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India’s financial sector landscape has been evolving fast over the last several years as it has emerged as a key centre for innovation, not just in fin-tech but also financial products. As a country with a natural tendency to save, it comes as no surprises that many products are focused on catering to risk-adverse individuals. Thus, the increase in small finance banks is not something that should be unexpected.

The banking sector across the world is tightly regulated to protect the interests of depositors, however, we must welcome the increase in number of players that cater to financial needs irrespective of whether of depositors or lenders. From an economic standpoint, in India the lending rates and deposit rates are both high, as are the spreads in some instances and more competition will bring a sense of balance as far as rates are concerned. This is precisely why even the RBI has been proactive in allowing new type of institutions such as payment banks, etc to become a part of India’s financial system.

Double-edged sword

Small savings banks and their participation will most certainly lead to greater competition in the space — and this competition may at times lead to consequences. A close parallel can be made with regards to co-operative banks, which co-existed with India’s big financial players. They too were instrumental in further deepening the access to financial products in India. However, as we have witnessed over the last few years, these institutions were not subject to adequate regulation which created balance-sheet issues for them thereby leading the RBI to find a resolution plan. In fact, one of the private scheduled commercial banks too was rescued in a similar manner by the RBI and a consortium of banks in early 2020.

Therefore, while we must welcome more participants in the banking services space, we must also recognize the lapses as far as the supervisory role of the central bank is concerned. This is important as the supervisory role is critical for preserving confidence in the financial system which is a key objective of any modern central bank. Such lapses also point at the overstretched nature of the operations that our central bank is required to perform – and there is a case to increase its bench-strength given its recently expanded role of supervising even co-operative banks. However, merely auditing excel sheets and statement of accounts while mandating capital adequacy won’t be sufficient in a country where disclosure standards are not the best.

Safeguards needed

The question that then arises regarding what should be done to ensure that the rise of small finance banks overall strengthens India’s financial system? The first step would be to identify a supervisory framework based on the kind of financial institution — with tighter supervision of some entities from time to time. Early identification of stress with any of the participant will help in timely intervention thereby preventing it from escalating the situation. Ultimate objective is to reduce systemic risks in any possible way.

As with most solutions to public problems in India, the solution to the problem of supervision of financial entities will have to be solved by greater use of technology. This should not be problematic as most financial institutions in India produce huge amounts of data. Technology in the form of artificial intelligence can help in early identification of stress on balance-sheets while further enabling the central bank to identify nodes. Nodes refers to those financial institutions that are exposed to the risks associated with the stressed balance-sheets of a market participant.

As far as the expansion of small finance banks are concerned, given the liquidity situation and the demand for credit, it is no surprises that they are rushing to fill the gap created by banks due to their heightened risk aversion. But when the money is cheap, everyone makes some quick bucks — to separate the wheat from the chaff, we will have to see who registers grown once the liquidity situation is normalised.

Unenviable past

Given the prolonged trouble in India’s financial system due to aggressive lending post-2008, we must be mindful of the risks that aggressive growth of any one institution to the aggregate system. More importantly, we must recognise the behavioural response by other financial intermediaries to aggressive growth by one market participant. This sets in a chain of heightened risk-taking till a point where bankers lose control over the risks that has been piled on to their balance-sheets.

One good thing is the way in which the RBI has handled most instances of stress on balance-sheets of banks, NBFCs and co-operative banks as it has managed to protect the interests of depositors to a great extent — but then again, preventing a crisis is far better than managing the crisis well. With back-to-back rescue efforts in recent past, the RBI must recognise its limitations in supervisory functions. Use of technology, reforming governance structures of these institutions and creating a framework for early stress-detection will certainly help better prepare for any such situations in the future.