Ownership and governance of private sector banks - Part III

The way forward for banking in India: Further issues

Going beyond its recommendations on ownership of private sector banks, there are some other internal working group (IWG) recommendations that bear scrutiny. The IWG suggests that, along with the resting limit for promoter shareholdings to be raised from 15 to 26 per cent, the non-promoter shareholdings limit be raised from 10 to 15 per cent for all kinds of shareholders, including other industrial houses and presumably other banks. This can potentially contribute to a great degree of tension in the management of the bank concerned. It would be possible, for example, for two other nonfinancial companies to own, say 15 per cent each, then exceed the promoter’s shareholder of 26 per cent. Similarly, conflict of interest would arise if another bank, domestic or foreign, is allowed to own as much as 15 per cent of another bank’s equity. The objective of raising this limit from 10 to 15 per cent has not been made clear.

The IWG also recommends that banks can invest in other companies up to 20 per cent of their paid up capital and reserves. If this is taken in conjunction with the proposal to allow large corporate/industrial houses to become bank promoters, it will enable the bank itself to then invest in the promoter’s companies, once again bringing into question the separation of commercial and banking interests. The Banking Regulation Act does not permit this in its current form. The intention of this recommendation is perhaps to enable banks to invest in other financial companies such as insurance and other financial activities. In principle, as recommended by the IWG, all banks should move to a non-operating financial holding company (NOFHC), which should then make any such investments in other financial companies rather than the bank itself.

Finally, among other key IWG recommendations is the one suggesting that well-functioning non-banking financial companies (NBFCs) promoted by large corporate/industrial groups may be allowed to get bank licences. Such a bank would effectively be promoted by a corporate/industrial group subject to all the issues outlined above. However, in view of the fact that there are a few well-functioning NBFCs of this character, there would be merit in permitting their graduation to banking companies but with the proviso that the promoter corporate/industrial company reduce their shareholding to less than 10 per cent. The experience has been that the most successful private sector banks are indeed those that have metamorphosed from being large NBFCs or development finance institutions (DFIs), including a successful microfinance company, into banking companies, so this should be encouraged.

What then is the way forward?

Illustration: Ajay Mohanty

The key problem facing the financial sector at present is the lack of credit growth in view of the legacy overhang of large nonperforming assets, which is likely to get worse as a consequence of the ongoing Covid crisis. Thus the cleaning of balance sheets of public sector banks must get the highest priority rather than the government and the regulator getting sidetracked through licensing of new banks. What should be brought back into consideration is the setting up of a government promoted bad bank (or by a consortium of banks) so that existing banks can be freed of the overhang and can resume productive growth inducing credit creation.

Second, in view of the large number of public sector banks, it is now time to consider bringing down government ownership to less than 50 per cent starting with some of the remaining smaller public sector banks. This would enable the emergence of new widely held private sector banks, which can then possibly be subject to mergers and amalgamations leading to greater effective competition within the banking sector.

Third, as the IWG has noted, existing banks have been set up under six different statutes. It would be advisable to bring them under one statute, possibly the Companies Act itself, but also make the privatisation process easier.

Finally, the various failures in the financial sector that have arisen in the last few years suggest that there is a great need to strengthen regulation and supervision of the financial sector as a whole, particularly banks and NBFCs. Thus, a specific task ahead is the rapid strengthening and expansion of the RBI. It is surprising that as the financial sector has grown in both complexity and size over the last 10 years, the strength of RBI professional staff has actually reduced by a third from around 9,400 in 2009 to 6,670 in 2019. Of these, about 1,300 or so are entrusted with banking regulation and supervision. In comparison, the US Federal Reserve has around 22,000 professional staff, which are in addition to the many other financial regulators that exist in the United States. It is not surprising then that the financial sector has been subject to various regulatory and supervision failures in the last few years. The task of strengthening the RBI must be undertaken on an urgent basis in the interest of ensuring growth and financial stability in the coming years. There is also need for pre-emptive supervision and anticipation of emerging problems about the quality of assets.

Licensing new banks and making major controversial changes to their ownership structure is not the answer.

The writer is President, Centre for Social and Economic Progress (formerly Brookings India), and former Secretary, Department of Economic Affairs, and former Deputy Governor, Reserve Bank of India 

Series concluded