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1. 2.8 Payment Banks and Small Finance Banks

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 2.8 Payment Banks and Small Finance Banks
M L Tannan: Banking Law & Practice in India, 28th edn
M L Tannan Vinod Kothari

M L Tannan: Banking Law & Practice in India, 28th edn > M L Tannan: Banking Law & Practice in
India, 28th edn > CHAPTER 2 BANKING SYSTEM AND BANKS IN INDIA > HISTORY OF INDIAN
BANKING SYSTEM

CHAPTER 2 BANKING SYSTEM AND BANKS IN INDIA

HISTORY OF INDIAN BANKING SYSTEM

2.8 Payment Banks and Small Finance Banks

Reserve Bank of India (“RBI”) has brought in transformative changes in the financial scenario of the country by
giving licences to Payment banks and Small Finance banks. The chief objective of this move is to bring the weaker
section of the society under a formal banking system.
2.8.1 Payment Banks

A Payment Bank is a type of niche non-full service bank, which can receive deposits and provide remittances but
cannot lend money. The main target customers for them will be low-income households, small businesses and
migrant labourers. The concept of payment banks was given by “Committee on Comprehensive Financial Services
for Small Businesses and Low Income Households” set up by the RBI in September 2013 under the chairmanship
of Nachiket Mor.

RBI felt that there was a need for transactions and savings accounts for the underprivileged in the society. This was
supplemented by the fact, that remittances have both macro-economic benefits for the region receiving them as
well as micro-economic benefits to the recipients. Higher transaction costs of making remittances diminish these
benefits. Therefore, the primary objective of setting up of Payments Banks will be to further the financial inclusion
by providing:

(i) small savings accounts; and

(ii) payments/remittance services to migrant labour workforce, low-income households, small businesses,
other unorganised sector entities and other users, by enabling high volume-low value transactions in
deposits and payments / remittance services in a secured technology-driven environment.

RBI has issued Guidelines for Licencing of Payments Banks2.

2.8.1.1 Scope of activities

The setting up of a Payment Bank as a differentiated bank, is to confine its activities to further the objectives for
which it is set up. Therefore, the Payments Bank shall be permitted to undertake only certain restricted activities
permitted to banks under the Banking Regulation Act, 1949, as given below:

(i) Acceptance of demand deposits, i.e., current deposits, and savings bank deposits.
(ii) Issuance of ATM/ Debit Cards – note that a Payment Bank cannot issue credit cards.
(iii) Payments and remittance services through various channels including branches, BCs and mobile banking.
(iv) Issuance of PPIs as per instructions issued from time to time under the PSS Act. Internet banking
(v) Payment Banks may offer Internet Banking services for which the banks will have to comply with the RBI
instructions on internet banking; and information security, electronic banking, technology risk management
and cyber frauds.
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2.8 Payment Banks and Small Finance Banks

(vi) Functioning as Business Correspondent (BC) of other banks – A Payments Bank may choose to become a
BC of another bank for credit and other services which it cannot offer.
(vii) As a channel, the payments bank can accept remittances to be sent to or receive remittances from multiple
banks under a payment mechanism approved by RBI, such as RTGS / NEFT / IMPS.
(viii) Payments banks will be permitted to handle cross border remittance transactions in the nature of personal
payments / remittances on the current account. All facilities / approvals incidental to undertaking such
transactions in foreign exchange will be enabled by RBI on an application made to it.
(ix) Payments banks can undertake other non-risk sharing simple financial services activities, not requiring any
commitment of their own funds, such as distribution of mutual fund units, insurance products, pension
products, etc. with the prior approval of the RBI and after complying with the requirements of the sectoral
regulator for such products.
(x) The payments bank may undertake utility bill payments etc. on behalf of its customers and general public.

It is to be noted, that a Payment Bank cannot set up subsidiaries to undertake non-banking financial services
activities. The other financial and non-financial services activities of the promoters, if any, should be kept distinctly
ring-fenced and not combined with the banking and financial services business of the Payments Bank. These banks
are required to use the words “Payments Banks” for identification.
2.8.1.2 Registration, licensing and regulations

A Payment Bank shall be registered as a public limited company under the Companies Act, 2013, and licenced
under section 22 of the Banking Regulation Act, 1949, with specific licencing conditions restricting its activities to
acceptance of demand deposits and provision of payments and remittance services.

