A Case for Corporate Ownership of Banks

Crony Capitalism and What Not!

Recent news of RBI superseding Reliance Capital’s Board rekindled the debate on permitting Non-Financial Corporates (NFC) in banking. Many legitimate commentaries by ex-Governors, Economic Advisors, Finance journalists et al have filled the print and bandwidth over last few months. While the jury is still out, the bias is clearly towards ‘NFC ownership of Banks is bad’.

Their fears aren’t unfounded and there remains a worry about long term structural impact

– NFC banks may lead to economic concentration in the hands of few with inherent conflict of interest (borrower is the lender),

– Increased supervisory burden: How will RBI track related party transaction? Will this require RBI to micro monitor bank portfolios?

– Increases the risk and impact of bank runs with linkages to other businesses of the NFC group (for eg. in case a group company faces challenges, depositors will lose confidence in the bank owned by same promoters)

– Such banks have higher risk of political or transactional quid pro quo, higher possibility of favouritism or exclusion (say towards the competitors in non-financial businesses).

Then there are apprehensions about the intent ‘Why now?’, Raghuram Rajan asked immediately after RBI’s Internal Working Group (IWG) report suggested NFC ownership.

Is it being done at the behest of a large business house? Is it aimed at providing back door entry to select few through PSB privatisation or upgrading a specific Payments Bank? In essence, this may encourage crony capitalism, especially during tough times where the normal channels for capital raise may be constrained.

While NFC ownership may indeed have pitfalls, the case is not as black and white as the experts make it out to be.

RBI’s deliberations have somewhat vacillated over the years. However, barring a short period in the initial stages of privatisation, when Times Bank and IndusInd got license, RBI’s ‘fit and proper’ criteria has de facto barred the entry of NFCs into Banking. Although, there has been no such reservation on the NBFC side. A big perceived risk, therefore, seems to be around deposit security.

While the critics site some global stories, our understanding of how this can work in India, remains anecdotal at best.

Interestingly, the existing template of bank licensing that excludes NFCs’, is not without loopholes either. We continue to see cases of dubious corporate governance and poor risk management, time and again.

The moot points, therefore, are – does NFC ownership significantly increase the existing risks? and, can the risks be mitigated?
There are no clear answers and hence much seems to be driven by sentiment and fear of unknown. We further explore the need and some ideas that can help bring objectivity.

Need for a Cultural Shift

A look at the banking history points towards the gap this approach of ‘bank for bankers’ has created. The Global Financial Crisis (GFC) and the ensuing big bail outs or the billion-dollar fines paid by biggest of the banks for breach of KYC and AML regulations or the current NPA crisis, the sample of bank failures is large enough to derive conclusions. Globally, Banks have paid approximately $ 8 Bn as fines in 2019 and around $12 Bn in 2020.

In India, promoters are selected based on ‘fit and proper’ criteria and rely on past banking experience. It may sound prudent but not necessarily scientific. Number of years of banking experience is not necessarily an indicator of wisdom. It isn’t good heuristics either.

Apart from the problems with current ownership and management templates, the contribution of banks towards larger socio-economic objectives has been patchy at best.

India’s credit to GDP ratio continues to be low (50.4% in 2019 compared to 135% for China), indicating that banks have had only partial success in their key function of liquidity creation. High NPLs indicate poor lending practices. And as the IWG report notes, average operating efficiency of Indian banks is fairly low.

“The net pre-tax profit generated by the Indian banks per unit of operating costs is just around $ 0.14 million (approx. ₹1 crore) as against a global average of $ 1 million.”

All these point towards sub-optimal delivery and a status quo-ist attitude.

Do note that RBI also has a significant control on the leadership team appointments in private banks. Yet, Global Trust Bank, Yes Bank, Lakshmi Vilas Bank (LVB) and PMC indicate there are cracks on the wall.

PSBs are little different since appointments are managed by Ministry of Finance with RBI having little formal say. But things aren’t great there either. They haven’t been for decades.

