On November 20, 2020, the Reserve Bank of India (RBI) released the report of the Internal Working Group (IWG) that reviewed the existing licensing, regulatory guidelines, and corporate structure of Indian private sector banks and came out with certain recommendations. The group, consisting of five members, was constituted by the RBI on June 12, 2020. In the report, the IWG evaluated the eligibility criteria for individuals/entities to apply for banking licence, examined preferred corporate structure for banks and harmonisation of norms in this regard, and reviewed norms for long-term shareholding in banks by the promoters and other shareholders.
Need of Constituting IWG
A well-structured banking system serves as the backbone for sustaining the economic growth of any country. The present Indian banking ecosystem inherits its work culture from pre-independence era. Although the Indian banking sector has undergone many changes since independence, even after decades it struggles to meet the credit demands of a growing economy like India. Today, the total balance sheet of Indian banks stands below 70 per cent of the GDP, whereas this ratio is 175 per cent in China. Another major area of concern is expanding domestic bank credit to the private sector. Here, the data paints a very dismal picture. In India, it stands at just 50 per cent of GDP, while for economies like China, Japan, the US, and Korea it is 150 per cent. The situation is such that only State Bank of India (55th rank) finds its place among the top one hundred banks of the world. Compared to international standards, Indian banks are less efficient in terms of speed of functioning and delivering the desired services. It has been also observed that public sector banks have been steadily losing ground to private banks in terms of efficiency and profit. Private banks also demonstrate more risk taking ability.
It is in this scenario that the IWG was asked to suggest measures that not only boost private sector banking but also make it safer.
Corporatisation of Banks and the RBI’s Stance
Background Since the nationalisation of 14 large private banks in 1969, the RBI has not given licences to large corporate and industrial houses for setting up banks. At present, there are a total of 21 private banks, with the majority of ownership held by individuals and financial entities. These banks were established in the post-1991 era. Before the nationalisation of 1969, India’s banking system was in the hands of the private sector. Most of the privately-owned banks were in the form of joint-stock companies controlled by big industrial houses; for instance, the Tatas were the major shareholders of the Central Bank of India, established in 1911, and the Birla family, one of the leading corporate houses of India, controlled the United Commercial Bank set up in 1943 in Kolkata. The period was marked with rampant ‘connected lending practices’ which meant lending promoters of private banks, corporate and industrial houses large sums of low-cost depositors’ money. Consequently, as many as 361 banks failed during 1947–58. This failure of banking system halted social and developmental banking by private banks that led to severe droughts, food shortages, and high inflation in the country.
Since the initiation of banking sector liberalisation in the early 1990s, RBI has not come out with a clear policy and, so far, has not issued a banking licence to corporate houses, even though the 2013 guidelines briefly allowed it. In February 2013, the RBI had issued guidelines that permitted corporate and industrial houses to apply for a banking licence. Among those who applied, only two entities qualified for a licence—Infrastructure Development Finance Company (IDFC) and Bandhan Financial Services. Most applicants could not meet ‘fit and proper’ criteria. In 2014, the RBI restored the prohibition on the entry of corporate houses into banking.
Key Recommendations of the IWG
Key recommendations of the IWG are as follows:
- The cap on promoters’ stake in the long run (15 years) may be raised from the current level of 15 per cent to 26 per cent of the paid-up voting equity share capital of the bank.
- As regards non-promoter shareholding, a uniform cap of 15 per cent of the paid-up voting equity share capital of the bank may be prescribed for all types of shareholders.
- Large corporate/industrial houses may be allowed as promoters of banks only after necessary amendments to the Banking Regulation Act, 1949 (to prevent connected lending and exposures between the banks and other financial and non-financial group entities); and strengthening of the supervisory mechanism for large conglomerates, including consolidated supervision.
- Well run large non-banking financial companies (NBFCs), with an asset size of 50,000 crore and above, including those which are owned by a corporate house, may be considered for conversion into banks subject to completion of 10 years of operations and meeting due diligence criteria and compliance with additional conditions specified in this regard.
- For payments banks intending to convert to a small finance bank, track record of 3 years of experience as payment bank may be considered as sufficient.
