Swaminathan J: Governance in Small Finance Banks - driving
sustainable growth and stability
Keynote address by Mr Swaminathan J, Deputy Governor of the Reserve Bank of India,
at the Conference of Directors of Small Finance Banks, Bengaluru, 27 September 2024.
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Chairpersons and Directors of the Boards of Small Finance Banks; Chief Executive
Officers of SFBs; Executive Directors, Chief General Managers and colleagues from the
Reserve Bank of India; ladies and gentlemen. A very good morning to all of you.
It is an honour to address this distinguished gathering in the inaugural conference of
Board of Directors of Small Finance Banks organised by the RBI. As has been
mentioned, this conference is in continuation of the Reserve Bank's efforts to reach out
to its supervised entities through a direct dialogue with their Boards and Top
Management. Our objective is to reaffirm the importance of good governance for
maintaining financial stability and fostering sustainable growth.
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In his address to the Directors of Public and Private Sector Banks last year, the
Governor outlined a comprehensive 10-point charter that addressed key aspects such
as the role of the Board, its independence, the importance of setting the tone from the
top, etc. His speech serves as an excellent blueprint for regulatory expectations from
the Boards of Directors, and I encourage you to review it if you haven't already.
Today, I would like to discuss three key issues with you: (i) the vital role of Small
Finance Banks in promoting financial inclusion, (ii) the necessity of strengthening
governance and assurance functions for sustainable growth, and (iii) important
considerations regarding business models and risks that Boards should be mindful of.
Important Financial Inclusion objective of SFBs
As you are aware, the licensing of Small Finance Banks was introduced a decade ago,
in 2014, with the primary objective of advancing financial inclusion. Beyond serving as a
vehicle to mobilise savings, SFBs were also envisioned to extend affordable credit to
underserved and unorganised sectors, such as small and marginal farmers as well as
small business units, by leveraging technology to reduce costs and improve
accessibility.
India, today, stands at a pivotal moment in her development trajectory. In the last 75
years, we have transformed ourselves from an agrarian economy into one driven by
industry and services. However, translating our GDP into higher per capita Gross
National Income comparable to developed economies will require a comprehensive
approach towards inclusive and sustainable economic growth. This will inter-alia entail
education, skill development, employment generation, and more pertinently further
deepening of financial inclusion. Thus, the goal for small finance banks is not 'small'. On
the contrary, it is very significant, as SFBs play a crucial role in extending financial
services to the underserved, fostering entrepreneurship, and driving inclusive growth
that will be essential for India's progress towards becoming a high-income economy.
In a developing country like India, it is imperative for the financial sector, including small
finance banks to strike a balance between profitability and social objectives. This can
be achieved through a strategic focus on sectors that deliver high social impact,
ensuring that financial growth is aligned with the broader goal of inclusive development.
It is therefore essential for SFBs to actively participate in extending credit under various
Government Sponsored Schemes to promote greater accessibility of affordable credit,
especially among the vulnerable sections of the society.
As the target group of such lending is mostly the marginalised and underserved
sections of the society, it is essential for the SFBs to adopt responsible lending
practices. It is disheartening to come across egregious practices by some SFBs, such
as charging excessive interest rates, collecting instalments in advance as well as not
adjusting such advance collections against loan outstanding, levying of usurious fees,
etc. It is also observed that grievance redressal mechanism is far from adequate in
most SFBs.
I therefore feel that periodically reviewing how your bank is fulfilling its financial
inclusion objectives is an area that Boards should give much deeper consideration to. It
is not just about meeting regulatory requirements such as priority sector lending but
also about assessing the true impact of your efforts on underserved communities.
Boards can reflect on whether the bank is genuinely reaching marginalised groups,
such as low-income households, small businesses, and rural populations, and how
effectively it is using technology and innovative products to bridge financial gaps, as
these were the objectives of having a differentiated licensing for SFBs.