However, it would be unfair to blame banks for everything gone wary. Historically, our legal and political structures have created enough hurdles. The marquee loan defaults in the past have political-business-banker nexus written all over it. But, even with this alibi, data does not indicate that bankers have played their part well.

Till 2014, even access to basic banking services (bank account) was an unknown to large part of population. 29 crore Accounts and 31 crore Rupay cards under PMJDY indicates the real depth of the market was never explored by existing banks. PSL and other methods of coaxing are just a tick mark exercise.

But interestingly, the credit for improvement is largely due to structural changes done by the Government. Bankers had little interest in finding opportunities in granular, smaller entities or financing bottom of the pyramid business.

In essence, the current structure and reliance on certain category of promoters has only brought limited success. While Banks have moved forward, the pace of change has been slow, documentation remained bureaucratic and customer service orientation has been inconsistent. PSBs and old private banks are still inefficient and slow, new private banks seem to be ultra-prudent (read risk averse) while NBFCs have been constrained on liquidity and cost of capital. Yes, there are a few exceptions in the banking industry but that has to do with business acumen of the management rather than just being a banker. We need more such exceptions.

Banks seem to be risk averse on three counts- loan tenors, amounts and sectors, owning to commercial considerations. To go beyond the box, we need that resourcefulness and those deep pockets. With this in background, it will be naïve to assume that banks can do it any better than a well-established corporate house. 

Contrastingly, recent decade has seen non-bank players leverage technology to redefine banking models. Not so long ago, Wallets upended the way Banks relied on the transaction banking fees. Digital lenders are identifying newer segment and methods of lending. There are numerous Fintechs changing the way Bank back-office should work. Even NBFCs, many owned by NFCs, have filled the lending void, in spite of higher cost of capital, liquidity issues and challenges like IL&FS and DHFL.

In short, banking, despite its prudence and intent to safe-guard public good, needs more resources and a refresh, including the change in ‘banker’s mindset’. There is a case to look beyond the coterie. A need for ‘Cultural Shift’

Just like there are good banks, there are good business houses too. The premise that a well-diversified NFC entering banking, despite a proven track record of successful and ethical businesses, will lead to crony capitalism, may be an over-generalisation.

Some Checks and Balances

Some experts argue that NFC Banks is a plausible idea, but our system isn’t ready! System does not become perfect without the users. While cornerstones need to be laid, there will be unknowns. Hence waiting for the spring when the overall accounting, integrity and autonomy benchmarks will be achieved as a precondition, sounds rather utopian.

What we possibly need is the look at the existing checks and balances and how these can be strengthened.

The current RBI condition of having a Non-Operative Financial Holding Company (NOHFC) for banks already creates a layered filter to separate owners from the execution as well as ring fence the capital base. Another way could be to counter-balance the NFC owned banks with a minor government or a PSB stake or mandating an Government appointed Board Member, at least in the initial stages.

On the Deposit issue, the depositors’ feeling of safety is driven much more on RBI’s proactive interventions than on Bank’s own standing. Th de facto sovereign backing of deposits, formally or informally and pro-active bailouts. The story of LVB, YES or PMC Banks are case in point. Government and RBI has ensured the depositors are secured to avoid any bank run en masse.

Formal security through Deposit Insurance and Credit Guarantee Corporation (DICGC) further strengthens the framework. Respective Banks bear the cost of insuring deposits through DICGC (0.01%). Here are some suggestions that can further strengthen this

1. Differentiated DICGC pricing for NFCs to cover for any incremental risk.

2. Capping the minimum amount of deposit to avoid small depositors of the perceived pain.

3. Segmenting the deposit mobilisation for specific purposes. That means, the small deposits go towards only select assets, say retail. While the more informed large/bulk depositor money may be used for other lending purposes.

4. Sectoral caps on high volatility sectors. Permit these banks to raise purpose specific deposits say for a specific infrastructure project.

For managing the concentration risks and giving impetus to socio-economic objectives, another approach may work- Differentiated Licensing

This is already in play with Small Finance Bank and Payments Banks and can be further extended. An initial license of sector specific NFC owned banks may be the first step. Consider an exclusive Agri Bank or Micro finance bank or an Exporters bank or a large ticket Corporate bank with sector specific targets.

