The business of banking

Jaimini Bhagwati assesses the key points in RBI's discussion paper on new bank licences.

A discussion paper put out by the Reserve Bank of India in August 2010 examines the pros and cons of the 'Entry of New Banks in the Private Sector'.

The central issue in the paper is whether large industrial houses should be allowed to sponsor new private sector banks. This article reviews the discussion paper and comments on the six topics listed in it for further debate.

The RBI paper starts with a discussion on widening financial inclusion as one of the objectives in granting licences to new private sector banks. A separate July 2011 RBI paper titled 'Financial Inclusion in India: A Case Study of West Bengal' rates Indian states on the extent of financial inclusion achieved.

Kerala, Maharashtra and Karnataka are ranked one, two and three and Uttar Pradesh, Madhya Pradesh and Bihar are at positions 13, 20 and 21. Clearly, there is a positive correlation between social development levels and financial inclusion.

New private sector banks could be required to help promote financial inclusion by using profits from their branches in urban clusters. However, such cross-subsidies will not be sustainable since banks can only complement development efforts, not substitute for them.

The first and second questions posed in the discussion paper are: (a) what should be the minimum capital requirements for new banks; and (b) what should be promoters' contribution?

My sense is that these two capital requirements may be Rs 1,000 crore (Rs 10 billion) and 40 per cent, respectively, with the latter number to be brought down to, say, 20 per cent over 10 years.

The guiding principle for required minimum capital and ceiling on promoters' contribution should be consistency with a risk management framework that includes existing banks.

The third question is the extent to which foreign shareholding is to be allowed in new banks. The licensing norms for new banks should not be complicated by simultaneously reopening the issue of caps on foreign ownership of banks in India.

If anything needs to be changed on norms for foreign holdings in the financial sector, it is the often misused distinction between non-resident Indians and non-Indians.

Everyone permanently residing outside India should be in one category for investment and taxation purposes.

The fourth, and most important, question posed in the paper is "whether large industrial and business houses could be allowed to promote banks". The Indian licensing guidelines of 2001 do not allow "large" industrial houses to sponsor new banks.

The reasons go back to the dubious practices of such banks directing credit to preferred borrowers prior to bank nationalisation in 1969. All the disadvantages of allowing industrial houses to sponsor banks are as valid today as before.

Among major economies, Canada, the United Kingdom, Germany and France do not bar industrial companies from promoting banks.

In contrast, the United States does not allow industrial houses to own banks. It is evident from the dispersed nature of past banking sector breakdowns that permitting industrial houses to own banks or disallowing them was not a good indicator of whether banks would need government back-stop funding assistance.

As the RBI paper has suggested, the probability of industrial houses interfering in banks promoted by them could be reduced by restricting banking licences to companies with diversified ownership.

On balance, continuing indefinitely with policies that restrict the entry of new private banks and, thus, inhibit competition would not be efficient. There could be ways through which large industrial houses can provide equity capital without the egregious wrongdoing of the past.

The downside risk is that it may be practically impossible for RBI to prevent crony lending practices. Consequently, it is for RBI to assess whether, at our current stage of development, it can consistently monitor bank lending and stand up to pressures from corporate oligopolies.

The fifth question is whether non-banking financial companies (NBFCs) should be allowed to convert into banks or promote banks. A large number of Indian NBFCs are engaged in tax and other forms of financial arbitrage.

Hence, while in principle NBFCs can be allowed to sponsor new banks, their antecedents and possible ownership links with corporate houses through non-transparent cross-holding structures should be investigated and taken into account.

The last question is what the business model for new banks should be. The short answer is that there is no need for a separate business model for new banks.

Taking a step back, the RBI discussion paper needs to be broader in its outlook and should analyse the causal reasons for banks having to periodically depend on funding support from taxpayers.

The section in the paper titled "lessons from the recent global financial crisis" is too short and perfunctory. Indian household and private sector debt, as a proportion of GDP, is lower than comparable numbers in several developed countries.

As for smaller Indian companies, they often pledge shares as collateral to borrow. Indian banks have recently had to take over equity stakes in some companies that were not in a position to service their debt. Further, dark clouds are again gathering on the European and US economic horizons.

Consequently, we need to assess if periodic banking sector crises are inevitably linked to business cycles or whether they are more influenced by unconstrained and under-regulated growth of the banking sector as compared to the rest of the economy.

For example, the banking sectors in the US, the UK, Iceland, Ireland, Cyprus and regional savings banks in Spain are significantly oversized and/or over-leveraged. It is high time to reflect on the received wisdom that more is good in banking since this promotes growth.

A related issue is the extent to which deposit taking and investment banking should be segregated in new private banks in India. In this context, it has been reported that the UK Independent Commission on Banking headed by John Vickers is likely to recommend strict segregation of deposit taking from investment banking (the report is expected in October 2011).

According to press reports, RBI would soon issue draft guidelines for large industrial houses to sponsor new private banks.

RBI should take its time to reassess outstanding levels of household, corporate and public internal and external debt, sectoral growth of credit and preferred size of the banking sector versus that of the economy before issuing licences for the entry of new private banks.

The author is India's Ambassador to the European Union, Belgium and Luxembourg. Views expressed are strictly personal.