Niche banking are those banks that target a specific market or specific type of project and bridge the needs of banks tailored to the specific needs of certain categories of customers.

Why do we need such a banking system? What is the problem with the banking system that is run under the Scheduled commercial banks? We shall study in this chapter.

Problem of India’s Niche Banking Sector

A significant portion of India’s population, especially in rural areas, remains unbanked or underbanked. India faces two types of challenges in the banking sector:

1. Indian Banking system operates with less capital: The impact of insufficient capital can extend beyond the banking sector, affecting various industries. With banks lacking capital, they are less likely to expand their outreach to these underserved areas. This creates a vicious cycle of financial exclusion, leaving these populations dependent on informal or predatory lenders.
2. People are not financially included in the formal banking system, especially in rural areas where people have to rely on informal lenders.

Impact of Insufficient capital on the Indian economy

• Higher Interest Rates: When banks operate with less capital, they increase interest rates, making it expensive for small businesses to operate.
• Access to Credit: people have to rely on informal lending and shadow banks or face a complete lack of access to credit.
• Supply Chain Disruptions: Banks provide crucial financing to supply chains, particularly in manufacturing industries. Poor lending leads to disruptions or delays in production schedules.
• Reduced Consumer Spending: Lower credit leads to to lower consumption and often even leads to lower consumer incomes which can hurt overall economic growth.
• Investment Slowdown: Limited access to capital stifles new investment in sectors like infrastructure, technology, and renewable energy, where significant capital is required. This hampers long-term growth and job creation.
• Low Access to Agricultural Credit: The risk on agricultural credit is high but the return is low.
• Rural Distress and Dependence on Informal Credit: With limited access to formal financial systems, farmers often resort to informal, high-interest lenders (like moneylenders). This can lead to cycles of debt, worsening rural poverty, and contributing to even farmer suicides.
• Crop Failure and Lack of Insurance: In the absence of working capital and loans, farmers may not be able to afford crop insurance or mitigate the impact of crop failure due to climate change or other adverse conditions.
• Disparities: The lack of capital often exacerbates the existing disparities between urban and rural India, small and big businesses and the rich and the poor.

How can we bank the unbanked?

1. Niche banking Products: Financial companies (such as NBFCs) and development banks can be developed with expertise in the different sectors.
2. Cooperative banks: They utilise the financial resources of the community itself to fund the businesses of the community.
3. Government support: The government can take initiatives to extend financial inclusion such as by running schemes to inject money into the rural market at lower rates.

We shall study Niche banking in this chapter and Financial Inclusion and cooperative banking in the next chapters.

Non-Banking Financial Companies (NBFCs)

NBFCs are defined in Section 45-I of the RBI Act, 1934 as follows:

A non-banking financial company (NBFC)” means:

1. A financial institution which is a company;
2. …a company which has as its principal business the receiving of deposits, under any scheme or arrangement or in any other manner, or lending in any manner;
3. such other non-banking institution or class of such institutions, as RBI, may, with the previous approval of the Central Government and by notification in the Official Gazette, specify.

Features of NBFC:

1. Are authorised to accept deposits; The NBFCs are allowed to accept/renew public deposits for a minimum period of 12 months and a maximum period of 60 months. [No demand liabilities]
2. Have customer interface, with assets size of one billion rupees(100Cr) or above, as on the date of the audited balance sheet of the previous financial year, or of any such asset size as the RBI may prescribe, are covered under the Scheme.

Over the last few years, RBI has carved out some specialized NBFCs like:

• Core Investment Companies (CICs): They hold not less than 90% of their net assets in the form of investment in equity shares, preference shares, bonds, debentures, debt or loans in group companies; For example, Mutual funds.
• NBFC- Infrastructure Finance Companies (IFCs),
• Infrastructure Debt Fund- NBFCs; For example, ILandFS.
• NBFC-MFIs: Micro Finance Institutes.
• NBFC-Factors: whose financial assets in the factoring business constitute at least 75% of its total assets and income derived from the factoring business (paying on behalf of a party for the purchase of raw material).

