Corporates as banks - Concerns

Related article: RBI's IWG Recommendations

Why in news?

• An Internal Working Group (IWG) of the RBI constituted to “review extant ownership guidelines and corporate structure for Indian private sector banks” recently submitted its report.
• Among the recommendations, a key and controversial one is to do with allowing large corporate/industrial houses to be promoters of private banks.

Had there been similar recommendations before?

• In February 2013, the RBI had issued guidelines that permitted corporate and industrial houses to apply for a banking licence.
• Some houses applied, although a few withdrew their applications subsequently.
• No corporate was ultimately given a bank licence.
• Only two entities qualified for a licence, IDFC and Bandhan Financial Services.
• The RBI maintained that it was open to letting in corporates. However, none of the applicants had met ‘fit and proper’ criteria.
• RBI had also emphasized on the public concern about bank governance at that time.

• In 2014, the RBI restored the long-standing prohibition on the entry of corporate houses into banking.
• The RBI Governor then was Raghuram G. Rajan who had headed the Committee on Financial Sector Reforms (2008).
• The Committee had been against the entry of corporate houses into banking.
  • It felt back then that it would be premature to allow industrial houses to own banks.
  • This prohibition on the ‘banking and commerce’ combine still exists in the United States today.
  • The same is certainly necessary in India till private governance and regulatory capacity improve.
• The RBI’s position on the subject has remained unchanged since 2014.

What is the rationale now?

• The Indian economy, especially the private sector, needs money (credit) to grow.
• The government-owned banks are far from being able to extend this credit.
• Even more, the government-owned banks are struggling to contain their own non-performing assets.
• Government finances were already strained before the COVID crisis.
• With growth faltering, revenues have fallen and the government has limited ability to push for growth through the public sector banks.
• Given all these, large corporates are the ones with the financial resources to fund India’s future growth.
• Corporate houses can bring capital and expertise to banking.
• Moreover, not many jurisdictions worldwide bar corporate houses from banking.

What are the concerns with 'corporate-owned banks'?

• Concentration of economic power - Corporate houses can easily turn banks into a source of funds for their own businesses.
• In addition, they can ensure that funds are directed to their cronies, provide finance to customers and suppliers of their businesses.
• Even in private bank ownership, past regulators have preferred it to be well diversified i.e. no single owner has too much stake.
• Risks - RBI has always been of the view that the ideal ownership status of banks should promote a balance between efficiency, equity and financial stability.
  • A greater play of private banks comes with its own risk element. The global financial crisis of 2008 is a case in point.
  • On the other hand, a predominantly government-owned banking system tends to be more financially stable given the trust in government as an institution.
• Moreover, banks owned by corporate houses will be exposed to the risks of the non-bank entities of the group.
  • If the non-bank entities get into trouble, sentiment about the bank owned by the corporate house is bound to get affected.
  • In that case, depositors may have to be rescued through the use of the public safety net.
• Connected lending - The main concern in allowing large corporates to open their own banks is a basic conflict of interest, or more technically, “connected lending”.

• In simple terms, connected lending refers to a situation where the promoter of a bank is also a borrower.
• In other words, it is possible for a promoter to channel the depositors’ money into their own ventures.

Why is connected lending a big challenge?

• Connected lending has been happening for a long time and the RBI has been falling short in having a check on it.
• The recent episodes in ICICI Bank, Yes Bank, DHFL etc. were all examples of connected lending.
• The so-called ever-greening of loans is often the starting point of such lending, wherein one loan after another is extended to enable the borrower to pay back the previous one.
• Regulation - The IWG has called for a legal framework to deal with interconnected lending.
• It also recommended having a mechanism in place to effectively supervise conglomerates that venture into banking.
• However, any legal framework and supervisory mechanism will be less adequate to deal with the risks of interconnected lending in the Indian context.
  • Corporate houses are proficient at routing funds through a network of entities in India and abroad.
  • So, tracing interconnected lending will be a challenge.
  • Also, monitoring of transactions of corporate houses will require the cooperation of various law enforcement agencies.
• Ex-post - The RBI can only react to interconnected lending ex-post i.e. after substantial exposure to the entities of the corporate house has happened.
• Given this, it is less likely to be able to prevent such exposure.
• Even after spotting, it is challenging to make course corrections.
• This is because any action that the RBI may take in response could cause a flight of deposits from the bank concerned and precipitate its failure.

• Public sector banks - Beyond the idea of growing a bank on their own, the real attraction for corporate houses will be the possibility of acquiring public sector banks (PSBs).
• Notably, the valuations of PSBs have been weakening in recent years.
• Public sector banks now need capital that the government is unable to provide.
• So, the entry of corporate houses, if it happens at all, is likely to be a prelude to privatisation.

• In that case, any sale of public sector banks to corporate houses would raise serious concerns about financial stability.

How about NBFCs conversion into banks?

• The IWG argues that corporate-owned NBFCs have been regulated for a while and thus the RBI understands them well.
• However, there is much difference between a corporate house owning an NBFC and one owning a bank.
• Bank ownership provides access to a public safety net whereas NBFC ownership does not.
• The reach and influence that bank ownership provides are vastly superior to that of an NBFC.
• In all, it is advisable in the present context to keep the class of borrowers (big companies) apart from the class of lenders (banks).

Source: The Indian Express, The Hindu