Why Waiving Off UP Farm Loans is a Bad Idea, Nevertheless…

In the run-up to the assembly elections in Uttar Pradesh, the Bhartiya Janata Party had promised that it would waive off crop loans taken by the small and marginal farmers of the state.

Political parties promising to waive off crop loans is nothing new. Before the 2009, Lok Sabha elections, the Congress led United Progressive Alliance government had carried out a similar exercise.

The question, as always, is how much is it going to cost and where is the money going to come from? The State Bank of India in a research report expects the cost of waiving off crop loans to small and marginal farmers to come at around Rs 27,419.7 crore. How have they arrived at this estimate? The total loans given by banks to the agriculture sector in Uttar Pradesh stands at Rs 86,241 crore.

As the SBI report points out: “According to RBI data (2012), 31% of the direct agriculture finance went to marginal and small farmers (landholdings upto 2.5 acres). Taking this as a proxy for Uttar Pradesh as well, approximately Rs 27,419.70 crore will have to be waived off in case loan waiver scheme is implemented for the small and marginal farmers for all banks (scheduled commercial banks, cooperative banks and primary agricultural cooperative societies).”

The SBI estimate suggests that the loan waive off will cost around Rs 27,420 crore. The banks which had given these loans will have to be compensated for this waive off. The union agriculture minister Radha Mohan Singh in a series of tweets on March 17,2017, made it clear that the union government wasn’t picking up the tab. In one of the tweets he said that, if any state government waives off the loans of small and marginal farmers using the state treasury, the move should be welcomed. Hence, from the looks of it, if the loans are waived off, the Uttar Pradesh government will have to pick up the tab.

Take a look at Figure 1. It shows the fiscal deficit of the Uttar Pradesh government over the years. A government is said to run a fiscal deficit if its revenue is less than its expenditure. This difference the government makes up through borrowing money.

As can be seen from Figure 1, the fiscal deficit of the state has risen at a much faster pace than its gross domestic product over the years. While, the state GDP has jumped by 59.3 per cent between 2011-2012 and 2015-2016, the fiscal deficit has jumped from 2.13 per cent of the state GDP to 5.57 per cent of the state GDP, at a much faster pace.

Figure 1:

YearGross Fiscal DeficitState GDP at current prices (in Rs crore)Fiscal Deficit as a percentage of GDP

*budget estimate
**revised estimate
Source: /or GSDP, the RBI’s Database on Indian Economy.
For deficit, budget.up.nic.in and RBI Reports on State Finances
^Source: www.business-standard.com
^^ Calculated on the basis of 4.04 per cent and Rs 49,961 crore fiscal deficit estimates.

In 2016-2017 which is the current financial year, the fiscal deficit of the state government is expected to be at 4.04 per cent of the state GDP. In absolute terms it was expected to be at Rs 49,961 crore. If the Uttar Pradesh government waives off the loans during the course of this financial year, then the fiscal deficit in absolute terms would shoot to Rs 77,381 crore (Rs 49,961crore plus Rs 27,420 crore of the waive off), assuming that expenditure and revenue assumptions made at the beginning of the year, hold true. This works out to 6.26 per cent of the state’s gross domestic product and is a really high figure.

So, the question is can Uttar Pradesh government afford this? The answer clearly is no. Can the union government in Delhi afford it? The answer is yes. Rs 27,420 crore is not a large amount for it. But if it goes ahead and finances this write off, similar demands will be raised by other states as well. And given that the Bhartiya Janata Party governments now govern large parts of the country, it will be very difficult for the union government to say no.

Over and above the one-time cost to the state government, there is also the question of moral hazard. The economist Alan Blinder in his book After the Music Stopped writes that the “central idea behind moral hazard is that people who are well insured against some risk are less likely to take pains (and incur costs) to avoid it.”

This basically means that once the farmer sees a loan being waived off today, he will wait for elections in the future for the newer loans he takes on to be waived off as well. Essentially, he will see little incentive in repaying loans that he takes on in the future.

