Subject: Differentiated Banks

Why in the News

A former Reserve Bank of India (RBI) Governor has criticised the consolidation of Regional Rural Banks (RRBs), calling it “a step in the wrong direction”. The consolidation has left one RRB in each State, and in one State the sponsoring commercial bank absorbed the RRB outright. The stated purpose of the exercise is operational viability and economies of scale. The objection is that scale removes the local and regional character that was the reason for creating these banks in the first place. A second claim runs alongside it: the alternative local lender, the small finance bank (a bank licensed to take deposits and lend, required to direct 75 per cent of its lending to priority sector borrowers and half its loan book to small-ticket loans), has not been allowed to expand.

What are Regional Rural Banks?

1. Origin: RRBs were set up under the Regional Rural Banks Act, 1976 to lend to small and marginal farmers, agricultural labourers, rural artisans and small entrepreneurs.
2. Ownership: Each RRB is jointly held by the Centre, the sponsoring commercial bank and the State government, in a 50:35:15 shareholding.
3. Design logic: Each bank was confined to a defined group of districts. That local presence was the design feature meant to push credit to borrowers a national bank would not reach.

How far has the consolidation gone?

1. Two decades of amalgamation: The Centre has consolidated RRBs since 2005 to improve operational viability and capture economies of scale, according to a written reply in the Lok Sabha in July 2025.
2. The first phase: Between 2005 and 2010 the number of RRBs fell from 196 to 82, and later phases reduced it further.
3. One State-One RRB: The latest phase cut the number from 43 to 28, with effect from 1 May 2025.
4. Absorption by the sponsor: In one State the sponsoring bank absorbed the RRB into itself rather than merging it with another RRB.

Why is the loss of local character the objection?

1. Local character was the justification: RRBs were created on the premise that a bank rooted in a defined area would distribute credit more evenly than a national bank operating from outside it.
2. Scale erases the distinguishing feature: A single State-level entity lends across an entire State. Its credit decisions move away from the cluster of districts the bank was built around.
3. Merger into universal banks is the endpoint: Once the local and regional character is gone, these banks may eventually be merged into universal banks, which removes the category altogether.

What has India’s institutional answer to credit gaps been?

1. A sequence of institutional experiments: Credit delivery to vulnerable and weaker sections has been extended through bank nationalisation, priority sector credit, RRBs, Local Area Banks, self-help groups and small finance banks.
2. The default response is a new institution: Each time a gap appeared, the response was to create a new institution rather than to repair the existing one.
3. Structure alone does not deliver: Creating an institution is not by itself the answer, since the underlying problem continues after the institution exists.
4. Execution decides the outcome: The record of small finance banks shows that the spirit in which management takes on the mandated task is what separates performance from form.

Why are small finance banks not filling the gap?

1. The number is too small: Only 11 small finance banks are in operation, which is not enough to meet unmet credit needs.
2. Same conditions as universal banks: A small finance bank has to satisfy the same set of regulatory conditions as a universal bank, without the balance sheet that makes those conditions affordable.
3. No incentive to enter: A promoter not driven by other considerations has little reason to set up such a bank on those terms.
4. The regulator has been asked to act: The RBI has been urged to find ways to incentivise the setting up of more small finance banks.
5. Graduation is not the objection: The ambition of a small finance bank to become a universal bank is not itself a problem, and these banks have performed well in the areas they were required to serve.

Challenges to Regional Rural Banks

1. Dependence on the sponsor bank: An RRB draws its technology, senior management and treasury operations from its sponsoring commercial bank, so its autonomy is nominal. Eg. Core banking platforms in most RRBs are maintained by the sponsor bank rather than by the RRB itself.
   The Fix: Move RRB technology and treasury functions to a shared national utility, so operational capacity does not depend on one sponsor’s willingness.
2. Thin capital and repeated recapitalisation: Capital has to be infused by three shareholders in a fixed ratio, so one shareholder’s fiscal stress stalls the entire infusion. Eg. The Centre approved a recapitalisation package of ₹10,890 crore for RRBs in 2021, with its own share at ₹5,445 crore.
   The Fix: Permit an RRB that meets the capital adequacy floor to raise capital from the market instead of waiting for all three shareholders to agree.
3. Concentration in crop lending: RRB loan books are weighted towards agriculture, so a single bad season hits borrower income and asset quality at the same time. Eg. Farm loan waivers announced by State governments leave RRBs holding written-off loans while awaiting State reimbursement.
   The Fix: Cap the share of any single sector in an RRB’s loan book and expand lending to rural non-farm enterprises.
4. Deposits raised locally are not lent locally: RRBs collect rural deposits and park surpluses through the sponsor bank’s treasury rather than converting them into local advances. Eg. Uttar Pradesh and Bihar carry among the lowest credit-deposit ratios in the country despite dense rural branch networks.
   The Fix: Tie an RRB’s branch expansion approvals to its credit-deposit ratio in the districts it already operates in.

Conclusion

Consolidation has settled the question of viability and left the question of reach open. A bank that is no longer local cannot claim the mandate that justified creating it, and a State-level entity is not a substitute for a lender that knows its districts. The regulator now has to decide whether rural credit is delivered by fewer and larger institutions or by more and smaller ones. Nothing in the current licensing terms pushes a new entrant towards the second answer.

Matching Previous Year Question

“[2013] Which of the following grants/grant direct credit assistance to rural households? (1). Regional Rural Banks (2). National Bank for Agriculture and Rural Development (3). Land Development Banks Select the correct answer using the codes given below. (a) 1 and 2 only (b) 2 only (c) 1 and 3 only (d) 1, 2 and 3 ANSWER: (c)”