An insight into long-term finance banks

As the financial sector grows, apart from a number of universal banks, experts say it may be useful to have differentiated banks focusing on different areas and developing competence.

Differentiated Banks means

• Universal Banking Model where banks are holding companies which operate different businesses like asset management, asset reconstruction, insurance, , stock broking, etc.,through subsidiaries, joint ventures and affiliates.
• Differentiated licensing refers to the system of different licenses in contrast to the existing universal bank (SBI, ICICI etc).
• The universal banks including the PSBs and private sector banks can provide all banking services and products.
• On the other hand, under differentiated banking license, the Small Finance Banks and Payments Banks can provided only selected products (and in prescribed geographies).

In this context, RBI recently published a discussion paper on the need for wholesale and long-term finance (WLTF) banks. The move comes exactly a year after former RBI governor Raghuram Rajan proposed a new category of lenders to take over the burden of financing long-term projects from commercial banks.

In favor of Differentiated Banking Model

• A wholesale bank dealing with corporate clients only, finds it costly to maintain a skeleton retail banking presence. For such bank, it is difficult to meet priority sector obligations along with the obligations for doing inclusive banking.
• Retail banks may have to create risk management and regulatory compliance structures which are more appropriate to wholesale banks, thus resulting in non-optimal use of funds. This may also result in non-optimal use of supervisory resources also.
• The priority sector lending regime has been causing discomfort for some of the foreign banks. For example, some of the foreign banks find it difficult to fulfil even the less rigorous target of 32 per cent in respect of priority sector advances.
• Given an opportunity, some of the banks would opt for a niche strategy rather than competing under liberal licensing policy.

Against Differentiated Banking Model

• In India, the penetration of banking services is very low. Less than 59 % of adult population has access to a bank account and less than 14 % of adult population has a loan account with a bank. Under such circumstances, it would be incorrect to create a regime where banks are allowed to choose a path away from carrying banking to masses.
• Priority sector lending is important for banks. The revised guidelines on priority sector lending have rationalized the components of priority sector.
• Investments by banks in securitised assets shall be eligible for classification under respective categories of priority sector depending on the underlying assets.
• These measures would make it easier to comply with the priority sector lending requirements by those banks which faced some difficulties in existing system.
• The business model adopted by such ‘niche’ banks depends heavily on ample inter-bank liquidity. Any shock leading to liquidity crunch can translate into a run on the bank.

Differentiated Bank license Policy

• Differentiated bank license policy refers to the new guidelines by the RBI inviting individuals/entities to start banks in the form of either small finance banks or payment banks.
• Differentiated licensing refers to the system of different licenses in contrast to the existing universal bank (SBI, ICICI etc). The universal banks including the PSBs and private sector banks can provide all banking services and products. On the other hand, under differentiated banking license, the Small Finance Banks and Payments Banks can provided only selected products.
• They can engage in sub sectors of the banking sector such as Limited Banking License, Commercial Banking License etc. A differentiated license will allow a bank to offer products only in select verticals.
• Several regulatory requirements for these banks also are different compared to the conventional universal banks. For example, the Payment Banks and Small Finance Banks should have a minimum capital of Rs 100 crores. On the other hand universal banks should have a capital of Rs 500 crore. Payment Banks can’t give loans. Small Finance Banks should give 75% of its loans to priority sectors.
• RBI has adopted differentiated banking license policy to promote financial inclusion and to enable quick payment services using the new technologies.
• This differentiated bank structure could help new banks focus on niche lending opportunities and get a regulatory treatment different from other banks.

What is a WLTF bank?

• The idea is that as the financial sector grows, apart from a number of universal banks, it may be useful to have differentiated banks focusing on different areas and developing competence.
• This will reduce the cost of intermediation and lead to better economic outcomes.
• It will be a combination of term-lending institution and an investment bank.
• Promoters eligible to apply for banking licence can apply.
• However, minimum capital proposed is Rs 1,000 cr. while they can’t accept savings deposits, they can raise money from current accounts, and bulk fixed amounts and bonds.
• WLTF is the third category of a differentiated bank licence. The RBI has already issued differentiated licences for payments banks and small finance banks.
• The WLTF banks will focus on lending to the corporate sector, small and medium businesses, and the infrastructure sector.
• They may also offer services in the area of foreign exchange and trade finance.
• Further, they can act as market makers in instruments like corporate bonds and credit derivatives.
• WLTF banks can raise funds through issuance of debt and equity. They may also be allowed to accept term deposits above a threshold.

