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Banking needs new thinking: RBI needs to consider custodian bank licensing.

Date: 08-12-2020
Subject: Banking needs new thinking: RBI needs to consider custodian bank licensing
India needs differentiated bank licences—new banking segments need to be opened up for capital creation, expansion, access and growth of credit.

By K Yatish Rajawat

A license to do business is also a way to restrict business. A banking licence is among the last vestiges of contentious control; banks control access and leverage of capital, the primary building block for enterprises or economy, and hence control and regulation remains. Whenever there is a debate on new licences, like the one now on entry of business houses in banking, it leads to heated discussions from incumbents and expectants.

But expansion of capital formation is the only way to kick-start an economy that has come to an abrupt stop due to Covid-19. India has a poor credit-to-GDP ratio of just 56%; in most developed countries and even in China it is more than 150%. During 2010-20, domestic bank credit to private sector as a percentage of GDP was stagnant at a lowly 50%, affecting capital formation and economic growth.

Current banking players cannot double the credit-to-GDP ratio because of gaping holes in their balance sheets due to scams and NPAs. The expansion from 1990 to 2010 happened because of the entry of new private players. Therefore, besides allowing new entrants, new segments for banking also need to be opened up for capital creation, expansion, access and growth of credit.

RBI’s Internal Working Group (IWG) report on allowing business groups to enter banking opens up the debate for expansion and new segments for credit growth. The IWG report wants the inclusion of large corporates in banking licences, after the required amendments to the Banking Regulation Act, 1949. This is a bold reform, but not enough to meet the objective of credit expansion. The last two licences granted were years ago, to IDFC First Bank and Bandhan Bank. There are several categories in banking that haven’t yet been explored due to foreign pressure, and these need to be opened up for Indian entrepreneurs.

RBI’s experiment with differentiated bank licences in 2015 did not work due to too many restrictions and did little to expand credit. Differentiated licences allow banks to operate in specific sub-sectors of the banking vertical. Small finance banks (SFBs) and payments banks fall in this category. Payments bank licences were granted to 11 players, but only six banks are now operational. Those who have not surrendered their licences are exploring ways to convert into SFBs. The Aditya Birla Vodafone Idea Payments Bank, when filing for liquidation in 2019, said the business model was ‘unviable’. Payments banks cannot compete with traditional commercial banks. The restriction on deposits up to Rs 1 lakh per person makes these banks unviable; they cannot offer loans, and their income comes from interest on government securities and offering niche services like insurance and mutual funds. Even the share of deposits is limited to 12.4%, and it fails to meet operational costs. According to RBI, the consolidated net loss for payments banks was Rs 515.6 crore in March 2018, and increased to Rs 626.8 crore in March 2019.

According to RBI’s analysis of payments banks, “The limited operational space available to them and the large initial cost involved in setting up prevents them from breaking even.” The learning from the payments banks is that deposit restriction is not a way to grow credit; it’s impossible for any banking entity to compete, grow or create a sustainable model without access to deposits. Instead of putting safeguards on deposit collection or size, risks on investment, lending and leverage of deposits can be done. Differentiated banking licences are sorely needed for custodian banking. India needs to have specialised custodian banking if it has to remain attractive for foreign capital flows.

The Indian custodian market has Rs 45,000 crore of deposits, but these assets do not have the flexibility and security that a banking licence can provide. There are 19 custodians in India, but the bulk of the assets are controlled by a few MNCs. India does not allow specialised custodian banks, and as a result Indian custodians are at a severe disadvantage to MNC players. According to a report, the assets under custody (AUC) have increased by 36 times between 2002 and 2020. This growth would have been higher with a specialised custodian banking licence.

A custodian bank licence can double the AUC as it strengthens a crucial financial infrastructure link in the market. The biggest flow of AUCs is from foreign portfolio investments (FPIs), and the US makes up 33% of these investments. Currently, Indian non-bank custodians cannot be appointed as custodians for American investment due to the discriminatory US SEC Rule 17f-5. This rule prohibits non-banking foreign institutions to be appointed as custodians for US funds. FPIs do not want to appoint Indian PSBs as custodians as they are not comfortable with the high NPAs and the risk it entails their assets. Custodian banks have a very low risk profile, with NPAs of less than 0.2% as they do not lend long term. FPIs, mutual funds, insurance companies, local or global, prefer custodian banks for their requirements. They do not get this in India.

As a result, almost 90% of the custodian market of FPIs is cornered by overseas custodians. This also affects intra-day funding needs of FPIs and reduces their flexibility and increases their transaction costs for Indian markets. It prevents diversification of FPIs base beyond US investors as they do not find a private sector Indian custodian banking service provider.

RBI needs to consider custodian bank licensing. These specialised banks will not compete against PSBs, universal banks or SFBs for deposits or lending. These will target the FPI segment for both services and deposits, and deepen the capital flows.

The AUC of the Indian custody market, as of May 2020, stands at Rs 97 lakh crore. It’s still 2% of the world GDP and has the potential to double over the next few years, and indicates the potential for future growth. This will directly help in increased capital formation through equity markets and higher capital flows in the country. By allowing specialised custodian banks, integrated services can be more lucrative for FPIs. Furthermore, it will provide a level-playing field against US hurdles such as US SEC Rule 17f-5.


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