Systemically Important NBFCs:

NBFCs whose asset size is ₹ 500 cr or more as per the last audited balance sheet are considered systemically important NBFCs.

• Systematically Important Non-Deposit taking Core Investment Company (CIC-ND-SI) is an NBFC with an asset size of ₹500Cr or above carrying on the business of acquisition of shares and securities and which satisfies the following conditions as on the date of the last audited balance sheet.
• It accepts public funds. But this is not an interest-earning deposit.

Advantages of NBFCs:

Role of NBFCs in enhancing credit markets. RBI has allowed NBFCs to function outside the strict regulations of the Banks. This allows NBFCs to function more freely. Thus, it gives the following advantages that suit the RBI’s overall objectives:

1. Specialized banking instruments: NBFCs are Sector-wise specialists. They give higher efficiencies by bringing in expertise in specialized sectors, such as Infrastructure Finance, Infrastructure Debt Funds, Micro Finance Institutes etc.
2. Innovative products: Over the years NBFCs have come up with innovative products such as mobile lending, which improves the lending market.
3. Easy lending: They follow easier lending procedures thus making lending accessible.
4. Greater reach: Given their reach in the underserved and under-banked sectors, they play a pivotal role in achieving the objective of financial inclusion.
5. Potential Banks: Some of these NBFCs have the potential to become full-fledged banks. For example, Bandhan Bank.
6. Innovative lending: They lend where banks can’t enter. For example, Used commercial vehicle loans.
7. Lower cost of borrowing: Lower the cost of borrowing when compared to banks.

Given these advantages, NBFCs have become a significant contributor to credit growth, having captured over 20% of the credit pie.

Greatest Challenge posed by NBFCs

Being less regulated, the NBFCs pose a certain risk for the system:

1. Risky Model: NBFCs borrow money from short-term markets and lend to long-term (Home, road, power sector). In theory, it is safe since long-term loans are safer. But if their long-term loans fail, the NBFCs have to rely on the expensive short-term loans. For example, Infrastructure Leasing and Financial Services (ILandFS) Ltd. Default crisis.
2. Shadow banking: NBFCs are lightly regulated by the RBI and therefore pose a greater risk to the stability of the economy. The Banks in India are highly regulated, but NBFCs are not. So. the banks find it easier to provide long-term capital to the NBFCs which in turn distribute short-term loans to the consumers.

Shadow Banking

Unregulated banking activities are generally done by Non-banking financial intermediaries that remain outside the formal banking system. These are characterised by the following: Less regulatory oversight of the RBI poses a greater risk for the economy. Higher cost of funding: NBFCs cannot take low-interest deposits from the public. High return: They can take any type of risk and can lend for even the riskiest of assets in India and take higher returns.

3. High spillover potential: By 2020, 5% of NBFCs were running 25% of the lending business. Thus, they have huge spillover effects on the banking system.
4. Escalation of solvency concerns: The whole financial system is so well connected that only a few defaults can pose a large-scale solvency risk. For example, Divan Housing Finance company’s insolvency put an extra burden on the already stressed Yes bank, which eventually came on the verge of failure.

The NBFC Crisis of 2018

Infrastructure Leasing and Financial Services (ILandFS) Ltd. is a Core investment company (an NBFC). In 2018, It faced a severe liquidity crunch of more than ₹30KCr. Similarly, several other NBFCs were on the brink of failure. Business model: NBFCs like ILandFS gained credit through channels: Banks (44%) and Mutual funds (33%). They invested in long-term projects such as road and power projects. Liquidity crisis: Borrow money from short-term market and lend to long-term (Home, road, power sector…). Now the projects were perfectly viable but were unable to repay their interests at that point in time. But the NBFCs had short-term loans to pay. This meant that few NBFCs like ILFS were at risk of failure. Solving the Crisis: The Government and RBI took several steps to resolve this crisis. NHB (National Housing Bank) increased its refinance limit to ₹30,000Cr from ₹24,000cr. Partial Credit Guarantee Scheme: offered by Gol to PSBs for purchasing high-rated pooled assets from financially sound NBFCs / Housing Finance Companies (HFCs). RBI has regularly infused more money specifically for NBFCs.

