Friday, January 10, 2014

Thoughts on Payments and Wholesale Banks

The RBI appointed Nachiket Mor Committee has recommended interesting reforms to promote financial inclusion. As it reports, more than 90% of small business have no access to formal institutions, while over 60% of Indians have no bank accounts. Two important reforms suggested are the establishment of a Payments Bank, to serve as a small savings platform, and a Wholesale Bank, to make larger consumption and investment loans. The former will not be allowed to assume any credit risk, while the later shall accept deposits of only more than Rs 5 Cr. Here are a few observations,

1. Since the Payment Banks will have to invest their proceeds in approved SLR securities, there is the strong likelihood that they'll become captive financiers for the government. Instead of aligning incentives so as to discourage the government's capital "crowding-out" tendencies, these institutions may actually end up furthering the distorted incentives.

2. The Committee also suggests that scheduled commercial banks (SCBs) too could establish Payments Bank. There is the possibility that the SCBs could focus their financial inclusion activities to mere provision of a savings channel, thereby lowering the focus on the provision of other benefits from access to full-service institutions - loans, insurance products etc.

3. Fundamentally, if the recommendations are acted upon, it will seek to dis-aggregate the banking system - a savings bank (payment bank), a lending bank (wholesale bank), and the existing regular banks. Even if it has functional benefits, by way of furthering financial inclusion, does it raise the transaction costs?

Consider this. Today the same bank does both deposit-taking and loan-making, thereby have negligible internal intermediation costs between the two activities. According to the recommendations, one set of banks will exclusively take smaller deposits, while another will exclusively make large consumption and investment loans, thereby adding a layer of intermediation cost between the now two distinct entities. In other words, if this is true, then the benefits of dis-aggregation has to outweigh the Coasean benefits (for both the bank as well as its customers) from a full-service bank. I am not sure.

4. Finally, what about the existing institutions like the regional rural banks and grameen banks set up to further financial inclusion? The Committee appears to have fallen victim to the illusion of creating new institutions instead of getting the existing ones working. With minimal reforms, effective management, and robust oversight, these existing institutions could well serve the same purpose, and at much lower cost.

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