It will be governed by the provisions of the Banking Regulation Act, 1949, Reserve Bank of India Act, 1934, Foreign
Exchange Management Act, 1999, Payment and Settlement Systems Act, 2007, other relevant Statutes and
Directives, Prudential Regulations and other Guidelines/ Instructions issued by RBI and other regulators from time
to time, including the regulations of SEBI regarding public issues and other guidelines applicable to listed banking
companies.
2.8.1.3 Eligibility criteria

The existing non-bank prepaid instruments (“PPI”) issuers authorised under the Payment and Settlement Systems
Act, 2007 (PSS Act) and other entities such as Non-Banking Finance Companies (NBFCs), corporate BCs, mobile
telephone companies, super-market chains, companies, real sector cooperatives and public sector entities may
apply to set up a Payments Bank.

Even banks can take equity stake in a Payments Bank to the extent permitted under section 19 (2) of the Banking
Regulation Act, 1949.

The entities and their Promoters/Promoter Groups as defined in the SEBI (Issue of Capital & Disclosure
Requirements) Regulations, 2009 should be ‘fit and proper’ in order to be eligible to promote Payments Bank. RBI
would assess the ‘fit and proper’ status of the applicants on the basis of their past record of sound credentials and
integrity; financial soundness and successful track record of at least 5 years in running their businesses.
2.8.1.4 Deployment of funds

A Payment Bank cannot undertake lending activities. Apart from amounts maintained as Cash Reserve Ratio
(CRR) with RBI, minimum cash in hand and balances with a scheduled commercial bank/RBI required for
operational activities and liquidity management, will be required to invest all its monies in Government
securities/Treasury Bills with maturity up to one year that are recognised by RBI as eligible securities for
maintenance of Statutory Liquidity Ratio (SLR).

See Chapter on Cash Reserve Ratio and Statutory Liquidity Ratio in Banks for detailed comments on CRR and
SLR.
2.8.1.5 Capital requirement

Since the Payment Bank will not be allowed to undertake any credit risk, and if its investments are held to maturity,
such investments need not be marked to market and there may not be any need for capital, for market risk. The
Payment bank however, will be sufficiently exposed to operational risk. It must be noted, that the capital will be
utilised for creation of such fixed assets. Therefore, the minimum paid up voting equity capital of the Payments
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2.8 Payment Banks and Small Finance Banks

Bank shall be Rs 100 crores. Any additional voting equity capital to be brought in will depend on the business plan
of the promoters. Further, the Payments Bank should have a net worth of Rs 100 crores at all times.

A Payment Bank shall be required to maintain a minimum capital adequacy ratio of 15% of its Risk Weighted
Assets (RWA) on a continuous basis, subject to any higher percentage as may be prescribed by RBI from time to
time. However, as Payments Banks are not expected to deal with sophisticated products, the Capital Adequacy
Ratio will be computed under simplified Basel I standards.

As the Payment Bank will have almost zero or negligible risk weighted assets, its compliance with a minimum
capital adequacy ratio of 15% would not reflect the true risk. Therefore, as a backstop measure, the Payment Bank
should have a leverage ratio of not less than 5%, i.e., its outside liabilities should not exceed 20 times its net-
worth/paid-up capital and reserves.
2.8.1.6 Promoter’s contribution

The promoter’s minimum initial contribution to the paid-up voting equity capital of Payments Bank shall be at least
40%, which shall be locked in for a period of five years from the date of commencement of business of the bank.
When the payments bank reaches the net worth of Rs 500 crore and therefore becomes systemically important,
diversified ownership and listing will be mandatory within three years of reaching that net worth. However,
payments banks having net worth of below Rs 500 crore could also get their shares listed voluntarily, subject to
fulfilment of the requirements of the capital markets regulator.
2.8.1.7 Prudential norms

As the Payment Bank will not have loans and advances in its portfolio, it will not be exposed to credit risk and, the
prudential norms and regulations of RBI as applicable to loans and advances, will therefore, not apply to it.
However, the Payments Bank will be exposed to operational risk and should establish a robust operational risk
management system. Further, it may face liquidity risk, and therefore is required to follow RBI’s guidelines on
liquidity risk management, to the extent applicable.
2.8.2 Small Finance Banks

Small finance bank is a type of niche bank, which can provide banking services like accepting deposits and lending
but mainly focusing on small businesses, small and marginal farmers, small and micro industries. Small finance
banks can undertake all the operations of normal commercial banks, but at a smaller level targeting low-income
segment.

RBI realised that small local banks can play an important role in the supply of credit to micro and small enterprises,
agriculture and banking services in unbanked and under-banked regions in the country. Therefore, the RBI has
decided to allow new “small banks” in the private sector.

The objectives of setting up of small banks will be for furthering financial inclusion by:

(i) provision of savings vehicles to underserved and unserved sections of the population, and
(ii) supply of credit to small business units, small and marginal farmers, micro and small industries, and other
unorganised sector entities, in their limited areas of operations, through high technology-low cost
operations.

