On November 20, the Reserve Bank of India (RBI) released the report of the Internal Working Group (IWG) that reviewed the existing licensing and regulatory guidelines relating to ownership, control and corporate structure of private sector banks in India. The working group’s most significant but contentious recommendation is to allow large corporate and industrial houses to promote and run banks in India. “Large corporate/industrial houses may be permitted to promote banks only after necessary amendments to the Banking Regulation Act, 1949,” states the report.
Since the nationalisation of 14 large private banks in 1969, the RBI has not given licenses to large corporate and industrial houses for setting up banks. At present, there are 12 old and nine new private banks (established in the post-1991 period) with the majority of ownership held by individuals and financial entities.
Another important recommendation of the IWG is to allow conversion of large non-banking financial companies (NBFCs), including those owned by corporate houses, with assets of Rs 50,000 crore and above and 10 years of operations into full-fledged banks. If the RBI accepts this recommendation, it would lead to a backdoor entry of corporate-owned NBFCs into the banking space.
Headed by Prasanna Kumar Mohanty, the RBI had constituted a five-member IWG on June 12 to examine existing licensing and regulatory guidelines related to private sector banks within a larger context of meeting the credit demands of a growing economy; fostering greater competition in the domestic banking sector through the entry of new private players; and scaling up the presence of India’s banks in the world rankings.
What’s the urgency?
The RBI has conveyed a great sense of urgency throughout the process. Within a brief span of about four months, the IWG deliberated on these important policy issues having far-reaching ramifications on the stability of the banking system and submitted its report of 100 pages to the RBI on October 26. The central bank has offered less than two months to submit comments on the report. If previous RBI reports are any sign, the usual time-period involved between issuing committee reports and final guidelines is over two years. This time, however, the RBI appears to be in a big hurry to complete the process, raising some unsettling questions.
What is even more puzzling is that the IWG has endorsed this controversial recommendation despite overwhelming evidence to the contrary. In the report’s Annex 1, the IWG has also admitted that “all the experts it consulted except one ‘were of the opinion that large corporate/ industrial houses should not be allowed to promote a bank’.” Hence, it raises several questions: Why this recommendation was made by the IWG despite hard evidence and experts’ opinion against such a move? What’s the urgency? What is the right sequence of policy priorities for the RBI?
While several large domestic conglomerates stand to gain from securing a banking license given a very high rent-seeking potential, it is pertinent that the IWG’s recommendations must be widely debated before implementation and the arguments put forward by it must stand up to scrutiny. Otherwise succumbing to lobbying pressures from large corporate houses may derail the ongoing efforts to ring fence the banking sector from the build-up of bad loans, which could imperil the stability of the entire financial system in the long run.
Unlike the US, India follows a bank-based financial system with banking assets accounting for 75% of the total assets held by the financial system. The contribution of the banking sector is very vital for economic growth and poverty reduction strategies. Hence, too much is at stake, and there are better sources of mobilising capital to meet the funding needs of the Indian economy other than corporate houses.
The fewer arguments put forward by the IWG in support of permitting the entry of large corporate houses into the banking sector are unconvincing. Evidence shows that the potential benefits are much fewer in comparison with the potential costs. Before we get there, let’s first examine India’s experience of allowing corporate houses to run banks in the post-Independence era.
India’s experience with corporate-owned banks
Surprisingly, the IWG report does not examine India’s past experience with corporate-owned private banks for over two decades after independence. Before the nationalisation of banks in 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 which was established in 1911. The Birla family, one of the leading corporate houses of India, controlled the United Commercial Bank.
In those times, connected lending practices were rampant in private banks. As promoters of private banks, corporate and industrial houses used to channel large sums of low-cost depositors’ money into their group companies. With many private banks pursuing imprudent lending, bank failures ballooned. During 1947-58, for instance, 361 banks of varying sizes failed in India. The failed banks were amalgamated or ceased to exist.
As I discussed elsewhere, private banks owned by industrial houses were operating predominantly in metros and urban areas. Much of their lending was concentrated in a few organised sectors of the economy and limited to big business houses and large industries. Whereas farmers, small entrepreneurs, artisans and self-employed were dependent on informal sources (mainly traditional moneylenders and relatives) to meet their credit requirements. The share of agriculture in total bank lending was a meagre 2.1% during 1951-67. Before the bank nationalisation, the limited outreach of banks coupled with a weak regulatory framework represented a classic case of market failure in the Indian banking sector.
Most analysts believe that politics mainly drove the decision to nationalise banks. No denying that the timing of the decision was influenced by political events, but one cannot overlook underlying economic reasons that motivated this bold step. The bank nationalisation took place against the backdrop of several private bank failures, neglect of social and development banking by private banks, severe droughts, food shortages, and high inflation.
With the initiation of the banking sector liberalisation in the early 1990s, the RBI’s policy towards the entry of large corporate houses in the banking space has been wavering largely because of political economy considerations. The RBI has so far not issued a banking license to corporate houses, even though the 2013 guidelines briefly allowed it. Of course, there are several NBFCs (such as Bajaj Finance, Tata Capital, and L&T Financial Holdings) promoted by large corporate groups but unlike banks, NBFCs are not allowed to accept demand deposits from public depositors and they are also not part of the payment and settlement system.
Globally too, regulators do not encourage the entry of large corporates into the banking sector mostly due to governance and financial stability concerns.
