The Reserve Bank of India’s Internal Working Group startled everyone last week when it recommended that “large corporate/industrial houses may be allowed as promoters of banks only after necessary amendments to the Banking Regulation Act, 1949 (to prevent connected lending and exposures between the banks and other financial and non-financial group entities); and strengthening of the supervisory mechanism for large conglomerates, including consolidated supervision.” In fact, so startling are the words “large corporate/industrial houses may be allowed as promoters of banks…” that you can read the rest of the sentence and the report later.
These recommendations fly in the face of international banking regulation norms and practices of the past couple of decades, and the RBI’s own stance since banks were nationalised in 1969. Not surprisingly, Raghuram Rajan and Viral Acharya, the RBI’s most recent ex-governor and deputy governor, were quick off the mark in strongly opposing the proposal. I will not rehearse their arguments here.
Also read: Rajan, Acharya hit out at idea of corporates in banking, say borrowers shouldn’t own banks
Why central banks separate conglomerates and banks
The best explanation for why conglomerates should not own banks comes from a speech by Singapore’s Prime Minister Lee Hsien Loong in June 2000 when he was the chairman of the country’s central bank. Arguing that the government cannot take a laissez faire approach to bank ownership, he said: “regulators cannot leave it entirely to the market to sort out such matters, especially where the banks involved are not peripheral players but perform key roles in deposit taking and the payments system. Strong banks are important to the health of the financial system and to the entire process of credit intermediation.”
He added that “regulators cannot guarantee that individual banks will never fail, but they have a duty to minimise the chances of a mishap and to maintain the integrity and overall stability of the financial system”.
Lee gave four reasons why Singapore had decided to force a clear separation between financial and non-financial activities. “Firstly, separation will limit the risk of contagion from non-banking businesses to the bank…Secondly, with banking and non-banking activities inter-meshed within a conglomerate, there will be a strong tendency to stretch any safety net intended for the banking system also to cover non-bank operations in the group…Thirdly, separation minimises the risk of non arms-length transactions between banks and their non-bank affiliates…Finally, separating out non-financial activities will focus management attention on their core business of banking and finance.” Following the government’s decision, the city-state’s banks had to divest their non-banking businesses that included real estate, shipping, hospitality and retail.
In doing so, Singapore was following the example of the United States, Britain, and many other countries that had evolved prudential norms, processes, or regulations that prevented non-financial firms from acquiring major stakes in banks. In South Korea, where chaebols dominate the economy, rules prohibiting non-financial investors holding significant equity stakes in banks have existed since the 1960s. Japan has been trying to distance its conglomerates from its banks for the past three decades, but with limited success given the culture of cross-shareholding across its economy. The international regulatory consensus is in favour of keeping conglomerates and banks separated, although the advent of internet banking and financial services is leading banking regulators to allow banks to invest in, or directly perform, some activities that were traditionally concerned “non-financial.”
Should India depart from this consensus? It is unclear why such a change is necessary, and the RBI report does not offer clear, compelling reasons. In a sector as important as banking, it is best to apply the conservative rule of “if it’s not broken, don’t fix it”. Indeed, RBI has licensed various flavours of banks and non-banking financial companies, and governs them with different sets of rules depending on when they were licensed. Then there are public sector banks that are treated differently. If there is a problem, it is in the complexity of the current framework that creates incentives for regulatory arbitrage. Bringing in industrial houses — with all the political and economic issues that it entails — will make the RBI’s task a lot more complex.
As the number of recent scandals in the banking sector show, the RBI finds it hard to prevent conflicts of interest and poor corporate governance in banks under the existing system. And banking is among the best-governed sectors in the country, the RBI still among the best regulatory institutions that we have. In contrast, the standards of corporate governance and regulatory oversight over other firms and industries are relatively weaker. So letting a relatively poorly governed industrial house control a relatively better governed bank is unlikely to be better for the banks. All four reasons that Lee gave in his speech apply in the Indian context — perhaps even more so — and should warn us of anticipated unintentional consequences.
Also read: India’s banking rules need to close the door to tycoon cronyism
A risky proposition
Expanding conglomerates are a sign of lack of economic freedom and difficulty in doing business, a sign that new entrepreneurs cannot grow and that only incumbents with access to capital and power can diversify to other industries. When they grow, they accumulate economic and political power that they can then use to stifle entrepreneurship and free trade. We know this from our own experience from the 1960s to the 1990s. It is not in the public interest to allow conglomerates to expand and dominate too many industries, and that includes banking. On the contrary, the RBI should make it easier for entrepreneurs to start banks — the IWG’s proposal to raise promoter shareholding to 26 per cent can be a good step, if it causes new banks to come up. It rightly recommends that new banks be held by non-operative financial holding companies, with diversified shareholding. Getting credible new entrants into the banking sector, in a prudent and conservative manner, is the path that the RBI should take.
Deepak Shenoy, founder of CapitalMind and one of the canniest minds on banking issues, has a slightly different view. He told me that he is not as concerned about industrial houses owning banks as much as indebted ones, and that big borrowers should not be allowed to own banks. To that, I would add that bank owners should not be allowed to become big borrowers. The problem is that the latter is hard to enforce. I agree with Shenoy when he says that the RBI needs to acquire much greater institutional capability, independence and credibility before we can be confident that it can govern banks that are owned by powerful, diversified industrial houses.
This is not the time for the RBI to be adventurous. It would do well to heed the words of Rakesh Mohan, one of its former deputy governors: “The owners or shareholders of the banks have only a minor stake and considering the leveraging capacity of banks (more than ten to one) it puts them in control of very large volume of public funds of which their own stake is miniscule. In a sense, therefore, they act as trustees and as such must be fit and proper for the deployment of funds entrusted to them. The sustained stable and continuing operations depend on the public confidence in individual banks and the banking system. The speed with which a bank under a run can collapse is incomparable with any other organisation. For a developing economy like ours there is also much less tolerance for downside risk among depositors many of whom place their life savings in the banks. Hence from a moral, social, political and human angle, there is a more onerous responsibility on the regulator. Millions of depositors of the banks whose funds are entrusted with the bank are not in control of their management.”
Nitin Pai is the director of the Takshashila Institution. Views are personal.