Rajan slams plans to allow India Inc to set up banks

The RBI working group's proposal to allow corporate houses to set up banks is a "bombshell" and at this juncture, it is more important to stick to the tried and tested limits on involvement of business houses in the banking sector, according to an article jointly written by former RBI Governor Raghuram Rajan and ex-Deputy Governor Viral Acharya.

They also said that the proposal is "best left on the shelf".

"The history of... connected lending is invariably disastrous -- how can the bank make good loans when it is owned by the borrower? Even an independent committed regulator, with all the information in the world, finds it difficult to be in every nook and corner of the financial system to stop poor lending," the article said.

Last week, an Internal Working Group (IWG) set up by the Reserve Bank of India (RBI) made various recommendations, including that a large corporate may be permitted to promote banks only after necessary amendments to the Banking Regulation Act.

The IWG was set up to review extant ownership guidelines and corporate structure for Indian private sector banks.

Referring to the group's proposal to allow Indian corporate houses into banking, the article said, "its most important recommendation, couched amidst a number of largely technical regulatory rationalisations, is a bombshell".

"... it proposes to allow Indian corporate houses into banking. While the proposal is tempered with many caveats, it raises an important question: Why now?," the article said.

The article -- posted on Rajan's LinkedIn profile on Monday -- noted that the IWG has suggested significant amendments to the Banking Regulation Act of 1949, aimed at increasing the RBI's powers, before allowing corporate houses into banking.

"Yet if sound regulation and supervision were only a matter of legislation, India would not have an NPA problem.

“It is hard not to see these proposed amendments as a subtle way for the IWG to undercut a recommendation it may have had little power over.

"In sum, many of the technical rationalisations proposed by the IWG are worth adopting, while its main recommendation -- to allow Indian corporate houses into banking -- is best left on the shelf," they opined.

"Have we learnt something that allows us to override all the prior cautions on allowing industrial houses into banking? We would argue no.

“Indeed, to the contrary, it is even more important today to stick to the tried and tested limits on corporate involvement in banking," the article said.

Further, Rajan and Acharya said that as in many parts of the world, banks in India are rarely allowed to fail -- the recent rescue of Yes Bank and of Lakshmi Vilas Bank are examples.

For this reason, depositors in scheduled banks know their money is safe, which then makes it easy for banks to access a large volume of depositor funds.

They noted that the rationales for not allowing industrial houses into banking are then primarily two.

First, industrial houses need financing, and they can get it easily, with no questions asked, if they have an in-house bank.

According to Rajan and Acharya, the second reason to prohibit corporate entry into banking is that it will further exacerbate the concentration of economic (and political) power in certain business houses.

"Even if banking licenses are allotted fairly, it will give undue advantage to large business houses that already have the initial capital that has to be put up.

“Moreover, highly indebted and politically connected business houses will have the greatest incentive and ability to push for licenses," they said.

The approach of the RBI regarding ownership of banks by large corporate/ industrial houses has, by and large, been a cautious one in view of serious risks, governance concerns and conflicts of interest that could arise when banks are owned and controlled by large corporate and industry houses.

For the first time in 2013, the RBI, in its Guidelines for Licensing of New Banks in the Private Sector, had prescribed several structural requirements of promoting a bank under a Non-Operative Financial Holding Company (NOFHC).

Rajan and Acharya, who are also eminent economists, questioned the urgency and timing of the IWG recommendations.

"After all, committees are rarely set up out of the blue. Is there some dramatic change in perception that it is responding to?" they wondered.

Interestingly, the IWG reports in its appendix that all the experts it consulted except one 'were of the opinion that large corporate/ industrial houses should not be allowed to promote a bank'.

"Yet it recommends change!," they pointed out.

Rajan and Acharya have also expressed their views against reducing the conversion time for payment banks to convert into banks.

"A second possibility is that an industrial house holding a payment bank license wants to transform into a bank.

"One recommendation of the IWG that is equally hard to understand is to shorten the time for such transformation from five to three years, so perhaps the surprising recommendations have to be read together," they argued.

Rajan is currently Katherine Dusak Miller Distinguished Service Professor of Finance at The University of Chicago Booth School of Business and Acharya is a professor at the Stern School.

Both of them are based in the US.

Photograph: Danish Siddiqui/Reuters