2.8.2.1 Scope of activities

The area of operations of the small bank will normally be restricted to contiguous districts in a homogenous cluster
of States/Union Territories so that the bank has the “local feel” and culture. However, if considered necessary, the
bank will be allowed to expand its area of operations beyond contiguous districts in one or more States with
reasonable geographical proximity. Its branch expansion plan for the initial three years would need prior approval of
RBI after which, based on experience, RBI may consider relaxing this condition. In the initial five years, the small
bank shall further the objectives for which it is set up. Therefore, the small bank shall primarily undertake basic
banking activities of acceptance of deposits and lending to small farmers, small businesses, micro and small
industries and unorganised sector entities. It can also undertake other simple financial services activities with the
prior approval of the RBI. It cannot set up subsidiaries to undertake non-banking financial services activities. The
other financial and non-financial services activities of the promoters, if any, should be kept distinctly ring-fenced and
not comingled with the banking business. After the initial stabilisation period of five years, and after a review, RBI
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2.8 Payment Banks and Small Finance Banks

may liberalise the scope of activities of the small banks. The small finance bank will be required to use the words
“small finance bank” in its name to differentiate it from other banks.
2.8.2.2 Eligible promoters

Resident individuals/ professionals with 10 years of experience in banking and finance at a senior level, Companies
and Societies in the private sector, that are owned and controlled by residents (as defined in the FEMA
Regulations, as amended from time to time), and having successful track record of running their business for atleast
five years, will be eligible as promoters, to set up Small Banks. Existing Non-Banking Finance Companies (NBFCs),
Micro Finance Institutions (MFIs), and LABs can also opt for conversion into small banks after complying with all
legal and regulatory requirements from various authorities if they conform to these guidelines. Further, existing
Payment Banks (PBs) which are controlled by resident and have successful track-record of five years are also
eligible for conversion into small banks. Preference will be given to professionals from banking/financial sector,
NBFCs and MFIs to set up small banks, if they meet the “fit and proper” criteria. Local focus and the ability to serve
smaller customers will be a key criterion in licencing such banks. Thus, this may be a more appropriate vehicle for
local players.

Promoters/Promoter Groups as defined in the SEBI (Issue of Capital & Disclosure Requirements) Regulations,
2018 should be ‘fit and proper’ in order to be eligible to promote small banks. RBI would assess the ‘fit and proper’
status of the applicants on the basis of their past record of sound credentials and integrity; financial soundness and
successful track record of running their businesses, etc. for at least a period of five years.

The joint ventures by different promoters for setting up small banks will not be entertained. Also, AIFs are not
eligible. Proposals from large industrial house or business group, i.e., a group with assets worth Rs 5,000 crores or
more with the non-financial business of the group accounting for 40% or more in terms of total assets/ gross income
are not eligible to become promoters of small banks.

Primary Urban Co-operative Banks (UCBs), which are desirous of voluntarily transiting into small bank will be
required to comply with the aforesaid requirements3.
2.8.2.3 Capital requirement

The minimum paid up voting equity capital for small banks shall be Rs 200 crore, except for transitioning UCBs
which may have a net worth of Rs 100 crores at the time of commencement of business of small banks. Though
such transited UCBs will also be required to raise its net worth to Rs 200 cores within a period of 5 years from
transition. Further, for the NBFC/MFI/PB converting into small banks, the net worth shall be either be Rs 200 crores,
or they shall arrange to infuse additional paid-up voting equity capital within 18 months from the date of in-principle
approval, or commencement of operations, whichever is earlier. Any additional voting equity capital to be brought in
will depend on the business plan of the promoters. In view of the inherent risk of a small bank, it shall be required to
maintain a minimum capital adequacy ratio of 15% of its Risk Weighted Assets (RWA), on a continuous basis,
subject to any higher percentage as may be prescribed by RBI from time to time. Tier I capital should be atleast
7.5% of the RWA, whereas Tier II capital may be upto a maximum of Tier-I capital. Basel II norms will be generally
applicable to the small banks.
2.8.2.4 Promoters’ contribution

The promoters’ minimum initial contribution to the paid up voting equity capital of such small bank shall at least be
40% which shall be locked in for a period of five years from the date of commencement of business of the bank.
Shareholding by promoters in the bank in excess of 40 % shall be brought down to 40% within three years from the
date of commencement of business of the bank. Further, the promoter’s stake should be brought down to 3% of the
paid-up voting equity capital of the bank within a period of 10 years, and to 15% within 15 years from the date of
commencement of business of the bank. Proposals having diversified shareholding and a time frame for listing of
the bank will be preferred.

However, listing will be mandatory within three years where the net worth of the small bank reaches Rs 500 crores
for the first time.

