13 Reasons RBI Shouldn’t Allow Large Corporates/Industrial Houses to Own Banks

Apna hi ghar phoonk rahe hain kaisa inquilab hai.

— Hasrat Jaipuri, Mohammed Rafi, Mukhesh, Ravindra Jain and Naresh Kumar, in Do Jasoos.

Should large corporates/industrial groups be allowed to own banks? An internal working group (IWG) of the Reserve Bank of India (RBI), thinks so. I had dwelled on this issue sometime last week, but that was a very basic piece. In this piece I try and get into some detail.

The basic point on why large corporates/industrial groups should be allowed into banking is that India has a low credit to gross domestic product (GDP) ratio, which means that given the size of the Indian economy, the Indian banks haven’t given out enough loans. Hence, if we allow corporates to own and run banks, there will be more competition and in the process higher lending. QED.

Let’s take a look at the following chart, it plots the overall bank lending to GDP ratio, over the years.


Source: Centre for Monitoring Indian Economy.

The above chart makes for a very interesting read. The bank lending grew from 2000-01 onwards. It peaked at 53.36% of the Indian GDP in 2013-2014. In 2019-20 it stood at 50.99% of the GDP, more or less similar to where it was in 2009-10, a decade back, at 50.97% of the GDP. Hence, the argument that lending by Indian banks has been stagnant over the years is true.

But will more banks lead to more lending? Since 2013, two new universal banks, seven new payment banks and ten new small finance banks have been opened up. But as the above chart shows, the total bank loans to GDP ratio has actually come down.

Clearly, the logic that more banks lead to more lending is on shaky ground. There are too many other factors at work, from whether banks are in a position and the mood to lend, to whether people and businesses are in the mood to borrow. Also, the bad loans situation of banks matters quite a lot.

In fact, even if we were to buy this argument, it means that the Indian economy needs more banks and not necessarily banks owned by large corporates/industrial houses, who have other business interests going around.

Also, the banks haven’t done a good job of lending this money out. As of March 2018, the bad loans of Indian banks, or loans which had been defaulted on for a period of 90 days or more, had stood at 11.6%. So, close to Rs 12 of every Rs 100 of loans lent out by Indian banks had been defaulted on. In case of government owned public sector banks, the bad loans rate had stood at 15.6%. Further, when it came to loans to industry, the bad loans rate of banks had stood at 22.8%.

Clearly, banks had made a mess of their lending. The situation has slightly improved since March 2018. The bad loans rate of Indian banks as of March 2020 came down to 8.5%. The bad loans rate of public sector banks had fallen to 11.3%.

The major reason for this lies in the fact that once a bad loan has been on the books of a bank for a period of four years, 100% of this loan has been provisioned for. This means that  the bank has set aside an amount of money equal to the defaulted loan amount, which is adequate to face the losses arising out of the default. Such loans can then be dropped out of the balance sheet of the banks. This is the main reason behind why bad loans have come down and not a major increase in recoveries.

This is a point that needs to be kept in mind before the argument that large corporates/industrial houses should be given a bank license, is made.

There are many other reasons why large corporates/industrial houses should not be given bank licenses. Let’s take a look at them one by one.

1) The IWG constituted by the RBI spoke to many experts. These included four former deputy governors of the RBI, Shyamala Gopinath, Usha Thorat, Anand Sinha and N. S. Vishwanathan. It also spoke to Bahram Vakil (Partner, AZB & Partners), Abizer Diwanji (Partner and National Leader – Financial Services EY India),  Sanjay Nayar (CEO, KKR India), Uday Kotak (MD & CEO, Kotak Mahindra Bank.), Chandra Shekhar Ghosh (MD & CEO, Bandhan Bank) and PN Vasudevan (MD & CEO, Equitas Small Finance Bank).

Of these experts only one suggested that large corporates/industrial houses should be allowed to set up banks. The main reason behind this was “the corporate houses may either provide undue credit to their own businesses or may favour lending to their close business associates”. This is one of the big risks of allowing a large corporate/industrial house to run a bank.

