India’s KYC crisis: A bank dedicated to welfare payments could resolve it

Bank accounts being suddenly frozen due to KYC issues is a growing crisis across India, leaving millions locked out of their savings. While customers blame banks and banks blame regulations, the real issue runs much deeper.

Banks are bound by regulations, including the Prevention of Money Laundering Act (PMLA), which requires them to track suspicious transactions. They must file suspicious transaction reports when red flags arise. 

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These indicators may be either probabilistic, such as high transaction volumes, or deterministic, involving a law-enforcement notice, for example. However, the rules do not let banks disclose this to their customers.

Every KYC verification comes at a cost. Banks do not just bear routine expenses. They also bear the financial and operational burden of compliance. When the cost of maintaining an account outweighs its value, banks face difficult choices. Rural branches are hit the hardest. They operate on thin margins and are usually understaffed. Yet, they handle a disproportionate number of direct benefit transfer (DBT) accounts.

When the Reserve Bank of India (RBI) mandates mass re-KYC under the PMLA, these branches struggle with backlogs that take months to clear. Customers, frustrated by frozen accounts, direct their anger at banks, often unaware that the latter have no choice.

The rise of fintech and digital banking has also made India a playground for scammers. Reports suggest that money mule networks—for which individuals ‘rent out’ their bank accounts to fraudsters—have proliferated with the ease of UPI transactions. Automated API-driven laundering operations move stolen money at lightning speed.

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Banks are caught in the middle. When they are pressured by law-enforcement agencies to freeze accounts, their frontline employees often face verbal abuse or physical threats. Yet, the perception is that banks harass customers, even though they are only acting as required by the regulatory regime.

DBT mechanisms were introduced to curb corruption in welfare distribution. In 2007, Montek Singh Ahluwalia estimated that only 50% of welfare funds reached the poor. Recent field studies by Jean Drèze indicate that things have worsened in 2025, with 69% of DBT-linked bank accounts frozen on account of KYC issues. If beneficiaries cannot access their money, financial inclusion becomes meaningless. This is only slightly different from corruption in in-kind welfare schemes. Yet, it is neither tracked nor acknowledged as a systemic failure.

If PMLA-driven KYC norms remain unchanged, then India must rethink its DBT mechanisms. One solution is to have a specialized banking arrangement for welfare payments, separate from commercial banks. India Post Payments Bank could take on this role, given its wide physical presence in rural India.

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Dedicated DBT bank accounts could process welfare payments. These must not be frozen so long as their holders are alive and could operate with Union government budgetary support rather than relying on commercial viability. Such a shift would reduce the KYC burden on regular banks and let them focus on core financial services.

Dedicated DBT accounts would function differently from regular accounts. Account opening would be automatic, linked to Aadhaar identification and welfare eligibility, and wouldn’t need to meet the demands of traditional bank protocols. Transactions would be limited to government-to-person transfers, preventing third-party fund movements and eliminating the risk of money mules exploiting these accounts.

Unlike accounts at commercial banks that must be monitored for suspicious activity, DBT-only accounts would need to be watched only for disbursal efficiency.

Such a system exists in other countries. Brazil’s Caixa Econômica Federal operates a dedicated welfare-payment system to ensure that benefits reach recipients without banking-bureaucracy delays. India can take a similar approach by expanding India Post Payments Bank into an entity dedicated to welfare transfers.

India also needs policy reforms to shield financial inclusion from financial regulation. Current KYC rules treat every account the same, whether it belongs to a business, an individual investor or a rural pensioner receiving government benefits. This one-size-fits-all approach is flawed. Moreover, freezing an account should be a last resort, not a default response to missing data.

Also, RBI and government agencies must coordinate better. Banks cannot be expected to enforce KYC rules while simultaneously ensuring seamless DBT disbursals. A centralized KYC database for DBT beneficiaries managed by a government body, rather than individual banks, would ease much of the compliance burden borne by banks and allow welfare payments to flow smoothly without compromising security.

Banks are not the villains in India’s KYC crisis. They are bearing the financial, operational and reputational costs of compliance while being pressured by regulators and suffering the ire of customers. If financial inclusion is a priority, the system must evolve. Otherwise, India’s most vulnerable will pay the price for a crisis they did not create.

The authors are, respectively, a corporate advisor and independent director on boards; and co-founder, DeepStrat.