SMALL FINANCE BANK GUIDELINES

OVERVIEW
In July 2014, RBI published draft guidelines for setting up Small Bank in the private sector and
invited comments and suggestions on the same. This was based on its key observations on access
to bank credit and services through expansion of Small Banks in unbanked and under-banked
regions of India in a Policy discussion paper on 'Banking Structure in India The way forward'
published in August 2013.
Post reviewing the comments, RBI has published the guidelines for Small Finance Bank on
November 27, 2014. Financially inclusive and Sound Business Model, Adequate Capital Structure,
Strong management track record and governance are the key considerations for issue of the Small
Bank license and the RBI has invited applications by January 16, 2015.
A
summary
overview
with
analysis
Objective & Scope of Activities

of

the

guidelines

is

presented

below:

The objectives of setting up of Small Finance Bank will be for furthering financial inclusion.

A Small Finance Bank can offer basic banking services (acceptance of deposits and lending
to unserved and underserved sections including small business units, small and marginal
farmers, micro and small industries and unorganized sector entities), non-risk sharing simple
financial services activities not requiring any fund commitment, such as distribution of MFs,
insurance products, pension products, etc. and the Small Finance Bank can also become a
Category II Authorized Dealer in foreign exchange business .

Eligibility

The entities eligible to set up a Small Finance Bank include resident individuals/professionals with 10
years of experience in banking and finance, Companies and Societies, Existing Non-Banking
Finance Companies (NBFCs), Micro Finance Institutions (MFIs), Local Area Banks (LABs).

The applicants have to show their due commitment to promote rural banking and financial
inclusion as against more profitable commercial and urban retail banking. A player with initial
local focus operating in the regions earmarked by the guidelines would stand a higher
chance of getting a Small Finance Bank license.

The RBI is looking for strong promoter/ promoter groups that have significant experience and
proven track record and doesn't envisage a Small Finance Bank with multiple promoter
groups.

The RBI would prefer entities with local area presence/ focus on lending to unserved/
underserved sections. Therefore, the RBI has discouraged large public sector entities and
industrial and business houses, including from NBFCs promoted by them in applying for a
Small Finance Bank license.

The RBI would focus on the 'fit and proper' status of the applicants very closely. The RBI
used similar criteria for Universal Bank license applications; however, for Small Finance
Bank, the track record has been curtailed to 5 years from 10 years.

The promoters have to bring in start-up capital of at least Rs. 40 crores and continuously
maintain that level by recapitalizing the balance sheet.

Ownership in excess of 40% shall be brought down to 40% within a period of 5 years in order
to ensure diversified ownership but at the same time holding promoter accountable for the
bank.

Lock-in would ensure serious commitment towards the development of bank with the
promoter playing an active role in forming and executing the vision and strategy for the bank.

As the guidelines clearly specifies that the promoter should be a resident of the country,
many NBFC-MFIs who aspire to apply for the license would have to infuse more domestic
money to meet the criteria which would in turn mean significant dilution of the existing
promoters.

The minimum paid up voting equity capital has been fixed at Rs 100 crores with a minimum
CAR of 15% on risk weighted assets. RBI perceives that once a Small Finance Bank reaches
the Rs. 500 crore net worth, they would have attained a significant scale. As a result, the RBI
would push for a public listing to diversify the shareholding as well as bring the Small
Finance Bank under the SEBI scanner with additional requirements for reporting, corporate
governance, etc. For others listing is voluntary. The promoter's minimum initial contribution to
at least 40% locked in for 5 years need to be brought down to 30% of the paid-up voting
equity capital within a period of 10 years, and to 26% within 12 years. Proposals having
diversified shareholding and a time frame for listing to be preferred by the RBI for a license

Aggregate foreign investment in a private sector bank will be allowed up to a maximum of

74% of the paid-up capital of the bank (automatic up to 49% and approval route beyond 49%
to 74%) At all times, at least 26% will have to be held by residents. In the case of FIIs/ FPIs,
individual FII/ FPI holding is restricted to below 10%, aggregate limit for all FIIs /FPIs / QFIs
cannot exceed 24%, which can be raised to 49% by the bank concerned through a resolution
by its Board followed by a special resolution by its General Body. In the case of NRIs, the
individual holding is restricted to 5% both on repatriation and non-repatriation basis and
aggregate limit cannot exceed 10%. However, NRI holding can be allowed up to 24%
provided the bank passes a special resolution in the General Body. As per Section 12 (2) of

the Banking Regulation Act, 1949, any shareholder's voting rights in private sector banks are
capped at 10%.As per Section 12B of the Act, any acquisition of 5% or more in a private
sector bank will require prior approval of RBI

The Capital and promoter requirements may pose different challenges for some of the MFI's
and there are areas for clarifications here with RBI.

