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New Banks: Don't Say 'Yes' If You Want to Say 'No'

The Reserve Bank of India has published its draft guidelines for new entrants to the banking sector. It would have been advisable for the RBI to spell out the principal objective in licensing new banks. Is the principal objective greater competition or is it financial inclusion? If it is competition, then it would be alright to subject the new banks to the same branch licensing norms as the existing ones; if it is inclusion then they must be told to focus to a greater extent on unbanked centres. Unfortunately, the RBI has not thought it necessary to make the case for new entrants.

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New Banks: Don’t Say ‘Yes’ If You Want to Say ‘No’

T T Ram Mohan

The RBI’s reluctance to rush into new private licences is entirely understandable, given that the global economic environment has turned turbulent and is unlikely to return to normal in the near future. S tability in banking has proved a bulwark against any undue contamination of the

The Reserve Bank of India has published its draft guidelines for new entrants to the banking sector. It would have been advisable for the RBI to spell out the principal objective in licensing new banks. Is the principal objective greater competition or is it financial inclusion? If it is competition, then it would be alright to subject the new banks to the same branch licensing norms as the existing ones; if it is inclusion then they must be told to focus to a greater extent on unbanked centres. Unfortunately, the RBI has not thought it necessary to make the case for new entrants.

T T Ram Mohan (ttr@iimahd.ernet.in) is with the Indian Institute of Management, Ahmedabad.

I
n August 2010, the Reserve Bank of India (RBI) issued a discussion paper on licensing of new private banks. It released its draft guidelines on the subject last month. This does not mean that a fresh set of entrants is round the corner.

The RBI will accept comments and suggestions on the draft guidelines until 31 October 2011. It will issue the final guidelines only after certain “vital amendments” to the Banking Regulation Act are carried out. These are removal of restriction of voting rights and concurrently empowering RBI to approve acquisition of shares and/or voting rights of 5% or more in a bank to persons who are “fit and proper”; empowering the RBI to supersede the board of directors of a bank so as to protect depositors’ interest; and facilitating consolidated supervision.

How long these amendments will take to be passed by Parliament is anybody’s guess. Once the amendments are passed and the RBI issues its final guidelines, it will be open to applications. The applications will be scrutinised by a high level advisory committee to be constituted for the purpose. The committee will comprise eminent personalities with experience in banking, financial sector and other relevant areas. The committee will be free to devise its own procedures for processing applications and will make recommendations on applications to the RBI. However, the decision on granting a licence will be the RBI’s.

It does appear that the grant of licences to new private players is at least two to three years away from now. The RBI is in no hurry. It could well be that the issue of draft guidelines is a concession to those seeking a fresh burst of “reforms” and is intended to show that the finance minister’s promise of new licences, made in his budget speech in February 2010, is being met.

september 10, 2011

Indian economy on account of the global economic crisis of 2007; it would be unwise to do anything to disrupt this stability.

Objectives of Licensing?

In devising guidelines, it would have been advisable for the RBI to spell out the principal objective in licensing a new set of private banks. (It is also not clear why only private players should be licensed, that is, why potential public sector entrants such as the Life Insurance Corporation or the Rural Electrification Corporation should be kept out.) Once that is done, key elements of the policy for licensing will automatically fall into place. Is the principal objective greater competition or is it financial inclusion? If the former, then it would be alright to subject new banks to the same branch licensing norms as the existing ones; if the latter, then the new banks must be told to focus to a greater extent on unbanked centres.

Unfortunately, the RBI has not thought it necessary to make the case for new entrants. The RBI’s draft guidelines quote the finance minister on the subject:

We need to ensure that the banking system grows in size and sophistication to meet the needs of a modern economy. Besides, there is a need to extend the geographic coverage of banks and improve access to banking services.

The above paragraph does not tell us much. Growth in size and sophistication can happen with the existing players, as it has over the past decade or so. If, however, the intention is to extend geographic coverage of and improve access to banking, that is, financial inclusion, then the guidelines for new banks should have fully reflected this priority.

The guidelines do not indicate the latter. They state that the newly licensed banks

shall open at least 25% of its branches in

unbanked rural centres (population up to

9,999 as per 2001 Census) to avoid over con

centration of their branches in metropolitan

areas and cities which are already having

adequate banking presence.

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Economic & Political Weekly

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Since existing banks are also subject to this stipulation, the new licences will not impose any special requirement of inclusion on the banks concerned.

If financial inclusion was indeed the priority and if we were looking for new banks to provide a technological breakthrough in the area of inclusion, then it would have been appropriate to mandate stiffer requirements of inclusion. The RBI has chosen not to go down this route. One must infer that the RBI believes that greater competition even in urban and semi-urban areas is the need of the hour. If that is indeed what the RBI believes, it should have argued its position by providing the appropriate measures of competition in Indian banking and comparisons with other banking systems.

Corporate Houses

One of the important questions in the issue of new licences is whether corporate houses should be allowed into banking. A close reading of the draft guidelines shows that the RBI has given itself enough room to keep corporates out altogether without saying so explicitly. It lays down stringent criteria that have to be met, with enormous scope for interpreting each of these criteria in any way that suits the RBI.

Thus, promoters must have “diversified” ownership (what this means is not spelt out) and a track record for at least 10 years of running their businesses. The RBI may seek feedback from regulators and enforcement agencies. Moreover, companies or industrial groups that have more than 10% of their income or assets from or in broking and real estate activities will be barred from consideration. The RBI believes the culture of such businesses is not conducive to that required in banking. The RBI cites the recent initiatives elsewhere to bar banks from proprietary trading.

