“Differentiated banks” are niche banks as they operate in specific sectors, under a different regulatory framework. The idea of “differentiated bank” was initially proposed by the RBI constituted Nachiket Mor Committee for financial inclusion (January 2014).

The committee envisaged the need for setting up specialized payment banks, wholesale banks, retail banks, corporate and infrastructure banks. Differentiated banks were propagated to address the financing needs of certain sections of the economy like infrastructure, micro, small and medium scale enterprises (MSME) and corporate businesses. The central bank is of the view that the advantages outweigh challenges in setting up a “differentiated banking licence regime”. As the regulator sets out to lay down a roadmap to roll out this new era, this paper attempts to explore the viability of the subject.

Universal banks vs Differentiated banks

While under universal banking, a single license enables a lending institution to lend across the credit spectrum; a differentiated license looks for specialised, niche lending. A universal banking license enables a bank to operate in both commercial and investment banking space and also act as a distributor of third party products.

Current status of differentiated license in India

RBI has granted approval for setting up of differentiated banks like, “small finance banks” and “payments banks”. The success of these new differentiated banks will depend upon its ability to reach out to the unbanked, rural sector of the economy, particularly micro finance units who have local market knowledge.

Next, in order for the differentiated bank license is wholesale and long term financing banks (WLTF). On April 7^th, 2017 RBI released a draft discussion paper to float wholesale and long-term finance (WLTF) banks that would fund long-term high-value projects – something similar to the development finance institutions (DFIs) of the past. These banks are expected to commence with a minimum paid up capital of Rs.1000 crore.

Need for WLTF banks in India now

Commercial banks account for almost 67% of the total financial sector assets in the country. As the economy is evolving, it is essential for the financial system to evolve towards a structure where apart from the universal banks; multiple differentiated banks also operate in their area of specialised domain. Competitive advantage, niche banking, core competency, enhanced efficiency, reduced intermediation cost, better pricing of products, improved allocation of capital, are some of the benefits expected to be accrued from these WLTF banks. Banks, due to asset quality setbacks have curtailed credit to industrial and SME sectors. Long term assets with maturity over three years have declined on the bank’s balance sheet. Thus, commercial banks have neither being able to meet the scale and sophistication needed by corporate nor infrastructure projects. It has also not penetrated adequately to reach out to unbanked sections of society. Long term infrastructure loans have been the biggest source of NPAs on the balance sheet of commercial banks, led by the power sector. This scenario presents an opportunity for differentiated banks like WLTFs to take up long term financing and also refinance MSMEs. They would also operate in the area of foreign exchange and trade finance. WLTF banks will also be the vehicles to provide impetus to market making in corporate bonds and credit derivatives, take out financing and warehouse receipts.

Universal banks – after differentiated banks are formed?

At the heart of the model of differentiated banks lies the vision of financial inclusion. Despite a universal banking license, the new generation private sector bank has not really made inroads in rural areas. While public sector banks led by the State Bank of India have managed to penetrate through the lengths and breadth of the country, financial inclusion remains a distant dream. As quoted in the report on financial inclusion, around 60% of households in rural and urban India do not have access to formal banking services. Differentiated banking model is expected to take away the burden or obligation to extend credit to infrastructure projects. Universal banks can focus on cleaning up its NPA problem and balance sheet. It would significantly free up capital to lend to productive avenues.

The model of differentiated licenses has strong positives and also a few negatives. Negatives originate from concerns of regulatory arbitrage, concentration and systemic risk and the past failed experiences (DFIs). The central bank will have to chalk out a roadmap for the roll out of WLTF licensing in a manner so as not to be reminiscent of the failed DFI model. IFCI and state finance corporations will also have to be reformed. Any significant government stake in these banks may stifle operational freedom. To set up a differentiated model of licensing banks is an enormous challenge for the central bank too. Each and every type of license will have to be backed up by its own set of regulations. So many banks also increase the risk of failures. Hence a resolution regime will have to be strengthened. As financial eligibility criteria are stringent seeking deep financial pockets, granting a license to the right market participant is crucial.