Regulation of the NBFCs

To prevent any future crisis from happening, a strong capital requirement was introduced for the NBFCs, which were even more stringent than the capital requirements for the banks.

The RBI introduced the Prompt corrective action (PCA) framework for the NBFCs in December 2021, in which the NBFCs were forced to increase their capital requirement.

1. The CRAR requirement was mandated to be at 15%. This applies even to the NBFCs that are owned by the Government.
2. The CET-1 for NBFCs should be above 10%.

1. Those NBFCs with a Net NPA greater than 6% were also placed under the PCA framework.
2. Additional requirements were mandated for those NBFCs that were declared as Core Investment Companies (CICs) by the RBI. For example, their leverage ratio had to be less than 2.5%.
3. Upon non-adherence to these requirements, the NBFCs were prevented from business expansion and distribution of profit.

Such requirements have made the NBFC business less lucrative. Additionally, NBFCs can only accept time deposits and No-demand Deposits. However, banks can obtain these low-interest demand deposits from the depositors. This is one of the reasons that now NBFCs like HDFC have merged themselves into their own subsidiary HDFC Bank.

The only advantage that NBFCs currently have over the banks is that the SLR and CRR are not required to be reserved by the NBFCs. They maintain only a 15% SLR for interest-earning deposits.

Differentiated Banks

Differentiated banks or Niche Banks are banking institutions licensed by the RBI to provide specific banking services and products. The term differentiated banks indicates that they are different from the usual Universal Banks. They aim to promote financial inclusion and payments.

This idea was mooted by Nachiket More Committee on Financial Inclusion, in 2014. Differentiated bank licensing was launched in 2015. These were of two types –

1. Payment banks and
2. Small finance banks.

Other specialized banks such as Regional Rural Banks (RRBs) can also be considered Niche banks or Differentiated Banks.

Payment Bank

Its main objective is to widen the spread of payment and financial services to small businesses, low-income households, and migrant labour workforce in a secure technology-driven environment.

Important Features of Payment Banks

• They can be operated by Prepaid card issuers, telecom companies, NBFCs, Business correspondents, Supermarket chains, Corporates, Realty sector Co-ops and PSUs.
• Payment Banks can open both current account and savings accounts for their users.
• They can issue ATM cards or debit cards and provide online or mobile banking.

Bharti Airtel set up India’s first live payments bank. India Post is another example. PayTM payment bank was closed by RBI recently due to regulatory mismanagement.

Regulation over Payment Banks:

• Minimum capital Requirement: Rs. 100 cr.
  • Have at least 26% investment by Indians.
  • Get listed if net worth crosses Rs 500 cr.
• Fund maintenance:
  • 75% of deposits in government bonds [for Earning] and
  • 25% of deposits in other banks. [for Liquidity]
• Banking requirement: It must have 25% of branches in unbanked areas and should be fully networked and technology-driven.

What Payment Banks cannot Do?

• Restricted Deposits: currently limited to ₹100,000 per customer and may be increased further. [Thus, you cannot deposit more than 1L in Airtel payments bank]
• No-Lending: These banks cannot issue loans and credit cards.
• Indian Market Only: They can’t accept NRI deposits or handle cross-border remittances.

Small Finance Banks

The Small Finance Banks primarily undertake basic banking activities of acceptance of deposits and lending to un-served and underserved sections including small business units, small and marginal farmers, micro and small industries and unorganised sector entities.

Important Features of Small Finance Banks

• Take small deposits (all types of deposits allowed) and disburse loans.
• Distribute mutual funds, insurance products and other simple third-party financial products.
• Lend 75% of their total adjusted net bank credit to the priority Sector (PSL).
  • While 40% of the lending has to be allocated according to the norms for commercial banks,
  • The remaining 35% can go towards any priority sector where the small finance bank has a competitive advantage.
• The maximum loan size would be 10% of capital funds to a single borrower, and 15% to a group.
• Minimum 50% of loans should be up to 25 lakhs.
• 25% branches in rural areas.

