OPINION The debate over foreign ownership of Indian banks: How the rules might change

One suspects the first question rose suddenly  because of the massive SBI QIP

Foreign investment in Indian banks has suddenly become a pet topic for equity markets. Here are the questions:

Should foreign ownership limit in PSU Banks which is capped at 20% be raised as there is no such cap for private banks?
Should the current 26% cap on voting rights in banks – for a single entity – be removed?

One suspects the first question rose suddenly because of the massive SBI QIP. The 20% FPI cap on PSU banks is written into the Bank Nationalization Act and “sources” connected to powers in Delhi say that amending the Banking Companies Act (as it is called) is not the government’s priority now.

Separately the govt has been trying to sell its stake in IDBi and here interested foreign banks are demanding 50% ownership. The Banking Regulation act, as said before caps the voting rights of any one entity in a bank to 26%. This rules also comes in the way of foreign banks wanting to do a strategic buy out of any small Indian bank. The issue became more intriguing after RBI governor said that the central bank is reviewing all bank ownership rules.

So it is worthwhile disentangling and enumerating the caps on foreign ownership and try to argue if any of them need to go.

FPI LIMIT ON PSU BANKS

Firstly we need to distinguish between overall foreign ownership, i.e. FPI limits on the one hand and on the other hand, strategic buys – which is a single foreign bank wanting to own an Indian bank foreign entity.

In the case of the PSU banks, it is the former that is the hurdle. Under Banking Regulation Act foreign stake in PSU banks can’t go over 20%. These rules were framed at the time of bank nationalisation in 1969 when import substitution, domestic centred economies and industrial policies were the order of the day.

Can these caps be discussed and even discarded today. Perhaps yes. With the government firmly in the saddle with over 51%, foreign stake whether it is 10%, 20%, 30% or 40% makes no difference to the running of the bank.

But it may make a difference to the share price if the 20% cap goes. It means technically FPIs can own 49%. Now weights of stocks in the MSCI and FTSE depends on how much headroom or floating stocks is available for foreign funds. Hence if the cap goes the potential passive flows into PSU bank stocks, as per IIFL Alternate Desk, are as follows:

Bank                      FPI Stake                                Additional Passive flows*($mln)

SBI                             11%                                                 1456

Bank of Baroda     9.43%                                             206

Union Bank             7.25%                                            165

PNB                            5.66%                                             58

Perhaps it now makes sense why it was useful to speculate on this issue on the eve of the SBI QIP issue.

FOREIGN BANK BUYING AN INDIAN BANK

The second issue is of giving any interested foreign bank more stake in and control over an Indian Bank. This is a more tricky issue. At the moment a foreign bank can enter the country by setting up a 100% subsidiary, and will be treated on par with Indian private sector banks. (Please note HSBC, Citi and Standard Chartered are all branches of foreign banks registered abroad; they are not 100% subsidiaries). Also foreign banks can technically acquire 50%, in an existing private sector bank. However their voting rights will be capped at 26%. This is not a constraint only on foreign banks. No single entity, not even an Indian entity or promoter, can have more than 26% voting rights in an Indian bank, as per Banking Regulation Act.

We have to constantly remember the two different sets of “foreign” that we are speaking about. Foreign investment (FPI+FDI) in Indian private sector banks, is allowed up to 74%, with automatic approval up to 49%. However, an individual foreign bank used to be disallowed by RBI from holding over 15% in an Indian bank.

It is this 15% that the RBI governor seemed to wave away in an interview with CNBCTV18, this week when he said that preventing a foreign bank to buy 26%, when they are allowed 100% in their banking subsidiaries defies logic.

WHY CAPS ON FOREIGN BANKS

To understand this 15% Laxman Rekha a bit of history needs to be recalled. RBI and Indian government were wary of allowing foreign banks to buy Indian private sector banks early in the century for two reasons:

1. Firstly, many foreign countries were resisting entry of Indian banks. In the US, banking is a state subject and hence any Indian bank setting up a branch had to take 50 licences in 50 states. This proved to be a non-tariff barrier. Likewise in the 2000’s Canada too didn’t allow customers of Indian Banks registered in Canada to access their money through the ATMs of Canadian Banks. (India always allowed a foreign bank customer to withdraw her money from say an ICICI ATM ).

2. Secondly, foreign banks were believed to be creaming away only the lucrative parts of banking and did little for financial inclusion. They were usually leading in areas like cash management, forex services, wealth management, credit cards which had low fixed costs and high rate of return. With a prestige attached to foreign banks, Indian customers even paid higher charges. So the “foreign” banks were seen as serving their own ends and not bringing much to the Indian economy at large.