As the SBI Chairperson Arundhati Bhattacharya said recently: “We feel that in case of a (farm) loan waiver there is always a fall in credit discipline because the people who get the waiver have expectations of future waivers as well. As such future loans given often remain unpaid… Today, the loans will come back as the government will pay for it but when we disburse loans again then the farmers will wait for the next elections expecting another waiver.”

All this makes tremendous sense. But given that we live in the age of whataboutery, you, dear reader, may comeback and ask us: “But what about the fact that banks have written off lakhs of crore of loans that they gave to corporates? If they can do that, why can’t they waive off Rs 27,420 crore?”

This is a very good question for which I really don’t have a straightforward answer. In situations like these I suggest, dear reader, that you read George Orwell. As he famously wrote in the Animal Farm: “All animals are equal, but some animals are more equal than others”.

The point is that if there is a moral hazard for the farmer, there is also one for the corporates.

For today, we will leave it at that.

The column was originally published on March 22, 2016

Why SBI is Launching a Home Loan that Caused the Financial Crisis




In August 2015, Arundhati Bhattacharya the Chairman of the State Bank of India (SBI), had suggested that the country’s largest bank be allowed to launch teaser rate home loans. As she had said back then:In fact, the first suggestion that I made (was) that, for a limited period, home loans could be given at below base rate for the already heavy stock of housing.” Base rate is the minimum interest rate a bank charges to its customers.

The bank had first launched teaser rate home loans in 2009. These loans are essentially home loans in which the interest rate is fixed in the initial years and is lower than the normal floating interest rate on a home loan. The lower interest rate is limited only to the first two-three years, after which the loan is priced at the prevailing interest rate on the home loans. Hence, the EMIs for the borrower during the first few years are lower than they would have been in the normal scheme of things.

Yesterday (i.e. February 1, 2016), SBI went a step further, and launched a home loan in which the monthly payments initially will be even lower than the EMIs paid in case of teaser rate home loans. It launched what it calls the SBI FlexiPay Home Loan.

As the press release of the announcement of this home loan points out: “The new offering, ‘SBI FlexiPay Home Loan’will enable young working professionals / executives to get higher loan amount compared to their loan eligibility under normal Home Loan schemes. The additional loan amount will help such professionals in acquiring better and spacious living spaces for themselves and their families, taking into account their future needs.”

Hence, anyone applying for a FlexiPay Home Loan will get a higher amount of home loan than his or her loan eligibility would permit under normal circumstances. And there is more to this as well. As the SBI press release points out: “Further, to lower the impact of such additional loan amount on monthly repayments in the form of EMIs, the customers availing Home Loan under ‘SBI FlexiPay Home Loan Scheme’ will also be offered the option of paying only interest during the moratorium (pre-EMI) period of 3 to 5 years, and thereafter, pay moderated EMIs. The EMIs will be stepped-up during the subsequent years.”

So, other than getting a higher loan amount, the loan also comes with the option of the borrower only paying the interest on the loan during the first few years. And this makes things very interesting.

As the SBI press release points out: “Soaring aspiration levels and rising awareness about the impact of quality living spaces on healthy and harmonious living are resulting in our newer generation of working professionals to show greater preference for better and larger homes. But they are constrained from purchasing their dream homes due to the relatively lower income available at early stage of their career.”

Hence, the FlexiPay home loan will essentially allow people buy a home which they otherwise wouldn’t have been able to afford given their current level of income. As SBI puts it, the loan tries to “to bridge the gap between affordability and demand for quality residential spaces in the country”.

There are multiple questions that arise here. Let me try and answer them one by one.

a) Why is SBI doing this? The answer lies in the numbers. The bank like other public sector banks has significantly lower bad loans when it lends to retail consumers than when it lends to corporates. As on September 30, 2015, the bad loans when it came to lending to retail sector (i.e. home loans, auto loans, personal loans etc.) were at 1.03% of the total lending carried out to the sector. This number had been at 1.37% as on September 30, 2014.

