Smbs

1. Analysis of viability of the business
models of Payment Banks and Small
Finance Banks

2. Payment Banks
• The Reserve Bank of India (RBI) on August 19, 2015 granted “in principle” approval to 11
applicants (out of 41) to set up Payments Banks. Given that Payments Banks will not
undertake lending activities and will thus not face the same business risks as a full-service
bank, the RBI has selected entities with experience in different sectors and with different
capabilities so that different service models can be tried out. Of the 11 entities selected, five
are telecom companies (or telecom joint ventures/tie up), one a mobile wallet company, one
an IT company, one the Indian postal department, one a non-banking finance company
(NBFC), and the rest two entities with good delivery channels.
• Banks have already opened a large number of savings deposit accounts (the number has even
outpaced the addition to mobile subscribers over the last few years) during the last few
years, and especially since the launch of Pradhan Mantri Jan Dhan Yojna (PMJDY) in August
2014.Given this fact, the potential for the Payments Banks to get new accounts has declined.
However, while PMJDY scheme has achieved opening of massive number of saving deposit
accounts, Payments Banks are expected to increase the usage of banking accounts by
reaching out to the transactors/depositors. Therefore, their ability to keep transaction costs
extremely low and get adequate deposit balances would be critical for their sustainability.
While payment banks are likely to complement full-service banks by increasing the number of
transactions and saving footprint to a bigger population, they may end up competing with
small banks, as there would be some depositor overlap between the two.

3. Impacts/Challenges of Payment Banks
• Payments Banks unlikely to be a threat for full
fledge commercial banks
• Large number of licenses (11) could intensify
competition in low income space however is not
likely to impact the deposits profile of full fledge
commercial banks in a significant way given the
restriction on maximum deposit per customer (Rs
1 lac) and most likely, unlike some private sector
banks, Payments Banks would not be able to offer
higher interest on saving deposits given their thin
interest spreads.

4. Impacts/Challenges of Payment Banks
• Profitability metrics for Payments Banks will depend upon scalability and ability to maintain
lower operating cost to serve customers
o As the Payments Banks are not allowed to undertake lending activities, their activities will be
restricted to acceptance of demand deposits (saving & current deposits) and provision of payment
and remittance services, their income profile would remain more concentrated vs. full fledge
commercial bank.
o In the longer run, Payment Banks’ interest spreads are not expected to be more than 3-4%.
Payments Banks’ ability to serve customers through a low operating cost structure (through BC
centric model of Payments Bank and through use of technology) and to build adequate
infrastructure(number of BCs as well as technology to provide convenient & safe transactions)
would be a key for achieving profitability. This apart, Payments Banks ability to grow balance sheet
in a significant way would have critical bearing on their profitability levels.
o The profitability of the Payments Bank would be highly sensitive to short term interest rate as the
Payment Bank would need to deploy minimum 75% of its deposits in Government
Securities/Treasury Bills of up to one year and balance maximum 25% in time/fixed deposits with
other scheduled commercial banks.
o Payments Banks are also allowed to become a Business Correspondents (BC) of another bank as
well as could undertake distribution of non-risk sharingsimple financial products like mutual fund
units and insurance products, etc. These activities could support earnings profile of Payments
Banks.

5. Impacts/Challenges of Payment Banks
• High leverage ratio may help to achieve
reasonable return on equity
o As Payments Banks are not allowed to
undertake lending activities, they are allowed
to maintain higher leverage (maximum 33.33
times). This may help Payments Banks achieve
reasonable return on equity.

6. • Payments Banks are expected to deepen last mile connectivity
(penetration/availability of payments points/ service outlets) in a significant way.
o Relatively moderate level of financial penetration, specifically in rural & sub-urban
areas, and limited number of payment points provides in relation to large number
of saving deposit accounts and population, expected to provide adequate growth
opportunities to Payments Banks.
o While large number of accounts opened under PMJDY scheme have lowered the
potential for Payments Banks, these banks are expected to improve last mile
connectivity, penetration of payments points/ service outlets in a significant way
(through business correspondent structure and through use of technology).
Several of these applicants (specifically telcos, Indian Post, NBFCs, mobile wallet
companies) have very strong franchise (in rural and semi urban areas as well) as
well as large number of customers which supports their ability to grow in a
significant way. Such last mile connectivity will provide Payments Banks edge in
payments/remittance services as well as attracting new customers/depositors.
Additionally, Payments Banks could also serve existing depositors of full fledge
commercial banks, if these banks can offer transactions at more competitive rates.