However, banks in India are not barred from proprietary trading nor are they prevented from having interests in broking or investment banking, so there does appear to be a contradiction here. It could well be that the RBI identified some corporates that would have otherwise qualified and decided to introduce these criteria to keep them out. On top of it all, the RBI reserves the right to withhold licences even from

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those who meet all the eligibility criteria listed in its guidelines!

Some commentators have observed that it is hard to see many industrial houses meeting this entire set of criteria; the end result may well be that no industrial house qualifies. But if that is the outcome the RBI desires, it is better for it to say so explicitly. To formulate guidelines that create the theoretical possibility of some corporate houses getting in is for the RBI to expose itself to charges of arbitrariness or inconsistency in the application of criteria.

Besides, it is not beyond the ingenuity of corporate houses to structure their operations in ways that allow them to meet criteria for diversified ownership, limits for income from broking and real estate and, having received a licence, criteria for interconnected lending as well. It would always be open to future top management at RBI to interpret provisions in ways that favour entry of corporate houses.

On the other hand, if the intention is to let in corporate houses, then the RBI might do better than laying down stiff eligibility criteria. I had argued in these columns that corporate houses should be asked to operate only in unbanked centres for an initial period (“Private Bank Licensing: Very Few Will Qualify”, EPW, 9 October 2010). This would also give the RBI an opportunity to finesse its surveillance of corporates that enter banking. Once corporates demonstrate that they can contribute to financial inclusion and the RBI develops a certain level of comfort in regulating them, we could think of letting them into other geographical areas.

Capital Requirements

The capital requirements and governance standards for the new banks are proposed to be stiffer than the ones we have for existing banks. Minimum paid-up capital required is Rs 500 crore with a minimum capital adequacy ratio of 12% for the first three years. These are not as onerous as they seem. First, the average capital adequacy of the Indian banking system today is 13.8%. New banks will have to operate at this level or an even higher level if they are to be taken seriously.

Second, newly licensed banks need to be listed within two years of licensing of

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the banks. To do so, they need to be sufficiently profitable. The minimum equity and capital adequacy requirements together would translate into a balance sheet size of around Rs 8-10,000 crore, which would hardly suffice for the purpose of profitability – it is hard to see banks making a reasonable profit at a size of less than Rs 20,000 crore. In all probability, therefore, newly licensed banks will soon require equity capital much greater than the regulatory requirement.

In terms of governance, a few requirements stand out. One, promoters will be required to create a 100% owned nonoperating holding company (NOHC) which will hold the bank as well as other financial services companies. Only non-financial entities and individuals in the promoter group would be allowed to own shares in the NOHC; financial services companies in the promoter group would not be allowed any shareholding in the NOHC. The idea is to ring-fence the banking and financial activities of the group from its other activities. This is a salutary requirement.

Two, the NOHC will have to own 40% of the capital in the bank (and no more) in the first five years; the NOHC holding must drop to 20% within 10 years, and 15% within 12 years. Thus, the RBI appears to be signalling that it is okay with promoter shareholding of 15% in a bank, up from the present level of 10%. (It is not clear whether this will apply to existing private banks.) Three, foreign shareholding in new private banks is to be capped at 49% in the first years. The RBI clearly has concerns about the lack of transparency in what passes for foreign direct investment.

Four, 50% of the directors of the NOHC shall be independent directors. (Since the bank is to be listed, presumably its board will be governed by listing requirements.)

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If the RBI believes that this requirement (or the presence of independent directors on banks’ boards) provides safeguards against the promoters controlling the bank, it is sadly mistaken. The so-called independent directors, whether on the NOHC or on the banks, will be chosen by the promoters and hence there will always be a question mark over the degree of independence they will exercise. It will be possible for promoters to decide the composition of the boards even where their shareholding is a mere 15%.

Independent Directors

As I have argued earlier, it would be better if the RBI were to limit the proportion of independent directors that the promoters can appoint and insist that a certain proportion be appointed by institutional and retail shareholders. The same principle should apply to banks’ boards as well. But this will require the RBI to make the post of independent directors at banks a little more attractive than it is today. Directors at private banks are limited to a sitting fee of Rs 20,000; at public sector banks, the fee is a pathetic Rs 5,000. We need some liberalisation of these norms if we are aiming at an improvement in governance (which is not to say that the matter of directors’ compensation should be left entirely to bank promoters or management).

In order to prevent conflicts of interest, the RBI stipulates exposure limits of 10% and 20% of the paid-up capital and reserves of the bank to any entity within the promoter group and the entire group, respectively. This is fine but conflicts of interest do not arise only on the asset side of the banks’ balance sheet. There are conflicts on the liabilities side as well, for instance, when a bank has salary accounts or corporate deposits from entities within the promoter book. This may not be in the best interests of the companies in question. Besides, easy access to bulk deposits of group companies could render the bank vulnerable to problems in the group at large. It will be necessary to frame guidelines with respect to such issues on the liabilities side as well.

NBFCs

It does appear, as has been generally noted, that it is non-banking finance companies (NBFCs) with an interest in setting up banks that appear to be best placed to secure licences under the new guidelines. The RBI is likely to take its time in dealing with applications from corporate houses. The entry of corporate houses is an issue that is fraught with serious implications for the banking sector and it is not something that will resolve itself with the passage of time. Even the actual processing of applications from corporate houses may not help the RBI make up its mind on this vexed issue. Some aspects will become clear only after corporate houses begin running banks. One can only hope fervently that it is not too late then.

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