What Small Finance Banks cannot do:

• Lend to big corporates and groups.
• Cannot open branches without prior RBI approval for the first five years.
• Other financial activities of the promoter must not mingle with the bank.
• It cannot set up subsidiaries to undertake non-banking financial services activities.
• Cannot be a business correspondent of any bank.

Regulations over Small Finance Banks

• Promoter must contribute a minimum of 40% equity capital which should be brought down to 30% in 10 years.
• The minimum paid-up capital would be Rs 100 cr.
• Capital adequacy ratio (CAR) should be 15% of risk-weighted assets, and Tier-I should be 7.5%.
• Foreign shareholding is capped at 74% of paid capital, and FPIs cannot hold more than 24%.

Small Finance Banks in India

In 2015, RBI gave in-principle approval to 10 entities for starting small finance bank operations. Most players that have received in-principle approvals are microfinance institutions (MFIs).

According to banking experts, 80-90% of the loan books at small finance banks are made up of priority sector loans (PSL). This means these banks will be able to create a buoyant market for PSLCs, which other established banks can buy to achieve their own PSL targets.

Development Bank

Financial institutions that provide long-term credit for capital-intensive investments spread over a long period. They are often supported by governments or international institutions in the form of tax incentives and administrative mandates for private-sector banks and financial institutions to invest in their securities.

Other Services:

1. In-house technical expertise,
2. Underwriting new capital issuance and
3. Creating confidence in other lenders.

In India, development banking was started immediately after independence.

• Industrial Finance Corporation of India (IFCI) was the first development bank in India. It started in 1948 to provide finance to medium and large-scale industries in India.
• Industrial Development Bank of India (IDBI): Organizes the activities of other development banks and term-financing institutions.
• National Housing Bank (NHB): A subsidiary of the Reserve Bank of India (RBI) that regulates and licenses housing finance enterprises.
• Small Industries Development Bank of India (SDBI): The parent organization of MUDRA (Micro Units Development and Refinance Agency), which provides funding for small businesses.
• Export-Import Bank of India (EXIM): The main financial institution in India for foreign and international trade.
• National Bank for Agriculture and Rural Development (NABARD): Focuses on the rural sector of the country.
• Industrial Finance Corporation of India (IFCI): A development bank in India.

Development banks today

After 1991, following the Narasimham Committee reports on financial sector reforms, development finance institutions were disbanded and converted to commercial banks.

The finance minister recently announced setting up a development bank as a slew of measures to boost the economy and financial market sentiments.

Ombudsman Schemes

Banking Ombudsman Scheme: It was introduced under the Banking Regulation Act, 1949 by RBI in 1995. A Banking Ombudsman is a senior official appointed by RBI to redress customer complaints against deficiency in certain banking services covered under the grounds of complaint specified in the Banking Ombudsman Scheme 2006 (as amended in 2017). All Scheduled Commercial Banks, Regional Rural Banks and Scheduled Primary Co-operative Banks are covered under the Scheme. Some other issues that can be reported are: Non-payment or inordinate delay in the payment or collection of cheques, drafts, bills etc.; non-acceptance, without sufficient cause, of small denomination notes tendered for any purpose, and for charging of commission in respect thereof; failure to provide or delay in providing a banking facility (other than loans and advances) promised in writing by a bank or its direct selling agents; Non-adherence to the instructions of the Reserve Bank with regard to Mobile Banking / Electronic Banking service in India by the bank Non-disbursement or delay in disbursement of pension etc. Ombudsman Scheme for Digital Transactions (OSDT): Launched under the Payments and Settlement Systems Act, 2007 which will provide a complaint redressal mechanism relating to digital transactions conducted through non-bank entities. OSDT is a senior official appointed by RBI for a period of maximum 3 years. Ombudsman Scheme for Non-Banking Financial Companies (NBFC), 2018: It is an expeditious and cost-free apex-level mechanism for the resolution of complaints of customers of NBFCs, relating to their services. ‘NBFC Ombudsman’ is a senior RBI-appointed official appointed to redress customer complaints against NBFCs for deficiency in certain services covered under the grounds of complaint specified under the Scheme. The Scheme initially covers those NBFCs authorized to accept deposits and would be gradually extended to cover other identified NBFCs.

 

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