In comparison, the bad loans while lending to mid-level corporates were at 10.62%. Bad loans while lending to small and medium enterprises were at 8.72%. Also, while the overall bad loan rate in case of retail loans is 1.03%, it is safe to say that the bad loans rate while giving out home loans would be lower.

One explanation for this lies in the fact that it is easy to unleash legal proceedings (or the threat of) against retail borrowers and get them to pay up than it is to do against corporates. Hence, it makes sense for the bank to give out home loans in comparison to other loans, where recovery is difficult.

In fact, between September 2014 and September 2015, 25% of all domestic lending carried out by the bank was in the form of home loans.

b) Should SBI be doing this? It is clear that SBI wants to give out more home loans. The trouble with the FlexiPay home loan is that it relaxes the lending standards while giving out a home loan. As the press release points out that the loan will help the borrower “to get higher loan amount compared to their loan eligibility under normal Home Loan scheme”.

While this will allow the bank to lend more, relaxing lending standards in order to lend more is not always the best way to expand the loan book. As the SBI press release further says the loan will help “to bridge the gap between affordability and demand for quality residential spaces in the country”.

The function of any bank is to give loans and to give them out to those people and institutions who are likely to return it. It is not the function of a bank to improve the real estate scenario in a country by lowering its lending standards.

Further, in the interest only version of the loan the EMI is likely to jump up once the principal repayment (through the EMI) also kicks in after a period of three to five years. In fact, even after three to five years, when EMIs kick-in, the borrowers will have to “pay moderated EMIs”.

The bank is essentially working with the assumption that the income of the borrower will go up during the period and he will be in a position to pay the higher EMI. But is that likely to be the case?

Let’s try and understand this through an example. The scheme allows for upto 1.2 times higher loan eligibility compared to the loan eligibility under the normal home loan scheme. The loan amount has to be Rs 20 lakh or higher. What this means is that anyone with a loan eligibility of Rs 50 lakh under normal conditions, can take a loan of upto Rs 60 lakh.

Over and above this he can choose only to pay interest on it for the first five years. The current rate of interest on an SBI home loan is 9.55% (9.5% for women). Hence, the monthly payment for the first five years will come to Rs 47,750 (9.55% of Rs 60 lakh divided by 12).

The question is if the borrower chooses to pay this amount as an EMI what loan amount will he be eligible for? SBI offers a tenure of up to 30 years on its home loans. At an interest of 9.55% and a tenure of 30 years, an EMI of Rs 47,750, is good enough to repay a loan of Rs 56.55 lakh, which isn’t very different from Rs 60 lakh. (The EMI for a Rs 56.55 lakh home loan to be repaid over 30 years and at an interest of 9.55% comes to Rs 47,757).

The trouble is the eligibility of the borrower under the normal home loan is only Rs 50 lakh and he won’t get a loan of Rs 56.55 lakh. By structuring the loan the way it has, SBI gets to collect interest longer than it actually would have.

What happens once the EMI kicks in after five years? The bank talks about moderated EMIs. It does not define what it means by it. Assuming that principal repayment starts after five years, the EMI will jump to around Rs 52,630.5. This means that the borrower will repay the home loan over the next 25 years, making the total tenure of the loan repayment 30 years. The scheme allows for repayment period of 25 to 30 years.

If the repayment is made over the next 20 years, meaning a tenure of 25 years, the EMI jumps to Rs 56,124. The EMI does not increase significantly in comparison to the earlier monthly payment. The reason for this lies in the fact that SBI has limited the loan eligibility under this scheme to just 20% more than the normal home loan scheme. Hence, to that extent SBI is not making a very risky loan, even though it is taking on some more risk than it currently is.

