Call for papers: IGIDR Emerging Markets Finance Conference, December 2012

EMF 2012, Call for papers

White label ATMs

by Harsh Vardhan.

On 20 June, RBI issued guidelines that permitted White Label ATMs (WLA) to be operated in India. These guidelines could make a very significant change in the banking business - one that would go a long way in improving penetration of banking. This was a move that was long overdue. We can now look forward to very rapid expansion of the ATM networks along with many new services being offered at them.

ATMs arrived in the US in the late 1970s and in India somewhere in the 1990s, when some foreign banks set up a few in Mumbai and other metros. It was not until the late 1990's and early 2000's that ATMs became an important channel and there was a rapid growth. This growth can be attributed to the new generation private banks who used ATM's cleverly to expand the reach of their (then) limited branch networks to attract customers. These banks realized that it will take them a long time to match the branch reach of public sector banks, and hence adopted a model where a branch surrounded by a slew of ATM's became the means of attracting customer. The proposition to the customer was - "Open an account in the branch which may be far away from your home or place of work but transact on an ATM which is very close to you". A new generation of customers, more amenable to the use of this channel also helped. Slowly, most of the new generation banks managed to transfer a sizeable part (in some cases over 80%) of basic transactions -- cash withdrawal, balance enquiry, etc. -- to ATMs. The cost advantage was compelling. Doing transactions on ATM's can be 50% to 80% cheaper than using branches. We also saw some small "value added services" emerge at the ATM, such as bill payments.

Despite the rapid growth of the ATM network, their density is still low compared to other countries. India has ~ 77 ATMs per million population which is much lower than even countries like Thailand and Malaysia which have ~200 ATMs per million and significantly lower than the US which has over 1200 ATMs per million people. Clearly, ATM density will have to grow which means a large number of ATM's will have to be rolled out. For this to happen, appropriate incentives have to come into play in this field.

How do ATMs work?

It is important to first understand the mechanics of ATMs, to fully appreciate the roles played by different entities and how the new regulations change these roles and thus the incentives.

ATMs are essentially electronic contact points between a bank and its customers. The jargon of the field involves three kinds of entities:

• Issuing banks - those that issue ATM cards (or debit and credit cards) to their customers
• Acquiring banks that operate ATMs and dispense cash (similar process also is followed in case of the so called Point of Sales (PoS) terminals that are used at merchant establishments for payments)
• Payment associations (also called Network Providers) - the intermediaries that facilitate the flow of information (payment instructions) and funds between issuing and acquiring banks

The process flow of cash dispensation by ATMs (which is 95% of what they do) works like this:

1. A customer approaches an ATM and inserts his card.
2. The ATM "reads" his card and passes the information to the bank which has set up the ATM. This bank is conventionally called the "acquiring" bank.
3. Computers of the acquiring bank read the information and determine if the customer is its own or of some other bank.
4. In case of its own customers the bank invokes his account, checks if there is enough money, and if the password is correct, sends instruction to the ATM to dispense cash. Such transactions, where the acquiring bank and the card issuing bank is the same, are called "On Us" transactions.
5. Sometimes the customer has a card issued by another bank ("the issuing bank"). The acquiring bank (i.e. the one which setup the ATM) sends a message to Visa, MasterCard or "NFS" the National Financial Switch (a system set up by National Payment Corporation of India) depending on the arrangements between the acquiring banks, the issuing bank and these entities. These entities are called "Payment Associations" and they perform the role of connecting card issuing banks with the acquiring banks
6. Upon receiving the information from the payment association, the issuing bank checks up the availability of a balance in the bank account, and sends the payment instruction to the ATM which dispenses cash. In this situation the acquiring bank is making the cash payment to the customer on behalf of the issuing bank. Such transactions are usually referred to as "Off Us" transactions
7. The payment associations keep records of all "Off Us" transactions. At the end of each day, they do clearing and settlement of funds whereby all banks pay or receive funds depending on the net Off Us transactions made through their customers and possibly their ATMs.
8. The issuing bank pays some fees to the acquiring bank and to the network providers for every transaction that their customers carry out on ATMs (i.e. for all "off us" transactions). These fees are a revenue for the acquiring banks which spends money in building and running the ATM network.

