Indian policymakers have long maintained the importance of banks adding a multiplier effect to the overall financial services sector. Banks have led in the entire financial inclusion and socio-economic growth of the nation.

The watershed moment of the 1990s economic transformation of India underscored the stark reality that little progress had been made in fostering financial inclusion, with the banking sector grappling with various challenges. The expert committees chaired by late RBI Governor M Narasimham in 1991 and 1998, collectively known as Narasimham I and II Committees, were instrumental in advocating wide-ranging reforms aimed at enhancing efficiency and competition in the banking sector.

It wasn’t until the 2000s that the spotlight shifted towards financial inclusion, with the term itself being coined in 2005 by then RBI Governor YV Reddy. The concept of financial inclusion was formally defined as ensuring access to financial services and timely credit to vulnerable groups at affordable costs.

Introducing Payments Banks

In 2014, the Committee on Comprehensive Financial Services for Small Businesses and Low Income Households set up by the RBI under the chairmanship of Nachiket Mor introduced the concept of “payments banks” as part of a vertically differentiated banking system, aiming to provide safe and secure electronic bank accounts to every Indian resident above the age of 18. Payments banks, focusing on payments and deposits but not credit, were envisioned to cater primarily to migrant labourers, low-income households, small businesses, and other unorganised sector entities.

The guidelines issued by the RBI in November 2014 laid the groundwork for the establishment of payments banks, with 11 entities receiving in-principle license approvals in August 2015. Several surrendered their licenses citing regulatory constraints and business model viability.

According to an RBI publication in the past, payments banks face challenges in achieving profitability due to limited operational space and high initial infrastructure costs, resulting in a prolonged break-even period. To ensure their survival and success, continuous investment in technology is crucial. Payments and remittance services, their primary revenue sources, operate on thin margins and high volumes. Although they can accept deposits and distribute third-party financial products, payments banks are prohibited from offering loans or credit cards.

Their ability to generate revenue is limited by regulatory restrictions, including caps on deposits. They are not allowed to offer credit. Additionally, they face competition from traditional banks, pure-play payments service providers, fin-tech firms with bank partnerships, without enjoying a level playing field. Unlike small finance banks, which have a broader scope of banking services, payments banks focus primarily on transactions such as bill payments, remittances, and cash management.

A Concept Not So Viable

Payments banks operate in a competitive landscape, sandwiched between commercial banks and pure-play payments service providers. While they offer comprehensive solutions to clients, regulations limit the amount of money that can be held in current accounts.

As mobile accessibility has become more affordable and rural connectivity has expanded through initiatives like "Digital India" and the Pradhan Mantri Jan Dhan Yojana (PMJDY), the landscape of financial services has evolved significantly. The widespread adoption of Unified Payments Interface (UPI) has empowered users to conduct a range of financial transactions directly from their mobile devices, diminishing the necessity for intermediary banking services offered by payments banks. UPI serves more consumers than Payments banks.

Secondly, the competitive landscape fueled by UPI has intensified, with traditional banks and fintech companies offering innovative digital payment solutions. Payments banks, constrained by regulatory restrictions on lending and deposit-taking activities, struggle to differentiate themselves in this crowded market. As a result, they face difficulties in generating revenue streams beyond transaction fees, limiting their ability to achieve profitability.

In banking, lending stands as the primary driver of revenue, with payments serving as a secondary source. However, the payments bank model disrupts this traditional hierarchy by prioritising payments as the primary revenue stream, with lending relegated to a supplementary role, primarily through loan distribution channels. This inversion is where the payments bank model falls short of expectations. Achieving scale may be achievable, but profitability proves elusive due to the inherently low-margin nature of the payments sector.

Payments banks are tasked with catering to a demographic that typically yields limited revenue from traditional deposit services. However, payments banks must still navigate the challenge of covering ongoing operating costs associated with maintaining and servicing deposit accounts.

The RBI guidelines allow for payments banks, after a fixed period of satisfactory performance, to be converted into a Small Finance Bank. The origins of SFBs came from the pre-digital and pre-UPI era. What worked as a concept to make microfinance entities to banks to scale their activities and segmental focus is now a larger business viability question mark. Do even the SFBs have a financially sustainable and scalable model?

Time To Rethink

With just three payment banks even making small profits, the question is for how long can loss-making banks survive? The worry is if any of these will cut corners to monetise data. Critically do they exist because they add value to consumers of today? Or is it the regulatory challenge of reviewing the various banking licence categories that exist despite poor to low consumer need or impact? Without such evaluation, there’s a risk of accumulating licenses, potentially leading to a proliferation of banking categories without substantial consumer benefits.

Regulatory reforms are needed to align with the evolving nature of the intersection of the digital public infrastructure that India has in plenty, along with mainstream banking. If UPI is fully equipped to facilitate financial inclusion in payments, rendering the need for payments banks redundant, should the RBI reconsider its approach to payments banks and consider discontinuing the concept altogether? The best way to answer is this: will anyone miss this bank category if none existed?

(The author is a policy researcher and corporate advisor. He is also the Editor and co-author of ‘Time for Bharat’, a book on public governance. Views expressed are personal)