The RBI is looking for strong promoter/ promoter groups that have significant experience and
proven track record and doesn't envisage a Small Finance Bank with multiple promoter
groups.

Corporate Governance

The regulator intends to follow the same guidelines that have been issued for the private
banks in India. This will help the Small Finance Bank to adopt the best corporate governance
practices right from the commencement of business. Majority of independent directors and
Compliance to the corporate governance guidelines including "fit and proper" criteria.

The RBI perceives a Small Finance Bank and Payments Bank have different value
propositions and has hence, allowed the two to be held under a single promoter/ promoter
group. However, in case of a Universal Bank and Small Finance Bank under a similar
structure, the RBI's perception is different. Therefore, a player looking for a Universal Bank in
future may need to clearly articulate if it should look for a Small Finance Bank license in the
short term

The guidelines intend to discourage creation of any other influential power centers apart from
the promoter/ promoter group that may derail the development of the Small Finance Bank

Companies aspiring to secure a license will have to invest significantly in the technology to
keep the servicing costs low and this has been clearly reiterated in the guidelines

Prudential Norms

The Small Finance Bank would need to have a robust risk management framework. This is in
line with the RBI's expectations from any banking entity operating in India

The Small Finance Bank would need to have a robust risk management framework. This is in
line with the RBI's expectations from any banking entity operating in India

The PSL targets are significantly higher compared to the scheduled commercial banks i.e.,
40% of ANBC. Therefore, a Small Finance Bank would need to quickly build capabilities to
lend to these sectors in a cost-effective sustainable way

The guidelines intend to ring fence the bank from any promoter or promoter group's
misconduct or negligence

Additional Conditions for NBFC/MFI /LAB

The guidelines strictly restrict any co-existence on the two entities

The RBI intends to make the conversion as seamless as possible for specific items on the
books of the entity seeking conversion

The relaxation of promoter shareholding till 26% dilution would be a breather for many
NBFCs, MFIs who otherwise would not meet the eligibility criteria.

Business Plan & Transition

Applicants need to submit a business plan with sufficient logical backing and actionable
strategies and need to clearly outline their strategy as well as implementation roadmap in
order to fulfill the objectives outlined in the guidelines.

In case of deviation from the stated business plan after issue of license, RBI may consider
restricting the bank's expansion, effecting change in management and imposing other penal
measures as may be necessary.

The RBI wants Small Finance Bank to become the Universal Bank of tomorrow. In this way,
the RBI would have an excellent opportunity to witness and assess the growth of a Small
Finance Bank and if that bank is capable of making the transition to the next level.

Likely Challenges

Cost of deposit mobilization could be very high at around 3.5- 4% at ticket size of around Rs.
3000 per depositor. Ability to scale up and increase depositors per branch will be key to
reduce cost of mobilization to 1.5- 3%.

Negative carry on CRR and SLR is likely to bring down the Net interest margins.

Access to deposits will improve the funding and liquidity only after a period of time.

Loss of control over long term may deter some banking aspirants

Small finance banks could be making losses/ very less returns and lower ROA in the initial
years owing to
o

Cost of deposit mobilization

Upgradation of systems/ investment in CBS/IT and implementation

Significant increase in HR costs, Recruitment and training & in Establishment costs

Standardization of processes to achieve scalability

Introduction of new products

Capital Infusion and bridging the funding gap during the initial years of bank
operations

Despite these challenges, the inherent advantage of operating as a bank and the opportunity to offer
a full range of services (credit, deposits and transactions) expand credit product offering (as against
a largely single product focus) and opportunities to cross sell as well as access to back up liquidity
support from RBI are some of the key motivating factors for NBFCs/MFI/HFCs to apply for a small
finance bank license.