Payment Banks

Payment bank’s seem to be much in news lately for a lot of wrong reasons. Some are questioning their continued viability, especially considering many of those who had shown interest in obtaining payment bank licenses have backed out. Others are questioning the very rationale of their existence / formation in view of seeming never ending violations of license conditions by the existing players. 

To appreciate this very topical and interesting issue, which might soon affect all our lives, one needs to appreciate a little more on how financial intermediaries, such as banks, operate and maintain their viability and profitability.

Bank's around the world are highly leveraged entities working on wafer thin margins and are able to generate profits by resorting to "economies of scope" and at the same time avoiding bad-debt losses. That is, they use the same set of available assets (investment in branches, information systems, people etc) to offer a wide variety of related services, on each of which they make small amounts of money. These services include deposits, loans & advances, money transfer services, payment services, investment advisory along with third party sales of investment products such as mutual funds, insurance etc. Bad debts, inflict a double whammy on banks. First, bank’s lose out on interest income on bad debts thereby depressing their operating profits  and second they have to make provisions out of their operating profits (and if that is insufficient from their Net Worth) on the quantum of bad debts. Incidentally, banks start making operating losses by the time their Gross NPA levels increase a level of 4% to 5%! This makes bad debts anathema for banks.

Payment bank's by definition / as per their licence conditions are precluded or restricted from offering a whole lot of these services, thereby, prima facie, making their operations sub-optimal by default! So would the brave-hearts (and their financial backers) who have ventured out in setting up payment banks eventually lose the shirts of their backs?

Inspite of this congenital draw-back, it was necessary to introduce this innovation in Indian financial markets, since they bring skills and technology which will help (is essential) to bring down transaction costs. Traditional banks not only lack this technology but are by experience / temperament hesitant in adopting it.

The question here is how would bringing down transaction costs, help. Consider a simple Jan Dhan Yojana Account. The government has pushed establishing these accounts and lap-dog banks have fallen all over themselves in fulfilling their quotas of opening such accounts. But then why are there so few operations in these accounts? Why have such a large number of JDY accounts virtually nil balance? The simple answer is because it is very expensive to operate these accounts!

A poor worker would have to lose a day's earning to go to the branch to either deposit / or withdraw funds, or for that matter do any transaction. The time, effort, and money spent in going to do the transaction and the opportunity cost of income foregone in going to the bank are all part of the customer's transactions costs. Similarly, these small value accounts add more to transaction costs of the banks than to their revenue and as rational entities they have no incentive to promote them. Don’t believe me? Try and open a JDY account in any branch, anywhere in India.

Now technology is available which would substantial bring down such transaction costs. Many of us are already benefiting from it. The trick is to take it to the masses. The way the market for shampoos / cell phones exploded in India when 5 rupees sachets and life time free incoming calls was introduced, the same way the banking market is very likely to explode with reduction in banking transaction costs. And this explosion will take the real economy along with it on a sustainable growth path where there would also be no need to cook up GDP figures.

Once the technology base of banks is strengthened and is assimilated, the same set of skills can further transform all the other area of banking operations bringing down overall operating costs of banks even further.

And such innovations, especially those bring about disruptive changes, are rarely brought about by existing players. Hence, Payment Banks, Small Finance Banks et al!

Over time, payment banks have only two options – either being bought out by traditional commercial banks or building up a customer base large enough to enable them buy out one of the existing banks. I expect that soon, very soon, they will have plenty of such options available. I don’t expect them to lose money or investors who have put their money in their equity to lose their shirts!

Yes, there are and will continue to be hiccups.  But wouldn’t life be extremely flat with nothing whatsoever to grumble at!