A higher threshold will ease systemic challenges but we need a more ambitious long-term roadmap for bank licensing
Partner, National Leader — Financial Services, Ernst & Young
Last week, the Reserve Bank of India (RBI) issued the gist of comments from various constituents and stakeholders as a prelude to announcing a new framework for new banking licences. One of the comments was on the entry capital. Whereas RBI’s discussion papers suggest a threshold of Rs 500 crore, some stakeholders say the limit should be raised to Rs 1,000 crore. There is a high order of prudence and analysis that seems to have gone into this suggestion. There are three important factors that may lead to such a conclusion.
The first is systemic. There is a high order of cross-subsidisation in the pricing of banking products. This arises out of a sizable amount of low yielding cash reserve ratio and statutory liquid ratio requirements as well as the pricing of mandated priority sector lending. This high cross-subsidisation arises out of a price the system pays. It is perhaps at the very core of the sector’s financial stability. One of the key lessons that we have learnt during the last financial crisis is that we cannot relax this requirement. Also, since a very large portion of the economy relies on unorganised methods to fund its economic activity, there is perhaps little room to reduce the mandated priority sector lending. In fact, the discussion papers suggest that there could be a higher order of such lending for new banks, hence the need for them to set up more branches in tier-5 and -6 locations particularly and tier 2 to tier 6 generally.
The second factor is the cost that new banks will have to incur to set up a spread-out infrastructure for the branch network. In order to compete with the existing banking system, these new banks will have to invest in technology and developing new skills; it may take them a little while to establish financial viability for the new kind of banking we are considering. A close examination of the financial performance of our old private sector banking companies could lead us to believe that a consistent long-term performance has a lot to do with the ability to raise capital at a reasonable cost.
In addition, many of these banks may not have grown since they have a sizeable number of small promoter-shareholders who individually or collectively may not have deep pockets. They may have been drawn into banking for other motivations, such as serving local areas or some regional sectors. Sometimes they may have a presence in and understanding of regional economic activities. Such banks will normally have higher cost of operations owing to scale issues and are also vulnerable to business cycles.
The gist of comments also touches on reducing the number of rural banking outlets (tier 5 and 6) from the present expected level of 25 to 15 per cent. This may be a largely unacceptable proposition. It may take away the very purpose of the reform set out by the government and regulators.
The third important aspect is the number of new banking licences. On one side we may have a large number of aspirants who would like to have a banking licence. The real question would be how many of them would end up putting up a robust and financially-sound institution? Given that banking companies are highly leveraged institutions, the system will not allow us to tamper with the “fit and proper” definition for promoters. It may be important for applicants to understand the various risks they face that could flow into their bank’s balance sheets. This would be dangerous. In establishing limits on various business activities, it is important to examine businesses that may have substantial price volatility or low liquidity or may be of a speculative nature. The concern here is not the proportion of such activities to the overall activity of the promoter but the contagion nature of it. There may also be a larger worry now of judicial intervention if some of the promoters are denied licences.
Keeping these factors in mind, a higher threshold of capital could perhaps give larger comfort to deposit holders and, therefore, the government and the regulator.
These views are personal
“Initial capital requirement at a level higher than that prescribed for incumbent banks may constitute an entry barrier, creating an unfair advantage for certain potential applicants”
Fisher describes an entry barrier as “anything that prevents entry when entry is socially beneficial”. There is broad consensus that it is socially beneficial to have more banking services in India. However, for good historical reasons, the entry of private banks has been calibrated carefully. Whether for want of, or in spite of competition, banking has proved to be good business. With stable growth and improvement in credit-related institutional infrastructure, it is expected to become better. The Reserve Bank of India (RBI) has successfully protected the banking system from shocks and ensured overall stability. In this context, it is surprising that the proposed framework for bank licensing does not build on this successful experience to offer an ambitious long-term roadmap for bank licensing and consolidation.
Prescribing tough eligibility conditions for systemically important institutions is a core responsibility of regulators. This is never more critical than now with freshly learnt lessons from the global financial crisis. Hence, the decision on whether a certain type of entity should or should not be eligible to apply for entry into banking is a matter of public policy. It ought to depend on the state of the economy, perceived risk from the economic activity, promoters’ background, and regulators’ confidence to manage such risk in depositors and other stakeholders’ interest. There is, in fact, too much public discussion on this issue, which detracts from the core issue of entry barriers for new banks.
From a commercial perspective, banking in India has significant entry barriers in the form of high technology costs, high customer loyalty and high cost of client acquisition. This is exacerbated by the fact that a new bank is required to fulfil additional conditions that the incumbent banks are not obliged to fulfil.
Let’s take a few examples. As long as incumbent banks are allowed to have group non-banking finance companies (NBFCs), mandating new entrants to carry out all business that is permissible in the bank becomes an entry barrier. If stockbroking activity of current bank groups is not capped at a certain level, prescribing such a cap for eligibility may be an entry barrier. Similarly, prescribing any condition to start with a higher branch ratio in under-banked areas compared to incumbent banks effectively means that new banks will start with a branch ratio that existing banks may not achieve.
Interestingly, the entry barrier debate is not limited to incumbent versus new entrants, but goes on to barriers among sections of potential entrants. Suggestions on increasing the proposed capital level to Rs 1,000 crore may be a good example of one such barrier. The actual capital proposed by a bank has to be a function of the business model and statutory ratios. Hence, initial capital requirement at a level higher than that prescribed for incumbent banks may constitute an entry barrier; this time creating an unfair advantage for certain potential applicants.
The second kind of barrier may exist owing to the “open and shut” nature of licensing for banks in India. This poses the double whammy of opportunistic applications being received and crowding out good applicants. In addition, multiple licences may be granted based on the same macro-economic assumptions that may or may not bear out. There is also the practical issue of all new licensees competing in the same business space for capital, talent or clients and then coming up against listing and divestment timelines at the same time. Further, the lack of free merger and acquisition activity in the banking space prevents consolidation and creates the impression that there are too many banks anyway; thereby justifying entry barriers.
To conclude, if the roadmap for bank licensing and consolidation is set out for the long term, aspirants can prepare long-term strategies and stakeholders can factor in such strategies and performance to evaluate the entrant. With the amendments to the Banking Regulation Act setting the stage, this may be an idea whose time has come!
These views are personal