Whither Bank HoldingCompanies?
The Reserve Bank of India recently released a discussion paper on the potential implications of alternative structures for bank/ financial holding companies. A description of the alternatives and a
discussion of the regulatory issues.
M K DATAR
A
The B/FHC structure is quite common in the US, Japan, UK and Canada as also in several other Asian countries such as Taiwan, Hong Kong, Korea and Singapore. A holding company structure enables undertaking several financial activities that result in deriving benefits arising from higher scales and the scope of activities undertaken under one roof. The holding company structure provides flexibility of combining different financial businesses, which may be organised in different legal entities as regulatory prerequisites. A case for facilitating/ permitting the formation of bank/financial holding companies in India was made in the report on making Mumbai an international financial centre. The case for the introduction of the holding company structure is based on enabling Indian financial entities to attain a global scale and scope through mergers and acquisitions. It also suggested encouragement of the formation of holding companies that would be governed by the companies act alone while the activities/operations of its subsidiaries are regulated by the appropriate regulatory authority.
Different Structures Available
The discussion paper issued by the RBI does not question the raison d’etre of the adoption of the holding company structure. It implicitly accepts the need for B/FHCs. As a result, the RBI paper seeks “to take a review of some the conglomerate structures and assess their suitability for the country given the prevailing legal, regulatory and accounting framework and highlight regulatory concerns for the RBI emanating from such structures”.
The alternative structures considered are (a) universal banking; (b) bank subsidiary structures and two alternative forms of holding company structures, viz;
(c) apex holding companies; and (d) intermediate holding companies.
The concept of universal banking was widely discussed in the mid-1990s when certain development financial institutions (DFIs) were seeking entry into the commercial banking space. Adoption of universal banking would have permitted these DFIs to start commercial banking activities without creating a separate banking entity. There was a debate on the need to regulate “activities” rather than “institutions”. However, the universal banking alternative was dropped as no acceptable mechanism to regulate the different activities of an organisation differently (and by different regulators if necessary) could be found. The said DFIs entered the commercial banking space by floating sub sidi aries and they eventually became banks themselves. At present, nonbanking financial activities of banks are organised as separate subsidiaries. Even non-banks (for example, Life Insurance Corporation of India and Housing Development Finance Corporation) have adopted the subsidiary model to organise financial activities, which fall in different regulatory jurisdiction.
Under the holding company structure, the holding company, as the name suggests would “hold” direct investments in all subsidiaries that operate (possibly) in separate regulatory domains, viz, insurance, banking, asset management, stock broking, etc. The holding company may be at the apex or it could be at an intermediate level. For example, a banking company may form an intermediate holding company, which in turn would promote/hold ownership of financial entities in other, i e, non-bank financial activities. Alternatively, a holding company would hold shares of all subsidiaries, including the bank itself. The former case is of an intermediate holding company while the latter would be an instance of apex holding company.
The proposals seeking the RBI nod are of the intermediate holding company type wherein an existing banking company is at the top of the organisational pyramid and would form a holding company, which in its turn would own and control nonbank financial subsidiaries. The formation of intermediate holding companies will facilitate raising additional capital to meet the requirement of growing business volumes. As long as a banking company remains a direct parent, its investment would be the subject of regulatory stipulation applicable to banks. Under these stipulations, commercial banks need to limit their aggregate investments in financial entities within 20 per cent of their net worth but an intermediate bank holding company would not face this constraint. This explains why two large Indian banks wish to form an intermediate holding company.
Regulatory Holding Companies
As the advantage of having a holding company arises because different entities are regulated differently, the issue of an ideal holding company structure relates to proper regulation of holding companies, which aggregates businesses that are regulated (differently) by separate regulatory agencies.
The RBI does not appear to be in favour of intermediate holding companies as it feels that such holding companies, if not undertaking activities other than holding shares of subsidiary companies, may remain outside any regulatory ambit. The RBI would prefer a structure wherein a holding company, with investments in all subsidiaries including banking subsidiaries, should be at the top of the organisational pyramid. It also feels that such financial conglomerates,
Economic and Political Weekly October 13, 2007
including a bank should be subject to regulation from bank regulator on a (banking) group basis. The banks, on their part, feel that the proposed holding company would be subject to the RBI’s regulatory control as a non-banking financial company (NBFC). As long as bank regulation is more rigorous than that of non-bank entities, there would be opportunities for regulatory arbitrage. This highlights the need to have coordination across different regulatory domains so that overall regulatory efficacy improves. Whether intermediate holding companies are subjected to RBI regulation cannot obviously be left to the opinion of banks and regulated entities. Therefore, the introduction of B/FHC structure would need several legal changes.
Though the high powered expert committee (HPEC) felt that holding companies be regulated by the Companies Act alone, the world over B/FHCs are subject to regulation and there is a need to have coordination among different regulators as the span of activities of a B/FHC cross several regulatory domains. All regulatory authorities need to specify the regulatory restrictions for holding companies that may lie in their regulatory domain. At present, the formation of holding companies is initiated by banks but in the future it could as well be an insurance or asset management company. In such a case, the holding company would be under the jurisdiction of an insurance or capital market regulator.