Need for specialised banks

• Presently, it’s not easy for companies to get long-term financing because of the underdeveloped corporate bond market and possible asset liability mismatch in the banking system.
• The banking system is also saddled with non-performing assets (NPAs), and a large portion is concentrated in the infrastructure sector.
• The financial sector has also not been able to meet the scale or sophistication of the needs of large corporates, as well as public infrastructure, and does not penetrate deeply enough to meet the needs of small- and medium-sized enterprises in many parts of the country.

What are the advantages?

• As specialized institutions, they will be in a much better position compared with commercial banks in evaluating and funding long-term projects.
• It’s not easy for companies to get long-term financing because of the underdeveloped corporate bond market and possible asset liability mismatch in the banking system.
• With specialized banks, NPA risks could possibly be avoided in the future.
• It may also help the rest of the banking sector in the case of joint lending, or by simply getting the project evaluation from these banks.
• Establishment of WLTF banks will also enhance competition, which will lead to more efficient allocation of financial resources.
• They reduce the cost of intermediation and lead to better economic outcomes.
• As specialized institutions, they will be in a much better position compared with commercial banks in evaluating and funding long-term projects.
• With specialized banks, NPA risks could possibly be avoided in the future.
• It may also help the rest of the banking sector in the case of joint lending, or by simply getting the project evaluation from these banks.
• Establishment of WLTF banks will also enhance competition, which will lead to more efficient allocation of financial resources.

Scope of activities

• WLTF banks focus on lending to the corporate sector, small and medium businesses, and the infrastructure sector.
• They may also offer services in the area of foreign exchange and trade finance.
• They can act as market makers in instruments like corporate bonds and credit derivatives.
• The banks can also raise funds through issuance of debt and equity. They may also be allowed to accept term deposits above a threshold.
• Besides providing long-term loans, it is envisaged that WLTF banks will act as market-makers on corporate bonds, credit derivatives, warehouse receipts and provide takeout financing. They will also provide investment bank services related to equity/debt investments and forex and trade finance to their clients.
• Apart from these, there is a gamut of specialized services that these banks can offer to Indian businesses.

Does India have prior experience?

• India has tried the development finance institution (DFI) model in the past with limited success.
• After independence, DFIs were established to increase the level of investment in the economy.
• Industrial Finance Corp. of India (IFCI) was the first such institution to be established in 1948.
• This was followed by the establishment of state finance corporations.
• In later years, other institutions like the Industrial Credit and Investment Corporation of India (ICICI) and Industrial Development Bank of India (IDBI) were established.
• However, DFIs struggled with government interference and changes in the economy, and accumulated high levels of NPAs.
• One of the biggest problems facing long-term finance institutions is competing for funds in the marketplace and being able to lend at competitive rates.

What are the factors to be considered?