- Small finance banks and payments banks may be listed within ‘6 years from the date of reaching net worth equivalent to prevalent entry capital requirement prescribed for universal banks’ or ‘10 years from the date of commencement of operations’, whichever is earlier.
- The minimum initial capital requirement for licensing new banks should be enhanced from 500 crore to 1000 crore for universal banks, and from 200 crore to 300 crore for small finance banks.
- Non-operative financial holding company (NOFHC) should continue to be the preferred structure for all new licenses to be issued for universal banks. However, it should be mandatory only in cases where the individual promoters/promoting entities/ converting entities have other group entities.
- While banks licensed before 2013 may move to an NOFHC structure at their discretion, once the NOFHC structure attains a tax-neutral status, all banks licensed before 2013 shall move to the NOFHC structure within 5 years from announcement of tax-neutrality.
- Till the NOFHC structure is made feasible and operational, the concerns with regard to banks undertaking different activities through subsidiaries/joint ventures/associates need to be addressed through suitable regulations.
- Banks currently under NOFHC structure may be allowed to exit from such a structure if they do not have other group entities in their fold.
- Reserve Bank may take steps to ensure harmonisation and uniformity in different licensing guidelines, to the extent possible. Whenever new licensing guidelines are issued, if new rules are more relaxed, benefit should be given to existing banks, and if new rules are tougher, legacy banks should also conform to new tighter regulations, but a non-disruptive transition path may be provided to affected banks.
A fundamental shift in the thinking of the RBI is evident in view of the IWG Report. The IWG has recommended to allow large corporate/industrial houses to promote banks in the country. The IWG report is motivated by the idea of creating a greater competitive atmosphere and generating private capital, which seems positive. However, all the members of IWG were not in agreement over the issue.
Concerns
The performance of India’s corporate sector over the past few years has been weak, with non-performing loans for the corporate sector as of March 2020 standing at around 13 per cent of total corporate loans.
Corporate ownership of banks raises the risk of intergroup lending, diversion of funds, and reputational exposure. Former Governor of the RBI Raghuram Rajan and former Deputy Governor of the RBI, Viral Acharya have warned about the consequences like ‘connected lending’.
The IWG report mentions that ‘it will be difficult to ring fence the non-financial activities of the promoters with that of the bank.’ There is every fear that politically strong corporates will obtain licences without having merit. The corporate-owned banks tend to favour their support groups and sister organisations driven by profit motif.
Corporate houses are quite proficient at routing funds through a network of entities in India and abroad. Tracing interconnected lending will be a challenge. Monitoring of transactions of corporate houses will require the cooperation of various law enforcement agencies. As pointed out by V. Raghunathan, ‘circular banking’ is another potential risk posed by corporate-owned banks because of the widespread prevalence of cartels in corporate India. Under circular banking, a corporate-owned bank A would finance the projects of corporate-owned bank B, B would finance the projects of corporate-owned bank C, and C would finance the projects of A, hence completing the cycle.
There are corporate houses that are already present in banking-related activities through owning non-banking financial companies (NBFCs). The recommendations of IWG allow NBFCs with a successful track record of 10 years to convert themselves into banks. There is a difference between a corporate house owning an NBFC and one owning a bank. Bank ownership provides access to public safety net (government guarantees provided to depositors and sometimes to all bank creditors) whereas NBFC ownership does not. A major concern regarding privatisation is that selling public sector banks to corporate houses would raise serious concerns about financial stability.
The report makes a proposal of allowing large NBFCs with the asset size of Rs 50,000 crore and above, including those owned by a corporate house, to convert into banks. However, NBFCs do not seem interested due to their fear of deploying funds for reserve requirements which will fetch negligible returns.
The American credit rating agency, S&P Global Ratings, is sceptical of the move. According to it, in the current weak corporate culture and governance prevailing in India, coupled with many large corporate defaults, the move is full of risk. It outlined that concentration of economic power and financial instability are some of the potential risks in permitting corporate houses to own banks. There is fear of excessive competition which may prove counterproductive as it enhances the systemic risks by eroding market power and profit margin of banks.
According to former chief economist of the World Bank, Kaushik Basu, there is a good reason why all successful economies have a clear dividing line between industries and corporations on the one hand, and banks and lending organisations, on the other. He is of the view that the proposal of the IWG to allow Indian corporate houses to own and run banks is a good-looking step in a bad direction, which may result in crony capitalism. Crony Capitalism is an economic system in which individuals and businesses with political connections and influence are favoured through such means as tax breaks, grants, and other forms of government assistance.