2) As the Report of the Committee on Financial Sector Reforms (2009) had clearly said:

“The selling of banks to industrial houses has been problematic across the world from the perspective of financial stability because of the propensity of the houses to milk banks for ‘self-loans’ [emphasis added]. Without a substantial improvement in the ability of the Indian system to curb related party transactions, and to close down failing banks, this could be a recipe for financial disaster.”

While, the above report is a decade old, nothing has changed at the ground level to question the logic being offered. Combining banking and big businesses remains a bad idea.

3) Let’s do a small thought experiment here. One of the reasons why the government owned public sector banks have ended up with a lot of bad loans is because of crony capitalism. When a politician or a bureaucrat or someone higher up in the bank hierarchy, pushes a banker to give a loan to a favoured corporate, the banker isn’t really in a position to say no, without having to face extremely negative consequences for the same.

Along similar lines, if a banker working for a bank owned by a large corporate or an industrial house, gets a call from someone higher up in the hierarchy to give out a loan to a friend of a maalik  or to a company owned by the maalik, will he really be in a position to say no? His incentive won’t be very different from that of a public sector banker.

4) As Raghuram Rajan and Viral Acharya point out in a note critiquing the entire idea of large corporates/industrial houses owning banks: “Easy access to financing via an in-house bank will further exacerbate the concentration of economic power in certain business houses.” This is something that India has had to face before.

As the RBI Report of Currency and Finance 2006-08 points out:

“The issue of combining banking and commerce in the banking sector needs to be viewed in the historical perspective as also in the light of crosscountry experiences. India’s experience with banks before nationalisation of banks in 1969 as well as the experiences of several other countries suggest that several risk arise in combining banking and commerce. In fact, one of the main reasons for nationalisation of  banks in 1969 and 1980 was that banks controlled by industrial houses led to diversion of public deposits as loans to their own companies and not to the public, leading to concentration of wealth in the hands of the promoters. Many other countries also had similar experiences with the banks operated by industrial houses.”

This risk is even more significant now given that many industrial houses are down in the dumps thanks to over borrowing and not being able to repay bank loans. Hence, the concentration of economic power will be higher given that few industrial houses have their financial side in order, and they are the ones who will be lining up to start banks.

5) Another argument offered here has been that the RBI will regulate bank loans and hence, self-loans won’t happen. Again, this is an assumption that can easily be questioned. As the RBI Report of Currency and Finance 2006-08 points out: “The regulators temper the risk taking incentives of banks by monitoring and through formal examinations, this supervisory task is rendered more difficult when banking and commerce are combined.”

This is the RBI itself saying that keeping track of what banks are up to is never easy and it will be even more difficult in case of a bank owned by a big business.

6) The ability of Indian entrepreneurs to move money through a web of companies is legendary. In this scenario, the chances are that the RBI will find out about self-loans only after they have been made. And in that scenario there is nothing much it will be able to do, given that corporates have political connections and that will mean that the RBI will have to look the other way.

7) There are other accounting shenanigans which can happen as well. As the RBI Report of Currency and Finance cited earlier points out:

“Bank can also channel cheaper funds from the central bank to the commercial firm. On the other hand, bad assets from the commercial affiliate could be shifted to the bank either by buying assets of the firms at inflated price or lending money at below-market rates in order to effect capital infusion.”

Basically, the financial troubles of a large corporate/industrial house owning a bank can be moved to the books of the bank that it owns.

8) If we look at the past performance of the RBI, there wasn’t much it could do to stop banks from bad lending and from accumulating bad loans.  This is very clear from the way the RBI acted between 2008 and 2015. Public sector banks went about giving out many industrial loans, which they shouldn’t have, between 2008 and 2011. The RBI couldn’t stop them from giving out these loans. It could only force them to recognise these bad loans as bad loans, post mid-2015 onwards, and stop them from kicking the bad loans can down the road. So, the entire argument that the RBI will prevent a bank owned by a large corporate/industrial house from giving out self-loans, is on shaky ground.

