All the way to the bank

Indian Express, 14 August 2010

The RBI discussion paper on bank licences is a welcome addition to policy thinking on banking. The need for new banks and more competition in banking is apparent. After 1993, RBI has mostly blocked entry into banking. After the Finance Minister's budget speech announcement that RBI would be giving licences for entry of new banks into the sector, RBI must have been under tremendous pressure both from industrial houses and non bank financial intermediaries keen on opening banks. The response to this has been the correct one. Let us discuss the pros and cons of opening entry into banking, and debate how to mitigate the risks. Putting forth its concerns without recommending what should be done, and leaving the issue open to debate, is particularly welcome in the period after the global crisis which has shown the world how interdependent and integrated financial institutions become and a few bad and unscrpulous players can pose risks to the system.

The business of banking is frought with risks. A promoter putting in Rs.1000 crore of own capital can raise another one thousand crore from others, then leverage it to 20 times to build a bank with assets of Rs 40,000 crores. Given this unusually high leverage ratio which Indian banks are permitted, there are perverse incentives in the picture. Even if the promoter lends one tenth of these assets, or Rs 4,000 crore, to his cronies, he obtains a return of 4 times by reneging on these loans. In the worst case there could be plain theft in the sense of wilful default by borrowers. A bank on the brink of bankruptcy is typically saved by a process of being purchased by a PSU bank. Promoters are able to get away scot free while cronies walk away without repaying their loan.

How can we deal with this? There are two possibilities. First, the ownership and governance can be left deregulated. In this case, banks will come about where the incentives are wrong. Regulation then needs to work hard in forcing banks to behave properly. In the best of times, this is hard. Banking is a particularly opaque business, and the regulator has to struggle to keep up with the private sector. In Indian finance and infrastructure, we are seeing a series of unpleasant situations where promoters launch media and political campaigns aimed at subverting regulation. Given the weaknesess of Indian media, courts and politics, we cannot be sanguine about how these battles will shape up. Once the incentives of banks are wrong, it is an uphill task to force them to get back to good behaviour. There is also the danger of RBI resorting to comprehensive central planning, thus killing the vitality of banking, in response to these difficulties.

The alternative strategy is to use regulation on ownership and governance as a way of modifying the incentive structure of banks and their promoters. If the incentives of banks are in the right direction, then regulation does not have to struggle as much to modify the behaviour of banks. This identical issue underpins SEBI's Bimal Jalan Committee which will have a report on ownership and governance of exchanges (which are an even more sensitive problem than banks).

There has been a lot of concern about industrial houses in banking. At first blush, this seems misplaced, because an unscrupulous promoter does not have to be an industrial house in order to steal. But when we think more carefully, it is true that the deep pockets and political/media connections of the big industrial houses represent a bigger threat in terms of the extent to which media, courts and politics can be subverted. This reinforces the prime concern as being that of blocking unscrupulous promoters and not just industrial houses.

How might the benefits of entry be maximised while the lowest risks are taken? The first point to emphasise is the creation of a strong deposit insurance corporation, which is able to pre-emptively close down weak banks even before their net worth becomes negative. Once this is in hand, it is safe to have a large number of small banks. E.g. if a strong Deposit Insurance Corporation was in place, we can be quite comfortable giving out licenses to many people to start new banks, subject to the constraint that in the first five years after the IPO, the total assets do not exceed Rs.5000 crore each. As Jayanth Varma has emphasised in his Financial Express column (13 August 2010), RBI has long had a wrong perspective on these issues.

What might be a governance structure where such conflicts of interest can be avoided? A structure in which the management team does not stand to strongly gain from the profits is generally a good one. This requires a professional management team and a dispersed ownership. As the crisis has shown, there needs to be an incentive structure for the management that induces long term thinking, prevents excessive risks and unethical business practices. There will still be a need for promoters until a diversified ownership structure can be reached and this is where RBI's difficulty lies.

At the end of the day RBI will have to make a call about how "fit and proper" the applicant for the licence is. A set of rules and risk mitigation strategies can help, but only to a limited extent. Ultimately it will be have to be a judgement call. RBI will have to assess whether Anil Ambani or Ratan Tata or whoever is coming to the RBI for a bank licence has decades of experience in adhering to the law of the land in spirit and not just in letter.

India desperately needs new energies in banking. RBI's discussion document is a good step forward. Now RBI needs to display wisdom and intelligence in translating this into a steady flow of new banks coming into business every month, so that dozens of new banks come about over the next decade.

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