The changing face of finance: Financial Express: 19th July 2014

RBI has taken two clues from the Union Budgetbanks should be allowed to raise long-term bonds with less regulatory encumbrance to enable them to lend to infrastructure, and differentiated banks need to be set up. While there is a strong case for the formerit is being linked to financing of infrastructure and affordable housingthe latter seems a bit odd as there are several sectors that may qualify for such treatment. There are two issues that are raised herewhether this will be a game-changer for banks and the infra sector, and whether it is prudent to make such exceptions, somewhat an ideological consideration. Banks have been allowed in the past to raise bonds that go beyond the Tier II capital. Yet, it has not been resorted to in a big way. As banks see it, it is useful to pursue the issuance of such bonds, with a maturity of over 7 years, through public issues or private placement as per RBI's directive. The prospect of regulatory benefits is quite inviting though RBI has already warned banks in its Financial Stability Report that infrastructure was a problem area when it comes to stressed assets. Each bank has to draw a trade-off here. On the demand side, there can be problems. Banks cannot have cross-holdings, which means that one side of demand has been blocked. Long-term investors like insurance and pension funds would find them attractive but will have to revisit their own investment guidelines as these bonds are unsecured. Retail interest has multiple issues. First, the returns have to be good. If a tax benefit is not provided, then a household may not be interested as there are tax-free bonds providing an 8% return. If banks offer a 12% nominal return to match this 8%, the advantage of SLR and CRR exemption may get diminished. Further, there are to be no call and put options which imply that exit can be a problem. Making them marketable is a way out; but for such bonds, there may be less liquidity, given the tenure. Even if retail interest is there, there could be substitution with deposits. Today, one does not have the option of investing in a 7-year deposit. With a 7-year bond providing acceptable yields, funds may move from long-term deposits to these bonds. Given that overall financial savings in the country have stagnated in the last couple of years, this possibility cannot be ruled out. At the ideological level, the question is whether it is prudent to make such exceptions or not. Today, all priority-sector loans are vulnerable and have a higher probability of default. Using the logic of such loans being very important, should funds earmarked for this purpose be freed from CRR and SLR? Where is one to draw the line? Also, banks are already maintaining excess SLR, of 3-5%, which indicates that such concessions may not really work when the quality of assets are under pressure. The payments bank concept is interesting because it will be a new initiative where banks take deposits and are not allowed to lend. They take zero risk and invest in government paper only. They are to harness technology but may also set up physical branches in remote areas. While risk has been reduced by not lending, they would closely resemble post offices which take in deposits and certificates which are passed on to the government with the latter paying for it. In case of the payments bank, the bank would carry the cost. This is the classic concept of narrow-banking, where banks only invest in government paper and hence avoid the pitfalls of NPAs or capital adequacy. Being driven by only technology, however, will not be feasible given the state of digital infrastructure and computer literacy in the country. In FY13, the average cost of funds was 6.12% for all banks, with the cost of deposits being 6.57% while the return on assets was 10.33% and return on investment was 7.57%. The payments banks will be holding their investments till maturity and would not have to do MTM. To that extent, there are no investment losses. Any entity going in for such an enterprise will face similar ratios. These banks will not be borrowing and hence will have only a cost of deposits. The spread between return on investment and cost of deposit would be around 100 bps which has to be managed by a bank to remain above the ground. Now, the cost of intermediation was 1.75% for the banking system, which would be lower for these banks as they would have lower expenses on most overheads given that they would be operating mostly in rural areas. Therefore, the focus has to be on cost control and this will be the challenge. Both these concepts are assuredly interesting and may be viewed as fairly innovative experiments that will be tested by the market. The success of bank bonds will provide a distinct fillip to the corporate debt market while that of a payments bank will work in furthering financial inclusion.