It is useful to think that there are 2 distinct flows in this process: a flow of information (or instructions), and a flow of money. Information flow takes place on communication lines between the entities involved and funds flow is mediated by the payment association through its own clearing and settlement processes. The two flows are linked but distinct.

The new guidelines

Historically, RBI regulations prevented non bank players from competing in this space. Regulations allowed only commercial banks to own and operate ATMs. This means that each ATM, in the view of the regulator, belonged to the acquiring bank. And no entity other than a commercial bank could do the acquiring part of this process.

Building and running ATMs is more of an IT/telecom business and many banks were not keen to create these capabilities. A significant amount of outsourcing was done by banks, whereby the maintenance and in many cases even the rollout of ATM's was done by independent companies for banks. But regulations dictated that all the crucial aspects of running the ATM network remained squarely with banks. Even the locations of ATMs - which banks needed to inform the RBI - were pegged to a bank. The new guidelines effectively open up most of the acquiring part of the process to non bank independent players. They clearly recognize that the information and the funds flow are distinct and while there may be some logic in keeping the funds flow within the ambit of commercial banks, the information flows can be performed by non banking entities. The new guidelines make some profound changes, including allowing:

• Independent white label ATM providers to set up and operate ATM networks (without being a bank); these companies can apply for and get approvals for the locations of ATMs - the locations will be assigned to these companies and not to banks
• Independent ATM networks to connect directly with network providers such as Visa Mastercard, and NFS - thus allowing them to pass on the payment instructions emanating from the ATM without having to go through the acquiring bank, While the cash settlement will continue to be via the acquiring banks (called sponsor banks under the new guidelines), an independent ATM operator can do such settlement through multiple sponsor banks
• Allowing companies to tie up with multiple banks as acquiring (sponsor) banks; this will meant that even if the arrangement between a particular bank and an ATM operator is discontinued, the operator can tie up with another bank and continue to operate ATMs
• ATM operators the freedom to offer value added services

Effectively, these changes imply that running the ATM network has now been recognized as an independent activity, but at the same time seeing that it is a business that needs the support by banks for activities such as managing cash and for settlement. Thus the RBI has taken significant part of running ATM networks out of the ambit of commercial banking.

Why is this a good idea? Building out the ATM network is not a core activity for banks. For banks, an ATM is a transaction point for customers. Setting up and running a large number of ATMs is an activity that adds little to the profitability and performance of banks but does add a significant amount of operational burden. This is the reason why many Indian banks started outsourcing ATM rollout and management once they reached a critical mass on ATMs. This is not the business of banking. At first blush, it is an IT or telecom business. But at a deeper level, it is closer to the retail business, with issues like location, branding, efficiency, multiple services, etc.

For independent white label operators, building out a large ATM network and squeezing operational efficiencies out of it would be the core business. They are expected to focus on much faster rollout of network, strategically thinking about locations, squeezing efficiencies in the management of the network, adding value added services, etc. An analog would be the case of money-changing business - what is popularly known as "Exchange Bureaus". For a long time only banks were allowed to run these and so we saw very few outlets even at airports and so on. This business was opened up for private independent players about a decade or so ago, which resulted in a dramatic increase in the number of outlets as well as the quality of their service. There are several classes of players that are likely to enter this business. Large established international players (eg Star, Pulse, NYCE from the US) should be interested as they would see India as a major growth market. Local players currently providing oursourcing services for ATM rollout and management would be another class of players that are likely to enter. ATM manufacturers (eg NCR, Diebold) also could look at this as an extension of their business. Other firms in related business such as telcos that provide the network connectivity could also consider entry. Each of these different classes of players have their own strengths and weaknesses. Time will tell which is the ideal business model. The competitive dynamics between these various kinds of players will give customers in India better ATM services in all respects: more locations, better locations, more services, and superior customer experience.

