PRESENT BANKING POSITION
It is general principle that greater financial depth, stability and soundness contribute to economic growth. But broadening and deepening the reach of banking is the important factor for growth to be truly inclusive. The union finance minister in his budget speech for the year 2010-11 had announced that ‘The Indian Banking system has emerged unscathed from the crisis. We need to ensure that banking system grows in size and sophistication to meet the needs of modern economy. Besides, there is need to extend the geographic coverage of banks and improve access to banking services. In this context, I am happy to inform the Honourable members that RBI is considering giving some additional banking licenses to private sector players. Non Banking Financial Companies could also be considered, if they meet the RBI’s eligibility criteria’.
As of March 31,2009,the Indian banking system comprised 27 public sector banks, 7 new private sector banks, 15 old private sector banks, 31 foreign banks, 86 Regional Rural Banks (RRBs), 4 Local Area Banks(LABs),1,721 urban cooperative banks, 31 state cooperative banks and 371 district central cooperative banks.
Systematic and broader distribution of financial services helps both consumer and producers to raise their welfare and productivity. Such access is especially powerful for poor as it provides them opportunities to build savings, make investment, avail credit, and more important insure themselves against financial downturns and emergencies. In spite of crossing such long steps in resource mobilization, geographical and functional reach, financial viability, profitability and competitiveness, vast segments of population, especially the underprivileged sections of society have still no access to formal banking services. RBI is therefore taking into account granting licenses to a limited number of new banks. A large number of banks would foster greater competition and thereby reduce costs, and improve quality of service. More importantly it would promote financial inclusion and support inclusive economic growth, which is major objective of public policy.
RESERVE BANK’S PAST GUIDELINES TO NEW BANKS
The objective of guidelines issued in january 1993 and subsequently revised in January 2001 was to instill greater competition in banking system to increase productivity and efficiency. The initial minimum paid up capital was prescribed at Rs. 200 crore to be raised to Rs. 300 crore within three years of commencement of business. Promoters were required to contribute minimum 40% of paid up capital of bank at any point of time within a lock-in period of five years. However if contribution exceeds more than 40% promoters are required to dilute their stake after one year of bank’s operation. Non Resident Indians (NRIs) were permitted to participate in primary equity of new bank to maximum extent of 40 percent, In case of foreign banking company or finance company (including multilateral institutions) acting as technical collaborator or a co-promoter it is restricted to 20%. Banks could not extend any credit facilities to promoters and business entities investing upto 10% of the equity. The relationship between business entities in promoter group and the bank had to be of similar nature as between two independent and unconnected entites. The shares of the bank had to listed on stock exchange. Capital adequacy of not less than 12% and net Non performing Assets of not more than 5%. Banks were required to maintain upto 40% of their net bank credit as loans to priority sector. Banks were obliged to open at least 25% of their total number of branches in rural and semi urban centers. An NBFC with good track records was considered eligible to convert into a bank, provided it was not promoted by large industrial house and satisfy other eligibility criteria. The revised guidelines by and large were still cautious in nature. Large industrial houses were not permitted to promote banks. However, individual companies, directly or indirectly connected with large industrial houses were not permitted to own 10 percent of the equity of bank, but without any controlling interest.
RESERVE BANK’S EXPERIENCE
The banks licensed after 1993 guidelines, promoted by individuals, though banking professionals, either failed or merged with other banks or had low growth. only those banks that had adequate experience in broad financial sector, trustworthy people, strong and competent managerial support could withstand the rigorous demands of promoting and managing a bank. Banks licensed in second phase i.e. after 2001 guidelines have been functioning for less than 10 years and their transition from settling stage has been fairly smooth. The experience with Local Area Banks and other small banks has not been encouraging, Low capital base lack of professional management, poor credit management and diversion funds have led to multi-faceted problems, the size of operations and also locational disadvantage of these banks act as a constraint to attracting and retaining professional staff as well as competent management. In support of financial inclusion and for strong economy banks are required to start with strong initial capital base so as to survive in any adverse condition in the financial sector as well as economy.
