Corporate-owned Banks: An Idea Whose Time Has Not Yet Come
On November 20, the Reserve Bank of India released the Report the Internal Working Group (IWG) that reviewed the existing licensing and regulatory guidelines relating to ownership, control, and corporate structure of private sector banks in India. The working group’s most significant but contentious recommendation is to allow large corporate and industrial houses to promote and run banks in India. “Large corporate/industrial houses may be permitted to promote banks only after necessary amendments to the Banking Regulations Act, 1949”, states the report.
Since the nationalization of 14 large private banks in 1969, the RBI has not given licenses to large corporate and industrial houses for setting up banks. At present, there are 12 old and 9 new private banks (established in the post-1991 period) with the majority of ownership held by individuals and financial entities.
Another important recommendation of the IWG is to allow conversion of large non-banking finance companies (NBFCs), including those owned by corporate houses, with assets of over Rs.500 billion and 10 years of operations into full-fledged banks. If the RBI accepts this recommendation, it would lead to a backdoor entry of corporate-owned NBFCs into the banking space.
Headed by Prasanna Kumar Mohanty, the RBI had constituted a five-member IWG on June 12 to examine existing licensing and regulatory guidelines related to private sector banks within a larger context of meeting the credit demands of a growing economy; fostering greater competition in the domestic banking sector through the entry of new private players; and scaling up the presence of India’s banks in the world rankings.
Outlining the need to transform the domestic banking landscape, the introduction section of the report states: “In alignment with the agenda set for the economic growth of the country to become a $5 trillion economy, there are heightened expectations for the banking sector to scale up for a greater play in the global financial system. It was in this context that, in order to leverage these developments for engendering competition through entry of new players, the Reserve Bank initiated the process for a comprehensive review of the extant guidelines on licensing and ownership for private sector banks.”
The IWG has made several recommendations on the licensing and regulatory matters. This briefing paper examines the potential implications of permitting large corporate houses to own banks in India.
Why Such Haste?
The RBI has conveyed a great sense of urgency throughout the process. Within a brief span of about four months, the IWG deliberated on these important policy issues having far-reaching ramifications on the stability of the banking system and submitted its report of 100 pages to the RBI on October 26. The central bank has offered less than two months to submit comments on the report. If previous RBI reports are any sign, the usual time-period involved between issuing committee reports and final guidelines is over two years. This time, however, the RBI appears to be in a big hurry to complete the process, raising some unsettling questions.
What is even more puzzling is that the IWG has endorsed this controversial recommendation despite overwhelming evidence to the contrary. In the report’s Annex 1, the IWG has also admitted that “all the experts it consulted except one ‘were of the opinion that large corporate/ industrial houses should not be allowed to promote a bank’.” Hence, it raises several questions: Why this recommendation was made by the IWG despite hard evidence and experts’ opinion against such a move? What’s the urgency? What is the right sequence of policy priorities for the RBI?
While several large domestic conglomerates stand to gain from securing a banking license given a very high rent-seeking potential, it is pertinent that the IWG’s recommendations must be widely debated before implementation and the arguments put forward by it must stand up to scrutiny. Otherwise succumbing to lobbying pressures from large corporate houses may derail the ongoing efforts to ring-fence the banking sector from the build-up of bad loans and could imperil the stability of the entire financial system in the long run.
Unlike the US, India follows a bank-based financial system with banking assets accounting for 75 percent of the total assets held by the financial system. The contribution of the banking sector is very vital for economic growth and poverty reduction strategies. Hence, too much is at stake, and there are better sources of mobilizing capital to meet the funding needs of the Indian economy other than corporate houses.
The fewer arguments put forward by the IWG in support of permitting the entry of large corporate houses into the banking sector are unconvincing. Evidence shows that the potential benefits are much fewer in comparison with the potential costs. Before we get there, let’s first examine India’s experience of allowing corporate houses to run banks in the post-Independence era.
India’s Experience with Corporate-owned Banks
Surprisingly, the IWG report does not examine India’s experience with corporate-owned private banks for over two decades after independence. Before the nationalization of banks in 1969, India’s banking system was in the hands of the private sector. Most of the privately-owned banks were in the form of joint-stock companies controlled by big industrial houses. For instance, Tatas were the major shareholders of the Central Bank of India which was established in 1911. The Birla family, one of the leading corporate houses of India, controlled the United Commercial Bank.