Also, it is important to understand here that once SBI launches a product, other banks and housing finance companies will have follow. If they stick to 1.2 times the normal loan amount, they will not be giving out very risky loans. If they get aggressive and up the ante, that will mean the lowering of home loan lending standards throughout the system. Hence, the RBI will have to keep a watch on this.

c) What can we learn from the American experience? Interest only home loans were a big reason behind the home loan bubble in the United States between 2000 and 2007. In the American context they were referred to as the option adjustable-rate mortgage (ARM). An option ARM was a 30-year home loan in which the borrower had the option of paying a lower EMI initially. One version of the product was called 5/1 interest-only option ARM.
In this, the interest rate was reset after the first five years and then every year after that. Also, for the first five years, the bor­rower needed to pay back only interest on the home loan. In the American case, the interest rate in case of an interest only home loan was significantly lower than the normal home loan.

Hence, this product allowed borrowers to buy homes which were significantly more expensive than they could afford. In the Indian case, the interest on the interest only home loan is the same as the normal home loan.

Also, in the United States, after a point there was a race among banks and financial institutions to give out these loans. As more such loans were given, home prices went up, leading to a huge real estate bubble.

Once the higher EMIs started kicking in, the borrowers started defaulting on their loans. This eventually led to the start of the financial crisis that the world is currently battling. Given this, the lessons from the American experience are very clear. Interest only home loans are pretty risky if the interest rate differential between a normal home loan and an interest only home loan is high. That is clearly not the case with the new SBI FlexiPay home loan and this brings us back to the original question.

d) Why is the SBI doing this? From what the RBI governor Raghuram Rajan has been saying, it doesn’t seem that this home loan scheme would have had a total buy-in from him. Given this, I think SBI may have been nudged to launch this scheme by the finance ministry, in order to get the real estate sector going in this country. Given that I have no evidence for this, to that extent this remains a conspiracy theory.

Nevertheless, if this scheme and other such schemes launched by other banks and housing finance companies gain some traction, they will prolong the real estate bubble in the country even more. Hence, instead of reviving real estate, it will make purchasing a home even more difficult. At the same time, I don’t think SBI is taking on an undue risk by launching this scheme. But it remains to be seen how other banks enter this space. If they lower lending standards by increasing the loan eligibility further, we may have a problem.

The column originally appeared on the Vivek Kaul Diary on February 2, 2016

Why the State Bank of India is in love with home loans

In yesterday’s edition of The Daily Reckoning
, I had discussed why teaser rate home loans are a bad idea. Arundhati Bhattacharya, the chairperson of the State Bank of India (SBI), recently put forward the idea that the country’s largest bank should be allowed to launch teaser rate home loans.

As I had explained yesterday, teaser home loans are essentially home loans in which the interest rate is fixed in the initial years and is lower than the normal floating interest rate on a home loan. The lower interest rate is limited only to the first two-three years after which the loan is priced at the prevailing interest rate on home loans.

The question is, why does Bhattacharya want to launch teaser rate home loans? Let’s look at some numbers of SBI. As on June 30, 2015, the bank had given out home loans worth Rs 1,63,678 crore, having grown by a robust 13.5% since June 30, 2014.This, when the overall domestic lending grew by a much slower 5.38%.

Between June 30, 2014 and June 30, 2015, the bank gave out home loans worth Rs 19,468 crore. Where did the overall lending stand at? The total domestic lending of the bank grew by Rs 54,255 crore during the same period. Hence, home loans formed a massive 35.9% of the total lending that SBI has done within India, between June 2014 and June 2015.

To rephrase the earlier sentence, more than one third of all domestic lending of SBI, over the last one year, has been in the form of home loans. For a diversified bank, which is not just a home loan company, this skew is way too pronounced.

Nevertheless, even after this, why does Bhattacharya want to give out more home loans, by launching teaser rate home loans? In order to answer this question I would need the average home loan size of SBI. I found two newsreports, which gave me two very different numbers. One report published in October 2014, quoted a senior SBI executive said that the average home loan size in case of SBI was at Rs 30-32 lakh. Another report published in April 2015 said that the average home loan size in case of SBI was at Rs 20 lakh.

