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Banking | The impossible trinity of India’s banking policy

The RBI has three goals: competition, scale and financial stability. Achieving this trinity is near impossible, and the RBI has always had to settle for two of these three goals 

December 09, 2021 / 03:47 PM IST

Last November, a storm brewed in stock markets over an RBI Internal Working Group (IWG) report, constituted to review the ownership structure of Indian Private Sector Banks. The storm was due to one IWG recommendation that the RBI could consider allowing large corporates/industrial houses to become promoters of private banks. A year later, the RBI in a December 2021 press release said that it had accepted 21 of the 33 IWG recommendations, staying silent on the controversial recommendation.

What is it about corporate ownership of banks in India? There is a history which needs to be reviewed to understand the current situation.

Historically, India has been home to moneylenders and indigenous banks, most engaging in commerce and trading. With the advent of British, they started organising both industry and banking under a common roof of the managing agency (MA) system. The first such bank viz. the Bank of Hindustan was organised under an MA by M/s Alexander and Company.

Indians also learnt the trade, and began to organise banking along with industry/commerce. Most of the Indian banks that started in the 19th and early 20th century were under the MA system with industrialists at the helm. It was also fashionable to add industry to the bank name as seen in the case of Syndicate Bank which started as Canara Industrial and Banking Syndicate. Under the MA, banks lent freely, even irresponsibly, to their group companies.

In 1935, the RBI was established, and the regulator prohibited managing agencies in banking. The banks had to reorganise themselves as a separate banking company. However, this did not mean industrialists stopped controlling banks. Industrialists not just remained promoters, but also established banks such as UCO Bank by GD Birla in 1942.

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Post-Independence, policymakers expressed concern over corporates controlling the banking sector, and not channelising funds for national development. The bank boards were filled by corporate directors. In 1969, Prime Minister Indira Gandhi nationalised 14 of the largest private banks. Nationalisation sent a strong signal and corporates stayed away from banking.

Following the 1991 economic reforms, in 1993, the government and the RBI decided to license new private banks to bring more competition to the sector. The 1993 guidelines did not explicitly ban corporates/industrial groups from setting banks. They vaguely said that interested corporates should avoid the shortcomings that existed before nationalisation, such as monopolisation of economic power, cross holdings with industrial group, and so on.

Since 1993, the guidelines have been revised multiple times with different views on corporate ownership of banks. In 2001, the RBI barred corporate/industrial houses from owning banks. However, companies connected directly/indirectly with industrial groups could be promoters, provided their equity was limited to 10 percent.

In 2005, the new guidelines allowed corporates to acquire up to 10 percent in private banks by way of strategic investment. In 2013, it was proposed that banks be held by a holding company, and there was no bar on large corporate/industrial house to be promoters.

In 2016, the RBI decided to award bank licenses in a continuous ‘on tap’ basis. It excluded corporates, but allowed them to invest in banks up to 10 percent. In 2020, the IWG suggested corporates to be given licences after ensuring legislation changes to deal with connected lending. Apart from ownership, the guidelines have also raised minimum capital to open banks overtime from Rs 100 crore in 1993 to Rs 1,000 crore in 2021.

The major objective of the new guidelines was to encourage applications, and award new licences. In 1993, the RBI received 143 applications, accepted 21, of which only 10 resumed operations. Of the 10, two banks were promoted by business groups — Times Bank by Bennett Coleman, and IndusInd Bank by the Hinduja Group. Of the 10, four, including Times Bank which merged with the HDFC Bank, failed.

In 2001, two banks were given licenses: Kotak Mahindra Bank fared well, whereas Yes bank went through a major crisis. In 2013, the RBI received 26 applications including from large industrial groups such as Tata Sons, Bajaj Finserv, Aditya Birla Nuvo. The RBI gave license to just two entities: Bandhan Bank, and IDFC Bank. In 2021, the RBI received four applications, but licenses are yet to be given.

The end result has been that the number of private banks has barely increased. We had 654 private banks in 1947; currently there are just 22. Post-1991-reforms, the share of the private sector in banking has increased to around 30 percent with around 26 percent contributed by new private sector banks. This implies that the increase has been concentrated in a few banks, which is contrary to the original (1991) idea of opening up the banking sector. The concentration has also not led to large banks at a global level, which is a long-standing goal of the government.

Banking-in-India-over-the-decades

The RBI has tried to work around this growing concentration by giving licences to differentiated private banks. In 1999, the RBI awarded 10 licences to Local Area Banks (LABs), In 2014, it awarded 10 licences to Small Finance Banks (SFBs), and 11 licences to Payment Banks (PBs). However, only the SFBs have been successful with all 10 functional, and one new Unity SFB joining the club recently. The RBI has also received six SFB applications. However, only three LABs and six PBs are functional. As these are small entities, they are unlikely to shake up the sector.

One way to bring more competition could be to encourage foreign banks as they constitute barely 2-3% of banking sector. The policy on this front has been muted but RBI allowing foreign owned DBS Bank to buy Lakshmi Vilas Bank has been welcome.

To sum up, in its banking outlook, the RBI has three goals: competition, scale and financial stability. Achieving this trinity is near impossible, and the RBI has always had to settle for two of these three goals. Under nationalisation, scale and financial stability were chosen. Post-1991, the RBI chose competition and financial stability, giving up scale and corporate participation.

The RBI has wisely not given into the temptation of choosing scale and competition as this would mean squandering financial stability. The discussion on Indian private banks has to also think on how we overcome this trinity.

Amol Agrawal is faculty at Ahmedabad University.

Views are personal and do not represent the stand of this publication.
Amol Agrawal is faculty at Ahmedabad University.

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