LESSONS FROM RECENT GLOBAL CRISIS
Global financial crisis has changed the way we think about bank regulation and competition The epicenter of the crisis lay in sub-prime mortgage market in the US, it was transmitted rapidly throughout the globe, destabilizing financial market and banking systems. The crisis strike the economic growth and employment throughout the world. A constellation of regulatory practices, accounting rules and incentives magnified the credit boom ahead of recent global financial crisis. The improper control of the same factors accelerated the downturn in markets and intensified the crisis. Macroeconomic stability and financial stability were generally treated as separate and unrelated constructs with former plays a key role on preserving low and stable inflation, while latter controls the firm level supervision of formal banking sector. In this process, not only was growing shadow financial sector ignored, but also factors such as interconnectedness within complex financial system, especially between banks and financial institutions. Magnitude of this crisis has signaled need for major overhaul of global financial regulatory architecture, there is need for allowing entry to private well-governed deposit-taking small finance banks with stipulation of higher capital norms, a strict prohibition on related party transactions, need to evolve various policies on case by case basis, allowing industrial houses to have stake in Indian banks or promote new banks with strict norms and regulations.
ISSUES FOR CONSIDERATION
The principal issues for framing RBI guidelines and granting of new banking licenses include:
Minimum capital requirements for new banks and promoters contribution
To insist either on initial capital to be brought by applicants1 or assess the required start-up capital to be brought by proposed bank based on the scale, nature, complexity and inherent risk of the operations as proposed in business plan2. Considering the lapse of time since last guidelines issued in January 2001, there is significant need to have minimum capital requirement more than Rs.300crore. nature and sufficiency of financial resources of the applicants shall be examined keeping in view as source of continuing financial support having minimum capital requirement of Rs.1000crore for new banks would evince interest from serious entities having strong capital base and would be able to play substantive role in financial inclusion as they can use strong capital to invest in technology and partnerships. Institutions should also be expected to meet minimum capital requirements for surviving in exposure to credit risk, operational risk and market risk. India already had experience with some of the banks in past that either failed or merged with other banks or had muted growth, so keeping minimum capital requirement of Rs.1000crore for new banks could withstand the rigorous demands of promoting and managing a bank.
Minimum and maximum caps on promoter shareholding and other shareholders
The 2001 guidelines restricted individual companies, directly or indirectly connected with large industrial houses to own 10 percent of equity of a bank without any controlling interest. They could not extend any credit facilities to promoters and companies investing up to 10% of equity. February 2005 Ownership and Governance (O&G) guidelines requires promoters and other shareholders of bank to dilute their shareholding to a level of 10% or below of bank’s share capital within specified time frame. Higher shareholding is permitted to a level of more than 10% up to 30%, exceeding 30% is subject to higher due diligence standards prescribed in February 2004 guidelines. As in interest of financial inclusion and in support of economy of country, the Canadian model could be best for India, In case of small banks no restriction on ownership up to 10% with permission to hold up to say Rs.1000crore, 30% of capital in banks with shareholders equity more than say Rs. 1000crore and up to say Rs.2000crore,the requirement of ministerial approval to own more than 10% of any class of shares and permitted maximum holding (10% or 20%) in banks with shareholders equity of more than say Rs.2000crore, person can own less than 10% of any class of shares without any approval, more than 10% and up to 20% of any class of voting shares or up to 30% of any class of non-voting shares, approval of minister is required, provided the person does not control the bank. but with strict watch on connected lending and to reduce control of functions, interference by promoters, so as to prevent misuse and diversion of funds. After achieving sufficient experience and growth in size, the bank would be performing professionally and on its own strength.