The second number seems to me more believable given that the average home loan size of HDFC is Rs 23.4 lakh (HDFC shares its average home loan size every quarter). My guess is that the average home loan size of SBI would be a little lower than that of HDFC, given its better reach.

So we will work with an average home loan size of Rs 20 lakh. The next number needed is that home loan to value ratio, at the time the loan is given out. I couldn’t find that number for SBI (dear reader, hope you understand how difficult it is to get numbers on anything in India, despite the improvement over the years).

The number in case of HDFC is 65%. What this means is that on an average HDFC gives 65% of the market value of a home being bought, as a home loan.  If we work with this number, the average market price of a home that SBI is giving a loan against is around Rs 31 lakh (Rs 20 lakh divided by 0.65). But this does not take one factor into account.

Almost no real estate deal in India is carried out totally in white money. There is a portion of black money that inevitably needs to be paid. It is very difficult to arrive at an all India number, but my guess is that 75:25 is a good conservative ratio to work with. This means that 75% of the value of the home is paid in white and the remaining in black.

Once this factor is taken into account the market price against which a home loan is given, shoots up to around Rs 41 lakh (Rs 31 lakh divided by 0.75). What does this mean? This means that the loan to value ratio is a little under 50% (Rs 20 lakh expressed as a percentage of Rs 41 lakh).

Hence, giving out home loans is a very safe form of lending. In fact, it is the safest form of lending. For mid-level companies, bad loans were at 10.3%. So for every Rs 100 that SBI gave as loans to mid-level companies, a little over Rs 10 wasn’t repaid.

For, retail loans the bad loans were at 1.17%. The bank does not give a separate number for home loans. Auto loans, education loans and personal loans, are the other forms of retail loans. The default rates in case of these loans is likely to be higher. Hence, the bad loans case of home loans should be lower than 1.17%.

The bad loans in case of HDFC amount to 0.54% of the total loans. What this means clearly is that almost no one who takes on a home loan defaults on it. Given this, it is not surprising that Bhattacharya wants to be allowed to launch teaser rate home loans. It is better for her to do that than be lending to corporates. As Bhattacharya had said: “This is one portfolio where NPAs are the lowest.”

The fundamental problem with teaser rate home loans is that a bank cannot be allowed to give out a loan at a rate of interest lower than its base rate or the minimum interest rate a bank charges its customers. Also, they cannot really be compared to normal home loans, given that the chances of the EMI jumping up in the years to come is significantly higher in case of teaser home loans. And that is a risk that Bhattacharya probably hasn’t taken into account.

The column originally appeared on The Daily Reckoning on August 27, 2015

Ms Bhattacharya, teaser rate home loans are a bad idea


Vivek Kaul

The recent suggestion by the State Bank of India (SBI) Chairperson, Arundhati Bhattacharya, to get back teaser rate home loans into the system, has once again sparked the debate over this controversial product. Bhattacharya recently said at an event where the Reserve Bank of India governor Raghuram Rajan was also present: “In fact, the first suggestion that I made (was) that, for a limited period, home loans could be given at below base rate for the already heavy stock of housing.”

In early 2009, SBI had started a teaser home loan scheme at 8%. Bhattacharya went on to add: “Of course, at that time, it was tagged as a ‘teaser’, but, we at SBI, refute that because the due diligence conducted for those loans was same as for others. Even the eligibility (criteria) was same as for regular loans.”

Teaser home loans are essentially home loans in which the interest rate is fixed in the initial years and is lower than the normal floating interest rate on a home loan. The lower interest rate is limited only to the first two-three years after which the loan is priced at the prevailing interest rate on home loans.

For example, the interest rate on a teaser home loan may be fixed at 8% for the first two years, when the prevailing home loan rate is 10%. From the third year onwards, the prevailing interest rate on home loans is charged to the borrower.

