has also specified diversification of shareholding within a 3-12 year timeframe. A review of the LAB experience shows that this was not possible. None of the LABs were listed even after 15 years of existence. RBI needs to look at capital requirements with care, else it might not get enough applications in areas that desperately need banking penetration.

The guidelines prescribe a capital adequacy of 15% as per the Basel I regime. Increased capital is justified because of concentration risks, and concentrated ownership. But as ownership diversifies would higher capital be required? A high capital adequacy means lower leverage—reduced headroom to raise money from the public at large. For LABs this norm has not been a constraint till now because they have grown at a moderate pace and never needed heavy capital infusion. In a fast growth scenario, this would result in a lower return on equity and would not be attractive to investors.

The assets side of small banks would have statutory liquidity ratio and cash reserve ratio on par with other banks. Revenues would accrue from loans deployed in a concentrated area with co-variance risks. While these risks could be covered by a pricing premium, the headroom for such premium is limited. RBI’s approach to addressing the assets side risk has been through increasing the capital requirement on the liabilities side. RBI needs to be more imaginative about assets side risk diversification. Permitting small banks to invest outside their area in securities and money market instruments would help.

On the operations side, RBI’s policy has stunted growth. Branch licencing for LABs was not on par with the mainstream banks. The new guidelines contemplate a liberal approach: new branches on the basis of an approved plan, something better than a permission at each instance.

The limits proposed for diversification of the loan book and the norms for priority sector will force small banks to reach out to the small customers. The guidelines are silent on whether these banks would be eligible to be scheduled. None of the LABs have been granted that status till now.

While the guidelines are positive, the following issues need consideration:

• In addition to the experience in banking, small bank promoters should have a deep engagement in the local area.

• The requirements of capital adequacy and the prudential norms should be harmonised for all categories of banks.

• There should be a framework for managing the concentration risks on the assets side of the balance sheet, by providing a framework for pricing premium; portfolio diversification and a framework to invest in financial assets outside the area of operation.

• The banks should be partially insulated from the mainstream financial system—while membership of clearing houses is necessary, the schedule status can be put on hold. The permission to grow spatially should be justified by saturation in the existing area through a financial inclusion index score. The growth path for these banks should be through penetration.

• Having granted the licence, the banks should get autonomy on the portfolio mix, branch location and business model. The regulatory and policy constraints on operations should be on par with mainstream banks.

In granting the licences RBI should also consider the reputational stakes of the promoters. RBI may want to prioritize underbanked regions. Of the four LABs, three were established in districts with a banking penetration greater than the national average. If the idea of small banks is predicated on the principle of inclusion, this can be achieved by controlling for the location, defining the area of operations and providing autonomy. If the RBI will walk that extra mile or would just do lip service is to be seen.

M.S. Sriram works with the Centre for Public Policy at the Indian Institute of Management, Bangalore.

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