Many aspects of the white label ATM business will only become clear as the story unfolds. The most critical is the long term sustainable economics of the business which will determine the capital that is deployed into the business. While the RBI guidelines prescribe overall restrictions on the fees charged by the ATM operator to the bank, they stay away from prescribing the exact charges, which is the right approach. At first, there will be a bit of a competitive frenzy; some players will set some charges to very low or very high levels. It will be some time before stable pricing structures and levels emerge. The guidelines are not absolutely clear if these companies can develop independent brands for their networks (such as Most and Cirrus in the US). Such branding will be a crucial part of making white label ATM an independent business. My interpretation is that independent branding is not explicitly prohibited but it is not explicitly permitted either and clarity on this count would be very useful. Overall these guidelines are a move in the right direction. There is a lot in the payment space that is currently tied to commercial banking due to regulatory reasons. The evolution of technology and consumer behavior suggests that many aspects of payment business need not remain confined to banking and in fact taking them out could unleash innovation that would drive significant efficiency gain and consumer value. We can hope that the deregulation of ATMs is the first of several similar steps that the RBI takes to allow the emergence of a payments industry in India, distinct from the business of banking.

Interesting readings

Bruce Riedel has a great story in the National Interest about the 1962 India-China war and its aftermath.

Nitin Pai in the Business Standard on how to better manage immigration into India.

The adventures faced in running household surveys in India.

I have written earlier about the new world of intense competition for the top two Indian financial products: Nifty and rupee. A big step up in competition against the NSE Nifty options has begun, against a serious and heavyweight rival.

Palak Shah, in the Business Standard, describes some interesting developments at the Delhi Stock Exchange. DSE has fumbled before on finding the right partners; perhaps this will set the stage for building DSE into a serious player in the Indian exchange industry. And, see Jeff Glekin on Reuters Breakingviews on India's 3rd stock exchange.

How should liberal democracies deal with China and Russia? by Michael Ignatieff.

Bo Xilai: power, death and politics by Jamil Anderlini in the Financial Times.

If you've wondered why Microsoft faded away in the recent decade, read Microsoft's lost decade by Kurt Eichenwald in Vanity Fair. On this subject, read David Stutz who wrote an open letter when he left Microsoft in 2003. I looked back into 1997 and thought that while parts did not work out, it was a pretty good call: two years before the MS stock price peaked and roughly four years before the cognoscenti understood that Microsoft was a utility in decline.

Robert Shiller interprets China's Great Leap Forward as a speculative bubble.

China's economy: Apocalypse soon? by Mark McDonald in the IHT.

Jayanth Varma on various notions of price. Also see one of my old columns, When marking to market fails.

Egregious Indian protectionism against trade in services

For many decades, India was one of the most protectionist countries in the world. This did great damage to growth and knowledge in India. Tariffs dropped from ridiculous levels to ridiculous levels in the early 1990s and then got stuck there. Yashwant Sinha, as Finance Minister, initiated a remarkable program of cutting the peak rate by five percentage points every year. This worked very well: It steadily got rates down and also gave a roadmap to the domestic industry about what would happen next.

In January 2004, Jaswant Singh as Finance Minister announced further cuts to customs duties even though it was not part of the budget. This was criticised in the press as being a `populist' move. I thought it was a big day in India's history: when a Finance Minister feels that trade liberalisation is so important that it cannot wait  for February 2005 (since Feb 2004 was to be a vote on account), and when he gets criticised on the grounds that this is populist.