9) Also, it is worth remembering that the RBI cannot let a bank fail. This creates a huge moral hazard when it comes to a bank owned by a large corporate/industrial house. What does this really mean? Before we understand this, let’s first try and understand what a moral hazard means.

As Alan S Blinder, a former vice-chairman of the Federal Reserve of the United States, writes in After the Music Stopped: “The central idea behind moral hazard is that people who are well insured against some risk are less likely to take pains ( and incur costs) to avoid it. Here are some common non financial examples: …people who are well insured against fire may not install expensive sprinkler systems; people driving cars with more safety devices may drive less carefully.”

In the case of a large corporate/industrial house owned bank, the bank knows that the RBI cannot let a bank fail. This gives such a bank an incentive to take on greater risks, which isn’t good for the stability of the financial system.

As the Currency Report points out:

“The greatest source of risk from combining banking and commerce arises from the threat to the safety net provided under the deposit insurance and ‘too-big-to-fail’ institutions whose depositors are provided total insurance and the mis-channeling of resources through the subsidised central bank lending to banks. Because of the safety net provided, the firms affiliated with banks could take more risk with depositors’ money, which could be all the more for large institutions on which there is an implicit guarantee [emphasis added] from the authorities.”

Other than incentivising the other firms owned by the same large corporates/industrial houses to take on more risk in its activities, it also means that now the RBI other than keeping track of banks, will also need to keep track of the economic activities of these other firms. Does the RBI have the capacity and the capability to do so? 

10) Another argument offered in favour of large corporates/industrial houses owning banks is that they already own large NBFCs. So, what is the problem with them owning banks? The problem lies in the fact that banks have access to a safety net which the NBFCs don’t. RBI will not let a bank fail and will act quickly to solve the problem. And that is the basic difference between a large corporate/industrial house owning a bank and owning an NBFC. Also, the arguments that apply to large corporates/industrial houses owning a bank are equally valid in case of them owning NBFCs, irrespective of the fact that large corporates already own NBFCs. Two wrongs don’t make a right.

11) We also need to take into account the fact many countries including the United States, which has much better corporate governance than India, don’t allow the mixing of commerce and business. As the Report of the Committee on Financial Sector Reforms (2009) had pointed out: “This prohibition on the ‘banking and commerce’ combine still exists in the United States today, and is certainly necessary in India till private governance and regulatory capacity improve.”

The interesting thing is that in the United States, the separation between banking and commerce has been followed since 1787.

As the Currency Report points out:

“Banks have frequently tried to engage in commercial activities, and commercial firms have often attempted to gain control of banks. However, federal and state legislators have repeatedly passed laws to separate banking and commerce, whenever it appeared that either (i) the involvement of banks in commercial activities threatened their safety and soundness; or (ii) commercial firms were acquiring a large numbers of banks.”

Also, anyone who has studied the South East Asian financial crisis of the late 1990s would know that one of the reasons behind the crisis was allowing large corporates to own banks.

12) This is a slightly technical point but still needs to be made. Banks by their very definition are highly leveraged, which basically means the banking business involves borrowing a lot of money against a very small amount of capital/equity invested in the business. The leverage can be even more than 10:1, meaning that the banks can end up borrowing more than Rs 100 to go about their business, against an invested capital of Rs 10.

On the flip side, the large corporates/industrial houses have concentrated business interests or business interests which are not very well-diversified. Hence, trouble in the main business of a large corporate can easily spill over to their bank, given the lack of diversification and high leverage. This is another reason on why they should not be allowed to run banks.

13) As Raghuram Rajan and Viral Acharya wrote in their recent note: “One possibility is that the government wants to expand the set of bidders when it finally sets to privatizing some of our public sector banks.”

This makes sense especially if one takes into account the fact that in recent past the government has been promoting the narrative of atmanirbharta.

In this environment they definitely wouldn’t want to sell the public sector banks to foreign banks, who are actually in a position to pay top dollar. Hence, the need for banks owned by large corporates/industrial houses looking to expand quickly and willing to pay good money for a bank already in existence.

