New Licenses in India’s Banking Sector

On April 2, the Reserve Bank of India (RBI) granted approval in principle to two of the twenty-five applicants for the first new banking licenses issued in over a decade. The move came following approval from the Election Commission to move forward now with granting licenses rather than waiting until after the election, which concludes May 12. The licenses were given to two relatively uncontroversial candidates: IDFC, a diversified financial services firm that focuses on infrastructure financing; and Bandhan, India’s largest micro-loan lender.

The in-principle approval granted to the two firms is valid for eighteen months. The firms will only be issued licenses to begin banking activities after complying with stringent requirements under RBI guidelines.

Licensing process

The two new licenses are part of a process that began in February 2010 when Pranab Mukherjee—then Minister of Finance—announced in his 2011 budget a new round of banking licenses, the first since 2003. When the RBI released the eligibility criteria for these new licenses, they were more inclusive than expected, opening the sector to Indian-owned conglomerates as well as financial services firms. The new criteria sparked interest in a diverse group of private sector players in India, from Tata Sons to Reliance Industries.

However, the licenses also came with strict guidelines designed to improve financial inclusion in India, where more than half the population still has no access to banking services. The guidelines require that the new banks set up 25 percent of their branches in rural areas with no banks having a population of no more than 10,000. In addition to the emphasis on serving the “unbanked” population rather than the more lucrative urban elite, the guidelines mandated that corporate applicants place existing financial services businesses into a holding company, a requirement which could pose difficulties for major conglomerates.

These challenges cause some corporate groups to revoke their applications, but the RBI still received applications from dozens of aspirants. Indian players were keen to follow the lead of other private sector players like HDFC Bank, which received a license in 1994 and is now India’s most valuable institution by market capitalization.

Ultimately, the RBI chose to issue licenses to two applicants unlikely to generate controversy. IDFC and Bandhan, the applicants granted licenses, are both financial services firms rather than corporate groups, and Bandhan’s emphasis on microloans is in line with the RBI’s goal of bringing banking services to the masses.

In addition to seeing the RBI as having made the “safe” choice, many firms that applied were disappointed that only two licenses were issued rather than the expected four or five. Among the applicants were conglomerates like Birla, Anil Ambani Group, Larsen & Toubro and Bajaj Group, as well as non-banking financial firms Edelweiss and LIC Housing Finance.

The RBI in its statement said that its decision to offer only two new licenses may be categorized as “conservative”, but given public concern about governance and the uncertain political climate due to elections, it was the “most appropriate” stance. The main opposition party, the Bharatiya Janata Party, was resistant to offering licenses before a new government is formed after the elections in May. Though the Election Commission gave the RBI to go ahead to issue licenses, the political uncertainty created by the election may have prompted the RBI’s cautious approach.

Future licenses

Applicants dissatisfied with the outcome of the current round of licensing have reason to be hopeful of a second chance. RBI Governor Raghuram Rajan has assured firms that banking licenses will be available “on tap” in the future, and that applicants can apply again for the RBI’s consideration. This would be a break with the RBI’s past practice of only occasionally and selectively offering banking licenses to new players.

In addition to a more frequent review of applications for banking licenses, the RBI has signaled that in the future it will also offer differentiated banking licenses. Differentiated licenses can be distinguished from the universal licenses recently granted to Bandhan and IDFC in that they will establish niche banks, which may offer only one service (for example, mortgages) or cater to only one sector. 

Niche banking in India?

The wide array of options available in India has created an inviting market for specialist banking. The prospect of a utility bank, for example, that provides transactional services, or a payment specialist bank that deals exclusively with home loans (one of the safest areas of lending for Indian banks), or an inclusion bank that serves only bottom-of-the-pyramid customers—all of these are untapped possibilities that can tremendously change the banking system in India and bring better services to large segments of the population.

India’s economic diversity is a ready ground for specialist and differentiated services where banks will be allowed to focus on individual niches and strengthen their capabilities – through access to payment systems, ability to raise deposits, regulatory oversight, etc.

The bank’s proposal to issue differentiated banking licenses has also gained attention from many foreign firms. Several mid-sized foreign lenders are keen to apply for such a license whenever the RBI decides to offer them in the future, though it is unclear whether the RBI would allow foreign lenders to operate under a differentiated license without first establishing a subsidiary. Under the current RBI rules, foreign banks that entered India after 2010 must operate as a subsidiary rather than setting up branches.

In an interview to Business Standard, an unnamed foreign lender said that “Of the 43 foreign banks in India, only four or five are engaged in full-fledged banking. The rest are doing specialized banking business, though they have been given a universal banking license. It makes sense for them to opt for a differentiated banking license and maintain focus on their core activity. We are certainly open to this idea.”

However, issuing differentiated licenses, whether to domestic or foreign players, will come with its own set of challenges. In the Economic Times, Shikha Sharma, chief executive at Axis Bank expressed her concern, saying, “India is a vast market and we need different approaches to different regions and segments, but we have to guard against regulatory arbitrage between differentiated banks. Different rules for different entities could be disruptive.”

Though differentiated banking offers significant possibilities, it is still unclear what the RBI’s timeline is for granting this type of license. In an October 2007 discussion paper, the RBI said that the case for such licensing may be reviewed after a certain degree of success in financial inclusion was achieved and the central bank was satisfied with the quality and robustness of the risk management systems of the entire sector. Subsequently, another paper published by the RBI recommended continuing with the current system until the RBI is satisfied with the quality and strength of the banks’ risk management system. One of the conditions for niche banks, the paper said, was a robust interbank market to avoid liquidity crunches and bank runs.

Early this month, RBI Governor Rajan was quoted as saying, "We hope to open the window soon...first for differentiated licenses like payment banks and then open the 'on-tap' licenses for universal banks." More frequent reviews of license applications and the possibility of differentiated licenses, along with the RBI’s decision last year to allow foreign banks to open subsidiaries in India, all indicate an ongoing interest in further opening India’s banking sector.