Will NBFCs bite the banking bait?

At long last the banking sector has been opened to the big guns of corporate India. The Budget has had only a day's impact on the market. But the release of final rules on how new bank licenses will be issued will have a longer lasting impact on the economy and financial sector.
But the door has been opened very slightly.

For one, real estate and broking companies stand very little chance of getting past the RBI’s sieve. Even the big guns may be deterred by the many rules to ring-fence banks. The new banks can't lend to their group companies or hold any other kind of investments. Corporate promoters have to own the bank through a holding company which will be owned by listed companies in the group. The promoter will have to list the bank in three years, and bring his stake down to 15 percent in 12 years.
The rules governing NBFC applicants are worse. They have to spin off businesses that can't be done by banks. Secondly, they have to meet CRR and SLR guidelines from day one. Thirdly, they can’t convert their offices in tier 1 cities into branches without RBI’s permission. Again, their promoters have to bring down their stakes to 15 percent in 12 years. 
Corporate India is deep in consultation with lawyers and consultants and they have four months to decide whether the whole exercise is worth their money.
 
CNBC TV 18’s Lata Venkatesh discusses these issues in Indianomics with a panel of three experts, all of whom are intimately connected with the launch of new banks. The panel comprises of AK Purwar, chairman, India Infoline Investments and former chairman, SBI, who could be in the process of buying a powerful Indian group; Naveen Tahilyani, partner, McKinsey & Company who is advising a bunch of corporates on this issue and Ramesh Ramanathan, chairman, Janalakshmi Financial Services, the banker with a conscience who started of in Citibank and is now running a successful urban microfinance institution called Janalakshmi Financial Services. Below is the verbatim transcript of the interview Q: Is it more difficult for a promoter or for an NBFC? Tahilyani: The first thing I would say that it is difficult for everyone. One thing we should talk about a little bit before we get into who stands to gain or lose is that fact that launching a successful new bank in this environment is not easy. We are well past the first era of liberalisation in the early 90’s, and also the period of 2002-03 when two new private sector banks came into being.
If you look at the environment today, whether in terms of customers, competition, or margins, or the requirements that the RBI is asking the new banks to comply with, the first thing I would say is that whoever is going to throw their hat in the ring has to be very clear about the basic question of why the new bank will actually succeed, make money, and be profitable. Q: The paragraph L, which refers to the NBFCs, ends by saying under the above options, the promoters have to set up a non-operative financial holding company (NOFHC) and the NOFHC and the bank should comply with all the requirements laid down in the guidelines. This sounds a little in contradiction to the opening paragraphs, where clearly the RBI says that two kinds of entities will be allowed. One will be these conglomerates and two, promoters of NBFCs. So it looks like they have recognised two different groups. But if the holding company, which is applicable to promoters, also becomes applicable to NBFCs, it is impossible for an NBFC to have its holding company owned by non-financial listed companies. So should we assume that that rule does not apply to NBFCs? Do you have any clarity there? Tahilyani: I think it is early days in terms of the guidelines and their interpretation. But I would say that I see no inconsistency here. I think the RBI is very simply recognising that existing NBFCs can also participate in this opportunity, as they are recognising that there are other candidates who could also participate.
The last thing I would just say is on your point of NOFHC itself. I think the way I interpret that is the NOFHC is a structure to make sure that all assets of any entity whether it is an NBFC or not, come under one umbrella. Also, there is the ability for the RBI to regulate the NOFHC for the purposes of banking supervision because the NOFHC holds the bank under it. I think all the RBI is saying is it doesn’t matter as to what the starting point is, all entities that get these new bank licenses operate under one consistent structure and have one consistent set of guidelines to follow.
_PAGEBREAK_ Q: The charge has been that it is going to be very difficult for new banks, whether they are set up by conglomerates or by non-banking financial companies (NBFCs), to make profits very quickly. Would you agree that this is going to deter people? According to you, will three years be enough to be profitable enough to list the bank? Purwar: Banking is not a business of one or three years. It is a business of 5, 10, 15, 100, 200 years. Therefore, looking at profits in a three-year time frame, and getting it listed in my view is extremely challenging. I don’t think that many NBFCs, or rather any NBFCs would be able to do it unless they have already created a huge platform which is profitable. The one thing they have to do is to adhere to statutory liquidity ratio (SLR) and cash reserve ratio (CRR) requirements. Q: You are saying that making profit within three years is difficult, and in 12 years you have to bring your stake down to 15 percent. So, you are jacked either ways. Even if you work very hard in the third and fourth year and are allowed to list – maybe you are given a year more, like the insurance companies have now been given. What is the incentive if you have to bring your stake down anyway? So, do you think there won’t be too many applicants? Purwar: Everybody would be interested in setting up their banking systems because you get access to very low-cost funds. If you manage things efficiently, then you create value in the long run. Going by certain examples in the Indian economy, particularly HDFC Bank, people do believe that if newly setup banks are run professionally, this will create huge value for everyone involved – every stock owner. Q: HDFC started in 1994, and