Given this, the government wants banks owned by large corporates/industrial houses in the banking space, so that it is able to sell out several dud public sector banks at a good price. But then this as explained comes with its own set of risks.

 

To conclude, the conspiracy theory is that all this is being done to favour certain corporates close to the current political dispensation. And once they are given the license, this window will be closed again. Is that the case? On that your guess is as good as mine. Nevertheless, if this is pushed through, someone somewhere will have to bear the cost of this decision.

As I often say, there is no free lunch in economics, just that sometimes the person paying for the lunch doesn’t know about it.

Aa gaya aa gaya halwa waala aa gaya, aa gaya aa gaya halwa waala aa gaya
— Anjaan, Vijay Benedict, Sarika Kapoor, Uttara Kelkar, Bappi Lahiri and B Subhash (better known as Babbar Subhash), in Dance Dance.

How to Run Public Sector Banks Well Without Privatising Them. And Why That’s Not Going to Happen

As of March 31, 2020, the total bad loans of public sector banks stood at Rs 6,78,318 crore. This is a drop of 24.3% from a peak of Rs 8,95,600 crore as of March 2018. Bad loans are largely loans which haven’t been repaid for a period of 90 days or more.

So how did bad loans of public sector banks come down by nearly a fourth? First and foremost, as of March 31, 2018, IDBI Bank, the worst performing bank when it comes to bad loans, was a public sector bank. From January 21, 2019, the bank was categorised to be a private bank. Accordingly, its bad loans moved to the overall bad loans of private banks. But we need to remember IDBI Bank is owned by the Life Insurance Corporation of India, that makes it as close to being a private bank, as Indian Chinese food is close to the real Chinese food.

As of March 31, 2020, the overall bad loans of IDBI Bank were Rs 47,272 crore. If we add this to the bad loans of public sector banks, the real bad loans of public sector banks work out to Rs 7,25,590 crore (Rs 6,78,318 crore + Rs 47,272 crore). This means that the real fall in bad loans of public sector banks in the two-year period has been around 19% and not 24.3%, as we originally calculated.

So, bad loans worth Rs 47,272 crore came down, simply because IDBI Bank got recategorised as a private bank.

Let’s move to the next point. Take a look at the following chart, which basically plots the bad loans of public sector banks over the years. The bad loans of IDBI Bank are included in this chart.

India’s Manhattan

Source: Centre for Monitoring Indian Economy and Indian Banks’ Association.

As I elaborate in detail in my book Bad Money, the RBI practiced regulatory forbearance between 2011 and 2014 and did not force public sector banks to recognise their bad loans as bad loans, even though they had started to appear by then. In simple English, regulatory forbearance, essentially means the central bank looking the other way from the problem.

An asset quality review (AQR) was launched in mid 2015 and this forced banks to recognise their bad loans as bad loans. As you can see in the chart, the overall bad loans of public sector banks take a huge jump post 2014-15. This was the AQR at work.

Now loans which have been bad loans for four years can be dropped from the balance sheet of banks by way of a write-off. Hence, many loans which had been categorised as bad loans in 2015-16 would have spent four years on the balance sheet by 2019-20.

Accordingly, they got written off from the balance sheet of banks. Of course, before such bad loans are written off, a 100 per cent provision needs to be made for these bad loans. This means that banks need to set aside money to meet the losses arising from these loans. This essentially led to the overall bad loans of banks coming down as well.

And over and above this, the banks would have managed to recover a portion of the bad loans (which includes bad loans that have been written off as well). The overall recovery rate for banks through various recovery channels during 2018-19 was around 15.5% of the amounts involved. (Numbers for 2019-20 aren’t currently available or at least I couldn’t find them anywhere).

In fact, a bulk of the current accumulated bad loans will disappear from the balance sheets of public sector banks over the next two to three years, thanks to the fact that bad loans can be written off after they have spent four years on the balance sheet.

Nevertheless, the question is: even after this can the public sector banks operate in a healthy way where they don’t need to be constantly recapitalised. In fact, once public sector banks get around to identifying post-covid bad loans early next year, their balance sheets are likely to come under stress again.

