A monumental folly in the making

On November 20, 2020, an Internal Working Group (IWG) constituted to “review extant ownership guidelines and corporate structure of Indian private sector banks” under the leadership of P K Mohanty, senior director of the RBI Central Board, submitted its report to the RBI Governor. One of its recommendations, to permit large corporate/industrial houses to promote banks, has raised eyebrows.

As a topic of discussion, this is not new. It has been examined in the past on several occasions by expert groups, but it never passed muster. However, it was decided in RBI papers in 2005, 2010 and further in 2013 that these bodies may be permitted to have equity holdings of 10%.

A large industrial house is defined by the IWG as an entity having total assets of Rs 5,000 crore, with non-financial businesses of the group having more than 40% of total assets or gross income. The IWG this time obtained expert opinion in this regard, and was told, almost unanimously, by the experts not to permit such entities to run banks, essentially on the ground of risks, governance and conflict of interest. There is inherent and potential danger of misallocation of credit to own businesses or close business partners as there is a propensity for ‘connected lending’ and mixing banking with commerce. Furthermore, the experts had pointed out that the prevailing corporate governance in corporate houses is not up to international standards and it would be difficult to ringfence their non-financial activities. Thus, assessing the “fit and proper” status is difficult.

There is inherent and potential danger of misallocation of credit to own businesses or close business partners as there is a propensity for ‘connected lending’ and mixing banking with commerce. Furthermore, experts had pointed out that the prevailing corporate governance in corporate houses is not up to international standards and it would be difficult to ringfence their non-financial activities.

The IWG has mentioned that the permission may be granted only after necessary amendments to the Banking Regulations Act 1949 “to deal with 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. RBI may examine the necessary legal provisions that may be required to deal with all concerns in this regard.” The prerequisites as suggested above are in the nature of conventional narrative cautions. It essentially means nothing in an operational sense.

It is well-recognised that the private sector banks vis-a-vis the public sector banks (PSBs) have exhibited much cleaner balance sheet, operational efficiencies, and face no problem for capital. As reported by the working group, during the past years, private sector banks mobilised resources to the tune of Rs 1,15,328 crore as compared with Rs 79,823 crore by the public sector banks (PSBs). Observing on the shortfall in the capital, the IWG further mentioned that this gap “needed a massive infusion of another Rs 3,18,997 crore from the GoI.” Moreover, even with entry of private sector banks and large presence of PSBs, the credit disbursement by the banking sector remained low as per the IWG report.

The need of the hour is consolidation of the banking sector as a whole, including small private banks, payment banks and cooperative banks.

The Herfindal Hirschman Index (HHI, measuring market concentration) is 0.08 for both credit and deposit mobilisation by the PSBs. This indicates weak market concentration, or in other words, the market is not competitive enough. However, this does not necessarily mean that having more banks will solve the problem of lack of competitiveness. It is worrisome that even though India is a bank–based economy, the credit disbursal to finance growth is low. Many of the banking indicators, such as bank assets to GDP, domestic bank credit to private sector, average Tier 1 capital and pre-tax profit per operating cost, are not in line with the global scenario. For example, as reported in the IWG report, the bank assets relative to GDP in 2017 was lower, at 70%, than that of China, Thailand, Korea, and Egypt; similarly bank credit as a per centage of GDP at above 60% was much lower than the 160% in China. More importantly, in terms of cost efficiencies, Indian banks are just at the bottom of the list, primarily on account of large staff costs. The net pre-tax profit generated by the Indian banks per unit of operating costs is just around $0.14 million, as against a global average of $1 million.

The Indian banking system, as mentioned by the IWG itself, suffers from inefficient credit allocation, high interest rates, weak credit enforcement mechanism, operational inefficiencies and, on top of it all, one of the vexed problems associated with the banking sector in India is non-performing assets (NPA). Non- performing loans in 2018 were 9.5% in India, compared to 3.1% in Brazil, 1.8% in China, 2.1% in Mexico. The capital to risk asset ratio in 2018 was 14.1% in India, compared to 18% in Brazil, 16.8% in South Africa, 22.5% in Indonesia. These factors together act as impediments to credit-creating capacity.

The Indian banking system, as mentioned by the IWG itself, suffers from inefficient credit allocation, high interest rates, weak credit enforcement mechanism, operational inefficiencies and, on top of it all, one of the vexed problems associated with the banking sector in India is non-performing assets (NPA).

As the Report on Trend and Progress of Banking 2018-19 observed: “The slowdown in global and domestic growth impulses in the recent past impinged on credit demand. The asset quality, capital adequacy and profitability of scheduled commercial banks improved after a long period of stress, although challenges emerged from other areas like non-banking financial companies and cooperative banks. Going forward, issues such as resolution of stressed assets, weak corporate governance and frauds need to be addressed to reaffirm a robust financial sector that minimises systemic risks.”

The above discussions bring forth the fact that Indian banking system is in a structural crisis. What is required is providing a strategic direction to banking operation and enhancing supervision capacity. As evidence suggests, capital is not a constraint for private sector banks. It is being said that the Insolvency and Bankruptcy Code (IBC) is a “game changer.” The critical need is a cautious approach. The need of the hour is consolidation of the banking sector as a whole, including small private banks, payment banks and cooperative banks. Besides, correction of the structural rigidities in the PSBs for improvement of transmission of monetary policy to revive growth is a priority. These burning underlying problems we see today in the banking sector cannot be solved by opening bank ownership to corporate houses.

(The writer is a former central banker and a faculty member at SPJIMR. Views are personal)