Foreign shareholding in new banks
NRIs participation in primary equity of new banks was permitted to maximum extent of 40% as per 2001 guidelines. However in case of foreign banking company or finance company (including multilateral institutions) acting as technical collaborator or a co-promoter, equity participation was restricted to 20%. The aggregate foreign investment from all sources (FDI, FII, NRI) in private sector banks was raised to 74%. FDI policy further prescribes that at least 26% of the paid capital of the of private sector bank will have to be held by residents, except for wholly owned subsidiary of foreign bank, this has allowed foreign capital to be used in promotion banks, and foreign technical collaboration in setting up domestic banks. As the objective is to create strong domestic banking entities and a diversified banking sector which includes public sector banks, domestically owned private banks and foreign owned banks, aggregate non-resident investment including FDI, NRI and FII in these banks could be restricted at level of below 50% and locked at that level for 5 to 10 years and as per results within that years on the performance, because 74% could be dangerous as profit outcome by these investment will flow to foreign countries, and also global financial crisis indicated that size is evil in itself, so keeping below 50 percent could be reasonable.
Whether industrial and business companies could be allowed to promote banks
Promotion of new banks by industrial houses were prohibited as per 2001 licensing guidelines ,but individual companies, directly or indirectly connected with large industrial houses were permitted to acquire by way of strategic investment shares not exceeding 10 percent of the paid-up capital of bank, subject to RBI’s prior approval. The ownership of banks by business entities is prohibited by most of the countries but there is strict norms, strong laws and regulations of the countries which typically limit the percentage of voting rights and controlling positions that any shareholder can obtain with prior approval of regulatory authorities. In USA, industrial houses are not allowed to own banks. The regulatory framework is designed to protect a bank from risks posed by the activities or conditions of its parent’s company and parent’s non-bank subsidiaries and maintain the general separation of banking and commerce. This has been formulated by way of GLB Act, 1999 by authorizing financial holding companies to affiliate only with companies to affiliate only with companies that were engaged in activities determined to be of financial nature. Industrial houses are permitted to set up banks in Brazil. However ownership limits beyond certain percentage require regulatory approval so as to manage the moral hazards of intra-group lending and also prevent regulatory capture. In Korea, subsequent to Asian crisis, the industrial houses are barred from promoting new banks as they believe in keeping banking and commerce separate from each other. Twelve percent of countries including the USA restrict the mixing of banking and commerce Prior to nationalization of major commercial banks in 1969, the industrial houses having control of the bank, diverted bulk of bank advances to industry, particularly to large and medium-scale industries and big and established business houses, while the needs of vital sector like small-scale industry, agriculture and exports were neglected. There are several deep rooted fears in allowing industrial and business houses to own banks. Even though industrial and business houses are already permitted in other areas of financial services, banks are special as they highly leveraged fiduciary entities central to the monetary and payment system. If allowed to own such affiliation tends to undermine the independence and neutrality of banks as arbiters of the allocation of credit to real sectors of economy. Conflict of interest, concentration of economic power, likely political affiliations, potential of regulatory capture, governance and safety net issues are the main concerns.
If industrial houses permitted to promote banks they could bring in the required capital for banks, in view of the large developmental needs of the economy, even if threshold levels are kept high. They can be important source of capital and can provide management expertise and strategic direction to banks as they have done to broad range of non-banking companies and other financial companies. These business entities already have their presence in insurance companies, asset management companies and other non-banking finance companies, they are already competing with banks on both assets and liabilities side. Equity of large industrial and business houses is widely held and all are listed on stock exchange and subject to company laws, SEBI laws and regulations on transparency, disclosure and corporate governance. These business houses face a high reputational risk compared to pure individual promoter or other financial services company. Stronger corporate governance norms, competitive banking market, strict prudential regulations, strengthening banking regulation and strict disclosure requirements could mitigate the risks of affiliations of banks with business, but at the same time the cause of concern is that banks are flush with liquidity, there is great risk of diverting funds, as industrial groups are involved in different activities they may be able to rotate funds from one entity to another, which is very difficult for regulator to trace source and utilisation of funds, especially when all entities in the group are not regulated by one regulator.