Strengthening Governance
An effective governance framework is the foundation of resilient and well managed
institutions, especially in the context of banks. There needs to be a clear division of
responsibilities between the Board and the management to ensure smooth functioning
of the bank. While the Board is responsible for setting the overall strategic direction,
establishing policies, and ensuring that the bank adheres to regulatory frameworks and
ethical standards, the management is responsible for the execution of the Board's
strategy and operations. It is the Board's role to provide oversight, asking the right
questions and holding the management accountable for executing the bank's strategy
within the agreed risk appetite.
In this context, it is imperative that the views of the Board are clearly articulated and
documented in the minutes of the meetings of the Board and its various
subcommittees. It is said that the 'palest ink is better than the best memory'. Proper
documentation serves as a vital record of the Board's deliberations, decisions, and
rationale behind those decisions, ensuring transparency and accountability in
governance. Clear minutes not only provide a historical account of the Board's
discussions but also serve as a reference for future decision-making, helping to
maintain continuity and clarity in governance practices.
Boards should prioritise proper succession planning for top management. Having just
one Whole Time Director (WTD) can create potential vulnerabilities, especially in times
of transition or unforeseen circumstances. Without a well-thought-out succession plan,
the bank may face leadership gaps that could disrupt operations and affect strategic
decision-making. A broader pool of experienced leaders also contributes to better
governance and more resilient management structures. We observe that while the
SFBs are strengthening their Boards by bringing in new directors, some SFBs are yet to
ensure the presence of at least two Whole Time Directors. I would request these banks
to expeditiously consider appointing more WTDs.
Empowering Assurance Functions
Boards should accord due importance to assurance functions, namely, risk
management, compliance and internal audit. These functions play a critical role in
identifying and mitigating risks, ensuring compliance with laws and regulations as well
as safeguarding the organisation's integrity.
Boards should ensure that heads of assurance functions are positioned appropriately
within the organisational hierarchy and granted direct access to the Board. Dual-hatting,
or combining assurance responsibilities with operational or management duties,
undermines the independence and objectivity of assurance functions by creating
conflicts of interest. Therefore, any dual hatting of assurance functions, should be
avoided.
Key risks to reflect upon
Small Finance Banks have demonstrated strong growth since their inception, now
accounting for 1.18 percent of total banking assets (as of March 2024). This is a
substantial rise from 0.44 percent in March 2018. The deposit base has grown at a 32
per cent compounded annual growth rate (CAGR) over the last five years whereas net
advances recorded a CAGR of 26 per cent. While the business growth in Small Finance
Banks is indeed impressive, it is imperative that Boards remain vigilant for hidden and
emerging risks that could jeopardise their long-term success.
In this context, I would like to highlight a few areas that Boards could keep in mind.
Business model
Firstly, I would urge Boards to consider the sustainability of their growth strategies and
business models by conducting a thorough review of both the liability and asset sides of
the balance sheet. Specifically, they should assess whether there is an
overdependence on high-cost term deposits or bulk deposits from a limited number of
institutions. Additionally, they should evaluate any substantial asset exposures that
could adversely impact the bank if they were to sour. These are essential aspects that
the Board and its Risk Management Committee must scrutinise to ensure long-term
stability and resilience.
Credit risks
Secondly, I would like to emphasise proper credit risk underwriting. While many banks
have expanded into unsecured retail lending, hoping to leverage the diversification
benefits it offers, there is an underlying correlation risk that becomes more pronounced
during economic downturns. In such scenarios, the credit profile of a large segment of
borrowers can be significantly impacted, leading to higher default rates. This highlights
the importance of rigorous underwriting processes that carefully assess the
creditworthiness of borrowers, rather than relying solely on automated systems or
algorithms. Effective underwriting should consider a comprehensive range of factors,
including income stability, credit history, and the overall economic environment, to
ensure that loans are made judiciously.