While there is more ground to cover on removing barriers to trade in goods (e.g. barriers to trade in agricultural products), by and large, India is doing well on this. The old instinctive protectionism has subsided. Two big areas for work remain. First, all customs duty rates are not yet at zero. And, we have one big gap: the lack of a proper GST, through which we would get to residence-based taxation. The GST on imports would be charged on imports, giving parity between a factory just inside the border and one just outside. And, the zero-rating of exports would mean that the GST burden suffered by a non-resident is refunded to him. The fundamental law of tax policy in this age of globalisation is: You do not tax non-residents.

Does this mean that we're in good shape on trade liberalisation? No. The big gaping problem is trade in services. Most of world GDP and India's GDP today is services. Even if we do full free trade on agricultural and non-agricultural goods, that only covers 40% of GDP. The real story of international trade is now in trade in services.

With trade in services, old-style Indian protectionism reigns. For the first time now, we have some hard data on this. The World Bank has released a `Services Trade Restrictions Database' which measures protectionism in services across the world. To get the story about what was done, read the voxEU column by Aaditya Mattoo, Ingo Borchert and Batshur Gootliz. Here's the key picture:

The graph puts per capita GDP (in log scale) on the x axis and the measure of barriers to services trade on the y axis. Values of 0 imply perfectly open and values of 100 imply perfectly closed. The regression line shows us that by and large, when countries get richer, they reduce restrictions. The score goes down from roughly 40 (on average) for the poorest countries to roughly 20 (on average) for the richest ones.

India sticks out as an outlier, with a score of above 65.7. We are more restrictive than Iran. Only Ethiopia is more restrictive than India, among all the countries of the whole world. Here is some more detail about what is going wrong:

This shows us the variation of India's restrictions by sub-sectors and by modes. While there is some variation, it is all appallingly bad. If we only got to the conditional mean for the Indian level of per capita GDP, we'd have to get the score from 67.5 to roughly 37.5, which is a big decline. And there is no reason to stop there; we need to eliminate protectionism far beyond what's seen in the conditional mean.

To be open to trade in today's world is to be open to trade in services, given the preponderant share of services in GDP. What we are doing is profoundly wrong. We always had an instinctive sense that India does worse on trade in services when compared with trade in goods. The World Bank has made a great contribution by building a comparable database across countries, to give us a concrete sense of where we are and how bad things are.

If we want to harness gains from trade in goods, we have to open up to trade in services also. Finance, transportation, and other services are the vital glue that makes trade in goods possible. Our mistakes on services trade liberalisation are holding back our gains from trade in goods also.

You may like to also see older blog posts: Globalisation: the glass is half empty, 28 January 2011, and Getting to a liberal trade regime, 15 December 2009.

The disaster at Maruti

The news from Maruti is disgusting. I have been curiously watching how the stock market takes it in:

That Maruti has serious labour problems has been known for a long time. But the brutality that unfolded in recent days was out of the world. It was news. When I read about it on Thursday, it seemed to me that Maruti was facing a Tata Motors style situation: of suffering the fixed cost of closing down the existing plant and relocating to a state with better governance. The costs faced in this would be substantial. In that case, a 6 per cent decline of the stock price seemed pretty modest. I watched the small recovery on Friday with surprise. Surely, the cost and complexity of moving out of Manesar is worse than 5%.

Today, on Monday, the market has shifted from a less sanguine assessment to a 10% drop in the stock price. I wonder if this is new information or a modified judgment about how this will play out. Were the speculators on late Friday evening just wrong, or did some new information break?

Bad macroeconomic outcomes and social stress

I would conjecture that poor macroeconomic performance -- low GDP growth and high inflation -- is correlated with greater stress of this nature. With inflation, the logic is straightforward: The worker who had a nominal wage contract finds the need to renegotiate when the value of the rupee changes. This links back to the earlier discussion here on why solving India's inflation crisis is important. Too often, we in India are cavalier about inflation. But we should see inflation as an acid that corrodes all nominal contracts, whether stated or unstated. Renegotiation is costly.

