Ownership and governance of private sector banks: Part II

Why has the RBI Internal Working Group (IWG) made the controversial proposal to allow corporate/industrial groups to own banks?

It is suggested that the credit-GDP ratio in India is too low at around 50 per cent, which is lower than in many other emerging markets, thereby providing evidence that India is underbanked. This proposition is commonplace in India. But it is worth examining if this is really true. The comparison made of the Indian credit-GDP ratio is almost always made relative to countries that have much higher per capita incomes, which includes most Southeast Asian and East Asian countries. The correct way to assess whether India is underbanked is to compare it with countries with similar per capita incomes. If a trend line is drawn of credit-GDP ratio with respect to per capita income, it is found that India has been above the trend line for at least the last 20 years. At present, based on data for over 160 countries, if India would be on the trend line, the credit-GDP ratio would need to be around 33 per cent if the GDP per capita is taken at market exchange rates, and around 41 per cent at purchasing power parity exchange rates. Thus, the credit-GDP ratio at 51 per cent can in no circumstances be seen as being too low. The extension of the Jan Dhan-Aadhaar-Mobile (JAM) revolution has indeed brought retail banking to almost every household in the country. What is at issue, however, is that credit growth has been stagnant for the last decade, as has deposit growth and needs to be revived. This is undoubtedly true and desirable for promoting further economic growth, but the solution may not lie in the promotion of new banks, whether promoted by corporate/industrial groups or otherwise.

Second, it is argued that greater competition is also needed to bring more efficiency to the banking system. In terms of numbers of banks, the IWG itself shows that India does not have concentration of banking and the various dispersion indices show that there is adequate competition in the country. Nonetheless, the on-tap licensing policy is a desirable policy change and new banks of quality should indeed be encouraged.

Third, it is argued that corporate/industrial groups will bring the much-needed new capital in the banking system: Where else can such capital be found? In fact, given the very high leverage inbuilt in the banking capital structure, the marginal resources that could be brought in by corporate/industrial groups will not be of great significance, and small relative to the resources that they would then have access to through the deposits garnered by the banks. Similar arguments were made when we opened the infrastructure sector to private investment through public-private partnership arrangements. Whereas a new dynamism did enter the infrastructure sector the new equity brought in was small relative to the borrowed resources that largely came from the banks. The problem was partly that infrastructure also typically has higher leverage than industrial companies, though of course much lower than banks.

Fourth, for the economy to ascend to a higher growth path subsequent to the current Covid crisis, it is imperative that private corporate/industrial groups utilise whatever capital they have to invest in real economic activities that generate growth in output and employment. Similarly, if they have excess finance and managerial resources, once again it would be much better for the country to encourage them to stick to their core activities and utilise these resources there. Furthermore, one of the key problems besetting Indian industry is their lack of competitiveness, resulting from inadequate investment in technology, technical competence at all levels and in R&D. So corporate/industrial groups will be well advised to invest much more in these activities. Why should then these groups be encouraged to be distracted in setting up banks?

Given the need to ensure appropriate and intrusive regulation and supervision of banks and their owners, the complex structure of Indian corporate/industrial houses poses significant problems. Indian conglomerates, like their Asian counterparts, exhibit a large range of activities and complex ownership structures that are not easy to penetrate. In the United States, the legislation mandates the designation of the owner of a bank holding company as a bank holding company itself, which implies that the regulator has full supervisory and inspection powers over the owner itself. A similar issue arises in India if the corporate/industrial house becomes the promoter of a bank through the bank holding company. The RBI would then need to extend consolidated supervision of the industrial house as a whole. This will not really be feasible, both from the point of view of the industrial house and from that of the RBI. The industrial house would presumably not welcome such intrusive supervision, nor would the RBI have the regulatory or supervisory capacity to do so. Moreover, this would reintroduce the old licence permit raj in a new garb. It would also introduce new issues of regulatory overlap with other regulators such as SEBI.

Among the key problems that arise from the ownership of banks by nonfinancial companies are those of conflict of interest. Would banks be allowed to lend to promoter companies and their affiliates or subsidiaries? If they are, what would happen if the companies generate non-performing assets (NPAs) in such borrowers? How will arm’s length be ensured in such transactions? There would then be a greater likelihood of reluctance by the bank to recognise the emergence of such NPAs and resort to evergreening. Even the bluest of blue-chip companies can sometimes get into trouble just because of an overall economic or sectoral downturn, so such risk can arise even without managerial financial malfeasance. Similarly, what would be the promoters’ view of the bank lending to their competitor companies? Furthermore, if the borrowing competitor company’s assets become stressed what would be the attitude of the promoter company? And finally, if they do become NPAs, the bank will have inside information. How will the promoter company then be kept at arm’s length on the disposal of such a competitor company’s NPAs? These are just some of the obvious kinds of conflicts of interests that arise from the ownership of banks by nonfinancial large companies. The burden on the regulator/supervisor will become intolerable and, therefore, infeasible, along with the burden on the governing board of a company-promoted bank itself.

Finally, if a window is opened for large corporate/industrial houses for obtaining bank licences, there could be a rush for such licences, as there always is whenever any licensing window is opened to Indian business. Would the RBI then have to give licences to all the qualified applicants? How would such licences be rationed? Furthermore, those groups who do get banking licences will then have considerable advantage over their competitors.

Read Part-I and Part-III of the three-part series.