• As the banking regulator mulls over issuing licences for new-age WLTF banks, there are at least three aspects that will need greater attention.
• First, government participation in setting up WLTF banks should be avoided as it could end up defeating the purpose.
• Government ownership would lead to the same problems that public sector banks are facing at the moment.
• Further, these banks will be highly specialized and will need operational freedom, which is not possible with government ownership.
• Second, licences should only be issued to entities that are able to demonstrate the ability to build such a highly specialized bank, and are in a position to bring in capital to both meet regulatory requirements and run the business on a sustainable basis.
• The central bank may allow industrial houses to participate to the extent that they are not in a position to influence business decisions.
• Third, the RBI will need to design a regulatory architecture that will enable growth with adequate safeguards.
• For example, the regulator may choose to exempt these banks from cash reserve ratio and statutory liquidity ratio requirements.
• These banks will compete directly with the bond market.
• Licences should only be issued to entities that are able to demonstrate the ability to build such a highly specialized bank, and are in a position to bring in capital to both meet regulatory requirements and run the business on a sustainable basis. The central bank may allow industrial houses to participate to the extent that they are not in a position to influence business decisions.
• The RBI will need to design a regulatory architecture that will enable growth with adequate safeguards. For example, the regulator may choose to exempt these banks from cash reserve ratio and statutory liquidity ratio requirements. These banks will compete directly with the bond market.
• Having bricks-and-mortar structures would add to costs and hence the option of being primarily an internet based bank can be considered.
• The WLTF banks can be made to apportion lending activity across both credit and debt markets. A 50-50 division will be useful as they can lend directly in the bond market for bonds which will be higher-rated. This will also be the preferred route for higher-rated companies. The balance lending should be based on collateral with insolvency laws in place. Also, RBI should focus simultaneously on credit enhancements to be provided by banks on such bonds which may be subscribed by the WLTFs.
• The WLTF banks should be freed completely from CRR and SLR obligations. The CRR is a disincentive while SLR will make them gravitate towards G-Secs.

Criticism against WLTF by experts

• RBI can set tenures for their lending, i.e., not less than five years or such a norm, but should give the freedom to lend to any sector. Bringing in priority-sector-like norms will impede their activity.
• Learning about the WLTF is just keep calling old institutions/policies/structures by a new name.
• It is hardly the case that these WLTF are new entities. These similar objectives were served earlier by Development Financial Institutions as well. Thankfully, the paper does acknowledge the same:
• Development Finance Institutions (DFIs) in the past had played a similar role in filling the gap in meeting the financing needs of medium and large enterprises, industry and infrastructure sector. However, due to change in the operating environment coupled with dearth of low cost long term funds as a result of withdrawal of Government guarantee for bond issuance and resultant non-SLR status of their bonds, high level of concentration risk caused serious stress to their financial position.
• Converted most of the DFIs barring IFCI into banks. Just three years back, converted an infrastructure DFI- IDFC into a bank. And now RBI want to create more IDFC kind of institutions. Why convert it into a bank at the first place?
• Each time these DFIs were converted into a bank, hype was generated saying DFIs no more serve the roles. The commercial banks can serve the same objectives and do a better job of the same. And now we are back to square one talking about similar objectives which were discussed when the DFI were established at the first place.
• Same is the case with Differentiated Banks as well. It is hardly a new term. Historically, we have had many types of financial institutions/intermediaries: indigenous banks, Joint stock banks, nidhis, chit funds, cooperatives, loan offices (in Bengal) and so on.
• But as these institutions evolved during a time when banking regulation was either absent or weak (RBI became tough with regulation only post Banking Regulation Act 1949 ), not much attention was paid.
• Policymakers only looked at these institutions with suspicion and wanted to close them at the first chance it got. Yes it is true that quite a few such institutions ran problematic operations and had to be closed down. But not all eggs were bad.
• What was needed was to understand the lessons of their evolution and different purposes they served. So much so, all these entities are now making a comeback in some form or the other with newer names and label.
• There is a reason why financial historians say that when financiers of yesteryears come back to today’s financial world, they will be confused and lost with the action and buzzwords.
• But the moment you explain them the crux behind the organisations and instruments, they will laugh and say we did most of these activities as well. But names and ideas were far simpler.

Way ahead

It should be remembered that WLTF will be starting with the handicap of lending to the non-retail segment and taking on higher risk as these loans would be of a long tenure. Focusing on infra projects and term-lending makes FIs more vulnerable to NPAs and hence, prima facie, the last decadal developments are a dampener.

In short, there should few inhibiting clauses in the terms of engagement for these banks, or else potential promoters would be at a disadvantage. An issue which should be kept in mind while giving permission is that all banks—including private sector—ones have faltered on asset quality when such long-term lending is concerned.

Well designed WLTF banks with right kind of ownership will go long way in helping the financial sector of the country. With right regulatory architecture, these banks will help improve efficiency in the financial system and enhance the flow of credit to businesses with large and long-term financing needs. The pitfalls in the earlier dispensation of DFIs need to be addressed in detail by the applicants to reassure the central bank that these models can work.