the terrain is very different now. HDFC itself is the competition now. It could be tough for new banks, but cheap funds would be a very big attraction. Do you think you will really have the benefit of cheap funds? After all, Yes and Kotak – the guys who are last in the line, are now offering 7 percent. Do you think that from day one, the new banks will be at a disadvantage - in that they have to compete with Yes Bank and Kotak Mahindra Bank? Ramanathan: At the heart of all of these answers is going to be the business plan of the entity that’s proposing to get a banking license. The perspective that one will have on all these questions in terms of competitive landscape, the ability to mobilise saving deposits and to be profitable, how long this will take depends on that. In urban India, 70 percent of people don’t have bank accounts, million of micro entrepreneurs are running extraordinary businesses, vibrant enterprises, but cannot access the formal banking system.
I have been a formal banker for a large part of my career and I can tell you that it has taken me 14 years to understand the gaps in our banking system’s coverage in India. If you have the right innovative model you can build a viable, credible, commercially-successful bank from the bottom-up and you can answer all these questions as well.
_PAGEBREAK_ Q: The minimum capitalisation has to be Rs 500 crore. Would this up scaling to Rs 500 crore create a dissonance because you all are operating at a different paradigm? Ramanathan: I am glad that the capital requirement barrier wasn’t brought down. I have consistently maintained for many years now that we should compete on a level-playing field. Those of us who are proponents of saying that there is opportunity for a breakout model in financial inclusion in India need to be able to play with the big boys, and say that we will play by the same rules of capital requirements and so on.
That, to me, is not a constraint. In fact I would argue that those NBFCs which have a different business model and are looking to convert into the structure that the RBI has put out in the guidelines - the opportunity space is a lot easier to be able to take. Lets say a for a company with a balance sheet of a few thousand crore, to transition it and manage the challenges of SLR, CRR and so on are a lot easier than those with balance sheets of Rs 20,000-30,000 crore and more.
It depends on the perspective that one takes in looking at this. I believe very strongly, having examined the guidelines, that the glide path for those who have a different business model is really the one that is going to matter here. Q: It seems like it is going to be extremely difficult to convert an NBFC into a bank,  because that will mean that some of the NBFC activities which is not allowed to a bank will have to be spun-off into another company, and the tier-I offices cannot be converted into branches. Is that therefore the tough way? Would it be easier to start on a clean slate and apply for a license? Tahilyani: If you are an existing NBFC which is looking to convert into a bank or promote a bank, there are certain advantages and disadvantages. The advantages are that you have an engine for profitability already up and running, you have a platform that you can build on as Purwar also earlier mentioned. You have a reach, you have a customer brand which is associated with financial services, and you have parts of technology which are already operating.
Admittedly, you may not have the core banking system, you have risk management systems which are operational and can be extended into what you would like to do. So, there are certain benefits which are already there by the virtue of the fact that you are a well functioning, well-performing NBFC.
On the other hand, as you rightly said, the issues of conversion come to be debated in two dimensions. One dimension which we talked of earlier is the whole asset-liability mismatch and the funding structure of the bank. Let us take a scenario that the CRR, SLR license or the CRR, SLR compliance which has to be done from day one, in which case it does have an adverse drag on profitability.
But in my opinion it can be managed. In terms of the branch expansion, my reading of the Reserve Bank of India (RBI) circular is that the RBI is being very consistent in terms of saying tier-II and below you can convert into bank branches and tier-I potentially can be converted with specific permission from the RBI. However, the new banks will have to maintain a certain ratio which is now the prescription for all banks in the country, that maximum 50 percent of your branches can be in tier-I.
So, most NBFCs will create a business plan which is conforming to this requirement of saying how many tier-II branches do they convert and in that proportion. (Interrupted) Q: Do you think, therefore, that most of the NBFCs will not launch a new bank and will convert? Tahilyani: The technicality around launch a new bank or conversion is one of the structures. (Interrupted)
Q: It is more than that, isn’t it? If someone like Shriram Transport takes a new bank, what does he do with the shareholders of the current NBFC? Divesting several things could be messy for him to do in terms of a legal structure; there is enough mess already with the holding company and question marks over it. So do you think groups like this will prefer conversion?
Tahilyani: That is exactly what I meant, which is that different NBFCs have different starting points that they come from. Many of them already have listed entities which could basically form the kernel of the promoter group of the NOFHC.
Many have cleaner structures to start with, many have more complicated structures to start with and that is the real issue that each individual NBFC will have to work through to say what they want to do.
The main thing I was just saying is that from a business model perspective, RBI has been very clear that any activity which can be done in the bank has to be done departmentally and the exceptions that they are making are para-banking activities. These are of two types. One category is insurance, mutual fund, broking which has to be done outside of the bank, and the other category is leasing, factoring, etc which can be done either within the bank or outside it.