the ultimate disruptor

It is not a recent, probably the first time it popped up was during the dot com boom, but it has gained momentum in recent times thanks to all the fin tech innovation. So on one hand we have the thread of rapid advances made on technology side in financial services field, and on the other hand we have the narrative of what exactly are the functions of a bank and how does it deliver on it.

Let us look at these parallel threads against a Virtual Bank, a bank with zero bank branches, with zero ATMs, yet a billion dollar balance sheet, highly profitable, yet conservative.

Is it possible?

Actually the first technology driven innovation happened more than a decade back, when the banks unveiled the Automated Teller Machine, to get the regular retail cash withdrawal transactions out of its premises, thereby reducing the labor intensity in the bank branch. Slowly they added a few more services and today, it has evolved a lot and there is practically no limit to the extent of services that can be offered through an ATM.

So we have the first service expectation of a bank, our ability to withdraw cash, from our account, whenever we need or want it. Until the ATM had come into the picture we had to visit the branch premises, during banking hours, fill in either the withdrawal slip or a self cheque, stand in the queue, and collect cash from a very bored teller. Bank had to incur a lot of cost in providing this core banking service to its customers.

Customers of a virtual bank can access these third party ATMs to withdraw cash. Or the Virtual Bank can simply waive off all fees for a customer using another bank’s ATM. With about a million ATMs littered across the country a new Virtual Bank need not spend a single penny on creating this infrastructure of ATMs.

Now let us take a step back. And begin at the beginning. How many of us remember the account opening process of a bank account? Well a few decades back we required an introducer to open a bank account, although the KYC norms were pretty simple. Over a period, the KYC norms became stricter with the banks demand all kinds of documents to open a bank account as a fraud prevention mechanism.

IMG_6057RDIf I walk into a bank branch to open a bank account, I would have to give a couple of photographs, a cheque drawn on existing account, PAN Card, Address Proof, lot of signatures, on a long application form, which is also a tool for cross selling various other bank products. Now banks like DBS has already initiated opening online bank account, so that the customer does not have to make a visit to the bank branch. This is actually a pretty old thing, even five years back when I had opened a bank account with HDFC Bank, they had come to my office with the form, filled it up and on the spot given me an account opening kit.

So what happens if the Virtual Bank accepts all these details through a web form on its website, and validates the identification like PAN Card/Aadhar from the central repository, takes the first account opening payment through an online transfer from an existing bank account. Absolutely eliminate all paper in the process. Paper costs. Big time!

The Virtual Bank would start by targeting the upscale urban customer who probably already has a few bank accounts. Why would she open another bank account? Well we will come to that, that’s the business aspect. Can it go beyond this urban already banked customer base to the semi urban setting? Eventually it would spread out.

On the liability side of the business, therefore the Virtual Bank can take deposits through online transfers, while customers can withdraw cash using third party ATMs, or make electronic payments using one of the many technology innovations, Wallet, IMPS, UPI, that obviates the need to either visit a branch or of any paper. Technology has made it possible for the bank to deliver the entire liability side of its services bringing the brick and mortar branches close to redundancy.

The core activity of a bank is to make loans and advances out of whatever money is left after providing for the statutory SLR requirements. This also determines the profitability of a bank. What is required to successfully deliver on this aspect?

On this perspective there is no difference between a NBFC and a bank. Both of them have the liability side comprising of deposits and the asset side comprising of loans & advances. The basic difference between a NBFC and a Bank being on the liability side, i.e. the banks has access to the low cost CASA deposits while the NBFC do not. But on the asset side, both deliver the same service, i.e. source loan proposals, do credit evaluations, sanction and disburse loans, and manage the collections.

If we analyse our current banking landscape, then the banks are not doing a very great job of evaluating credit proposals, with an average reported NPA of 15% which also appears to be an understatement thanks to the very liberal provisioning norms of the central bank.
Recently when I had analysed some of the bank financial statements published, I realized that the four broadsheet pages of Bank of Maharashtra results covered more that it revealed. A study of SBI financials actually is a post doctoral research thesis project. The 290 page annual report is a beautiful maze, with so many numbers thrown in it that one has to read it a few times, before one can really understand what it successfully attempts to keep under shrouds of secrecy. It reminded me of the classics by TS Elliott and the likes.

So when we try to find answers to basic banking questions, we are lost in a maze of numbers. Like what is the total number of loans that the bank has given out, (let us say 100) and how many borrowers turned out to be good i.e they made all the payments on time (let us say 25). Now these 25% of Assets are what I like to call as GPA (Good Performing Assets), where the bank got it right. It tells us how well the bank’s Credit function is working.

Instead we have a whole lot of numbers that go under some creative nomenclature, like standard NPA, sub-standard NPA, DoubtFul 1, DoubtFul 2, DoubtFul 3, Loss Assets, blah blah. It is high time that the RBI cuts down the noise and simplifies things for an investor. As it is central bank should not be involved in deciding the provisioning norms, but should focus on the monetary and forex aspects of the economy, but then that is another discussion on the structural aspects of oversight on the economy.

How does a Virtual Bank go about delivering on the Asset side? There are some pointers drawn on the basis of what is being done by the existing banks and the NBFCs. Firstly all the activities are segregated into different pieces, Sourcing, Credit Evaluation, Sanctions, Disbursements, and Collections.

The last four activities, i.e. Credit Evaluation, Sanctions, Disbursements and Collections, do not need a branch infrastructure, as these can be centralized in one building in a low cost location may be Manmad or even Manila. The resource quality required for these different activities are different. Credit Evaluation probably is the highest cerebral activity that would require well qualified business professionals, and on the other extreme, the lesser they are qualified the better job they would do on the Collections front.

