Why Corporate Houses Should Not be Allowed to Promote Banks: A Reading List

The new proposal by an RBI Internal Working Group to allow large corporate/industrial houses to float banks poses various risks for the banking sector.

In November 2020, the Reserve Bank of India (RBI) released a report of its Internal Working Group, which recommended that large corporate/industrial houses be permitted to promote banks, subject to necessary regulatory amendments.

In a similar vein, it recommended that well-run non-banking financial companies (NBFCs), including those owned by corporate houses, be considered for conversion into full-fledged banks. It also allowed for raising of the cap on promoters’ stake in a private bank from the current 15% to 26%.

Put together, the recommendations make way for corporate entry into banking, which has not been possible since the bank nationalisation of 1969.

At present, the RBI lists 22 private sector banks in India, but none of these have been set up by large corporate and industrial houses.

Experts have had varied responses to the move—some have been cautiously optimistic that corporate entry could bring in capital and competition to the banking sector, while many others warned that corporate-owned banks could lend to corporate houses run by the same promoters (connected lending), leading to a conflict of interest and risk of bad loans. Critics have also expressed concerns over the further concentration of economic power in the hands of a few.

Former RBI governor Raghuram Rajan and former deputy governor Viral Acharya have criticised the RBI recommendations, highlighting that the RBI failed to take into consideration the advice of experts it had itself consulted. They have also questioned the urgency behind the proposal.

The timing of the RBI report in the middle of a pandemic and a technical recession is suspect but the gradual liberalisation of Indian banking has been underway since the banking sector reforms of the 1990s. 

Calls to allow banking licences to more private players and even to privatise the public sector banks are not new and have often stemmed from the problems of bad loans and mismanagement, perceived to be exclusive to the public sector.

In this reading list, we dig into the EPW archives to explore why allowing large corporate/industrial houses to enter banking is not the best idea.

Connected Lending and Circular Lending

The primary argument against corporate entry into banking is the problem of connected lending, wherein banks could lend to related-party corporate entities owned or managed by the bank’s promoters, without regard to prudential norms.

An EPW editorial (2020) argued that only independent banks, with no connections to business houses or other powerful partisan groups, can effectively screen loan applicants without biases. They can also efficiently monitor the implementation of funded projects to minimise moral hazards.

Industry-group-owned banks, on the other hand, will be under constant pressure to favour group companies, at the expense of more deserving ones. Labelled as connected lending, this will not only erode the bank’s role as an effective financial intermediary and deter efficient fund use but also affect its profitability and solvency.

Thus, connected lending by corporate-owned banks can be used to fund projects by group companies at cheap interest rates. Effectively, the project risks are transferred from the business group to the banks.

The editorial added:

Another risk associated with banks owned by industry groups is circular lending, with corporate bank X funding projects of an industry group, which owns corporate bank Y, and corporate bank Y funding projects of an industry group owning bank Z, and finally, corporate bank Z funding projects of industry group owning bank X, which is hard to track on a real-time basis.

History May Repeat Itself

The fear of connected lending is backed by the experiences with private banks prior to bank nationalisation in 1969.

C P Chandrasekhar (2011) wrote:

In the years preceding nationalisation, when leading banks were part of business groups, an excessively large and disproportionate share of advances by these banks went to firms in which directors had [a direct or indirect interest]. An official committee found that two-thirds of advances by banks were being directed either to firms belonging to the same business group as the bank itself or to firms in which directors of the bank had an identifiable connection. Influence rather than project screening was clearly determining lending and leading to overexposure to a few clients.

Therefore, the current RBI recommendations fail to take into account the circumstances in the bank sector that necessitated nationalisation. Chandrasekhar (2017) observed:

Nationalisation was unavoidable because, despite repeated efforts of the government, private promoters of banks who put in little by way of equity, diverted public savings to projects in which the promoters had a direct or indirect interest. 

In the pre-nationalisation era, such connected lending was a problem not only from an ethical perspective, but also in terms of credit risk exposure and access to credit. Agriculture and the small-scale sector were starved of credit. In an effort to cut costs at the expense of inclusion, privately owned banks limited their branching and restricted their activities to cities. Finally, with exposure to a few projects that interested the promoters, many banks were vulnerable and fragile.

Further, there is nothing to suggest that the situation would be any different, if corporate banks were to operate now.

