On payment banks: Rajan is right, Bhattacharya is wrong

On August 19, 2015, the Reserve Bank of India (RBI) gave an approval to 11 entities to start “payment banks”. These include Vodafone, PayTM, Department of Post, Aditya Birla Nuvo, Reliance Industries, Airtel M Commerce, Vodafone m-pesa etc. As the name suggests, payment banks will be allowed to collect money from depositors and make payments to others, on their behalf.

These banks can accept deposits of up to Rs 1 lakh only. Further, they are not allowed to give out loans like normal banks are. A bulk of the deposits they collect need to be invested in government securities which mature in a period of up to one year.

So what is the idea behind setting up these banks? The simple answer is financial inclusion—to improve the penetration of the banking system in India. A recent World Bank report points out that between 2011 and 2014 the number of bank accounts in India increased by 17.5 crore, thanks to a massive push by the government. With this increase in numbers, the penetration went up from 35% to 53%. The worrying thing is that even after this massive increase, half of India does not have a bank account.

Further, the high dormancy rate is another worrying factor. As the World Bank report points out: “India, with a dormancy rate of 43 percent, accounts for about 195 million of the 460 million adults with a dormant account around the world.”

The hope is that payment banks will help address this problem to some extent.  As the Draft Guidelines for Licensing of “Payments Banks” document points out: “There is a need for transactions and savings accounts for the underserved in the population…Higher transaction costs of making remittances diminish these benefits. Therefore, the primary objective of setting up of Payments Banks will be to further financial inclusion by providing (i) small savings accounts and (ii) payments / remittance services to migrant labour workforce, low income households, small businesses, other unorganised sector entities and other users, by enabling high volume-low value transactions in deposits and payments.”

The RBI governor Raghuram Rajan has been a driving force behind these banks and sees them as a game-changer. Nevertheless, the existing banks are not looking forward to the competition that these new banks will bring in.

As Arundhati Bhattacharya, chairperson of the State Bank of India said recently: “Why this payments bank is a little worrisome is because they will be allowed to have savings deposits. What if they go for poaching rates, then many of the commercial banks could lose a portion of the deposits which are relatively lower priced so that will take away the ability to transmit rates and give further loans at lower rates.”

What Bhattacharya is worried about is that the new payment banks will try and attract savings deposits at a higher rate of interest. Most big banks currently pay around 4% on deposits on their savings accounts. It is a cheap source of funding for them.

The payment banks will offer higher rates of interest on deposits, Bhattacharya feels. This is a possibility. The question is how high? The payment banks are not allowed to give out loans. Further, they are allowed to invest only in government securities of up to one year. Also, they are supposed to maintain a cash reserve ratio of 4% with the RBI. On these deposits no interest is paid. If all these factors are taken into account, the payment banks cannot go overboard with offering very high rates of interest on deposits, if the idea is to make profits.

As Rajan said in response to Bhattacharya: “I don’t think these 11 new banks are a threat to the existing banks. These new banks will complement the existing system by traversing the last mile. The reason for this is that there is nothing the universal banks cannot do that the payments banks can do. But there are some of the things that the payments banks can’t do which the universal banks can.”

What Rajan meant here was that payment banks unlike scheduled commercial banks cannot give out loans. And that limits their ability to make profits. And given that they cannot go overboard while offering a higher rate of interest to attract deposits.

Another fear that has been raised is that people will move their money from scheduled commercial banks to payment banks in order to be able to pay electricity/telephone bills etc. The point is that people are already using services offered by scheduled commercial banks to pay such bills. Hence, there is no real reason for them to move on to a payment bank, lock, stock and barrel.

If we might just rephrase what Rajan said: “A scheduled commercial bank can do everything that a payment bank can do.” In fact, a lot of them already have the necessary infrastructure in place to do things that payment banks are likely to do.

Also, banking in cities and urban areas is pretty much stagnated. The low hanging fruit has more or less been taken. If payment banks want to attract deposits, they need to look beyond the middle class, and look at the urban poor as well as the rural areas to attract deposits.

Anybody who has read Rajan’s first book Saving Capitalism from the Capitalists (co-authored with Luigi Zingales) would know where his thinking is coming from. In this book Rajan explains in great detail as to how the only way to develop finance is to increase competition. As he writes along with Zingales: “Finally, and perhaps most important, increased competition resulting from forces beyond control of incumbents—in particular, competition as a result of technological changes…—can reduce incumbents’ incentives to use financial underdevelopment as a barrier to domestic entry.”

What does this mean in the context of payment banks? Payment banks will bring in increased competition through forces that are beyond the control of incumbents i.e. the scheduled commercial banks. Further, payment banks are likely to use a lot of technology in their bid to expand the market. This will keep the scheduled commercial banks on their toes.

Rajan is hoping that payment banks will bring in a new way of doing things. As he said last week: “The bank branch can become a centre of activity, helping with cash handling or do some completely new work…There is a lot of scope for everyone… not everybody will succeed but this is a revolution which can happen.”

Further, if these banks end up expanding the banking penetration of the country, Bhattacharya’s fear of interest rates going up, will not hold true. If payment banks are able to expand the total deposit base of the country at a faster rate than the current rate, the interest rates are likely to come down.

So, why did Bhattacharya react the way she did? Rajan and Zingales have an explanation for that in their book. As they write: “Throughout its history, the free market system has been held back, not so much by its own economic deficiencies as Marxists would have it, but because of its reliance on political goodwill for its infrastructure. The threat primarily comes from…incumbents, those who already have an established position in the marketplace…The identity of the most dangerous incumbents depends on the country and the time period, but the part has been played at various times by the landed aristocracy, the owners and managers of large corporations, their financiers, and organised labour.”

Bhattacharya runs the biggest bank in the country, the State Bank of India. And given that she is an incumbent, and incumbents don’t like increased competition. It tends to disrupt their existing business model. Hence, her reaction was not surprising.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on SwarajyaMag.com on August 25, 2015