Wednesday, November 25, 2020

RBI report on bank ownership raises a storm

The report of the Internal Working Group of RBI on bank ownership has unleashed a storm of mostly negative comment.

Leading the charge are Raghuram Rajan and Viral Acharya, as this report bears out.  Rating agency S&P has raised concerns as have many banking analysts. 

Most of the recommendations are unexceptionable. For instance, the recommendation that promoter's be allowed to retain their stake at 26% instead of the current ceiling of 15% after having diluted to 40% by the end of five years of starting a bank. Promoters have exercised full control even at the lower stake of 15%, so why not let them  exercise control with more skin in the game at 26%? Point taken.

Then, the idea that entities with multiple financial interests should come in through the Non Operating Holding Company Route. This is merely a reiteration of a position the RBI has held for long.

The hot potato is the recommendation on letting corporate houses into banking. This can take one of two forms. Corporate houses with no interest in banking-related activities can come in. Secondly, those who own NBFCs can convert these into banks. For the first category, the report suggests that the Banking Regulation Act be amended to give the RBI adequate powers to track and supervise inter-connected lending amongst corporates. For the second category, the report says that the current record of NBFCs, 'fit and proper' criteria for promters, etc be applied.

The difference in treatment is baffling. If corporate houses that are new to banking are to be effectively monitored, so are corporate houses that own NBFCs. Amendments to the Banking Regulation Act should be a condition precedent for either category.

And the concerns are identical to both categories- one is not riskier than the other (although it could be argued that NBFC-owning entities that do not have a significant exposure to non-finance or industrial activities are less of a problem).

Inter-connected lending is not easy to track and supervise. It's very difficult for the supervisor to judge whether an entity is part of a group or not. And how does the supervisor keep watch on funding of a corporate's suppliers and customers? 

The problems of inter-connected lending are well known. Not as well recognised are the issues that can arise on the liabilities side. Corporates park their cash surpluses with banks at negotiated rates. A corporate owning a bank may be able to get a price on its surpluses that is above the market rate at a given point in time- in effect, the concerned company will be gaining at the expense of the bank. 

Banks have privileged access to information. They have better information that the public on the current financial condition of their clients, the status of projects, which companies in a group are doing well and which aren't, projects that clients are bidding for, etc. A corporate owning a bank will have access to the information and hence an informational advantage over rivals.

One could go on and on. The conflicts of interest inherent in letting a corporate house into banking are mind-blowing. Managing these conflicts is beyond the competence of even the most upright and competent regulator. The regulator will fail in this unequal contest and its reputation will take a beating. The entry of corporate houses into banking, make no mistake, is a threat to financial stability.

More in my article in the Hindu, Say 'no' to corporate houses in Indian banking.

As the article is behind a pay wall, here it is:

Say ‘no’ to corporate houses in Indian banking

The banking sector needs reform but the recommendation of corporate-owned banks is neither ‘big bang’ nor risk free

T.T. Ram Mohan

An Internal Working Group of the Reserve Bank of India (RBI) has recommended that corporate houses be given bank licences ( In today’s pro-business climate, you would have thought the proposal would evoke jubilation. It should have been hailed as another ‘big bang’ reform that would help undo the dominance of the public sector in banking. Instead, the reaction has ranged from cautious welcome to scathing criticism. Many analysts doubt the proposal will fly. It is worth examining why.

First, the idea

The idea of allowing corporate houses into banking is by no means novel. In February 2013, the RBI had issued guidelines that permitted corporate and industrial houses to apply for a banking licence. Some houses applied, although a few withdrew their applications subsequently. No corporate was ultimately given a bank licence. Only two entities qualified for a licence, IDFC and Bandhan Financial Services.

The RBI maintained that it was open to letting in corporates. However, none of the applicants had met ‘fit and proper’ criteria. The IWG report quotes the official RBI position on the subject at the time. “At a time when there is public concern about governance, and when it comes to licences for entities that are intimately trusted by the Indian public, this (not giving a license to any corporate house) may well be the most appropriate stance.”

