The above excerpt is from the Report of the Committee on Financial Sector Reforms, chaired by Raghuram Rajan in 2008-09, of which the author was also a member. Comparing this with the RBI Guidelines on Small Banks released a few days ago, one can see how consistent Raghuram Rajan has been and how he has implemented the idea faithfully now that he is able to, as the RBI Governor. For this he, his RBI Board colleague Nachiket Mor and the senior RBI team all deserve congratulations. The draft guidelines have only a few minor flaws and, if these are attended to, we can hope to see the rise of a new generation of financial service providers, who would help end the currently unacceptable situation in terms of gross spatial, sectoral and segmental inequalities in terms of access to financial services.
The draft guidelines state the area of operations of the small bank will normally be restricted to contiguous districts in a homogeneous cluster of states/Union territories so that the bank has the local feel and culture. Homogeneity is almost always drawn from linguistic-cultural and agro-climatic factors. These would mostly mean within state boundaries as generally one ends up crossing linguistic zones along with state boundaries. There are a few exceptions to this in the Hindi heartlandfor example, Bundelkhand covers a few districts each of Uttar Pradesh and Madhya Pradesh. But the rest of the country has very few such examples. As a result, the top 25-30 microfinance institutions (MFIs), which are the most suitable vehicles for small finance, will not be eligible for licences. If they choose to apply, they would have to do so for a small part of their operations. In light of the fact that the largest MFI, Bandhan, has been awarded a full banking licence by RBI just a few months ago, the central bank should consider dropping the requirement of contiguity for MFIs and award them multi-state small bank licences. In turn, RBI can insist on a 3:1 ratio of financially excluded versus regular districts (the list was first drawn by the Rangarajan Committee on Financial Inclusion in 2007, of which the author was also a member, and it has since been updated by CRISIL as the Inclusix index).
Let me emphasise that this dropping of contiguity does not take away from the important requirement of local feel, with all its benefits. An MFI whose head-office is, say, in Bangalore, but which has worked in Rajasthan for five years and has over 1 lakh small borrowers in that state and a 99.6% repayment record, is, to my mind, local enough. Such MFIs tend to have 90% or more of their staff not just from the state but from the same district and are local in every respect except where their head-office is. Another advantage of non-contiguous multi-state licences would be reduction in risk concentration due to weather, natural calamities and any man-made eventssuch as announcement of loan waivers by local politicians!
The second improvement required in the draft guidelines is related to the fact that only 50% of the lending has been mandated to be loans below R25 lakh. The remaining 50% can be lent to anybody, as long as it meets RBIs risk concentration limits of 15% of capital. With R100 crore capital at birth, a small bank could lend R15 crore to a single party and still be compliant with RBIs limit. This would be wrong and the loan size should be capped to no more than R1 crore for a single party. It is the lower end of farmers and micro-enterprises who are starved of credit, so there should be a sub-category of specified lendingat least 40% of the total loans below R1 lakh (the present MFI limit is R50,000 per loan and 75% of their loans); another 40% should be between R1 and R25 lakh, to cater to the dynamic part of the local economyprogressive farmers and growth enterprises; and the final 20% can be for any size above that, subject to a lower risk concentration limit, say, 5% of the capital. I want to underline that unless these sub-limits are imposed, there is a serious danger of small banks becoming banks for local big-wigs and not banks for the small people.
A few other small improvements required are: (1) laying down clear criteria which, if achieved, must lead the small bank to get a scheduled status; (2) doing away with the need for branch licensing in tier-3 and below towns and in specified urban low-income areas such as resettlement colonies in Delhi; (3) permitting small banks to offer micro-insurance and micro-pensions at the very beginning; (4) permitting small banks to lend to farmers against warehouse receipts and including them in the interest subvention scheme; and (5) including small banks under deposit insurance scheme.
The final suggestion is to establish a new loan waiver regulatory guarantee mechanism which will safeguard locally-vulnerable small banks against political leaders who declare loan waivers to win votes. Otherwise fit and proper promoters will shy away. As one who has seen 15 years of financial inclusion work wiped out by such an action in Andhra Pradesh, my warning should have some credibility.
The author is founder & CEO of the BASIX Social Enterprise Group, which set up Indias first local area bank in 2001. It works with over 2 lakh poor households and has been profitable since birth