A 10 percent safeguard

Indian Express, 1 September 2011

RBI has issued draft guidelines for private bank licences. These emphasise dispersed shareholding. Proposed rules on entry into banking require that for a company to get a bank licence no one entity holds above 10 percent shares in a company. These rules are similar to those proposed by the Bimal Jalan committee that for the ownership of an exchange no one entity holds above 5% shareholding. These rules are on the right track. However, as recent experience in telecom and stock exchanges has shown, enforcing such rules is going to be a challenge. RBI will need strong investigative capabilities, such as in SEBI, in carefully sifting through the bank license applications that it will receive.

The business of banking is different from other businesses. What is special about a bank? As an illustration, consider a person who puts up Rs.51 to start a bank with an equity capital of Rs.100. With 51 percent shareholding, he has full control of the bank. On average, Indian banks have total assets which are 20 times the equity capital, so the bank will borrow Rs.1900 from depositors and give out loans of Rs.2000. Retail depositors are rarely well informed enough to understand unethical practices by banks. This problem is made worse by the political reluctance to let a bank fail. The belief that the government would bail out a bank reduces any incentives of depositors to worry about risks being taken by banks. Data and analysis of who the bank is lending to is not made public. Even if it were, in a complicated structure of company ownership, it is hard for depositors to know if promoters are lending to related parties. This puts the onus on the bank supervisor. The proposed ownership structure for bank licences is intended to address this issue.

A promoter who puts in Rs.51 crore to control a bank gets to control bank assets of Rs.2000 crore. The world over, promoter-controlled banks have got into trouble because there is the temptation for the promoter to give out dubious loans and thus siphon out more than Rs.51 crore. If promoter-led banks come about, what will ensue is a continual warfare between promoters and bank supervisors. Given the governance problems of India, prevention is better than cure. The best way out for Indian banking is to open up only to dispersed shareholding banks.

In all countries, at an early stage of development, firms start out family dominated. In India today, most companies have atleast 51% shares with the promoter. From a policy viewpoint, the main concern with this arrangement has been that of corporate governance: where a promoter with 51% of the shares grabs more than 51% of the cash flow of the company by siphoning out cash through underhand means.

In certain fields, the concerns about promoter-led companies go beyond the corporate governance problem. Banking is an example. A promoter-run bank features concentration of decision making in a few hands. The promoter can give out loans to accomplices adding up to Rs.102 crore. If these loans are not repaid, the promoter has converted Rs.51 crore of investment in setting up the bank into winnings of Rs.102 crore, i.e. a 100% return on investment.

What is the alternative to a promoter-run company? All over the world, capitalism grows up, from family-dominated companies to dispersed shareholding companies with a professional management team. A key feature of professional management is the dispersion of information and decision-making among many people. It is harder to execute a scam, when many people, and checks and balances of internal processes, are in the fray. The CEO of a dispersed shareholding company is a professional. If a scandal erupts, it destroys his reputation and thus his lifetime income. Dispersed shareholding with professional management is usually less likely to indulge in corrupt practices. We see this phenomenon with the new private banks that came into operation in India after 1993. By and large, the promoter-led banks got into trouble (other than Kotak Bank). By and large, the dispersed-shareholding banks did well.

The debate in India has been primarily about whether industrial houses should promote banks or not. This is because it is expected that the promoter may use the licence to lend to his industries. But the real issue is about whether a promoter should control a bank or not. We have seen examples of private banks in India where the promoter constructed side businesses to give bad loans to, or gave loans to cronies, even when the promoter was not an industrial house. The real issue is that of incentives and information; not about whether the promoter controls an industrial empire on the side.

Given the difficulties in obtaining information, understanding complex ownership structures and in supervising and prosecuting fraud of the kind described above, RBI has proposed to address this issue by emphasising dispersed shareholding banks, where there is no promoter.

Dispersed shareholding corporations, with a professional management team, are in any case the destination for Indian capitalism. All over the world, the shareholding of promoters inevitably gets fragmented among many children. The imperatives of growth require bringing in external equity capital which dilutes the shareholding of the promoter. Thus, all over the world, promoter-led companies transition into dispersed-shareholding companies. In India, we should accelerate this process, so as to avoid the difficulties of the first stage. We would be getting to the same end-destination -- a landscape dominated by private banks all of which lack a promoter -- but we would be avoiding many a scandal and some macroeconomic crises along the way. Perhaps one question worth pondering is: What would have happened in Indian telecom if, in 1993, when telecom first opened up, private telecom companies were constrained to have dispersed shareholding?

Back up to Ila Patnaik's media page
Back up to Ila Patnaik's home page