Further, while digital lending solutions have streamlined the process and made access
to credit easier, on-the-ground presence for collections remains crucial. Resorting to
coercive recovery practices as a means of mitigating risk is not a sustainable solution.
Such practices not only harm the bank's reputation but can also lead to legal and
regulatory repercussions. A better approach is to implement collection strategies that
prioritise communication and collaboration with borrowers. This includes strictly
adhering to fair practices code and adopting an empathetic approach while dealing with
stressed loan book.
Cyber-security risk and third-party dependencies
Thirdly, I would like to address the issue of cyber security and IT vulnerabilities. Being
relatively new entities, SFBs have used technology to enhance their product offerings
and customer service. However, with their increasing digital footprint, these banks face
significant operational risks from growing cyber threats, digital frauds, and possible data
breaches.
The cyber security landscape is evolving rapidly, and SFBs must stay ahead of
emerging threats to protect their customers' data and maintain operational resilience.
The SFBs should adopt robust business continuity plans and effective IT outsourcing
strategies. There is also a need to ensure rigorous change management processes,
comprehensive data protection measures, vigilant transaction monitoring, stringent
access controls and network security protocols. These measures will help SFBs to
significantly enhance their IT resilience against possible disruptions.
Operational Risk
Fourthly, while I have covered cybersecurity threats, I would also like boards of SFBs to
be mindful of the larger issue of operational risks. During periods of rapid growth, the
focus on increasing market share, launching new products, and acquiring customers
can lead to a neglect of essential risk management practices. For example, hastily
onboarding new customers without thorough KYC due diligence or rushing the
deployment of technology solutions without adequate testing can increase the likelihood
of frauds, errors and service disruptions. Growth is important for the success of Small
Finance Banks. However, it must not come by overlooking operational controls.
Another significant area of concern for operational risk is the high attrition rate among
staff in Small Finance Banks. While the branch network and employee headcounts are
expanding, the sector faces a very high attrition rate of nearly 40 per cent, particularly
among frontline staff and junior management. Such elevated turnover, though mostly at
the entry and junior management levels, poses substantial operational risks, as it can
lead to a loss of institutional knowledge, disruption in service delivery, and increased
training costs for new hires. To mitigate these risks, Board-level efforts are essential to
focus on employee retention strategies at all levels. Further, the absence of succession
planning for critical managerial positions is a common issue across SFBs, which
requires immediate attention from Boards to ensure a smooth transition of leadership
and maintain operational effectiveness.
Conclusion
In conclusion, SFBs with their outreach to rural and semi-urban areas, are intended to
be one of the key enablers in credit offerings to individuals, weaker sections,
entrepreneurs, SHGs/JLGs and MSMEs. They have a large role to play in achieving our
aspirational goal of becoming a developed nation by 2047.
As RBI celebrates 90 years of its foundation this year, we have set deepening financial
inclusion as one of our cherished objectives for RBI@100. RBI, with its continued
commitment towards a financially inclusive India, has taken several measures to
support these segments ranging from Priority Sector Lending targets to the introduction
of TReDS for MSMEs. A new chapter in this book is the Unified Lending Interface (ULI)
platform which aims at "enabling frictionless credit" with the 'new trinity' of
JAM-UPIULI, further propelling India's growth story.
SFBs should strive to harness this opportunity and other such opportunities offered by
latest technological innovations for efficient and cost-effective service delivery. Further,
with robust governance and effective board oversight, SFBs can capitalise on their
strengths while meeting growth and stability objectives.
With this, I wish you all the best for the coming sessions and hope that you find these
sessions professionally enriching and stimulating. Thank you!
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Governance in Banks: Driving Sustainable Growth and Stability', Inaugural Address by Shri
Shaktikanta Das, Governor at the Conference of Directors of Banks organised by the Reserve Bank of
India for Public Sector Banks on May 22, 2023 in New Delhi and Private Sector Banks on May 29, 2023
in Mumbai. https://www.rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=1364