7. Small Finance Banks
• The Reserve Bank of India (RBI) on September 16, 2015 granted “in principle” approval to 10
applicants (out of 72 applicants ) to set up Small Finance Banks(SFB) under the “ Guidelines for
Licensing of Small Finance Banks” issued on November 27, 2014. The list of successful applicants
being dominated by NBFC MFIs (7), one Core Investment Company (with 3 entities as subsidiaries
operating in Housing Finance, Microfinance and Vehicle Finance space) and one Local area bank is
likely to increase financial inclusion as most of the new in principle licensees have been operating
in a space not very well covered by the existing banks. While the new players have in any case been
lending to their target segments, a banking licence would help them offer full-fledged services to
their customers. This could lead to expansion in banking assets with newer customers getting into
the banking net.
• While the expansion of banking is a positive step, the ability of small banks to achieve sustainable
growth would be linked to several structural changes, such as realignment of shareholding (to bring
foreign shareholding below 50%), organizations strengthening, and development of processes to
serve customers for multiple products. The operations-related challenges would include hiring and
training of manpower and reduction in attrition rates, which currently exceed 25%. Further, the
new small banks would need to mobilize deposits to meet the cash reserve ratio (CRR) and
statutory liquidity ratio (SLR) requirements, replace maturing liabilities, and support growth. The
additional reserve requirement would also have a negative impact on earnings as these banks may
have to deploy 16-17% of their total funds (21.5% of deposits, which are 80% of total funds) in low
earning government securities (G-secs) and 3% in ”non-interest yielding” CRR. If the small banks
succeed in meeting these challenges, their credit profile will benefit from improved liquidity and
more resilient earnings with more diversity and better credit risk management.

8. Impact/Challenges for Small Finance
Banks
• Asset mix likely to diversify further
o Most of the players so far have been offering one or two loan products and some
fee based distribution products due to regulatory restrictions. Though the under
banked customers need a variety of products to meet their financial needs (such
as home improvement loans, education loans, higher value business loans), funds
transfer, deposit products, insurance etc, the MFIs/NBFCs remained constrained in
offering multiple products to their customers owing to the guidelines in place.
Therefore, despite a sizeable customer base and demand for these products, these
entities could not exploit their franchise to its complete potential.
o Upon conversion to small banks, these entities will be able to diversify their asset
mix too, within the limits imposed on SFBs that is priority sector requirements of
75% and 50% of the loan portfolio of the ticket size upto Rs 2.5 million.
o Consequently, the riskiness of the product mix could change, depending on the
basket of products the small bank develops (for example focus on secured loans
such as secured housing loans could be risk neutral, whereas an increase in the
share of unsecured higher ticket microenterprise loans could lead to a riskier
product mix).

9. Impact/Challenges for Small Finance
Banks
• Overall equity requirement to be high in the medium term
o Apart from meeting the CRR/SLR requirement (in the event of non
mobilization of targeted deposits), the successful applicants would require
additional capital requirement for the following:
o Reduce foreign shareholding below 50%
o Tie-up capital to support growth
• Small Finance Banks would require sizeable growth capital as well.
o The cumulative equity requirement for the successful applicants assuming
25% CAGR over the next five years is expected to be ~ Rs. 26-28 billion.2
However, if the SFBs are able to raise equity upfront to reduce the foreign
shareholding as discussed, it would be sufficient to meet the growth
requirements as well. As far as reported capital adequacy is concerned, it
is unlikely to be a challenge for the new small banks as their current
Capital to Risk (Weighted) Assets Ratio (CRAR) exceeds 15% with minimum
Tier I at over 7.5%.

10. Impact/Challenges for Small Finance
Banks
• Cost of funds may remain high over short term
o With a relatively large customer base and reach, though there is potential
to develop a sizeable deposit base, however low ticket sizes are likely to
keep the cost of deposit mobilization high in the initial years, partially
negating the cost benefit arising out of relatively lower interest cost on
deposits vis-à-vis wholesale funding sources. Key factors influencing the
Profitability metrics of a small bank would be as follows:
o CRR and SLR requirements to be met without any regulatory for bearance
o Cost of institutional funding sources
o Share of retail deposits in overall funds (especially current and saving
accounts (CASA)
o Ticket size of deposits mobilized
o Ability to offer a larger bouquet of services to customers to increase
productivity and fee based income

11. Impact/Challenges for Small Finance
Banks
• SFBs could face following resource mobilization challenges with
institutional funding:
o There are caps on interbank lending upto 200%/300% of Net Worth.
Further this source is too short term in nature.
o If banks were to invest in Certificates of Deposits of these small finance
banks, these lines would also be less than 1 year in nature, which could
create Asset Liability Mismatch issues for the small finance banks.
o Risk Appetite of Scheduled commercial banks to extent credit lines to
small finance banks could be limited owing to their credit risk profile and
these facilities being subordinated to deposits. Therefore, access to a
refinance line from SIDBI, MUDRA Bank, NABARD as well as securitization
may remain an important route for such small banks to raise funds in the
short to medium term. Over the long term, the buildup of retail as well as
bulk deposit franchises would be a key determinant of the growth rates of
these small finance banks.