In those times, connected lending practices were rampant in private banks. As promoters of private banks, corporate and industrial houses used to channel large sums of low-cost depositors’ money into their group companies. With many private banks pursuing imprudent lending, bank failures ballooned. During 1947-58, for instance, 361 banks of varying sizes failed in India. The failed banks were amalgamated or ceased to exist.
Further, private banks owned by industrial houses were operating predominantly in metros and urban areas. Much of their lending was concentrated in a few organized sectors of the economy and limited to big business houses and large industries. Whereas farmers, small entrepreneurs, artisans and self-employed were dependent on informal sources (mainly traditional moneylenders and relatives) to meet their credit requirements. The share of agriculture in total bank lending was a meager 2.1 percent during 1951-67. Before the bank nationalization, the limited outreach of banks coupled with a weak regulatory framework represented a classic case of market failure in the Indian banking sector.
Most analysts believe that politics mainly drove the decision to nationalize banks. No denying that the timing of the decision was influenced by political events, but one cannot overlook underlying economic reasons that motivated this bold step. The bank nationalization took place against the backdrop of several private bank failures, neglect of social and development banking by private banks, severe droughts, food shortages, and high inflation.
At present, there are no corporate-owned private banks in India. Of course, there are several NBFCs (such as Bajaj Finance, Tata Capital, and L&T Financial Holdings) promoted by large corporate groups but unlike banks, NBFCs are not allowed to accept demand deposits from public depositors and they are also not part of the payment and settlement system.
With the initiation of the banking sector liberalization in the early 1990s, the RBI’s policy towards the entry of large corporate houses in the banking space has been wavering largely because of political economy considerations. The RBI has so far not issued a banking license to corporate houses, even though the 2103 guidelines briefly allowed it.
Globally too, regulators do not encourage the entry of large corporates into the banking sector, largely due to governance and financial stability concerns. Even in the US — the global beacon of unfettered, free-market capitalism — corporates cannot own banks. Those countries that allow corporates to promote banks maintain stringent ownership limits and supervise lending to related parties.
Risks Far Outweigh Benefits
Historically, the RBI has maintained a cautious approach towards corporate ownership of banks. Apart from the inherent conflict of interest, the poor quality of corporate governance practices is another key reason why the RBI has not issued banking licenses to corporate houses. Based on its interactions with outside experts, the IWG also admits that “the prevailing corporate governance culture in corporate houses is not up to the international standard and it will be difficult to ring fence the non-financial activities of the promoters with that of the bank.”
Over the years, the potential risks associated with connected lending have increased manifolds because of the quantum leap in size and complexities in corporate India. The pervasive use of front and shell companies makes it difficult to identify the actual owner of businesses. Opaque onshore and offshore ownership structures can easily circumvent any regulatory measures put in place by the RBI to curb connected lending within a corporate conglomerate.
As pointed out by V. Raghunathan, circular banking is another potential risk posed by corporate-owned banks because of the widespread prevalence of cartels in corporate India. Under circular banking, a corporate-owned bank A would finance the projects of corporate-owned bank B, B would finance the projects of corporate-owned bank C, and C would finance the projects of A, hence completing the cycle.
In India, incidents of frauds and defaults are increasingly at an alarming rate across the spectrum. Financial scandals have even occurred in some of India’s big corporate houses that have long prided themselves on being above-board. For instance, India’s biggest corporate accounting fraud came to light in 2009 at Satyam Computer Services, just five months after the company won the Golden Peacock Global Award for Excellence in Corporate Governance, instituted by the Institute of Directors (UK).
Tata Finance — an NBFC — is another case in point. Belonging to Tata Group (internationally well known for ethical business practices), a scandal rocked Tata Finance in 2001 when financial irregularities to the tune of Rs. 5 billion were detected. Thereafter, its senior executives were sacked, and it amalgamated the company with Tata Motors in 2005. All these instances have unraveled the flaws in India’s corporate governance practices.
The concentration of economic power is another major concern. The corporate ownership of banks would further concentrate economic power in the hands of a few corporate and industrial houses. Increased economic concentration would have adverse effects on the domestic economy and politics. It would not only widen inequalities but would also lead to policy capture where special interests would shape public policies.
