“Large corporate/industrial houses may be permitted to promote banks only after necessary amendments to the Banking Regulation Act, 1949” – IWG Report on Corporate Ownership of Private Sector Banks.

On November 20, the RBI released the Internal Working Group (IWG) report that reviewed the existing licensing and regulatory guidelines relating to ownership, control, and corporate structure of private sector banks in India. The IWG examined existing guidelines within a larger context of meeting the credit demands of a growing economy; nurturing greater competition in the domestic banking sector through the entry of new players; and scaling up the presence of India’s banks in the world rankings.

The most significant but contentious recommendations are:

• To allow large corporate and industrial houses to promote and operate banks in India and
• Awarding banking licenses to “well-managed” NBFCs including those owned by corporate houses, with assets of INR 50,000 crore and > 10 years of operations into banks.

At a time when our economy is in doldrum and the financial institutions are facing serious capital crunch, these recommendations of the IWG raises several questions.

First, if not regulated well, corporate ownership of banks may raise the risk of intergroup lending, diversion of funds, and reputational exposure. Also, the risk of contagion from business defaults to the financial sector increases significantly due to such ownership. Apart from the inherent conflict of interest, the “quality” of corporate governance practices is another key reason why the RBI had not issued banking licenses to corporate houses earlier. The IWG 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. Stress in non-financial activity may spill over to bank.”

Second, RBI has shortcomings in its oversight role. While allowing NBFCs to become banks is well intentioned and could improve financial stability as the NBFCs will then have access to larger pool of capital at lower costs, the RBI will face challenges in supervising these entities and supervisory resources could be further strained at a time when the health of India’s financial sector is weak. The liquidity risks, frauds, and malpractices witnessed recently in banks and NBFCs (from PNB, Yes Bank, PMC Bank, ICICI Bank, IL & FS to DHFL) have brought to the fore the shortcomings in the RBI’s regulatory oversight.

Third, the IWG report does not examine our earlier experience with corporate-owned private banks. Before 1969, large part of our banking system was controlled by the private sector. Most of the privately-owned banks were in the form of joint-stock companies controlled by large industrial houses. Connected lending practices were rampant in private banks. As owners of banks, industrial houses used to channel large sums of low-cost depositors’ money into associate entities. With many private banks pursuing imprudent lending, bank failures were the norm. During 1947-58, for instance, 361 banks of varying sizes failed.

Fourth, most crucially, ‘circular banking’ is a large potential risk posed by corporate-owned banks because of the prevalence of business cartels in India. Under circular banking, a corporate-owned bank A would finance the projects of corporate B, B owned would finance the projects of corporate C, and Corporate C owned bank would finance the projects of A, hence completing the cycle. The RBI needs to have very strong supervision to check such activities.

Fifth, the level of urgency is a bit unsettling. The IWG deliberated on these important policy issues having far-reaching ramifications on the stability of the banking system and submitted its report on October 26, a span of ~ 4 months! The RBI has offered <2 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 2 years. This time, however, the RBI appears to be in a big hurry to complete the process, raising some unsettling questions.

Lastly, what is even more perplexing is that the IWG has endorsed its recommendation despite overwhelming evidence to the contrary. In the report’s Annex 1, the IWG has 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.” Despite suggestions by the experts to the contrary, why this crucial recommendation is being made by the IWG?

OUR VIEW

We believe that the RBI does recognize the potential risks associated with large corporates owning banks. In fact, the IWG 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 surprising is that despite recognizing such risks, the IWG still endorses the entry of large corporate houses in the banking space.

Overall, our views are that conflict of interest, concentration of economic power, and financial stability in allowing corporates to own banks are significant risks. We are skeptical of allowing corporate ownership in banks, given our less than stellar corporate governance record amid large corporate defaults over the past few years, and lack of corporate governance and checks within our lending institutions. We believe that in case the RBI accepts the IWG’s recommendations to allow corporate ownership in banks, a question on our 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, and other fraudulent practices on a real-time basis?

To conclude, we believe, evidence to support the entry of large corporate and industrial houses into the Indian banking sector has not yet faced enough empirical scrutiny. The potential benefits do not outweigh the potential risks inherent in corporate ownership of banks. It is an idea which is premature and fraught with risk.

Note: Our views are personal