Further, in case of small banks transited from UCBs, the minimum promoter shareholding shall be 26% at all times
during the first five years. It may be brought down to 15% over a period of 15 years.
2.8.2.5 Prudential norms

The newly set up small banks should ensure that they put in place a robust risk management framework. The small
bank will be subject to all prudential norms and regulations of RBI as applicable to existing commercial banks
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2.8 Payment Banks and Small Finance Banks

including requirement of maintenance of CRR and SLR. However, in view of concentration of its area of operations,
the small bank will be required to have a well-diversified portfolio of loans and advances spread over its area of
operations. The maximum loan size and investment limit exposure to single/group borrowers /issuers would be
restricted to 10% (single)/ 15% (group) of its capital funds. At least 50% of its loan portfolio should constitute loans
and advances of size upto Rs 25 lakh in order to extend loans primarily to micro enterprises.

In view of the objectives for which small finance banks are set up, the banks will be required to extend 75% of their
Adjusted Net Bank Credit (ANBC) for Priority Sector Lending (PSL). While 40% of its ANBC shall be allocated to
different sub-sectors under PSL, the rest can be allocated to any one or more sub-sectors where it has competitive
advantage.

In addition to the restrictions placed on banks’ loans and advances to its directors and the companies in which its
directors are interested under section 20 of the Banking Regulation Act, 1949, the small bank is precluded from
having any exposure to its promoters, major shareholders (who have shareholding of 10% of voting equity shares in
the bank), the relatives [as defined in section 2(77) of the Companies Act, 2013 and rules made there under] of the
promoters as also the entities in which they have significant influence or control (as defined under Accounting
Standards AS 21 and AS 23).
2.8.2.6 Procedure for Licencing of Payments Bank and Small Finance Bank

(i) The applications will be initially screened by RBI to ensure prima facie eligibility of the applicants. RBI may
apply additional criteria to determine the suitability of applications, in addition to the prescribed ‘fit and
proper’ criteria.
(ii) Thereafter a Standing External Advisory Committee (SEAC) comprising eminent professionals like
bankers, chartered accountants, finance professionals, etc. will evaluate the applications. The names of
the professionals in EAC will be placed on RBI’s website.
(iii) The Standing External Advisory Committee will reserve the right to call for more information as well as
have discussions with any applicant/s and seek clarification on any issue as may be required by it. The
SEAC will submit its recommendations to RBI for consideration. The decision to issue an in-principle
approval for setting up of a bank will be taken by RBI. RBI’s decision in this regard will be final.
(iv) The Internal Screening Committee (ISC), consisting of the Governor and Deputy Governor will examine all
applications, and also deliberate on the rationale of the recommendations made by SEAC and make final
recommendations to the Committee of Central Board (CCB) of RBI for its final decision on issue of “in-
principle approval”.
(v) The validity of the in-principle approval issued by RBI will be until 18 months from the date of granting such
in-principle approval and would thereafter lapse automatically. Therefore, the bank will have to be set up
within 18 months of grant of in-principle approval.
(vi) After issue of the in-principle approval for setting up of a bank, if any adverse features are noticed
subsequently regarding the promoters or the companies/entities with which the promoters are associated
and the group in which they have interest, the RBI may impose additional conditions and if warranted, it
may withdraw the in-principle approval.
(vii) In order to ensure transparency, the names of applicants for bank licences will be placed on the RBI
website on receipt of the applications. The names of successful applicants will also be placed on the RBI
website.
(viii) Banking being a highly leveraged business, licences shall be issued on a very selective basis to those who
conform to the above requirements, who have an impeccable track record and who are likely to conform to
the best standards of customer service and efficiency. Therefore, it may not be possible for RBI to issue
licences to all the applicants meeting the eligibility criteria prescribed above. RBI will adopt a cautious
approach in licencing small banks in the initial years, and with experience gained, may suitably revise the
approach.

An applicant who is not found suitable for issue of licence will be advised of the RBI’s decision. Such
applicant shall not be eligible to make an application for a banking license for a period of 3 years from
such decision of RBI.
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2.8 Payment Banks and Small Finance Banks

This is a major step by RBI towards financial inclusion in the country. Cost of banking will become lesser due to
competition from payment banks and small banks. Not only this, the convenience of the customers will also be
taken into account. Cash transactions lessen, thereby moving towards the Government’s vision of “cashless” India.

See RBI Guidelines for Licencing of Payments Banks dated 27 November 2014 and RBI Guidelines for ‘on tap’
Licencing of Small Finance Banks in the Private Sector dated 5 December 2019 for detailed overview of the
regulatory regimes.

2 Source: https://www.rbi.org.in/scripts/bs_viewcontent.aspx%3FId%3D2900 (last accessed in June 2021).

3 The circular on voluntary transition of UCBs as issued by RBI can be accessed here at
https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11381&Mode=0 (last accessed in June 2021).

End of Document