Moreover, under the apex holding company structure proposed by the RBI, financial holding companies in non-bank businesses may fall under different regulatory jurisdiction and it may become necessary to harmonise the regulation of B/FHCs. All regulators and the central government would need to ensure that there are no regulatory domain disputes in the regulation of B/FHCs. Therefore, the observation in the discussion paper, that a “BHC/FHC structure could be useful if suitable regulatory framework is created a priori and unregulated entities within the structure are avoided” is unexceptionable.
Intermediate holding company structure results in a multilayered organisational structure, which may be undesirable from the perspective of internal management control as well as external regulation by regulators or monitoring by investors including shareholders. As pointed out by the discussion paper, if the intermediate holding company and its parent/subsidiaries are in different jurisdictions, possibilities of regulatory arbitrage could increase manifold.
Thus, the case against intermediate holding companies appears sound. In fact, press reports indicate that the Indian Banks’ Association has accepted the desirability of the structure suggested by the RBI but has recommended that the intermediate holding company structure may be allowed in the interim till necessary legal, regulatory and taxation changes are effected. The issue thus becomes how promptly different regulators and the government can put in place an appropriate regulatory framework for setting up B/FHCs.
Some Issues
While it would be keenly observed whether the RBI permits intermediate holding companies as a short-term measure or regulatory clearance will await appropriate legal and regulatory changes, certain long-term issues need careful consideration. The first issue relates to a proper regulatory structure while the other concerns the impact of the holding company structure on public sector bank (PSB).
The discussion paper often invokes the need for proper regulation of financial conglomerates under the holding company structure but the contours of such desired regulation remains unspecified. Bank regulation is considered to be relatively elaborate compared to the regulation of the insurance or pension sector. The Basel Committee has taken steps to achieve the international harmonisation of bank regulation practices. These standards (commonly referred to as Basel II norms) have three distinct dimensions, viz, minimum capital requirements, supervisory review and market discipline. The Basel II approach envisages higher autonomy for banks in computing regulatory requirements under advanced approaches of risk measurement. Under pillar III of the norms, outside investors and depositors are encouraged to monitor bank performance and banks have to provide information to the public that would facilitate such supervision. These different dimensions are often complementary; each channel supporting the other channels. It would have been useful for meaningful discussion if the discussion paper would have highlighted the intended approach towards the regulation of holding companies.
Holding companies are subjected to investor monitoring if these are listed on stock exchanges. Stipulation of minimum capital and market discipline are important channels for firm regulation and these should be used in the regulation of holding companies rather than depending on only one channel, i e, regulatory review. It is not obvious whether the RBI has only one channel in mind but the issue of potential conflict between the three pillars of bank regulation is raised. Hence,
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Economic and Political Weekly October 13, 2007 the preferred modes of effective regulation need explicit consideration.
The other aspect related to the use of a holding company structure for public sector banks. While the discussion paper refers to the necessary legislative changes needed to enable the formation of holding companies for PSBs, the potential benefits of flexibility could be more in the case of government-owned holding companies. Whether the government could form one BHC or one for each bank needs to be decided by the central government who owns different PSBs. The holding company structure would provide one mechanism for the consolidation of PSBs and may provide a different operational control mechanism if the government transfers its shareholding to one or several bank holding companies. It can also form a FHC, which can monitor the government’s interests in non-bank financial entities. At present, the proponents of holding company structures base their case on better access to the capital market. If a government holding company is to raise capital from outside investors, the government would need to consider listing B/FHCs that are promoted by it. Formation of holding companies for PSBs alone would not be sufficient if all potential benefits from the B/FHC structure could not be reaped unless such entities are also listed. In addition, the burden of regulating holding companies would be lower if these are listed.
In addition to the issues of proper regulation and governance, it appears that the issue of the extent of foreign ownership is also entangled with the question of the B/FHC structure. The discussion paper has mentioned this issue in the context of the limits on foreign investment in insurance companies. While determining the limit on foreign equity in an insurance company, the foreign equity in a promoter banking company is currently exempted. The discussion paper feels that this exemption accorded to a promoter bank would not be available to a non-bank holding (promoter) company, which itself would be a bank subsidiary. Similar issues of ownership and control would arise in case the holding company is promoted by the government or other public sector entities.
The RBI has expressed its reservations on the intermediate holding company structure that has been proposed by two banks. The discussion would, however, remain narrow unless issues such as
(i) the nature of regulatory regime faced by B/FHCs; and (ii) the desirability of forming holding company(ies) for PSBs is also discussed. Otherwise the focus would remain on whether or not the proposals under consideration get the RBI’s stamp of approval.
EPWEmail: mkdatar@gmail.com
References
Ministry of Finance, Government of India (2007): ‘Making Mumbai an International Financial’, Centre, High Powered Expert Committee, Sage Publications.
RBI (2007): ‘Holding Companies in Banking Groups’, a paper issued by RBI on its web site.
Economic and Political Weekly October 13, 2007
