Why PEs may be better source of capital for banks

India may adopt norms similar to the US Federal Reserve model, which regulates conglomerate-led banks in the country.

Recently, Reserve Bank of India’s (RBI’s) internal working committee (IWC) report proposed the idea of allowing business conglomerates to own banks.

Criticisms have far outweighed acceptance, even prompting the RBI governor to distance himself from the proposal recently.

Amid the debate, it would be pertinent to ask if corporations would be willing to participate in the banking sector any longer.

Barely one out of the 22 that had evinced interest when bank licensing opened up in 2016 seemed enthused today.

At least part of the reason could be the more stringent scrutiny that a banking licence would entail.

A finer reading of the IWC’s recommendation suggests that India may adopt norms similar to the US Federal Reserve model, which regulates conglomerate-led banks in the country.

The US Bank Holding Companies Act, established in 1956, was designed to tightly regulate banks floated by industrial houses.

Under these regulations, every other business or subsidiary other than the banking operations (which is directly monitored by Federal Reserve) also falls under the Fed’s supervision, and is subject to dual regulations and scrutiny.

“The bedrock principle is that don’t let commerce into banking, but it’s okay to allow banking into commerce,” says Jeff Berman, partner, financial services regulatory group, Clifford Chance US LLP, a top-tier US law firm.

US industrial houses have stayed away from the banking business ever since the law came into force.

If this is the case, R Gandhi, former deputy governor of RBI, is doubtful that Indian corporations would rush forward to own banks; he expects the response to be lukewarm and perhaps fade over time.

“Will business houses willingly submit themselves to such scrutiny?” he asks.

But Shailesh Haribhakti, a chartered accountant and managing partner Haribhakti & Co, says the terrain is slowly changing and greater regulatory scrutiny may not be a hurdle.

“Companies are happier to have a clean and transparent system and we need to view them with a new mindset,” he affirms.

Berman has an interesting example to suggest how corporate house interest in banks has dulled over the years.

“TransAmerica Corporation was the real instance of a conglomerate owning a bank,” he points out.

Bank of Italy, promoted by TransAmerica in 1902, subsequently became BankAmerica and was acquired by NationsBank in 1988, to now be known as Bank of America Merrill Lynch.

Apart from regulatory scrutiny, there are execution and operational challenges for the regulator, too.

As Gandhi points out, the process of reviewing the financials of group companies will be nothing short of forensic supervision and audit.

“The RBI needs to equip itself with required expertise,” he says.

In Haribhakti’s opinion, it is less a manpower problem and more a data and technology issue in today’s context.

Either way, the need to scale up and its consequent cost is the critical piece for the regulator.

Then, there is the perennial question of economic cost and political will. The first may be taken care of by setting up a non-operative financial holding company as proposed by the IWC, which is also the model in the US.

This should quell questions around intergroup lending, reciprocal or mutual lending and overall group indebtedness.

Despite this, when US retail giant Walmart aspired to set up a non-bank bank (as non-banking financial companies are called in the US) in 2005, it ran into controversies and dropped the plan two years later.

Berman, though, feels that the economic argument may be quite narrow.

In a traditional set-up, when banks have limited avenues to make money, being a part of a large conglomerate can help reduce excess risk-taking, he suggests.

“For the good of the entire group, banks won’t be allowed to take crazy risks in their loan portfolios, which they otherwise might be tempted to do in order to earn interest rate margin; since the conglomerate has other, diversified sources of revenue, they won’t have the same incentives to take on too much lending risk,” he says.

He also makes the striking point that the 2008 financial sector crisis in the US would have happened whether or not there were ownership restrictions.

“The jury is out on whether corporate ownership is good or bad and there is evidence that it would be better if we allow corporations to own banks,” he says.

But if business houses are reluctant to provide capital to the banking sector, what about private equity (PE) investors?

The IWC’s proposal to increase the shareholding of non-promoter investors to 15 per cent from 10 per cent may be useful since PEs evince better interest when a board seat is in play.

In Axis Bank, YES Bank, IDFC First and RBL Bank, PEs have lately assumed the role of a strategic investor rather than a financial investor and this trend is expected to continue.

PEs have deep pockets with the ability to recapitalise the bank as and when needed.

Often regarded as turnaround experts, they offer the prospect of good governance standards owing to their global experiences.

But whether financial or strategic, PEs enter into an investment with a fixed exit date.

“Their constant motivation is valuations, so PE-driven banks could be very aggressive on growth,” says Gandhi.

Super-normal growth has often irked the regulator and such banks tend to pose larger systemic risks (as, for example, YES Bank).

But, as Jaspal Bindra, a veteran banker and chairman of Centrum group that offers an array of financial services including investment banking and small business loans, points out, whether PEs have the capabilities to withstand in the initial years of establishment is another question.

HDFC Bank was barely popular or rewarding to its shareholders in its first 10 years of operations.

How many PEs would be willing to wait it out in the current market?” he asks.

RBL Bank and DCB Bank are success stories heavy-lifted by PEs, whereas Dhanlaxmi Bank and even Lakshmi Vilas Bank have waited long for buyers.

Having run out of large institutional options, Bindra stressed that to strengthen the banking system a combination of money from business houses and PEs is critical.

In the financial sector, the Hinduja-promoted IndusInd Bank is an example of coexistence of an industrial house and PEs.

The Hindujas hold about 15 per cent stake in the bank, and PEs collectively hold about 20 per cent.

“Whoever has the money and capabilities should be welcome,” Haribhakti adds.

Photograph: Krishnendu Halder/Reuters