India faces a major financial exclusion challenge. According to the World Bank Global Findex Survey, only 35% of Indian adults have access to a formal bank account and 8% borrowed formally in the last 12 months. The Reserve Bank of India (RBI) Committee on Comprehensive Financial Services for Small Businesses and Low Income Households (or “CCFS”) was tasked with formulating policy recommendations to close this exclusion gap while protecting the stability of India’s financial system and the safety of customers’ deposits. The CCFS report marks a big step forward in India’s financial inclusion deliberations. We evaluate the CCFS recommendations below, focusing our analysis on the most critical financial inclusion question confronting the RBI: how to regulate non-bank payment actors. We highlight several promising elements in the CCFS report, while highlighting two risks that warrant further attention.
The CCFS report starts off on a strong foot, positioning electronic payments as a central plank in India’s financial inclusion strategy and calling for universal access to an electronic payment system by 2016. This is the right approach. Electronic payments are the connective tissue of a financial system. They enable people to buy goods and services, pay utility bills, and send money to friends and family. They enable governments to disburse social payments and collect taxes. And they enable suppliers to collect payments from buyers. Payments are also the building blocks of financial services. Savings is little more than a sequence of deposit payments and withdrawal payments. Credit involves loan disbursements to the customer followed by repayments to the bank. When poor households are entrenched in a cash economy with no access to electronic payment channels, it drives a wedge between them and the formal financial system by making it prohibitively costly for banks, insurance companies, governments, and other institutions to transact with them.
After establishing the importance of electronic payments in India’s financial inclusion strategy, the report then wisely separates the risks created by payment and deposit activities from those posed by credit. It does this by recommending the creation of a class of narrow banks, or “Payments Banks,” which can offer payments and deposits but not provide credit. The core principle is that a payments provider that accepts funds from the public and places 100% of those funds in secure assets (as designated by the central bank) is not exposed to credit risk. Of course, the RBI must still mitigate the technology, operational, and consumer protection risks associated with Payments Banks, but full-fledged banking regulations are not required given the lack of credit risk.
The report also acknowledges the critical role played by non-banks in extending electronic payment networks into poor communities, recommending that mobile operators, consumer goods companies, and other non-banks be allowed to apply for Payments Bank licenses. While banks are well positioned to deliver credit services, they have struggled in every market to extend payments and deposit accounts into poor communities. By contrast, countries that have carved out regulatory space for non-banks to offer these services have seen dramatic expansions in electronic account access. Indeed, just 4-5 years after the central banks of Kenya, Tanzania, and Uganda allowed non-banks to launch payments and deposit services, 77% of Kenyan adults and 47% of Ugandan adults have an electronic account, while 46% of Tanzanian households have at least one member of the household with an electronic account.
These electronic payment platforms are quickly integrating into national financial ecosystems and radically altering the cost of reaching poor people with financial, utility, and other services. Inspired by the dramatic gains in these countries, central banks in several key markets – including Brazil, Indonesia, Malaysia, Mexico, Peru, Rwanda, and Sri Lanka (among others) – have allowed non-banks to offer payments and deposits.
While these CCFS Committee recommendations promise to catalyze a big increase in financial inclusion in India, we flag two possible risks that could undermine the Committee’s objectives:
First, there is a risk that the Payments Bank licenses will have compliance costs that impair the business case for serving poor customers. The business case for serving poor customers with payments and deposits depends on particularly thin margins and is thus sensitive to changes in the cost structure. While the report wisely recommends that Payments Banks should have lower minimum capital requirements than credit issuing banks (Rs.50 crore versus Rs.500 crore), the report also recommends that Payments Banks should “comply with all RBI guidelines relevant for scheduled commercial banks (SCBs).” Given that traditional banking regulations are primarily designed to mitigate credits risks, we worry that this blanket requirement could saddle Payments Banks with compliance costs that are disproportionate to payments and deposit providers.
Second, the Committee recommends that all pre-paid instrument (PPI) providers be required to convert to a Payments Bank or become a Business Correspondent. We worry that this could create an unnecessarily high entry barrier for providers wishing to test new business models in this nascent sector. As mentioned, serving poor households with deposit and payments services hinges on thin margins. Therefore, non-bank payment actors may want to test the viability of this market before converting to a full-fledged Payments Bank. But if entry costs are too high, providers may choose not to enter the space altogether. One alternative may be to allow PPIs to operate (with cash-out functionality) until they reach a certain threshold deposit balance or customers base, at which point they must convert to a Payments Bank. This would create a more gradual path for payments and deposit providers to pilot different business models without establishing a full-fledged Payments Bank at inception.
The CCFS report is the most comprehensive and forward thinking central bank policy assessment we’ve come across. If the Committee recommendations translate into regulations, we believe it would trigger a significant expansion in financial inclusion in India. The task now is to ensure that non-bank payments regulations are proportionate to the risks involved.