Risks far outweigh benefits
Historically, the RBI has maintained a cautious approach towards corporate ownership of banks. Apart from the inherent conflict of interest, the poor quality of corporate governance practices is another key reason why the RBI has not issued banking licenses to corporate houses. Based on its interactions with outside experts, the IWG also admits that “the prevailing corporate governance culture in corporate houses is not up to the international standard and it will be difficult to ring fence the non-financial activities of the promoters with that of the bank.”
Over the years, the potential risks associated with connected lending have increased manifold because of the quantum leap in size and complexities in corporate India. The pervasive use of front and shell companies makes it difficult to identify the actual owner of businesses. Opaque onshore and offshore ownership structures can easily circumvent any regulatory measures put in place by the RBI to curb connected lending within a corporate conglomerate.
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.
In India, incidents of frauds and defaults are increasing at an alarming rate across the spectrum. Financial scandals have even occurred in some of India’s big corporate houses that have long prided themselves on being above-board. For instance, India’s biggest corporate accounting fraud came to light in 2009 at Satyam Computer Services, just five months after the company won the Golden Peacock Global Award for Excellence in Corporate Governance, instituted by the Institute of Directors (UK).
Further, corporate ownership of banks would further concentrate economic power in the hands of a few corporate and industrial houses. Increased economic concentration would have adverse effects on the domestic economy and politics. It would not only widen inequalities but would also lead to policy capture where special interests would shape public policies.
It is not that the RBI is incognizant of potential risks associated with large corporates owning banks. In fact, the IWG report also lists several such risks including misallocation of credit, conflicts of interest, extensive anti-competitive practices, risks relating to intra-group transactions, moral hazard risks, and the risk of contagion. But what is astonishing is that despite recognising such risks, the IWG still endorses the entry of large corporate houses in the banking space.
More competition, more fragility
Competition is often viewed as a necessary precondition for promoting efficiency and innovation in the banking sector. The IWG also envisages that the entry of corporate players would engender greater competition in the Indian banking sector. While one welcomes competition in the Indian banking industry, but excessive competition may prove counterproductive as it enhances the systemic risks by eroding market power and profit margin of banks. Fearing erosion of the franchise value because of increased competition, banks have a natural tendency to lend more money to risky businesses (e.g., real estate and capital markets).
Of late, there is a growing recognition in academic and policy circles that increased competition in the banking industry may be good for efficiency and innovation but bad for financial stability. The 2008 global financial crisis is a case in point. Maintaining a fine balance between efficiency levels of competition and financial stability remains a key challenge for bank regulators.
Moreover, it has been widely observed that excessive competition could drive banks to speed up the consolidation process to protect their market power, thereby creating complex, large financial conglomerates that are “too big and complex to fail”. The higher levels of concentration in the banking industry can have adverse ramifications for consumers, small and medium enterprises, and retail depositors. In a country like India with millions of poor and low-income people lacking access to affordable banking services, the RBI cannot overlook such ramifications.
The RBI is still behind the curve
Although the Indian banking system showed resilience during the 2008 global financial crisis, the liquidity risks, frauds, and malpractices witnessed recently in banks and NBFCs (from Punjab National Bank, Yes Bank, PMC Bank, ICICI Bank, Infrastructure Leasing and Financial Services to Dewan Housing Finance Corporation Limited) have brought to the fore the shortcomings in the RBI’s regulatory oversight.
While the working group calls for a strong legal framework and scaling up the supervisory capacity before allowing corporate houses to promote banks, it is hard to dispute that the RBI’s existing supervisory mechanism is still behind the curve in ensuring real-time compliance and early detection of frauds.
At best, the RBI’s regulatory oversight efforts can be described as a work-in-progress. Only late last year, the RBI overhauled its internal functioning and created separate regulatory and supervisory cadre to address potential systemic risks arising out of the growing size and inter-connectedness of banks and NBFCs.
On regulatory matters, one should not miss the bigger issues. In India, the problem is not the dearth of strong banking regulations. The problem lies in their implementation. Well-intentioned banking regulations without the capacity to enforce them are meaningless, as observed during several banking scams. New regulations can be introduced quickly, but it takes time to build human and institutional capacity to strictly enforce them.
In case the RBI accepts the IWG’s recommendation to allow corporate ownership in banks, a question on everybody’s mind would be: Does the RBI have the capacity to track connected lending, circular banking, loans to front companies controlled by corporates, loans to suppliers and vendors of a corporate group, creation of fictitious loan accounts, “evergreening” of loans, and other fraudulent practices on a real-time basis? If the answer is yes, then why the RBI failed to detect so many frauds and could not respond quickly to troubles in the banking system needs explanation.
If the answer is no, then why further burden already overburdened RBI with the additional responsibility of regulating banks owned by large conglomerates with multiple lines of businesses. What if something goes wrong because of connected lending? In such a scenario, one cannot expect the RBI to scrutinise millions of financial transactions carried out within a large conglomerate and to establish a money trail. That is the responsibility of an investigating agency (not of the RBI), a point also acknowledged by the working group.
Lastly, regarding the IWG’s recommendation allowing large NBFCs to convert into full-fledged banks, the long-lasting solution lies in scaling up regulatory oversight of all NBFCs – big or small – given their distinct purpose and complementary role in the domestic banking system.
To conclude, there is no robust evidence to support the entry of large corporate and industrial houses into the Indian banking sector. The potential benefits do not outweigh the potential risks inherent in corporate ownership of banks. It is an idea whose time has not yet come.
Kavaljit Singh is director, Madhyam, a policy research think-tank, based in New Delhi.