In industrial groups conflict of interest situation arises from transactions between bank and its affiliates. A bank affiliated to business group may deny loans to its affiliate’s competitors, and instead favour its commercial affiliates in granting loans on preferential terms. There may be great risk of connected lending to companies within groups or to customers of such companies. This would transfer the risk of minority shareholders and relatively uniformed depositors. linking banking with commercial activities may tend to undermine the neutrality and independence of banks in deciding allocation of credit may have substantial adverse effect on productivity of the economy. Industrial groups may not be committed to broader objectives of financial development particularly financial inclusion and providing services to all sections of society.
Business groups having predominant presence and experience in financial sector could be allowed to set up banks, provided they should be subject to strict norms stronger governance guidelines other parameters such extent of financial activities carried out by industrial groups. Structure should be strict and properly regulated to ensure the independence of the banks. Stringent limits should be maintained on transaction between bank and other entities in the group to minimize the prospect of direct and indirect lending to other entities in group.
Restriction can be imposed on connected lending through various means, Brazil and Japan do not permit intra-group lending, Taiwan doesn’t allow unsecured lending and allows secured lending only permission is approved and Australia requires all intra-group to be cleared by board. The Japanese experience with Keirestu, the Korean experience with chaebols and the Indian experience prior to nationalization are strong reminders of pitfalls of commercial interest promoting banks. They could also be allowed to take over RRB’s, before considering them to set up banks. This will give them opportunity to prove their suitability for promoting banks. As the underprivileged sections of society still have no access to banking facilities, allowing industrial houses to promote RRBs provide an immediate impetus to financial inclusion and revitalize RRBs especially those in underbanked regions. The experience gained by allowing this would be much more measured and balanced and surely benefit in taking further steps. In all issuing guidelines on allowing industrial houses to promote banks should be strict and should be changed on case by case basis and regularly examined by regulators for adding impetus to financial inclusion.
Allowing non-banking financial companies to convert into banks or promote a bank
The 2001 guidelines on entry of new banks in private sector permitted NBFCs with a good track record for conversion into bank, provided it satisfied the specific criteria relating to minimum net worth, not promoted by large industrial house, credit rating in previous year, capital adequacy of not less than 12 percent and net NPA ratio of not more than 5 percent. after 2001 guidelines only one NBFC has been converted into a bank, and functioning has been fairly smooth. In some countries, the financial institution that are already well regulated are favoured for conversion into banks. The entry level criterion for an applicant in Hong Kong is that should already have been Deposit taking company (DTC) or Restricted license bank for not less than three years.
In USA state commercial banks, state saving associations, state saving banks, state trust companies and federal savings associations are allowed to convert into national banks, provided they must show ability to operate in safely and soundly and are in compliance with applicable laws, regulations and policies, and are consistent with National bank act and applicable OCC regulations and policies.
In determining action on conversion application in USA, the OCC normally considers the applicant’s condition and management. This includes compliance with regulatory capital requirements and conforms to statutory criteria, including many of the same standards applicable to chartering de novo national bank; CRA record of performance, etc. The OCC may impose special conditions for approvals to protect the safety and soundness of bank; prevent conflict of interest; provide customer protections; ensure that approval is consistent with statues and regulations or policy considerations.
NBFC model particularly those in lending activities has been successful in expanding the reach of financial system and thus by converting to banks, this model could be scaled up to better leverage the benefits and achieve objective of financial inclusion. The Non Banking Financial sector in India consists of various types of financial institution All-India financial institutions (AIFIs), development finance institution (DFIs), non-banking finance companies (NBFC), etc. NBFCs are mostly private sector institution, which have carved their niche in Indian Financial system. NBFCs proved boon to especially underprivileged sections of society in India. Unlike banking sector, the NBFC is heterogeneous in nature functionally as well as in terms of size, nature of activities and sophistication of operations. NBFCs consists of not only entities that are part of large multinational groups but also small players at district towns with net fund at statutory minimum of Rs 200lakh. Since NBFCs are already regulated by RBI and have track record, the ‘fit and proper concerns could be addressed more easily. As at the end of financial year of 2008-2009, the total assets of NBFCs were at Rs. 95,727crore and public deposits were at Rs. 21,548crore. The sector is being consolidated and while deposit taking NBFC have decreased both in size as well as in terms of the quantum of deposits held by them, NBFCs-ND have increased in terms of number and asset size. To protect interest of depositors, regulatory attention was mainly focused on NBFCs accepting public deposits (NBFCs-D). Over the years, however, this regulatory framework has been widened to include issues of systematic significance.
