Why private banks, their ownership structures need to be strictly regulated

Much heat and light has been generated on the publication of the recent internal working group report of the Reserve Bank of India on “Ownership Guidelines and Corporate Structure for Indian Private Sector Banks” (henceforth IWG). Quite rightly most of the attention has been devoted to the IWG’s proposal to consider ownership of banks by large corporate/industrial houses, which, of course, is a reversal of long-standing policy and practice in the country. However, the report is much more wide-ranging and deserves to be considered more holistically.

Let us start with considering why there was a need for this working group at this time. First, the policy relating to ownership and control of private sector banks has been based on the broad framework issued by the RBI in February 2005. There have, however, been tweaks to that framework in both policy and practice since then as encompassed in a discussion paper on the same subject issued in 2010; amended guidelines in 2013; introduction of small finance and payment banks in 2014; introduction of on-tap licensing in 2016; conversion of cooperative banks into small finance banks in 2018; and on-tap licences for small finance banks in 2019. In view of the legacy of the issuance of different guidelines over time, there is certainly a need for the harmonisation of various different guidelines that currently govern private sector banks. So, the time was perhaps ripe for the RBI to conduct a comprehensive review and then to issue policy and guidelines to provide a broad framework for the next 15 years or so. Second, an argument is generally made that India is underbanked with an excessively low credit-GDP ratio and, therefore, needs the entry of new banks to help credit growth needed to fuel further economic growth.

The 2005 policy framework started with the proposition that “banks are special”. This needs repetition to put in context any policy framework that we arrive at. Why are banks special? First, banks are unique institutions in that they are depositories of public funds which they effectively hold as trusts. Bank depositors range from households to individual entrepreneurs to small businesses all the way to large businesses, local and state governments. The implication is that a huge amount of trust is placed in banks as repositories of people’s money. Second, since banks intermediate these funds through credit creation, they are vulnerable to both credit risk and liquidity risk due to maturity and liquidity transformation, but they have to ensure that deposits are kept safe. Third, banks form the bedrock of the payment system which lubricates the whole economy. Fourth, banks are unique in that they have access to central bank money. Hence, most the banks themselves and their owners have to be scrutinised carefully on a continuous basis and controlled. And fifth, banks are privileged in being protected by deposit insurance, partly to protect them from bank runs. Furthermore, in India, being a relatively low-income country, depositors are seldom allowed to suffer as a consequence of bank failing. Liabilities of other companies are not protected in a similar fashion.

Banks are also special in their degree of leverage. Assuming a risk-adjusted capital asset ratio of around 12 per cent, banks are effectively leveraged by a factor of eight. If one then assumes that the major owner of a bank would own not more than 26 per cent of its equity (after dilution), the effect of leverage becomes over 30! So, the promoter of a bank would get access to resources at least 30 times their investment. Furthermore, bank failures involve externalities: they can lead to bank runs on other healthy banks and impose costs on bank borrowers.

Thus, the business and structure of banking embodies within it high incentives for risk-taking by the owners: Hence the need for strict regulation and supervision of banks and their owners.

Illustration: Ajay Mohanty
These simple facts form the basis for the modern approach to banking regulation and supervision. Internationally, most banking jurisdictions require banks to be widely held to avoid concentration of ownership in the interest of governance and financial stability”. However, while diversified ownership may minimise the risk of misuse or imprudent use of leveraged funds, it remains no substitute for effective regulation and supervision.

So, policy on bank ownership in India that has existed until now is consistent with international practice. Most significant jurisdictions in the world practise approval regimes for bank ownership through careful scrutiny of the level of ownership by single persons/entities, transparency of ultimate beneficial ownership and control, and ownership restrictions on non-bank financial entities, other banks and foreign entities. The key to scrutiny of owners is assurance of their “fit and proper” status at every stage of approval and on a continuous basis. It is true, however, that many jurisdictions do not have explicit caps on the shares of single owners and on non-financial entities on ownership of banks. As reported in the IWG, the United States, Australia, South Korea, the Philippines, Indonesia and Malaysia are among significant countries that do have explicit limits. The United States has long had a relatively strict prohibition against nonfinancial entities owning banks. It is notable that a number of Asian countries, which have large business conglomerates, as does India, also have such explicit limits on ownership of banks by conglomerates.

In terms of international policy and practice, it is useful to note some of the Basel core principles that are expected to be fulfilled in banking regulation and supervision. Supervisors should be able to assess the ownership structure, governance and suitability of promoters so that they can ensure their ability to provide financial support, prevent potential conflicts of interest between the business interests of the corporate group and the bank, prevent risk transfer from activities of the corporate group to the bank, and guard against the heightened reputational risk that can come from co-branding. We also need to ensure an arm’s-length relationship between the corporate group and the bank to prevent the obvious conflict of interest. The implication of these principles is indeed to severely limit the possibility of corporate business groups to own banks in practice. However, the Basel core principles do not provide any explicit limits on corporate ownership of banks.

Thus, basic principles and international practice suggest that opening the door to the ownership of banks in India by large corporate/industrial houses should be done, if at all, with utmost caution.

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