An RBI working group has proposed allowing corporate houses to set up banks in India. This step is fraught with risks.
Given RBI’s record of weak regulatory and supervisory capacity, will the central bank suddenly be able to monitor lending by these banks, especially to their related companies? The burden of failed banks has often rested on public sector bank purchases, with taxpayer money as capital injection.
As a first step, before even discussing such a proposition, the RBI and the government should set up an additional level of checks and balance for banking supervision. This can be provided by an additional supervisor in the shape of a resolution authority like the US Federal Deposit Insurance Corporation. This will require bringing back an amended Financial Resolution and Deposit Insurance bill.
Until the combined supervision capacity of the RBI and the proposed resolution authority has shown a healthy track record and been able to detect banks going towards failure, the proposal to allow corporates in banking should be put on the back-burner.
Weakness in RBI’s supervisory capacity
Over the last two years, IL&FS, DHFL, Yes Bank and Punjab and Maharashtra Co-operative (PMC) Bank have collapsed due to their weak financial position. The latest to the list of bank failures is Lakshmi Vilas Bank, which was recently placed under moratorium and is to be merged with DBS Bank.
Some of those who have seen the weaknesses in RBI’s supervisory capacity, including former RBI governor Raghuram Rajan and deputy governor Viral Acharya, have raised concerns.
They argue that the proposal to allow corporates in banking will lead to a concentration of economic power, and aggravate the problem of bad lending as depositors’ funds would be diverted to entities owned by the large corporate entities. Highly indebted and politically connected business houses will have the greatest incentive to push for bank licences. Failure of such banks will lead to significant costs to the exchequer. Large conglomerates could first acquire non-bank finance firms, which may then be allowed to convert into banks.
The recent episodes of bank failures show that concerns about RBI’s supervisory capacity are indeed very relevant. RBI could not detect the changes in the composition of banks’ loan portfolios and excessive build-up of risks. A common feature underlying these troubled banks is that RBI allowed the problem of bad loans to linger for long. Banks indulged in the practice of ‘evergreening’ of loans to hide the build-up of bad loans.
Current framework not enough
A framework that assumes healthy corporate governance and a PCA framework, as we have at present, cannot handle potential problems. A string of frauds like the Nirav Modi case and the Chanda Kochhar case show that vesting more powers through legislative amendments, and the regulator using those powers to issue circulars and directions, cannot be a substitute for active supervision and pre-emptive action.
The existing practice of placing banks under the Prompt Corrective Action (PCA) framework does not improve the viability of weak banks. As an example, Lakshmi Vilas Bank was placed under the PCA framework in September 2019, but it did not do much to improve the financial position of the bank.
The costs of lax supervision are borne by savers and depositors who lose access to their hard-earned money. The lack of a resolution framework and law means that if a bank fails, the taxpayer has to pay for it, either directly, or indirectly if SBI or LIC is asked to buy shares of the troubled bank.
If a bank owned by a corporate house fails, and if a public sector bank is forced to buy its shares, then effectively, the taxpayer will be bailing out corporate loans.
Banks set up by large conglomerates are likely to generate negative externalities for the entire financial system in case of their failure. Corporate insolvencies can lead to build up of bad loans in banks owned by big industrial conglomerates.
The inter-connections need to be monitored on a periodic basis. As an example, in the US, the Dodd Frank Act, 2010, created the Financial Stability and Oversight Council (FSOC), comprising the treasury and financial sector regulators. The mandate of the FSOC is to identify risks to financial stability, and respond to emerging system-wide threats.
India does not have the statutory framework to identify and monitor system-wide risks. Previously, it was found in case of the crisis-hit IL&FS that one of the group subsidiaries IL&FS Financial Services’ outstanding loans to other group entities were much higher than the permissible regulatory caps. Loans were routed through other group entities through circuitous transactions to circumvent regulatory norms. Connected lending emerged as one of the key sources of trouble in IL&FS. The problems in IL&FS, a systemically important NBFC, created a contagion impact on the other NBFCs.
Unless the RBI’s regulatory and supervisory capacity is improved, and the lacunae in the financial architecture are addressed through a failure resolution framework and systemic risk regulation, any proposal to allow large corporate houses to set up banks should be shunned.
Ila Patnaik is an economist and a professor at National Institute of Public Finance and Policy.
Radhika Pandey is a consultant at NIPFP.
Views are personal.