Shortly after he was appointed in 2013, Reserve Bank of India (RBI) Governor Raghuram Rajan promised a “dramatic remaking” of India’s banking sector. The Bank has recently announced a number of major reforms for public and private banks, and 2015 is now being hailed as the year of the biggest banking revolution since 1949.

Making public sector banks efficient

In August, Finance Minister Arun Jaitley announced a seven-point reform agenda to revamp public sector banks and improve efficiency. Private sector leaders are being appointed to public sector banks, capital outlays have been increased, and a newly-created Banks Board Bureau will now function as the bridge between the government and the public sector banks. 

Scaling up private sector banks

Another major focus has been scaling up the presence of private banks. Recently, the RBI granted several private entities in-principle licenses to open small finance banks and payment banks. According to the central bank’s estimates, close to 90 percent of small businesses in India have no links with formal financial institutions. Commercial and mainstream banks focus on large and medium corporations, or loans for home and vehicle purchases. Small finance banks operate similarly to normal commercial banks, but attempt to capture market segments that regular banks have ignored because of their smaller capital requirements and lack of formal documentation. Many of the entities granted small bank licenses are microfinance institutions (MFIs) that already have a wide reach. Becoming small banks will allow these MFIs to bring down the cost of funds, enabling them to offer lower interest rates to customers. 

Prime Minister Modi’s Jan Dhan financial inclusion plan has already provided more than 180 million bank accounts in the last year to unbanked Indian citizens. Payment banks present an unprecedented opportunity for the government to continue to push their financial inclusion goal by ensuring last mile connectivity – India Post and the three telecom companies that have been awarded payment bank licenses have access to millions of unbanked citizens in small towns and villages. Driven by mobile technology, the new payment banks will make banking accessible to everyone. Though payment banks are not allowed to offer loans, they will function as savings banks, allowing customers to make deposits, access ATMs, and take advantage of competitive interest rates. Payment banks are also collaborating with larger banks to offer a more comprehensive portfolio of financial products and services.

Channelling credit to new priority sectors

After more than 32 years, the RBI has taken measures to revamp Priority Sector Lending (PSL) norms, which require banks to provide credit to specific vulnerable sectors. The central bank is working to align the designated PSL sectors with the government’s current social priorities. Sectors such as social infrastructure, water and sanitation, and renewable energy have been added to the list of priority sectors. The scope of agriculture lending has been extended beyond farming to food processing, agriculture infrastructure, and other ancillary activities. To create a level playing field, foreign banks, which were previously exempt from the norms, have now been asked to meet PSL targets by 2018. For foreign banks, export credit up to 32 percent will be available as part of priority sector lending.

India’s banking sector outlook

Forty percent of India’s population remains unbanked, presenting a huge business opportunity for private banks. India requires around $750 billion for infrastructure investment over the next five years — this means that there could easily be over $200 billion a year in terms of credit requirements. Today, India only has $100 to $120 billion of capital available, leaving a massive supply-finance gap that new banks can address. The banking sector will also directly benefit from the rapid growth of e-commerce. Banks are increasingly investing in digital technology – transactions through mobile banking have increased exponentially in value, going from just over $277 million in FY12 to over $16 billion in FY15.

As competition intensifies, banks will be forced to innovate to stay relevant. Apart from the new licenses granted to payment banks and small banks, foreign banks are now looking to open subsidiaries and increase their branches in India. A new regulation allows foreign banks to expand aggressively and even buy out weaker local banks. The RBI may also allow some of the strong urban cooperative banks to convert themselves into commercial banks. 

Even though the government is making a significant effort to facilitate the “dramatic remaking” of India’s banking sector, the system still faces many challenges. India is overburdened with bad loans and many banks are starved of capital; several corporate entities are highly overleveraged, and are unable to service loans. Nevertheless, given India’s encouraging macroeconomic outlook and its overall favorability as an investment destination, the country is set to become one of the most dynamic banking industry hubs in the coming years.