Small Finance Banks and Payments Banks: Licensing Rules in India

For most of its history Indian banking knew only one kind of licence. A bank was a bank: it took deposits of every size and lent to borrowers of every size, and if it could not do both it did not get a licence at all. The difficulty with that model is that the fixed cost of being a universal bank is very high, and the customers who are hardest to reach are the ones who generate the least revenue. The guidelines of 27 November 2014 broke the licence into pieces. A small finance bank does the lending but keeps it small. A payments bank does the deposits and the payments but does not lend at all. Both are banks, licensed under Section 22 of the Banking Regulation Act, 1949, and both are deliberately incomplete.

1. Why differentiated licensing

The case for a differentiated licence rests on a simple observation. The two functions a bank performs, taking deposits and making loans, carry very different risks and very different costs. A bank that only holds money and moves it carries almost no credit risk, and can therefore be allowed to operate on a thinner capital base and a lighter branch network. A bank that lends only small sums, to borrowers in a defined segment, can build the appraisal skills for that segment without having to maintain a corporate credit department.

Figure 1: One section, four kinds of licence

2. Small finance banks

Guidelines were issued on 27 November 2014, and a second set for on tap licensing on 5 December 2019, which replaced the earlier window based approach with a continuous one. The objective stated in the guidelines is financial inclusion: supply of savings vehicles and of credit to small business units, small and marginal farmers, micro and small industries and other unorganised sector entities, through high technology and low cost operations.

Figure 2: The four requirements that define a small finance bank

Capital and ownership

• Minimum paid up voting equity capital or net worth of two hundred crore rupees, raised from one hundred crore in the earlier guidelines.
• An urban cooperative bank converting voluntarily into a small finance bank requires an initial net worth of one hundred crore rupees, to be raised to two hundred crore rupees within five years of commencing business.
• Eligible promoters are resident individuals and professionals with at least ten years of experience in banking and finance, companies and societies owned and controlled by residents, and existing non-banking financial companies, microfinance institutions, local area banks and payments banks owned and controlled by residents.
• The promoter's minimum initial contribution to the paid up voting equity capital is forty per cent, locked in for five years, and a holding above forty per cent must be brought down to forty per cent within five years and then in stages thereafter.
• Listing is mandatory once the bank's net worth reaches five hundred crore rupees, within three years of reaching it, and a bank below that threshold may list voluntarily.

Business

• It may carry on the basic banking business of accepting deposits and lending, and it may distribute mutual fund units, insurance and pension products with the approval of the respective regulators.
• Seventy five per cent of adjusted net bank credit must go to the priority sector.
• At least fifty per cent of the loan portfolio must consist of loans and advances of up to twenty five lakh rupees.
• It is subject to the same cash reserve ratio and statutory liquidity ratio as any other scheduled commercial bank, with no forbearance.
• It may not set up subsidiaries to undertake non-banking financial activities, and the activities permitted to it must be conducted within the bank.

3. Payments banks

The payments bank was conceived as a deposit and payments institution without a loan book. It holds small balances, moves money, and earns from fees and from the spread on very short government paper. Because it takes no credit risk, it needs less capital; because it takes no credit risk, it also has a very narrow path to profitability, which is the standing criticism of the model.

• Minimum paid up voting equity capital of one hundred crore rupees.
• It may accept demand deposits and savings bank deposits, subject to a ceiling on the end of day balance of an individual customer. That ceiling was one lakh rupees under the licensing guidelines of 27 November 2014 and was doubled to two lakh rupees by the Reserve Bank's circular of 8 April 2021, with immediate effect and with the other conditions of the guidelines unchanged.
• It may issue debit cards and automated teller machine cards, but not credit cards.
• It may not undertake any lending activity of any kind.
• It must deploy not less than seventy five per cent of its demand deposit balances in government securities and treasury bills with a maturity of up to one year that qualify for the statutory liquidity ratio, and may hold up to twenty five per cent in current and time deposits with other scheduled commercial banks for operational purposes and liquidity management.
• It may act as a business correspondent of another bank, and may distribute non-risk sharing simple financial products such as mutual fund units and insurance.
• It may undertake cross border remittance transactions in the nature of personal payments on the current account.
• The promoter's minimum initial contribution is forty per cent of the paid up voting equity capital, locked in for five years.

4. The route between them

The licensing framework is not a set of sealed boxes. A payments bank that has established itself may apply to convert into a small finance bank, and the on tap guidelines expressly list an existing payments bank among the eligible promoters, subject to its having completed the prescribed period of operation and meeting the capital and other requirements. An urban cooperative bank may likewise convert into a small finance bank on the concessional capital terms described above, which gives the cooperative sector a route out of the dual control problem if its members choose to take it.

The reverse movement, from a small finance bank to a universal bank, also exists. The Reserve Bank has set out a framework under which a small finance bank with a satisfactory track record of scheduled status, a minimum net worth, profitability and asset quality over a prescribed period, and a listed status, may apply for a universal banking licence. The transition is the explicit reward for building a track record in the harder segment.