Corporates Can Become Too Large to Control

An EPW editorial (2020) argued that new banking licences would only add more muscle to large industry groups that already dominate many important sectors of the economy, including telecom, retail and software. Having tied up with banks, the industry groups would be in a position to jeopardise the interest of smaller players. They would also be able to leverage their financial strength to enter new markets and increase their concentration of wealth.

The deep pockets and market dominance of large industrial and corporate houses can bring increased heft in terms of influencing policy as well.

This will lead to the emergence of new big power centres that would soon throttle the government’s ability to steer the economy in the right direction.

The same fear plagued critics when the RBI had previously considered corporate entry into the banking sector. T T Ram Mohan (June 2016) highlighted the inherent problem of the corporate sector in India:

The problem is not just the dangers of interconnected lending and their implications for financial stability. It is that large corporate houses, with their strong links to the political class, may not be entirely amenable to the sort of stringent regulation and supervision one associates with the RBI. There is every danger that, in any conflict between the RBI and a corporate entity, the former will lose out. The RBI’s enviable standing as a regulator will be undermined as a result.

Chandrasekhar (2011) raised similar concerns:

Once large private players with deep pockets enter, there are likely to be pressures to relax conditions relating to private banks.

Does the Banking Sector Need More Competition?

Rejecting the argument that “industrial houses had the deep pockets necessary to provide meaningful competition to entrenched players,” Ram Mohan (June 2016) explained that there was no compelling need to allow corporate houses to enter banking:

First, there is adequate competition in Indian banking today. The share of PSBs in assets has been falling over the years even as private banks have gained ground…
Second, there is a contradiction in saying that we need more competition in banking even while arguing for consolidation of PSBs.

K B L Mathur (2002) also wrote about the competitiveness of public sector banks:

PSBs in India have already been exposed to increasing competitive environment, which can be said to be neither low nor excessive. The forces of competition are already compelling the PSBs to optimise resource use to attain pure technical efficiency. Financial efficiency measured in terms of return on assets, though not strictly comparable with private and foreign banks, is also not low. 

Private Is Not Inherently Better Than Public

In light of RBI’s June 2020 discussion paper on governance in commercial banks, Ram Mohan (2020) observed that private and public banks are plagued with similar problems:

The paper’s approach is ownership-neutral: it makes no distinction in its broad approach between PSBs and private banks. Indeed, the principal recommendations of the paper leave us in no doubt that the issues of governance in banking cut across ownership categories.

He noted:

Governance at private sector banks has been found wanting in many respects. There has been at least one noisy chief executive officer (CEO) exit and one spectacular failure among private banks. 

In an article from 2010, he had also argued that the public sector parentage of private banks has been a factor in their performance:

The better performers in the private sector – ICICI Bank, HDFC Bank, UTI Bank (now Axis Bank) and IDBI Bank – have all been promoted by financial institutions. Moreover, the promoting financial institutions all had a public sector parentage. ICICI Bank was conceived as a semi-public institution. HDFC promoted HDFC Bank.

Private Banks Pose Macroeconomic Risks 

Referencing Aidar Turner’s work, Ram Mohan (March 2016) argued that too many banks, especially credit-expansion-oriented private banks, come with their own set of risks for the financial sector:

If too much debt is an evil, then banks are the root of that evil. They are central to “swollen finance” and to the devastation this can visit on economies. If we wish to prevent major financial crises, we need to face up to a brutal truth: private banks have the capacity and the incentives to relentlessly expand the supply of credit.

...Three features tend to turn private banks into weapons of mass destruction: the capacity to create credit, high leverage, and incentives for risk-taking. Of these, the last one is relatively muted under public ownership. In PSBs, bankers’ rewards are not tied to the profits they make. So PSBs tend to be relatively averse to risk and their decisions not as motivated by considerations of profit.

This may seem bad at the micro-level. PSBs tend to underperform private banks precisely for these reasons and have been faulted on this account. However, the macro outcome turns out to be a favourable one. We have a system that is stable because not everybody is chasing risky gambles with high pay-offs for managers.

Read more

‘Riskless Capitalism’ in India | Rohit Azad, Prasenjit Bose and Zico Dasgupta, 2017

Dynamics of Competition in the Indian Banking Sector | Pankaj Sinha and Sakshi Sharma, 2018

Comparing Performance of Public and Private Sector Banks | Subhas C Ray and T T Ram Mohan, 2004

Public Sector Banks Can Be Reformed Without Private Ownership | EPW Engage

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