Turning to GDP growth, most people that I know seem to think that a couple of per cent of real per capita GDP growth is important for keeping the peace. A lot of people become a lot more unhappy when growth slows. Indian democracy does a pretty good job of containing the angst. There will be no revolution here. But life is substantially easier if the engine of GDP growth is purring. When it stalls -- as it appears to have done in 2012 -- a whole host of social problems erupt.

Law and order as the fundamental foundation of civilisation

This is a reminder to us about how law and order is the fundamental precondition of civilisation. The most important public good of all, the first claim on the resources of the State including the time and attention of the senior leadership, is police, courts and laws. The entire story of the market economy and high GDP growth can only come about when safety of life and property is guaranteed. The events in Maruti are an important reminder to every investor about the weaknesses of governance in Haryana.

In tracking conditions in any state, I find it useful to watch the time-series of the share of the state in the overall all-India investments outstanding, that are `under implementation', in the CMIE Capex database. Here's an example, for Bihar:



November 2005 is the date that Nitish Kumar became the new CM of Bihar. He is widely reputed to have made important progress on improving law and order. At first, the share of Bihar (in all-India under implementation investment) continued to drop. I am sure the changes brought about by Nitish took time; Rome wasn't built in a day. And, after improvements come about, skeptical investors would take some time in making up their minds that conditions are now better. From 2009 onwards, it appears that there is some upward movement. The overall gain seems to be roughly 1 per cent of the all-India total, which is a significant change.

Compare this with Haryana:

There was a big spurt in the share of Haryana in the overall under-implementation investment in India. After that, the numbers have steadily trended down. Is Haryana suffering from a resource curse in terms of proximity to Delhi?

Rethinking labour law

In the early decades about independence, India constructed a remarkable legal framework which was strongly pro-trade-union. Few countries have enshrined trade unions into laws on the scale that India has done. In those years, trade unions were primarily led by socialist/communist parties. While we may disagree with their views, there was a fundamental decency about them. Some of the best human beings in India, in the 1950s and 1960s, were communist. Perhaps this coloured our thinking, and encouraged us to respect and empower trade unions strongly in the legal framework which fell into place over the 1960s and the dark days of the 1970s.

Today, a hyper-empowered trade union is a potent tool for extortion in the hands of local goons. To solve this problem, it is important to rethink the checks and balances embedded in labour law, which have gone too far in the direction of making trade unions strong. Now that we know that the people in trade unions are most likely local goons, do we want to hyper-empower them through labour law?

The two escape routes away from domestic formal-sector finance

Three problems afflict formal-sector finance in India today: capital controls, taxation, and financial policy. The most important financial products traded in the formal sector in India -- the stock market index (Nifty) and the exchange rate (the rupee) -- are under enormous pressure as a consequence.

One dimension, that has been emphasised in the existing discussions, is the flight to offshore markets. There is another: the trade goes off into underground markets. These come in two kinds. In the field of commodity futures, it appears that important price discovery and liquidity is found on unregulated markets. As an example, in Gujarat, the town of Bhabhar is famous for having a huge oilseeds and edible oil futures market. Babhar is a true market: it has liquidity and discovers the price.

A second mechanism is a class of market mechanisms which leech off the price discovery of a main market, do not really offer liquidity of their own, and let people achieve trades. In Indian parlance, these are called the `dabba market'. Here is how it works:

1. The main market where Nifty trades is NSE. But if a customer goes there, he has to suffer the full burden of the securities transaction tax, the charge by the NSE member firm, etc.
2. The dabba operator (`DO') sets himself up in business offering trading services in Nifty futures.
3. Many individuals place buy/sell trades with him. These are meticulously tracked; their profits and losses are calculated and money is exchanged w.r.t. each customer.
4. Through this, the DO is effectively accepting orders -- like an exchange -- and doing daily mark-to-market w.r.t. the customers.
5. On average, the sum total of trades by many customers adds up to zero. So the net exposure of the DO is roughly 0. If an exposure builds up, he might choose to lay off his risk on NSE.
6. The DO charges much less than the NSE member since he does not pay STT and his establishment costs are lower.
7. He is a big man in the community. He can break your bones. So you will not default on him. So he charges less margin. This is another attraction - but it means that some fraction of customers endup entangling with the underworld.
8. The DO will work with black money (i.e. cash). This is another attraction, compared with the all-cheques-and-PAN-numbers world of NSE. The short-term capital gains tax (or worse, ordinary business income treatment of winnings) is then avoided.

Bhavesh Shah, reporting from Ahmedabad in DNA, tells us that dabba trading has gotten bigger of late. He also points out that the DOs have been doing some system-building to make their business more efficient. Dabba trading is one response of economic agents to the problems of taxation and improper financial policy. It also happens to a varying degree with trading in India of international underlyings (e.g. crude oil or gold), where capital controls prevent locals from accessing the world market.

In summary, when India makes mistakes on three things -- capital controls, taxation and financial policy -- there are two kinds of responses on the part of onshore and offshore users of India-related financial markets. On one hand, users go off to overseas venues. On the other hand, users shift towards informality. In the limit, large scale mistakes on the three fronts will drive the bulk of customers away from the formal sector onshore market venues. RBI, the tax authorities and SEBI will then lord over an insignificant part of the market.

Attitudes and beliefs in India

We generally know remarkably little about what the people of India feel and think. Politicians have an interest in emphasising ideological biases. Systematic surveys about attitudes and beliefs are generally not taking place. Under these conditions, I find it useful to take whatever scraps of evidence one can get from efforts rooted outside India which are measuring attitudes and beliefs in India.

One important institution working on these things is the Pew Research Center which runs the `Pew Global Attitudes Project'. They regularly runs surveys in India, and I have blogged about some of these results before.

Some interesting new results were released yesterday. The focus of the study is on gloom in the world economy. With apologies to the authors, I'm going to ignore many elements of that effort, for I found some sub-components which interested me more. Their survey methods seem to be quite good; a sample of 4018 adults spread over a large swathe of India.

Are you better off than you were five years ago?

The basic engine of high growth is delivering: a lot of people feel they are better off than conditions prevalent five years ago. There is a holdout of roughly a quarter of India which says they are worse off.

Can most succeed if they work hard?

Do we have a Calvinist ethos? In the overall average, 67 per cent of India believes that most succeed if they work hard. This is behind the US (which is at 77 per cent) and Pakistan (81 per cent) but ahead of all countries in Europe and also China (45 per cent) and Japan (40 per cent).

The rich are more in favour of this proposition. There are 8 countries where this belief varies strongly by income:

While the overall average is 67 per cent, among the rich we have a much higher number (74 per cent in support). This is next only to the US. This drops off to 64 per cent among the poor. It is interesting that the middle class is what feels the least good about hard work, with 62 per cent. We have a bit more of a Calvinist ethos at the two extremes of the income distribution.

Support for the market economy

Support for the market economy is strong. Four large countries are ahead of India on this score: Brazil, China, Germany, the US. The UK is the same as India on this. Is there support for the market economy in these six countries because the outlook for these countries for the next decade is good, or is it the other way around?

The rich are particularly upbeat when compared with the poor

On an array of questions, the Indian rich are much more optimistic then the poor.

Finally, who's to blame

Those who said that economic conditions were bad were asked an additional question: Who is to blame. The results are unsurprising, for us:

92 per cent of India knows who is at fault: The Indian State. There isn't much anti-finance in India nor is there much anti-US. In places like Brazil, 29 per cent blame finance and in places like Pakistan, 32 per cent blame the US.


Most of us generally expect that mainstream attitudes in India would be quite left-wing, pro-State, anti-market, etc. The evidence does not seem to support these preconceptions.