Here are some ideas that can help further mitigate these real and perceived risks

I. Make vintage and dependence on business in India a significant criterion to ensure there is enough at stake for promoters and management to maintain reputation. Anyways, Banking Regulations Act empowers RBI to have significant say in key management appointments of a bank.

II. Higher capital and CAR requirements based on sectoral exposures/differentiated licensing requirements.

III. Lower borrower level exposure thresholds and limitations on related party transactions. Further, considering related party funding needn’t be directly to the borrowers, some controls for these banks on treasury operations as well as lending to para banking companies.

IV. Changes in reporting and accounting requirements, making it mandatory to declare even interim borrowing taken by any related party from the bank, including vendors. This can be based on materiality thresholds. The AML and CFT tracking is based on our ability to track transactions, perform require checks in real time and most importantly identify UBOs (ultimate beneficial owners). If the current AML and CFT technology suite can work for transactions, can it be enhanced to monitor money flows, based on new set of rules, on the fly?

V. RBI already mandates a cap of 25% (temporarily enhanced to 30% till June 21) of capital for existing banks. This can be calibrated downwards to further mitigate the risk.

VI. To further manage the risk of economic concentration, the recent guidelines by NPCI putting a volume cap on the transactions through a third-party app, may be a good template to prevent centralisation in services.

Conclusion

One of the key rationale of having corporates in banking is to channel the resourcefulness (read capital and investments) for a larger economic impact. But most importantly this has the potential to upend the way we see banking.

History proves that left to themselves banks will take much longer time to improve. Going by the way many non-bankers, technologists, or people with limited banking experience, have disrupted and added value to banking the world through Fintechs, corroborates this further.

The debate about whether corporates should enter banking needs to be looked wholistically. It has risks, especially business-political nexus, but the approach needs to be granular and nuanced. The key point is creation of better money flows. Unless the mold is reshaped, better models cannot emerge.

Neither the approach of dismissing it with a wave of hand nor a certificate declaring that this is excellent, would do us good. For sure it needs more deliberation. The debate needs to be centered around steps that can be taken to improve overall corporate governance structures. Differentiated regulation, like it has been done with SFBs and Payments Banks with conditions on capital, deposits, loans and PSL targets, can help allay the fears or risks.

A real value add is to debate what new ways India should adopt and what interventions will help mitigate the risks. We have our constraints of politics, scale, and economics. But as we chase a $5 Trillion GDP dream, outside the box is what will make it happen. Capital flows and Banking are the backbone for economic growth.

As an ex-Tata employee, the immediate poser that comes to my mind is- would you feel safe with a Tata Bank?

References

https://stats.bis.org/
https://pmjdy.gov.in/statewise-statistics
https://www.livemint.com/Industry/rpqFT2f63wTgzhy02eUDCI/New-bank-licences–The-contenders.html
https://www.rbi.org.in/Scripts/BS_ViewBulletin.aspx?Id=14475
https://m.rbi.org.in/scripts/bs_viewcontent.aspx?Id=2651#:~:text=Over%20the%20last%20two%20decades,guidelines%20issued%20in%20January%201993.&text=Non%2DBanking%20Financial%20Companies%20could,meet%20the%20RBI’s%20eligibility%20criteria.
https://www.moneycontrol.com/news/business/why-the-hindujas-demand-to-raise-stake-in-indusind-bank-will-cut-no-ice-with-rbi-despite-kotak-truce-5392511.html
https://www.npci.org.in/PDF/npci/upi/circular/2020/OC-97-Guidelines-for-TPAPs-in-UPI.pdf
https://sanctionscanner.com/blog/anti-money-laundering-aml-fines-in-2020-235#:~:text=Failures%20in%20the%20compliance%20processes,times%20to%20approximately%20%24%208%20billion.
https://www.acfcs.org/fincrime-briefing-aml-fines-in-2019-breach-8-billion-treasury-official-pleads-guilty-to-leaking-2020-crypto-compliance-outlook-and-more/