In 2014, the RBI restored the long-standing prohibition on the entry of corporate houses into banking. The RBI Governor then was Raghuram G. Rajan. Mr. Rajan had headed the Committee on Financial Sector Reforms (2008). The Committee had set its face against the entry of corporate houses into banking. It had observed, “The Committee also believes it is premature to allow industrial houses to own banks. This prohibition on the ‘banking and commerce’ combine still exists in the United States today, and is certainly necessary in India till private governance and regulatory capacity improve. (” The RBI’s position on the subject has remained unchanged since 2014.

The worry is the risks

What would be the rationale for any reversal in the position now? The Internal Working Group report weighs the pros and cons of letting in corporate houses. Corporate houses will bring capital and expertise to banking. Moreover, not many jurisdictions worldwide bar corporate houses from banking.

It is the downside risks that are worrying in the extreme. As the report notes, the main concerns are interconnected lending, concentration of economic power and exposure of the safety net provided to banks (through guarantee of deposits) to commercial sectors of the economy. It is worth elaborating on these risks.

Corporate houses can easily turn banks into a source of funds for their own businesses. In addition, they can ensure that funds are directed to their cronies. They can use banks to provide finance to customers and suppliers of their businesses. Adding a bank to a corporate house thus means an increase in concentration of economic power. Just as politicians have used banks to further their political interests, so also will corporate houses be tempted to use banks set up by them to enhance their clout.

Not least, banks owned by corporate houses will be exposed to the risks of the non-bank entities of the group. If the non-bank entities get into trouble, sentiment about the bank owned by the corporate house is bound to be impacted. Depositors may have to be rescued through the use of the public safety net.

The Internal Working Group believes that before corporate houses are allowed to enter banking, the RBI must be equipped with a legal framework to deal with interconnected lending and a mechanism to effectively supervise conglomerates that venture into banking. It is naive to suppose that any legal framework and supervisory mechanism will be adequate to deal with the risks of interconnected lending in the Indian context.

Corporate houses are adept at routing funds through a maze of entities in India and abroad. Tracing interconnected lending will be a challenge. Monitoring of transactions of corporate houses will require the cooperation of various law enforcement agencies. Corporate houses can use their political clout to thwart such cooperation.

Second, the RBI can only react to interconnected lending ex-post, that is, after substantial exposure to the entities of the corporate house has happened. It is unlikely to be able to prevent such exposure.

Third, suppose the RBI does latch on to interconnected lending. How is the RBI to react? Any action that the RBI may take in response could cause a flight of deposits from the bank concerned and precipitate its failure. The challenges posed by interconnected lending are truly formidable.

Regulator credibility at stake

Fourth, pitting the regulator against powerful corporate houses could end up damaging the regulator. The regulator would be under enormous pressure to compromise on regulation. Its credibility would be dented in the process. This would indeed be a tragedy given the stature the RBI enjoys today.

What we have discussed so far is the entry of corporate houses that do not have interests in the financial sector. There are corporate houses that are already present in banking-related activities through ownership of Non-Banking Financial Companies (NBFCs).

Under the present policy, NBFCs with a successful track record of 10 years are allowed to convert themselves into banks. The Internal Working Group believes that NBFCs owned by corporate houses should be eligible for such conversion. This promises to be an easier route for the entry of corporate houses into banking.

The Internal Working Group argues that corporate-owned NBFCs have been regulated for a while. The RBI understands them well. Hence, some of the concerns regarding the entry of these corporates into banking may get mitigated. This is being disingenuous.

There is a world of difference between a corporate house owning an NBFC and one owning a bank. Bank ownership provides access to a public safety net whereas NBFC ownership does not. The reach and clout that bank ownership provides are vastly superior to that of an NBFC. The objections that apply to a corporate house with no presence in bank-like activities are equally applicable to corporate houses that own NBFCs.