5. What differentiated licensing has and has not achieved

1. It has widened access. Small finance banks reach borrowers whose ticket sizes a universal bank would not pursue, and they do so as banks, which means their funding comes from deposits rather than from wholesale borrowing. That alone lowered the cost of credit in the microfinance segment.
2. It has not made payments banks profitable. A model that forbids lending leaves fee income and a thin spread on short government paper. Several of the in-principle approvals granted in the first round were surrendered before operations began, and the raising of the balance ceiling to two lakh rupees was a response to that difficulty.
3. It has raised a concentration question. A small finance bank whose book is overwhelmingly unsecured microcredit in a few districts is exposed to a single kind of shock, which is why the prudential framework and the priority sector composition rules matter more for these banks than for a universal bank.

6. Quick Revision

1. Both are licensed under Section 22 of the Banking Regulation Act, 1949 and are scheduled banks.
2. The guidelines of 27 November 2014 created both categories; on tap licensing for small finance banks followed on 5 December 2019.
3. A small finance bank has no ceiling on deposits but a ceiling on how large its loans may be in aggregate composition.
4. A payments bank has a ceiling on deposits and no lending at all.
5. Neither is exempt from the cash reserve ratio or the statutory liquidity ratio.
6. A payments bank may be a business correspondent for another bank, which is how its customers reach credit.
7. The local area bank is a closed category superseded by the small finance bank.

7. Frequently Asked Questions

If a payments bank cannot lend, what does it do with the money?

It invests it, on very short tenors, in instruments that carry almost no credit risk. At least seventy five per cent of its demand deposit balances must go into government securities and treasury bills with a maturity of up to one year that qualify for the statutory liquidity ratio, and up to twenty five per cent may be held in current and time deposits with other scheduled commercial banks for operational purposes and liquidity management. Its earnings therefore come from the spread on that paper, from transaction and remittance fees, and from commissions on the third party products it distributes.

Can a payments bank customer get a loan?

Not from the payments bank. The customer can get one through it, because a payments bank may act as a business correspondent of another bank. In that arrangement the payments bank sources and services the loan while the lending bank carries the credit on its own books and bears the risk. The distinction matters: the payments bank earns a fee and takes no credit exposure, which is precisely the boundary the licence was designed to hold.

Why must half a small finance bank's loans be of twenty five lakh rupees or less?

To stop the licence drifting. A bank granted a concessional entry on the footing that it will serve small borrowers has every commercial incentive, once it has deposits and a franchise, to move up the ticket size, where appraisal is easier and the cost per rupee lent is lower. The composition requirement anchors the book to the segment the licence was granted for, and it works alongside the seventy five per cent priority sector target, which anchors the kind of borrower rather than the size of the loan. The two together are what make a small finance bank small.

Is the two lakh rupee limit a cap on transactions?

No. It is a cap on the end of day balance of an individual customer. A customer may receive and send considerably more than two lakh rupees in the course of a day, so long as the balance standing to the account at the close of the day does not exceed the ceiling. Banks ordinarily manage this by sweeping the excess into a linked account with a partner bank, which is permitted, or by declining further credits once the ceiling is reached.

Can a small finance bank become a universal bank?

Yes, and the framework for it exists. A small finance bank seeking a universal banking licence must have a satisfactory track record over a prescribed period of operation, scheduled status, a minimum net worth, profitability in recent years, asset quality within prescribed limits on gross and net non-performing assets, and its shares listed on a recognised stock exchange. The application is considered on the same footing as any other application for a universal licence, and the earlier performance as a small finance bank is the principal material on which the Reserve Bank judges it.

Are deposits in a small finance bank or a payments bank insured?

Yes. Both are banks licensed under Section 22 of the Banking Regulation Act, 1949 and both are insured by the Deposit Insurance and Credit Guarantee Corporation on the same terms as any other bank, up to the limit in force, which applies per depositor per bank in the same right and capacity. For a payments bank the insurance covers the whole balance in practice, since the balance cannot exceed two lakh rupees in any event. The deposit insurance obligation is also a reason the differentiated licences carry real capital requirements rather than nominal ones, because the insurance fund stands behind them.

Why has the payments bank model proved commercially difficult?

Because the licence removes the two things from which a bank ordinarily earns. It may not lend, so there is no interest margin, and it must hold at least seventy five per cent of its demand deposits in government paper of up to one year, where the yield is low and the spread over the rate paid to depositors is thin. What is left is transaction fees, which competition and the zero charge on the prescribed electronic modes have compressed almost to nothing, and commission on third party products. Several of the in-principle approvals granted in the first round were surrendered before operations began. The doubling of the balance ceiling to two lakh rupees in April 2021 and the route permitting conversion into a small finance bank are both responses to that difficulty. The defence of the model is that it was never meant to be a bank in miniature. It was meant to carry payments and remittances to customers whom a universal bank would not pursue, and judged by accounts opened and money moved rather than by profit it has done that.

8. Related Topics and Provisions

• Structure of the Indian banking system
• Licensing of banking companies under Section 22
• Priority sector lending and the targets for different classes of bank
• Reserve Bank regulation of non-banking financial companies and payment systems
• Cooperative banks and the problem of dual control
• Capital adequacy and the Basel framework in Indian banking