Allowing large industrial houses into banking is unwise

The Reserve Bank of India (RBI) is expected to issue final guidelines for licensing private sector banks shortly, allowing large corporate houses into banking. Industrial houses are, of course, bound to love the initiative.

The same proposal had come up over a decade ago, in 2010-11, when the RBI had considered issuing additional banking licences to private sector players. RBI had placed a discussion paper titled “Entry of New Banks in the Private Sector” in August 2010 on its website to “marshal the international practices, the Indian experience as well as the extant ownership and governance guidelines,” and invited comments.

The discussion paper had looked into several issues such as foreign shareholding in the new banks; whether industrial and business houses should be allowed to promote banks; whether Non-Banking Financial Companies be allowed conversion into banks or to promote a bank; and the appropriate business model for the new banks.

At the time, the RBI had commented on their website that “the range of comments received has been very wide and did not indicate consensus on any of the issues,” and the dialogue had gone on well into 2015, before 23 new licences were granted to new players for payments banks and small finance banks aimed at deepening financial inclusion. But at the time, allowing industrial houses for setting up banks was a definite no-no. If the current business environment has necessitated the need to have industrial houses set up banks, one is not aware of any new discussion paper circulated by the RBI or invitation for any public comments.

It is therefore not clear exactly what may be the reason for considering the entry of large industrial houses into banking once again. I do not think a discussion on the number of banks, branches and ATMs spread between public and private sector banks or between urban and rural areas is likely to settle this question. To my mind, the most important issue is that the quality of corporate and regulatory governance in India today does not augur well for the initiative.

It is not as if the RBI is not aware of this risk. That’s why, according to RBI itself, “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.”

While that rider may sound reasonable, RBI can hardly deny that the quality of banking oversight in the country is far from adequate, if their extremely poor asset quality (NPAs), balance-sheet management and crony-lending -- rampant in public and private sector banks alike -- is any evidence. Clearly, it is too early to allow more industrial houses into the banking sector.

For starters, such a move is bound to concentrate political and economic power in the hands of a handful of industrial houses. Worse, our standards of corporate governance in corporate houses, banks and NBFCs alike – if recent examples are any evidence – are far from comforting. Some of the troubling developments at Café Coffee Day, Jet Airways, Zee TV, Yes Bank, ICICI Bank, IL&FS, DHFL, etc., are well known. Moreover, the sunny days of infrastructure companies already seem to be under a cloud. Six of the top 10 infrastructure companies – all of them with unsustainably enormous debts -- have either gone bankrupt or are nearly there. Most of them, virtually unknown entities some two decades ago with barely Rs 100 crore of net worth to their name, today have debts of the order of Rs 25,000 crore or more – mostly from banks, including private banks. Many of them funded the operations of literally hundreds of subsidiaries, only by constantly promoting new and seriously over-invoiced projects from bank financing, thus perpetually funding their operations and profligacy from the cash flows of new projects – an obfuscated Ponzi-like scheme, if there was one, making the tracking of funds utilisation nearly impossible.

Corporates have been known to divert funds in plain sight, without a banker ever enquiring into the source of funding of their huge unproductive assets and capital expenditure on planes, luxury homes and yachts. A corporate house wishing to finance a jet with bank funding may not be a problem in itself, provided the jet could be justified as being cost-effective for the CEO-promoters, given their supposedly huge opportunity cost of time. The profitability of the business could make such loans justifiable, even sustainable. But if the profits are zero or entirely inadequate even to service their debt, isn’t the opportunity cost of such corporate czars zero? Where then is the case for financing such assets? Allowing corporate houses into banking may well encourage circular banking, where the house of A banks the projects of B, B that of C, and C that of A, in a tight cartel-like mutual understanding not unknown in the corporate world. Allowing corporate houses into banking may well make the plight of the depositors much riskier.

Besides, shouldn’t capital frugality be an important consideration whether the capital in question is equity capital or debt capital, whether at the hands of a corporate house or a bank? Poor corporate governance implies greater Principal-Agency costs which erode shareholder value. Allowing corporates into banking may increase these agency costs.

Capital frugality is sadly wanting among Indian corporates. Time and again, we have seen boards, internal auditors, statutory auditors, credit-rating agencies and CFOs closing their stable doors only after the horses have bolted.

I, for one, am convinced that unless we tighten our corporate and regulatory governance standards a good deal more, industrial houses ought not to be allowed even a 26% stake in the banks. The old ceiling of 15% should be adequate. After all, no amount of auditing and RBI’s regulatory skill prevented the motivated lending mishap at ICICI, did it?

(The writer is an academic, author and a former president of a private bank)