But the basic problem of public sector banks remains interference by the government. This interference can take several forms. As Viral Acharya and Raghuram Rajan write in a research paper titled Indian Banks: A Time to Reform?: “Interference, including appointing favoured candidates to management, expanding lending just before elections, or directing banks to lend to favoured borrowers is obviously harmful.” (Again, something I discuss in great detail in my book Bad Money).

To ensure that public sector banks do not face this kind of interference it has been suggested that they need to be privatised. Over and above this, there have been news reports which suggest that the government is looking to privatise public sector banks.

This remains a difficult decision politically. Also, in an economic environment like the one prevailing, there will be fairly limited number of firms looking to buy government banks saddled with a huge amount of bad loans and a section of employees not used to the idea of working.

Further, unlike other public sector enterprises, the government has to be even more careful while selling a bank. As Acharya and Rajan write:

“The experience in other countries with allowing corporations to own banks is that it increases the possibility of self-dealing within the group – the bank is used to make risky loans to failing group entities, and the bill is paid by the tax payer when the bank is eventually bailed out.”

They further say that the Indian industry is already heavily concentrated. As a recent McKinsey Knowledge Centre report titled India’s turning point An economic agenda to spur growth and jobs points out: “Our analysis shows that just 20 of the country’s roughly 600 large firms contribute 80 percent of the total profit of large firms.” The report defines large firms as firms with an annual revenue of more than $500 million.

If India’s large corporates end up buying its banks, the industry is likely to get even more concentrated. Hence, while privatisation of public sector banks remains a good idea over a long-term, currently, the government can initiate the reform process through the Axis Bank model, wherein the government is an investor in banks rather being a promoter.

The Committee to Review Governance of Boards of Banks in India (better known as the Nayak Committee, after its chairman, PJ Nayak) which presented its report to the RBI in May 2014, suggested the Axis Bank model.

Axis Bank was originally called UTI Bank. It was set up in 1993. It was owned by the Unit Trust of India (UTI) and a clutch of public sector banks. Even though ownership was 100 per cent in the public sector, the bank got a licence to operate as a private sector bank. The bank was listed on the stock exchanges in 1998. UTI Bank was later renamed Axis Bank.

Even at that point of time, the public sector shareholding continued to be the majority shareholding. In early 2000s, when the Unit Trust of India ran into trouble, the government broke it down into two parts. One part became the UTI Mutual Fund and the other was the Specified Undertaking of the Unit Trust of India (SUUTI).

In February 2003, the shareholding of UTI in the bank was transferred to SUUTI. UTI Bank was later renamed Axis Bank.

As the Nayak Committee Report pointed out:

“The Government-as-Investor stance has characterised the control of the Bank, with SUUTI acting as a special purpose vehicle holding the investment on behalf of the Government. The CEO is appointed by the bank’s board, and because the bank was licensed in the private sector, it sets its own employee compensation, ensures its own vigilance enforcement (rather than being under the jurisdiction of the Central Vigilance Commission), and is not subject to the Right to Information Act. SUUTI appoints the non-executive Chairman and up to two directors on the Board, and there is no direct intervention by the Finance Ministry.”

This means that the bank has been run as a proper banking business, without much intervention from the government. Between March 2003 and March 2014, the share price of Axis Bank rose thirty-two times. Over the years, the government has been able to sell its stake in the bank to raise a decent amount of money.

The point being that even though, as per its shareholding, Axis Bank ‘was for many years a public sector bank’, but ‘fortuitously, the bank was licensed at the commencement of its business as a private sector bank’.

The Nayak Committee Report suggests that the government should look at public sector banks as an investment and not as a business it has to run, and follow the Axis Bank model. This essentially means the government reducing the stake in these banks to less than 50 per cent, and letting the bank’s management and its board do their job, like in the case with private sector banks.