It is not that the RBI is incognizant of potential risks associated with large corporates owning banks. In fact, the IWG report also lists several such risks including misallocation of credit, conflicts of interest, extensive anti-competitive practices, risks relating to intra-group transactions, moral hazard risks, and the risk of contagion. But what is astonishing is that despite recognizing such risks, the IWG still endorses the entry of large corporate houses in the banking space.
More Competition, More Fragility
Competition is often viewed as a necessary precondition for promoting efficiency and innovation in the banking sector. The IWG also envisages that the entry of corporate players would engender greater competition in the Indian banking sector. While one welcomes competition in the Indian banking markets, but excessive competition may prove counterproductive as it enhances the systemic risks by eroding market power and profit margin of banks. Fearing erosion of the franchise value because of increased competition, banks have a natural tendency to lend more money to risky businesses (e.g., real estate and capital markets).
Of late, there is a growing recognition in academic and policy circles that increased competition in banking markets may be good for efficiency and innovation but bad for financial stability. The 2008 global financial crisis is a case in point. Maintaining a fine balance between efficiency levels of competition and financial stability remains a key challenge for bank regulators.
A cross-country study by Andrew Sheng of the World Bank found that increased competition was responsible for bank failures in Chile, Argentina, Spain, and Kenya. One also needs to keep in mind that increased competition does not always lead to more investment in the real economy. Fierce competition in the banking sector could encourage banks to adopt riskier strategies to reap higher profits, which in turn, would cause banks to fail and induce instability in the entire banking system if the regulatory and supervisory infrastructure is not robust.
Moreover, it has been widely observed that excessive competition could drive banks to speed up the consolidation process to protect their market power, thereby creating complex, large financial conglomerates that are “too big and complex to fail”. The higher levels of concentration in banking markets can have adverse ramifications for consumers, small and medium enterprises, and retail depositors. In a country like India with millions of poor and low-income people lacking access to affordable banking services, the RBI cannot overlook such ramifications.
Banking is Not Like Any Other Commercial Activity
Banks are not butcher shops, as pointed out by Carlos Diaz-Alejandro. Banks differ vastly from non-financial commercial firms, and differences are not merely restricted to goods and services transacted but also in terms of their operations. Banks are essentially financial intermediaries facilitating transactions between lenders and borrowers. Banks give loans to borrowers on the expectation that the loan will be repaid in the future as promised with interest. That is why banks are often hesitant in lending to customers even if they will pay higher interest rates because banks want loans to be repaid.
Banks are more vulnerable to failure because they are afflicted with asymmetric information, herd behaviour, and self-fulfilling panics. Asymmetries of information exist between borrowers and lenders. For instance, a borrower who takes a loan has much better information about the potential returns and risks associated with the investment financed by that loan, as compared to the lending bank.
Systemic risks in the banking sector are also much greater than any other commercial sector. For instance, if a commercial firm (say a shoe company) fails, it may not have a sectoral or macroeconomic impact. But if a large bank fails, it could lead to the collapse of other banks — which may be otherwise sound — because of heavy inter-bank lending and other inter-linkages through the payment and settlement system.
Unlike non-financial commercial firms, banks are often bailed out using taxpayers’ money to stop individual bank failures from turning into a systemic banking crisis. As witnessed during the 2008 global financial crisis, bank failures generate instability in the banking system with large social costs. Problems in the banking system can have a crippling effect on the real economy. That is why, unlike commercial firms, banks are required to maintain capital ratios and reserve requirements, and their operations are regulated and supervised by regulatory agencies.
The RBI is Still Behind the Curve
Although the Indian banking system showed resilience during the 2008 global financial crisis, the liquidity risks, frauds, and malpractices witnessed recently in banks and NBFCs (from Punjab National Bank, Yes Bank, PMC Bank, ICICI Bank, Infrastructure Leasing and Financial Services to Dewan Housing Finance Corporation Limited) have brought to the fore the shortcomings in the RBI’s regulatory oversight.
While the working group calls for a strong legal framework and scaling up the supervisory capacity before allowing corporate houses to promote banks, it is hard to dispute that the RBI’s existing supervisory mechanism is still behind the curve in ensuring real-time compliance and early detection of frauds.
At best, the RBI’s regulatory oversight efforts can be described as a work-in-progress. Only late last year, the RBI overhauled its internal functioning and created separate regulatory and supervisory cadre to address potential systemic risks arising out of the growing size and inter-connectedness of banks and NBFCs.