THE RUN-UP TO LEHMAN AND AFTER

Thirdly, RBI in the 2004-2008 period believed, (and rightly) that foreign banks are poorly regulated. The governor of the day Y V Reddy, famously smelt the Lehman crisis,(brewing due to under capitalised banks taking risky derivative positions), and didn’t want them to own large Indian banks.

The matter came to a head when HSBC made a bid to acquire Axis Bank in mid-2004. RBI stopped it for an important technical reason. It said any banking entity should have only one kind of presence. HSBC Plc already had branches in India and hence it cannot assume a second presence as owner of an Indian bank. Around the same time RBI brought out a guideline paper on “foreign ownership of Indian banks” which stated that 1. No bank can have more than one form of presence and 2) that a foreign bank would not be allowed to own more than 10% in an Indian bank until 2009. After this 5-year period RBI would review the rules. In 2008 came the Lehman crisis and all banks on both sides of the Atlantic saw huge losses, fell short on capital and started to withdraw capital aggressively from their branches and subsidiaries in emerging economies. EM countries including India realised that entrusting any sizeable part of their banking to foreign banks opened them to the danger of sudden shortage of banking capital. RBI never changed the foreign bank ownership guidelines in 2009. In fact, they became more wary of foreign banks.PRIVATE BANK OWNERSHIP RULES

The rules on ownership of private banks by foreign banks also get intertwined with the more general ownership rules governing private banks. The Indian government and RBI want banks to have a diversified ownership so that no one entity has too much influence on the bank’s deposits. Here’s the logic: Assume Mr ABC has a 50% stake in a bank whose total capital is Rs 8. Now for every 8 rupees a bank can raise Rs 92 as deposits, due to the 8% capital adequacy rule. In effect for a 100 rupee loan, Mr ABC has full control with a 50% capital ownership, although he has brought only 4 rupees to the table. In short, banks being leveraged institutions, a dispersed ownership made for checks and balances, per RBI.

Hence when new bank licences were given out in 2003, promoters were allowed to start with a 50% stake but had to bring it down to 15% in 15 years. This same 15% limit applied to foreign banks as well. This limit was later raised to 26% for Indian promoters.

FIT & PROPER RULES

There are more rules: any entity can acquire only 4.99% stake in a private bank. For a higher stake it needs to get a “fit & proper” approval from RBI. The idea is to prevent questionable parties from getting control over a bank’s deposits. This rule was occasioned by the many examples of siphoning by some promoters of old private sector banks. After the first “fit & proper” approval from RBI before crossing 5%, entities have to seek RBI nod when crossing the 10% mark and the 15% mark as well. But now with private sector bank promoters allowed to own 26%, perhaps the RBI governor was right in questioning why the fuss over allowing a widely held foreign bank to own 26% in an Indian bank.

NOT REGULATORS, BUT FOREIGN BANKS RESIST

Technically today, a foreign bank can own even 51% in an Indian bank. But as said before, the Banking Regulation Act doesn’t allow a single entity to have more than 26% voting rights in a bank. Foreign banks wanting to buy large stakes in Indian banks baulk at this rule. They can’t convince their shareholders that they will buy 50% stake in an Indian bank but will get only 26% voting rights. Partly for this reason and partly because of RBI’s rule of diversified ownership no foreign bank has so far tried to buy a large stake in an Indian bank

EXCEPTIONS TO THE 26% LIMIT

Although RBI generally doesn’t like one entity to own more than 26% in a bank, it made exceptions for troubled banks. Fairfax, the fund run by angel investor Prem Vatsa was allowed to buy 51% stake in the troubled Catholic Syrian Bank (now called CSB), although Fairfax had only 26% voting rights. Banking experts believe Japanese bank SMBC may also be given RBI’s fit & proper nod to buy 26% in Yes Bank

And now, after the RBI governor’s statement to CNBCTV18, it appears any foreign bank will be allowed to buy 26% stake in any Indian bank. Indeed it can buy more, but its voting rights will be restricted to 26%.

So now two asks rise:

Can the 20% cap on foreign investment in PSU banks be removed.
Can the voting rights cap of 26% be removed if the owner is a widely held well run bank that passes the RBI’s fit & proper muster.

Both require amending Acts. The Banking companies Act for number 1. And the Banking Regulation Act for number 2. The government, sources say is awaiting RBI’s review of the entire bank ownership rules. This will take time. Secondly, removing the 26% voting cap on foreign banks but not on Indian promoters will trigger a public debate. Changing these rules could cost the government some political capital as it will be accused of selling out to foreign forces. Also there is the old argument of “why give away our lucrative market to foreign banks, especially at a time when every country is raising tariff barriers on other sectors.

However if one has only the good of the banking sector in mind, removing the 26% cap on foreign banks wanting to own an Indian bank may be good because it will bring much needed capital for Indian banks to grow.

Let us see when the RBI review paper comes out and what it says.