Corporate group-run banks: Are they USEFUL?

It is generally agreed that lending is currently constrained because existing banks are short of capital and their risk appetite is low due to the economic slowdown, notes Jaimini Bhagwati

The opportunity cost of allowing firms to run banks seems to outweigh the intended higher lending and competition

On February 22, 2013, the Reserve Bank of India issued guidelines on 'Licensing of New Banks in the Private Sector'.

Indian companies and others can now seek licences to set up new banks.

Incidentally, the United States does not allow corporate groups to set up banks, although this is permitted in the United Kingdom, Germany and France.

This article reviews the perceived advantages and downside risks of allowing Indian companies to set up new banks.

The primary motivation for allowing companies to sponsor new banks has to be to promote lending and competition.

It is generally agreed that lending is currently constrained because existing banks are short of capital and their risk appetite is low due to the economic slowdown.

Therefore, it is unclear why lending would be enhanced if companies use retained earnings or access funds from capital markets to sponsor new banks.

If the argument is that Indian firms are in a better position than banks to assess local risks, corporate capital could instead be invested directly in fresh projects.

Further, if the new corporate group-owned banks are expected to boost lending by unlocking additional savings because they can convince depositors of their ability to assume longer-term project risks, they could do the same as companies.

At an international level, the US and European central banks are continuing to keep interest rates low and monetary liquidity levels high by buying government and other fixed-income securities.

Now that Japan, too, has embarked on a concerted drive to meet higher inflation targets, there should be enough capital sloshing around for Indian entities to borrow from foreign sources.

A counter-argument is that there are a number of reasons, including perceived exchange rate and creditworthiness risks, that make it difficult for Indian firms, particularly small- and medium-sized enterprises, to access longer-term foreign capital.

The bottom line is that for long-term lending to increase in India, we need credible projects in tandem with creditworthy borrowers.

Consequently, it is likely that companies are seeking to set up banks on the expectation that the return on shorter-term capital, on a risk-adjusted basis, will be higher in the banking sector.

This motivation could be coloured with the temptation to engage in camouflaged lending to related companies and it would be extremely difficult for regulators to disentangle and identify such lending.

Foreign banks operating in India prefer to open branches rather than set up subsidiaries.

The RBI is going slow on allowing foreign banks to set up new branches, as it is evaluating the benefits and costs of branches versus subsidiaries.

Foreign banks rated double-A and higher, which are currently not present in India, may seek licences if the RBI allows a larger number of branches to them based on stiffer credit rating and capital requirements.

That is, capital inflows could be encouraged through new foreign banks setting up business in India even as the RBI resolves the overall subsidiary-versus-additional-branches issue.

Insolvent public and private banks have been repeatedly bailed out by taxpayers in the past.

Effectively, the implicit government guarantee for the too-systemically-important-to-fail banks is equivalent to an American put option with no expiry date.

Bank management owns this valuable put option for free, which gives them the right to sell bank equity in times of stress at prices much higher than what markets would provide.

The December 2010 issue of the Bank of England’s Financial Stability Report pegged the value of this government guarantee for UK banks, in 2009, at £107 billion.

The same put option was subsequently valued by the Bank of England at £30-120 billion.

Bloomberg, the financial news and analytics service, estimates the value of this put option for all US banks at $80 billion per annum.

At the time of the financial sector meltdown in 2007-08, there was an exodus of deposits from private to public sector banks in India.

It is apparent that depositors value the government’s implicit back-stop support for banks and ascribe a higher value to it for public as compared to private banks.

Irrespective of the difference in value of the put option between public and private banks, the government guarantee for banks is probably an explanatory factor for Indian companies seeking to sponsor new banks.

The discussion on private versus publicly owned banks usually does not focus on banks sponsored by companies as a subcategory of private banks.

For instance, an Inter-American Development Bank paper of February 2005 prepared for a conference on public banks was titled 'State-Owned Banks: Do They Promote or Depress Financial Development and Economic Growth?'.

This paper concluded that private banks tend to be more profitable than public sector banks.

Further, public banks may not allocate credit 'optimally'.

However, according to this IADB paper, it is not clear that government ownership of banks retards financial development or economic growth.

The paper also suggests that publicly owned banks can play an important countercyclical lending role in times of stress.

The higher profitability of private banks looks less impressive if adjusted for risk over several economic cycles.

More recently, an April 2013 World Bank policy paper by Cesar Calderon and Klaus Schaeck titled “Bank Bailouts, Competition, and the Disparate Effects for Borrower and Depositor Welfare” analyses how 'blanket guarantees, liquidity support, recapitalisations and nationalisations during crises affect competition'.

A key finding of this paper is that such interventions do not reduce competition.

This conclusion cannot be meaningful till records about discussions between governments and central banks, which led to taxpayer support after 2007, are declassified. 

In what could be called black humour, the lead item in the Finance and Economics section of The Economist dated May 4, 2013, is titled “Why have so few bankers gone to jail for their part in the crisis?”.

Clearly, it is difficult to prove criminal conduct as distinct from wilful breach of fiduciary responsibility.

It is surprising that despite the evidence of 2007-08 and other failures of private banks, there is continuing faith that private banks are inherently less prone to wrongdoing than publicly owned banks.

Recent Indian press reports seem to indicate that three large private sector banks have been identified by the RBI as having engaged in the mischief highlighted by Cobrapost. To sum up, at this time the opportunity cost and risks of licensing new corporate group-run banks in India seem to outweigh the intended higher lending, competition and efficiency benefits.

The writer is India’s High Commissioner to the UK. Views expressed are personal.