Need for Strong Supervision
It is believed that concerns can be addressed by strong supervision and well thought out regulations. But the episodes like collapse of the infrastructure leasing & finance services (IL&FS), the Nirav Modi scam at the Punjab National Bank, and the implosion of the Punjab & Maharashtra Co-operative Bank Ltd, do not inspire confidence. Politicians have used banks to further their political interests, so corporate houses will also be tempted to use banks set up by them to enhance their clout. In India, incidents of frauds and defaults have increased at an alarming rate across the spectrum. Financial scandals have occurred in some of India’s big corporate houses that have long prided themselves on being above board. India’s biggest corporate accounting fraud came to light in 2009 at Satyam Computer Services, just five months after the company won the Golden Award for Excellence in Corporate Governance, instituted by the Institute of Directors, UK.
While the working group recommends a strong legal framework and augmenting the supervisory capacity before allowing corporate houses to enter the sector, it is to be noted that the RBI’s existing supervisory mechanism does not succeed in ensuring real-time compliance and early detection of frauds. Recently, RBI’s regulatory capability came under the scanner for failing to spot the Yes Bank issue in time.
Analysis
Allowing industrial houses to own banks has few benefits and many risks. According to the report, the main benefit is that industry-owned banks would increase the supply of credit, which is low and growing slowly at present. The power acquired by getting banking licences will not just make the corporates stronger than commercial rivals, but even relative to the regulators and government itself. If the suggestions of the report are implemented, the corporate houses that are already big will become even bigger by having power to raise and redirect resources, allowing them to dominate the economic and political landscape. Corporate ownership of banks would further concentrate economic power in the hands of a few corporate and industrial houses. This would have adverse effects on the domestic economy and politics. It would increase the already prevalent wide inequalities and would also lead to public policy being held captive to and compromised to serve a few vested interests.
Some experts are of the view that the nation’s economic future should not be held back because of the shortage of a new class of promoter-driven big, and smartly governed private banks. This shortage can be made up by establishing more banks like HDFC Bank and Kotak Mahindra Bank. As per their opinion, there is a strong need for liberalising entry into the banking sector, and to encourage the creation of big private banks capable of meeting the financing needs of the economy rather than allowing industrial houses to take over Indian banking sector. A system of stringent checks and balances with a strong, vigilant, autonomous and impartial supervisory body would serve the purpose. However, mixing industry and finance will set us on a road full of danger—for growth, public finances, and the future of the country itself.
The US banking system comprises the Federal Reserve System, commercial banks, savings institutions, and credit unions. The whole system is regulated at both federal and state levels. Unlike the US, India follows a bank-based financial system in which banking assets account for 75 per cent of the total assets held by the financial system. So, the contribution of the banking sector is quite significant for economic growth and poverty-reduction strategies. In this situation, any venture fraught with risks must be avoided.
The concerns are also based on the past experiences of large-scale financial frauds by corporate houses. As such, there are apprehensions whether the profit-oriented industrial houses would support financing developmental works.
As far as regulation is concerned, it appears doubtful that the regulator would take strong steps against powerful corporate houses. It would face enormous pressure to compromise on regulation as many large corporate houses are backed by powerful politicians. Ultimately, the dignity of RBI being the supreme financial regulator will be dented.
Corporate houses raise funds in India and abroad, thus, it will become difficult to trace their financial activity. Therefore, monitoring of transactions of corporate houses will require various law enforcement agencies. But they can use their political influence to defend themselves. The RBI can only react to interconnected lending after substantial exposure to the entities of the corporate house has happened. It is unlikely to be able to prevent such exposure.
Therefore, it becomes necessary to equip the RBI with a legal framework before corporate houses are allowed to enter banking sector. It will deal with interconnected lending and a mechanism to effectively supervise conglomerates venturing into banking.
India’s banking sector is in dire need of reforms but corporate houses owning banks are not the answer. The reach and clout that bank ownership provides are vastly different from and superior to that of an NBFC. So at this point, the entry of corporate houses into banking remains a risky proposition.