How does a Virtual Bank with no branch network go about sourcing Loan Proposals? The answer to the question is a recent innovation, which has already started blooming, the “P2P” works like Faircent, LenDen Club. Sometime back the answer was DSA. Another indicator is the current customer base of PayTM of 100 Million plus, which it acquired in a short period of a year or max two, through advertising blitzkrieg. In the end it is always a combination of all possibilities.

As it is, as a product it is a pull product. People look for debt, both for productive and non-productive. There are two factors which is holding back a burst in demand for the loan products, first is the cost and second is the convenience. This is a concern area as our SME sector is not witnessing much of investment.

There are some other functions that a bank does, most important of which is ALM and Treasury functions, which requires some highly qualified finance professionals, but does not require a branch network. Again these are housed either in the low cost location or probably in physical proximity to the financial center, although there is no real case for such proximity. The revenues from these activities far outweigh the cost as would be seen if it is structured as a SBU in the Virtual Bank.

So given this background what does it mean for the banking sector as we see it currently. How would it evolve with all these exciting possibilities?

As banks go about harnessing technology on the payment side, they would slowly reduce the branch traffic, which has shown a continuous downward trend ever since ATMs were launched. When we walk into a bank branch the usual crowd that one used to witness in the past of people lining up for withdrawals or deposits has disappeared. Last year I had walked into the Fort Branch of Citibank and saw more employees than customers.

Now only those with problems caused by the bank walk into a branch or those who have a problem and expect help from the bank in terms of a loan walk into the bank. Sooner or later, the banks would start looking at the distance between its two branches. This distance is set to increase.

This has implications not just on the opening of new branches but also a closer look at the existing network of bank branches. A churn is expected as some branches may be closed while some new may open in uncharted geographies. Of course in the Indian context where business decisions also have to factor in non-business variables, like regulatory requirements, there will be constraints more on the PSU banks than on the private sector banks. Things would not be as simple as we would like them to be. But we can expect a negative growth in the branch network in the next five years and a large section of banking employees is set to become redundant, much before that.

Virtual Bank is an idea whose time has arrived. Purely from a business perspective, there are two possibilities, the existing banks reduce its physical footprint and move towards becoming a Virtual Bank or a Virtual Bank comes into play. Both may happen. Either way the inter mediation costs are set to fall.

The cost of borrowing has been high for some real and some unreal reasons. First is the high cost structure of our banks which ensures that the lending rate is far higher than the cost of funds. Second is the cost of default that these banks have to factor into their lending rate. So essentially a borrower has to pay a higher price due to the wrong credit decisions the bank had taken in the past.

The NIM enjoyed by SBI has almost always been 300 bps plus. Some banks enjoy even more. Now there is no reason why in these brutally efficient times a bank should enjoy such commission for the intermediation role. It gets worse when we look into the gory details.

A customer gets about 8% on a one year deposit on average in the banking sector, and the lending rate on almost any loan, starts at 14% plus. Six percent spread! The supernormal spread is too tempting, and this is one of the basic reason for the blooming of the P2P business which benefits the lender by getting a higher rate and the borrower by getting loans at a lower rate.

Once upon a time the brokers who formed a cosy Broker Club on Dalal Street used to earn brokerages in the range of 2-3%, and now technology has helped cut down the rates to under 50 bps, thereby helping the volumes expand and benefited everybody.

Even when the RBI has been cutting down interest rates, the banks have not passed the benefits onto the borrowers. Of the 150 bps cut that the central bank has done in the past few quarters, only half of it has been passed on by the banks. Now if that makes the banks to be the villain of the piece, let us see how they continue to prosper.

Firstly most of them are public sector. They don’t disappoint us for we expect them to be inefficient. Even when they lose money, we (i.e. our government) recapitalize them.

Second this is a very restricted business with RBI standing at the gate as the entry barrier, carefully licensing new banks. In short RBI is standing guard outside the cosy Banker Club.

Thirdly, even when the new banks come into play, like Yes, Kotak, AXIS etc…they did not cause any disruption in the market. They play along the game, for then they can enjoy even better margins than the old banks due to lack of legacy.

A new player, a Virtual Bank, on the lines of WeBank, can come in and play the usual volume game, to bring down these spreads to a significant level. Even if it reaches one hundredth the size of SBI, and at one tenth the spread that banks presently enjoy, the Virtual Bank may make more money due to its lean structure, operational efficiencies and an efficient Credit team. It can reward the depositors with higher rates and benefit the borrowers with much lower rates. A parallel can be drawn with what a brokerage firm like ICICI Direct did when it took the equity brokerage business online, it benefitted investors (and also traders) by cutting down the intermediation costs through cost efficiency, speed and convenience.

Besides making money for its shareholders, the contribution that such a Virtual Bank can do for the economy would be tremendous. It can be a real DISRUPTOR.


China has already taken steps in this direction with entities like We Bank, ANT Financial going live. The Regulator over there is still struggling to deal with such disruptors, which is understandable, but at the same time they look at the big picture, on how to bring down the costs of intermediation, to boost savings and investment, so as to put the economy back on the double digit track.

IMG_1405_G“We will lower costs for and deliver practical benefits to small clients, while forcing traditional financial institutions to accelerate reforms,” Mr Li, premier, said a year back, “It’s one small step for WeBank, one giant step for financial reform.” He was speaking at the launch of China’s first private bank that would also be only online, the Virtual Bank, the Ultimate Disruptor.


by sanjayshankar

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