On regulatory matters, one should not miss the bigger issues. In India, the problem is not the dearth of strong banking regulations. The problem lies in their implementation. Well-intentioned banking regulations without the capacity to enforce them are meaningless, as observed during several banking scams. New regulations can be introduced quickly, but it takes time to build human and institutional capacity to strictly enforce them.
In case the RBI accepts the IWG’s recommendation to allow corporate ownership in banks, a question on everybody’s mind would be: Does the RBI has the capacity to track connected lending, circular banking, loans to front companies controlled by corporates, loans to suppliers and vendors of a corporate group, creation of fictitious loan accounts, “evergreening” of loans, and other fraudulent practices on a real-time basis?
If the answer is yes, then why the RBI failed to detect so many frauds and could not respond quickly to troubles in the banking system needs explanation. If the answer is no, then why further burden already overburdened RBI with the additional responsibility of regulating banks (owned by large conglomerates) that may be too complex and too interconnected to regulate.
What if something goes wrong because of connected lending? In such a scenario, one cannot expect the RBI to scrutinize millions of financial transactions carried out within a large conglomerate and to establish a money trail. That is the responsibility of an investigating agency (not of the RBI), a point also acknowledged by the working group.
Lastly, regarding the IWG’s recommendation allowing large NBFCs to convert into full-fledged banks, the long-lasting solution lies in scaling up regulatory oversight of all NBFCs — big or small — given their distinct purpose and complementary role in the domestic banking system.
To conclude, there is no robust evidence to support the entry of large corporate and industrial houses into the Indian banking sector. The potential benefits do not outweigh the potential risks inherent in corporate ownership of banks. It is an idea whose time has not yet come.
Notes and References
 Reserve Bank of India, Report of the Internal Working Group to Review Extant Ownership Guidelines and Corporate Structure for Indian Private Sector Banks, October 2020, p. 4. Available at: https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/IWG988615AAEB4A42729542102111DCA5FC.PDF.
 Ibid. p.7.
 Ibid. p. 73.
 For more analysis on bank nationalization in India, see D.N. Ghosh, No Regrets, Rupa Publications, 2015. Available at: https://rupapublications.co.in/books/no-regrets/; and Kavaljit Singh, “50 Years of Bank Nationalization: A Peek into Social and Development Banking”, Commentary, Madhyam, July 19, 2019. Available at: https://www.madhyam.org.in/50-years-of-bank-nationalization-a-peek-into-social-and-development-banking/.
 Reserve Bank of India, op. cit., p. 73.
 V. Raghunathan, “Allowing large industrial houses into banking is unwise”, Deccan Herald, November 25, 2020. Available at: https://www.deccanherald.com/opinion/panorama/allowing-large-industrial-houses-into-banking-is-unwise-919620.html.
 Manu Balachandran, “The Satyam scandal: How India’s biggest corporate fraud unfolded”, Quartz India, April 9, 2015. Available at: https://qz.com/india/379877/the-satyam-scandal-how-indias-biggest-corporate-fraud-unfolded/.
 Vivek Law and Malini Goyal, “Tata Finance fraud: Probe points fingers at group’s practices, managers”, India Today, August 26, 2002. Available at: https://www.indiatoday.in/magazine/economy/story/20020826-tata-finance-fraud-probe-points-fingers-at-groups-practices-managers-794490-2002-08-26.
 See, for instance, Franklin Allen and Douglas Gale, “Competition and Financial Stability”, Journal of Money, Credit and Banking, Vol. 36, No. 3, 2004, pp. 453-480. Available at: www.jstor.org/stable/3838946.
 Andrew Sheng, Bank Restructuring: Lessons from the 1980s, World Bank, January 1996. Available at: https://elibrary.worldbank.org/doi/abs/10.1596/0-8213-3519-7.
 Carlos F. Díaz-Alejandro, Good-Bye Financial Repression, Hello Financial Crash, Center Discussion Paper, No. 441, Economic Growth Center, Yale University, 1983. Available at: https://www.econstor.eu/bitstream/10419/160365/1/cdp441.pdf.
 In simple terms, evergreening of loans is a practice whereby banks extend new loans to borrowers so that borrowers can repay previous loans. Because of evergreening, the borrower does not default on a previous loan and that loan is not classified as non-performing asset.