The idea with teaser rate home loans is that at lower rates of interest initially, the EMI will also be lower. This will encourage more people to take on a home loan and buy homes. This Bhattacharya feels will help in clearing the inventory of unsold homes that has piled up all over the country. As she said: “Today, the base rate is 9.7%. I am told that real estate inventory is at a two-year high and I was thinking if it is possible for a little while… could something of this (teaser loan) kind be allowed.”

There are multiple problems if anything of this sort were to become a reality. First and foremost, is it the job of the nation’s largest public sector bank to help real estate companies’ clear unsold inventory? From whatever little I have learnt on how banks should operate, the primary objective of a bank is to lend to those who are likely to repay and also, make money in the process, without increasing the overall riskiness of the financial system. Second, why should a bank be allowed to lend below its base rate or the minimum interest rate a bank charges its customers?

Third, if a bank gives out a teaser rate home loan at let’s say 8%, is it making money on that lending? And if it’s not, why is it lending in the first place?
When SBI first started offering teaser rate home loans in February 2009, under the leadership of OP Bhatt, it received criticism from all fronts. Teaser loans were a major reason behind the financial crisis that had started in the United States in September 2008. The difference in the Indian and the American context was that the teaser home loans that SBI was offering, were nowhere as aggressive as the teaser home loans that had been offered in the United States.

In the American context some teaser loans were so structured that only a certain amount of interest had to be paid in the first few years. Hence, the difference between the initial EMI and the actual EMI which kicked in after the “teaser-rate” was over, was huge. Hence, it led to huge defaults. That wasn’t the case in India.

Nevertheless, given the environment in the immediate aftermath of the financial crisis, the teaser home loan did not go down well with the banking regulator. Also, as we shall see, a certain amount of risk did remain in the product. Further, even though, the other lenders such as HDFC, ICICI Bank etc., joined the teaser loan bandwagon and started offering teaser loans, they made it amply clear that they were only responding to competition.

In fact, Deepak Parekh, Chairman of HDFC had called teaser loans a “marketing gimmick”. He had also explained why the product remained risky, even in an Indian context. As he told the Mint newspaper in an interview: “Today what we are saying is, if it’s 8% or 8.25% for the first two years, the rate will be 9% afterwards and so the gap is very little. Suppose interest rates in India shoot up in the next three years, then what will happen? These are all floating rate loans and fixed only for first two years. So, 8% interest will become 12% or even more. Then, the gap will be too much and it’s a problem for the individual home-owners.”

And home loan interest rates did rise eventually in the years to come. There is no data available in the public domain to figure out what was the impact higher interest rates had on those who had taken on a teaser loan.

Further, as Parekh explained: “Financial innovation doesn’t take time; if one does it, everyone copies. It can be done in 24 hours.” If SBI were to launch a teaser rate home loan right now, every other bank would launch a similar product in quick time. This would increase the overall risk in the financial system.

Given all these reasons, teaser loans are a bad idea. And it is surprising that the idea to re-launch them has come from the head of the largest bank in the country. The good news is that it is unlikely that Raghuram Rajan is in the mood to listen to this suggestion.  In fact, he made it clear recently to real estate wallahs (real estate companies, lobbies and others associated with the sector) that they should stop asking for lower interest rates every time they open their mouths to speak. He asked them to start cutting prices instead.

As Rajan said: “It would be a “great help” if realty developers sitting on unsold stock bring down prices…Once the prices stabilise, more people will be keen to buy houses…I think we need the market to clear. With growing unsold stock, we need to see the ways to do it. Some of it might be by making loans easier, but we also don’t want to create a situation where prices stay high at the level which means demand can’t pick up.”

Also, as I have said many times in the past, real estate prices are at a level, where slightly lower EMIs really won’t make much of a difference. The real demand for homes to live in will only come in once builders start to cut prices.

The column originally appeared on The Daily Reckoning on Aug 26, 2015

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