Points to privatisation

There is another aspect to the proposal that cannot be ignored. Corporate houses are unlikely to be enthused merely by the idea of growing a bank on their own. The real attraction will be the possibility of acquiring public sector banks, whose valuations have been battered in recent years. Public sector banks need capital that the government is unable to provide. The entry of corporate houses, if it happens at all, is thus likely to be a prelude to privatisation. Given what we know of governance in the Indian corporate world, any sale of public sector banks to corporate houses would raise serious concerns about financial stability.

India’s banking sector needs reform but corporate houses owning banks hardly qualifies as one. If the record of over-leveraging in the corporate world in recent years is anything to go by, the entry of corporate houses into banking is the road to perdition.




Saturday, November 21, 2020

Rescue of Lakshmi Vilas Bank

 RBI's move to get  Lakshmi Vilas Bank to merge with DBS India removes a huge uncertainty for depositors. They can now breathe more easily. 

Saving small depositors is an important consideration for the regulator in India. The political costs of letting them go to the wall are unaffordable. But a bank rescue also makes good economic sense. A branch with over 560 branches has franchise value. What's the point in liquidating it? You are not going to raise enough to pay depositors and you will be starving borrowers of funds. The issue is a requirement of capital. LVB management tried hard to raise capital but failed- they obviously didn't inspire confidence in investors. The next best thing was to look for buyer with deep pockets. DBS fills the bill.

The good thing is that LVB has not been foisted on a public sector bank. The scapegoat would have been SBI in the normal course but it was obviously not available after having to reckon with Yes Bank. PNB, the other potential scapegoat, is wrestling with its ongoing merger with OBC.

Is the acquisition of LVB by DBS a pointer to the shape of things to come? Do we expect more foreign banks to come in and acquire assets in the Indian banking sector? I doubt very much. If foreign banks are to acquire Indian entities, they will need to have wholly owned subsidiaries (WOS) in India. Only two foreign banks have shown an appetite for such subsidiaries. (DBS is one of them). 

A WOS  is subject to stringent governance requirements, including the requirements that 50 per cent of the directors should be Indian and one-third must be independent directors. Foreign banks may not be comfortable with such requirements. Nor do they have much of an appetite for infusing capital into emerging markets in a big way, given that are grappling with higher capital requirements in their home markets consequent to Basel 3 norms. 

Besides, foreign banks would think hard about organic growth in a market in which both PSBs and private banks have substantial distribution networks. They would be more interested in growing through acquisition of PSBs. That is a no-no at the moment. The government needs to amend the Bank Nationalisation Act to facilitate such acquisitions. Besides, the RBI is wary of the financial stability implications of a large foreign bank presence. The foreign bank policy unveiled in 2013 says:

From financial stability perspective down side risk may arise if the foreign banks, i.e. WOSs of the foreign banks and foreign bank branches together come to dominate the domestic financial system. To address this risk, restrictions would be placed on further entry of new WOSs of foreign banks, when the capital and reserves of the foreign banks (i.e. WOSs and foreign bank branches) in India exceed 20% of the capital and reserves of the banking system. 

The RBI is unlikely to change its stance even though there is a large need for capital. It would be more receptive to acquisitions of PSBs by Indian entities, whether corporate houses or large NBFCs that convert themselves into banks. The timing of the recommendations of the RBI's internal working group on the subject are thus significant.

LVB shareholders are upset that equity is being written of in the proposed merger. At Yes Bank, bond holders had to take some of the hit, so why not in this case? Well, the RBI does not have a consistent policy on this issue, as this piece in BQ shows. One must reckon that the write off at LVB was intended to make the proposal palatable to DBS. 

More in my BQ article, The Lakshmi Vilas Bank Rescue does not mark a trend.




Sunday, November 15, 2020

Pandemic's economic impact was exaggerated

 When the pandemic erupted in a big way in the US and Europe and engulfed the rest of  the world, including India, many forecasts verged on the apolycaptic. We were told that the global financial crisis would pale in comparison with the havoc wrought by the pandemic.

