Prudent regulation

Banks promoted by business houses would raise systemic risk

One of the important factors that will determine the longer-term growth trajectory of the Indian economy is the strength of the financial sector, particularly the banking system. But, as things stand today, the Indian banking system, dominated by public-sector banks with higher levels of non-performing assets, could pull down the growth potential. India needs more private-sector banks to fulfil the funding needs of the productive sectors of the economy. In this regard, the Reserve Bank of India (RBI) did well to constitute an internal working group to examine the licensing and regulatory guidelines for private banks. The group submitted its report last week and made several recommendations, including allowing large business houses to promote banks. This has always been a contentious area in India. It was permitted in the 2013 guidelines for licensing new private-sector banks with some structural requirements, but did not work. The 2014 licensing requirements for small finance banks, however, explicitly prohibited large corporate houses from promoting banks. In its report, the working group has said that internationally there are very few countries that explicitly bar companies from running banks and has recommended amendments to the Banking Regulations Act, 1949, to address the issue of connected lending.

But the risks associated with allowing large business houses to promote banks are well known. A potential collusion between industrial and financial capital is per se a bad idea. It could result in governance issues and conflicts of interest. In the Indian context, it will concentrate too much power in some hands and it becomes a systemic risk. Also, regulatory supervision is already under pressure, which is reflected in the collapse of several financial institutions and delayed regulatory intervention in recent times. Therefore, both the regulator and the government would be well advised to take a cautious approach. It is important to first build adequate regulatory capabilities before potentially exposing the banking system to increased risk.

The other important recommendation of the group is that large non-banking financial companies (NBFCs) with assets worth over Rs 50,000 crore be allowed to convert into banks, including those run by corporate houses, provided they have completed 10 years of operations and satisfy certain other conditions. The idea to allow NBFCs to convert into banks on easier terms is good, as the latter are better regulated. One way of addressing the concern over allowing NBFCs run by large corporations to convert into banks could be to consider applications from only those entities which are part of a group with interests primarily in the financial sector.

The RBI committee has further recommended raising the cap on promoters’ stake in the long run from 15 per cent to 26 per cent of the paid-up voting equity capital. This will help balance the need for diversifying ownership and also allow the promoter to put more capital in the bank when needed. In a way, the recommendation recognises the futility of the earlier policy of forced dilution to 15 per cent. On balance, while there is no dispute that India needs more competition in the banking sector to channelise savings and improve access to financial services, the regulator must ensure that new banks by their design and ownership don’t end up increasing systemic risk.

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