Conversion of NBFCs into banks would require folding up of large number of branches and withdrawal from many segments of businesses as well as disinvestment from subsidiaries not engaged in businesses permitted to banks. The initial capital requirement for NBFCs is a miniscule Rs.2crore and the due diligence and fit & proper assessment exercise of promoters is minimal both in terms of scope and rigour, as compared to banks. The NBFC model and the bank model are entirely different as NBFC model provides financial access to excluded categories without the same regulation as applicable to banks. On the other hand, the banking license gives the institution full scope to carry out full-fledged banking activities, with stricter regulatory requirements.
The maturity mix of the asset portfolio is also skewed toward long term and the asset mix may not be compatible to banking liabilities. If NBFCs are converted into banks they may take long time to align themselves to banking activities.
Permitting independent NBFCs which are not promoted by industrial houses to promote banks and which are having good track record and enhanced the financial inclusion may be useful at the rural levels as the Reserve bank is taking steps to provide opportunities to the poor to build their savings, make investment, avail credit and to insure themselves. The expertise of the NBFCs in financial sector could flow into the bank if NBFCs are allowed to promote banks. There may be improved possibilities of governance in banks due to ownership by experienced entities in financial sector.
The NBFCs if permitted to convert into banks should then be subject to strict governance norms, stringent limits on transaction between bank and related entities in the group. Intra-group lending should not be permitted and secured lending should be permitted only with approvals, they should be regulated with proper care and legislative amendments should be made for efficient transition.
As objective of granting license for new banks is financial inclusion, the guidelines stipulations shall be on incorporating goals of business plans, financial projections of balance sheet, cash flows and earnings key financial and prudential ratios for proposed bank and its subsidiaries on consolidated basis. The other factors such as appropriate risk management and internal control systems, information and accounting systems, external and internal audit arrangements, and sensitivity analysis should also be addressed.
To cover regional rural areas the minimum capital should be kept low and may be allowed at Rs. 300 or 500crore and license may be given to NBFCs or small players as big promoters are not willing to invest in small regions as intention of RBI is to cover underprivileged sections of society. Global financial crisis has indicated that in world of finance, size is evil in itself. In the height of Asian crisis, one of the few healthy and solvent Indonesian Bank was one of their smallest banks (bank NISP). But Indonesian central bank’s response (probably encouraged by IMF) was to impose one of highest minimum capital requirement in the world. It would have been utterly hilarious were it not so tragic.
The project report should business potential and viability of the proposed bank, business focus, the product lines, proposed regional or locational spread, level of information technology capability and any other which is relevant, detailed information on background of promoters, their expertise, track record of business and financial worth, investment in companies and details of credit facilities availed by promoters. 40 percent lending to priority sector of net bank credit and 25 percent of its branches in rural and semi-urban areas, other modern infrastructural facilities should also be observed.
It is thus advised that licenses should be given to limited number of banks and for industrial and other promoters the activities in the initial period of granting licenses should be restricted to some reasonable extent and after gaining confidence in promoters and different entities full-fledged banking licenses could be given after restricted period (restricted period may be kept till 2-3 years). The existence and success of banks depend on their ability to meet various needs and wants of customers. The millennium has brought with it challenges as well as opportunities in various fields of economic activities. It is not possible to figure out what will or will not work in emerging banking environment. Failures cannot be avoided, but can be managed and goals should be to maintain attractive risk reward ratio. This again may require the same approach of granting licenses, to weed out failures and give enough freedom to allow success to bloom.
* IV B.S.L., LL.B.
 Discussion paper on entry of new banks in private sector August 11th 2010 http://rbidocs.rbi.org.in/rdocs/content/PDFs/FIDIS110810.pdf
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