This is not unusual. Overshooting of forecasts is as common as overshooting of stock prices or exchange rates. In 1987, when the stock market crashed (for technical reasons), many in the US gloomily forecast the end of capitalism. They were proved wrong- the markets and the economy bounced back quickly.Then came the millenium IT bug and the imminent collapse of software systems. The millenium came and went without any turbulence. The global financial crisis was, in some sense, the real thing. But its impact was felt more in the advanced economies and, amongst these, the US recovered faster than Europe.

On now to the pandemic. The immediate impact of the pandemic is turning out to be greater than that of the financial crisis- in other words, the trough is deeper. But the bounce back promises to be faster. One reason is that banking systems have proved resilient, unlike in the global financial crisis, thanks to bigger capital buffers at banks. Another is a greater willingness on the part of policy makers to do what it takes in respect of fiscal stimulus. A third is that the fatality rate in the pandemic is lower than initially feared and this has emboldened governments everywhere to ease lockdown restrictions faster than supposed.

There is, of course, the second wave in Europe and US and the fear of a similar wave elsewhere. But the trend towards easing of restrictions on economic activity is unlikely to be reversed a great deal. So, the loss of economic output will be not as great as in the financial crisis.

More in my BS column, Covid shock versus global financial crisis

Wednesday, November 04, 2020

Robert Fisk, peerless journalist

Robert Fisk, one of UK's globe-trotting journalists in the tradition of James Cameron and John Pilger (Pilger worked for British papers although he's an Australian), passed away recently.

Fisk was a fearless reporter who distinguished himself with his coverage of the Middle East, mostly from Beirut which had become a second home to him. Western coverage of the Middle East is hopelessly biased in favour of Israel and is often no more than an arm of Western propaganda. It routinely portrays the struggles of the people there as acts of terrorism. 

Fisk was different. He was unbiased in his reporting and he showed a lot of empathy for the suffering he saw and chronicled. Not many Western papers other than the Independent would have been willing to host him. There aren't many like Fisk in journalism today. Robert Parry, the American investigative reporter, is no more. Seymour Hersh, another American great, is still around. In an era of fake news, Fisk will be greatly missed.

Here's an obit in the Independent. Patrick Cockburn, another veteran journalist, pays a tribute here.

Sunday, November 01, 2020

Air India disinvestment

Air India's disinvestment- or, more accurately, privatisation- is stlll on after having been started in January, 2020. (An earlier attempt in 2018 proved unusccessful). 

After contemplating a majority stake sale initially, the government decided to sell 100 per cent of equity in Air India at one go. According to media reports,  it has also moved about half of the debt out of Air India to a Special Purpose Vehicle. The debt that remains is around Rs 23,000 crore and this is said to relate to the aircraft bought by AI.

Neither of these has sufficed to attract bidders thus far. The government, it is reported, is now offering a further sweetener. It has allowed bidders to choose how much of the existing they would like to take up in making their offers for equity.

I must confess I am not able to fathom what this means. 

Let us take V =D +E, where V is the value of the firm, D is the debt and E the value of equity.

Bidders will estimate a value for V. In bidding for equity, they will subtract D from V. If they want to take up less debt, they will bid more for equity; if they want more debt, they will bid less. I guess that is the proposition being made.

But this holds true only if V remains unchanged with the change in debt. I can't see how this is possible. Most of the debt in AI relates to aircraft. If some of the debt is to moved out, some of the aircraft too will have to go. When that happens, V drops correspondingly, leaving E unchanged. 

Can somebody explain to me how leaving it to bidders to choose the level of debt is going to help?

There is another thought. If moving out debt is going to make AI more attractive, that is, it will improve the bottomline, why can't the government keep AI? After all, the presumption underlying disinvestment is that AI will continue to bleed, that is why it's important for the government to get AI off its hands.

One final point. It is important that the government realise the correct value for AI assets, however the deal is structured. If the sale is under-priced, there is little incentive for the bidder to improve efficiency- the bidder gains without having to lift his little finger. Secondly, if AI is not correctly priced, the deal could invite a legal challenge, which would mean that it will be stymied for quite some, leading to a further worsening of performance.