A reasonable request: RBI should allow Indian banks to finance M&As

The Reserve Bank of India (RBI), the regulator of the banking sector, has historically set some fairly constraining limits on banks’ participation in sensitive, volatile sectors. These limits were usually introduced for good reasons and have served a valuable purpose; the 1992 securities scam, in which bank funds were diverted towards speculative activities in the stock market, led to a strengthening of the regime. It seemed clear, at that point, that the banking sector in India did not have the capacity or expertise to finance certain kinds of activities. Since then, however, much has changed. The sector has matured, and regulatory capacity has expanded alongside. The Indian Banks’ Association (IBA) is thus right to request the RBI to review its restrictions on bank finance. The chairman of State Bank of India, C S Setty, has said that the IBA will request that banks be allowed to finance mergers and acquisitions (M&As) within the domestic corporate sector, beginning with listed companies. This would be a welcome move, and the regulator should look with favour at this request.

 

Restrictions on bank finance for M&As have had some perverse and unintended consequences. One complaint that is often heard is that it puts Indian companies at a disadvantage in the M&A space. Foreign rivals may be able to draw on bank financing in their home countries and thus outbid local contenders in an acquisition race, especially at times when the interest-rate differential between India and other geographies is substantial. India is a primarily bank-finance dominated market and this source of funding is not available to companies looking for acquisition. It is also worth noting that the funding structure in India is changing. As things stand, corporations have deleveraged over the past few years and are approaching financial markets for funding requirements. As financial markets develop, more companies will take this route for funding. It is thus important that some of the constraints imposed on banks are revisited in the context of changing market conditions.

 

When the RBI examines the IBA’s proposal, it should evaluate the ways in which M&A financing is different, in terms of risk management requirements, from the existing corporate finance provided by banks. If a listed company decides to buy another, how different are the risks involved than if it decides to invest in a new project? If the profiles are similar enough, then why is bank finance available for the latter but not the former? Both may involve a similar evaluation of risks, balance-sheet stability, and future revenue streams. The RBI should also consider whether greater macro-prudential stability will be achieved through the participation of regulated entities like scheduled commercial banks in this space, or whether non-banking financial companies and foreign funds should dominate a growing market. The explosion of private credit abroad is also a reminder of what happens when banks retreat. The transactions conducted by such entities are not entirely transparent, and can conceal the buildup of risk in the system. The regulator’s preferences, over the past decade, have been to ensure that such activity is conducted by large, transparent, and regulated entities rather than by private or shadow concerns. Given that, it might be time for it to recognise that Indian banks are ready for an expansion of their lending practices to corporations. 

(Disclosure: Entities controlled by the Kotak family have a significant holding in Business Standard Pvt Ltd)