Crumbling Firewalls

The recommendation of an internal working group of the Reserve Bank of India (RBI) to allow industrial houses to promote commercial banks has stirred up stiff opposition all around. This is not surprising as even the working group acknowledges that almost all experts they consulted, except one, were against it. But the opening up of the banking sector to the corporate sector has been a work in progress for almost a decade now.

The late Pranab Mukherjee, in his budget speech, spoke about the need for giving additional banking licences to more aspirants, including non-banking financial companies. The RBI followed this up with a discussion paper listing out, among various other matters, the pros and cons of allowing industrial houses to promote banks either on their own or by allowing some major financial sector players to promote banks, or even by facilitating their takeover of regional rural banks as an intermediate step before letting them set up banks.

However, the final licencing guidelines issued in 2013 effectively stymied this move by clearly stating that private and public sector entities and non-banking financial companies will be eligible to set up a bank only if they pass the fit and proper test of the central bank, have a past record of sound credentials and integrity and are financially sound with a successful track record of running their business for at least 10 years.

This felled the licence aspirations of many large industrial groups. Now, the internal working group has, hurriedly, in less than five months, gone a step further and recommended the entry of industrial groups, as in the pre-bank-nationalisation era, after making necessary amendments to the Banking Regulations Act, 1949.

Ownership of banks by business groups has always been a contentious idea the world over with many countries opting to build strong firewalls between banks and other businesses. Advanced economies like the United States disallow such ownership almost completely, while many others allow it in varying degrees. The reasons for such onerous restrictions on bank ownership by industry groups are many.

One is that only a stand-alone bank, with no connections to business houses or other powerful partisan groups, can effectively screen loan applicants to overcome the problems of adverse selection, and also efficiently monitor the implementation of funded projects to minimise moral hazards, and thus ensure efficient allocation of funds to accelerate overall growth of the economy.

Industry-group-owned banks, on the other hand, will be under constant pressure to favour group companies, at the expense of more deserving ones. Labelled as connected lending, this will not only erode the bank’s role as an effective financial intermediary and deter efficient fund use but also affect its profitability and solvency. Funding group companies, at cheaper rates from connected banks, effectively transfer the project risks from the business group to the banks, with the costs finally being borne by the other shareholders of the bank or even by the taxpayers in the case of a bank collapse.

Another risk associated with banks owned by industry groups is circular lending, with corporate bank X funding projects of an industry group, which owns corporate bank Y, and corporate bank Y funding projects of an industry group owning bank Z, and finally, corporate bank Z funding projects of industry group owning bank X, which is hard to track on a real-time basis. And available legal structures, like front and shell companies and onshore and offshore ownership, also make it much easier to dodge regulatory restrictions.

This is especially so when the regulatory capabilities of the central bank are limited, as in ­India where severe malpractices by banks crop up at regular intervals, which points to not only poor governance structures in banks but also to the inadequate regulatory competence of the central bank.

Remember, it took the central bank long years till then governor Raghuram Rajan launched the asset quality review to recognise the full extent of the bad loan problem, which was finally two to three times larger than expected. Rather than just bad accounting, it was regulatory forbearance that allowed the situation to deteriorate for so long.

Handing over banks to industry groups at this critical juncture, when the pandemic is expected to further bloat the bad loans, will then require the central bank to concurrently monitor and prevent connected and circular lending, identify front and shell companies, track credit sanctions to vendors and suppliers of group companies, and take up many other tasks which will surely test its capabilities to the limits, and finally become a sure prescription for disaster. And punishing bankers is no easy task as it is difficult to prove whether the malfeasance is merely because of poor due diligence or because of pure incompetence or just plain corruption.

Finally, new banking licences would only add more muscle to big industry groups, which already dominate many important sectors of the economy, including telecom, organised retail, aviation, software and e-commerce. Their tie-up with banks, which is the core of the financial sector, will not only jeopardise the interests of smaller players but also help them leverage their strength into other new markets and further accelerate the concentration of wealth. This will lead to the emergence of new big power centres that would soon throttle the government’s ability to steer the economy in the right direction. All in all, the entry of industry groups in the banking sector will certainly prove to be a big mistake that will cost the economy dearly.



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