But then as the oft-repeated cliche goes, public sector banks are not just about making money. They also need to keep the social objectives of the government in mind. This is something that even Prime Minister Narendra Modi had suggested at the First Gyan Sangam in 2015 (a meeting of bureaucrats, bankers and insurers). As Modi had said on that occasion, while “government interference was inappropriate, but government intervention was needed to further public objectives”.

It’s this line of thought has driven India’s public sector enterprises for seven decades now and gotten them nowhere in the process.

R C Bhargava, the current Chairman of Maruti Suzuki, who was also an IAS officer for a very long time, writes the following in his book Getting Competitive: A Practitioner’s Guide for India:

“The USSR was the pioneer in attempting industrialization along with creating a communist society. It did not succeed. On the other hand, Japan became a highly competitive and industrialized nation and has a high degree of equality and social justice. The policies for regulating and promoting industrial growth do not have any social content in them [emphasis added]. Social equality was a result of the political and industrial leadership understanding that manufacturing competitiveness would be enhanced if there was greater equality and the bulk of the people were enabled to become consumers of manufactured goods.”

What Bhargava, who has worked for long periods of time, both for the government and the private sector, is basically saying is that social objectives of the government shouldn’t become objectives of its enterprises.

This does not mean that the government should do away with meeting its social objectives. Not at all. But what it should do instead is incentivise banks on this front.

As Acharya and Rajan write:

“Perhaps a better approach would be to pay for the mandates (such as reimbursing costs for maintaining branches in remote areas or opening bank accounts for all) so that both private banks and public sector banks compete to deliver on them. This will distance the public sector banks a little from the government. While public sector banks may be given a slightly different set of objectives than private banks (for example, they may put more weight on financial inclusion), their boards should have operational independence on how to achieve the objectives.”

Competition and incentivisation goes a much longer way in delivering services than a government diktat.

The question is, where will the money for all this come from? Allow me to throw a few numbers at you, before I answer this question.

The market capitalisation of the State Bank of India, India’s biggest bank and the biggest public sector bank, is Rs 1.67 lakh crore. The total assets of the bank as of March 2020 were at Rs 41.97 lakh crore. Now compare this to Kotak Mahindra Bank. Its market capitalisation is at Rs 2.53 lakh crore. The total assets of the bank as of March 2020 stood at Rs 4.43 lakh crore.

Hence, in comparison to the State Bank of India, the Kotak Mahindra Bank is a very small bank. But its market capitalisation is almost Rs 86,000 crore more. Why? Simply because Kotak Mahindra Bank is run like a proper bank and the stock market gives it a proper valuation for the same.

Or take the case of HDFC Bank, which has a market capitalisation of Rs 5.80 lakh crore, which is more than all public sector banks put together. Both these well-run banks have much lower bad loans than public sector banks. The overall bad loans of private banks, Yes Bank notwithstanding, are significantly lower than public sector banks even after adjusting for their size.

The point I am trying to make here is that if public sector banks end up being much better run than they currently are, the stock market will give them a higher market capitalisation. And the government can then finance its social objectives by gradually selling the shares it owns in these banks.

Of course for anything like that to happen, the Department of Financial Services in the Finance Ministry which controls the public sector banks, needs to take a backseat. As Rajan writes in I Do What I Do: “Unless PSBs are run like normal corporations, they will not be competitive in the medium term. I have a simple metric of progress here: We will have moved significantly towards limiting interference in PSBs when the Department of Financial Services (which oversees public sector financial firms) is finally closed down, and its banking functions taken over by bank boards.”

But as we all know, bureaucrats don’t take backseats.

Oh and politicians. Let’s not forget them here. Back in 2000, the Atal Bihari Vajpayee government tried to push through the move and dilute the government stake in PSBs to 33 per cent. And it failed. Why?

Vajpayee’s finance minister, Yashwant Sinha, had introduced a bill to reduce the government’s stake in PSBs to 33 per cent. It never saw the light of day. In a 2018 interview, Sinha said: “The parliament and the people were not prepared for such [a] kind of step”.

In fact, all these years down the line, we are still grappling with the same issue.

The more things change…

And I sincerely hope, I am proven wrong on this.