NBFCs

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.

Sahara and Ponzi schemes: What are the parallels?

 J164133002

Vivek Kaul

Dr K M Abraham of Securities Exchange Board of India (Sebi), in his June 23, 2011 order, against two Sahara group companies, Sahara India Real Estate Corporation Limited and Sahara Housing Investment Corporation Limited, had alluded to the possibility of a Ponzi scheme.
In his order Abraham had said “The Learned Counsel, at one point in the submissions before me, mentioned the fact that there are no investor complaints at all, from any investor in the OFCDs (optionally fully convertible debenture) raised by the two Companies. Going by the history of scams in financial markets across the globe, the number of investor complaints has never been a good measure or indicator of the risk to which the investors are exposed. Most major ‘Ponzi’ schemes in the financial markets, which have finally blown up in the face of millions of unsuspecting investors, have historically never been accompanied by a gradual build up of investor complaints.”
A Ponzi scheme is essentially a fraudulent investment scheme where money brought in by the newer investors is used to pay off the older investors. This creates an impression of a successful investment scheme. Of course as long money entering the scheme is greater than the money leaving it, all is well. The moment the situation is reversed, the scheme collapses. (For a more detailed and historical treatment of Ponzi schemes click here).
So does that mean that Sahara is a Ponzi scheme where money is simply being rotated? While there is not enough information available in the public domain to come to this conclusion nevertheless several interesting points can be made.
One of the characteristics of a Ponzi scheme is that the scheme appears to be a genuine investment opportunity but at the same time it is obscure enough, to prevent any scrutiny by the investors. The optionally fully convertible debentures that the two Sahara group companies issued to raise money from nearly 3 crore investors do fall into this category of investment which sounds genuine enough and at the same time is obscure enough to prevent any scrutiny by investors. Further, Sahara raises its money from the lowest strata of the society, a lot of whom do not even have bank accounts. So the chances of questions being asked are very low.
Another characteristic of a Ponzi scheme is that the operators of the Ponzi Scheme persuade the investors to roll over the profits into the next investment cycle. So the returns remain on paper. Since the money remains with the operator the Ponzi scheme keeps running.
This is exactly what was done by a host of Non Banking Financial Corporations (NBFCs) in the nineties. Billboards promising exorbitant rates of return started showing up all over small town India. Money from the later investors was used to pay off the earlier investors. In many cases, once their investments matured, the investors were persuaded to reinvest the principal and interest on the investment back into the scheme.
This seems to be true in case of Sahara by their own admission. As their spokesperson recently told the Business Standard “Right from last 30 years, we have observed that our field workers try their best to pursue the depositors/investors to reinvest in some other scheme of the group because they get their livelihood from that since they earn commission on it. They always impress and hold their introduced depositor/investor by giving best human service throughout the tenure of the scheme.”
Most of the Ponzi Schemes start with an apparently legitimate or legal purpose. Hometrade started off as a broker of government securities, Nidhis were mutually beneficial companies and Anubhav Plantations was a plantations company. They used their apparently legitimate or legal purpose as a façade to run a Ponzi Scheme. Same stands true for the present day Ponzi schemes. Speak Asia was in the magazine and survey business. Emu Ponzi schemes were in the business of rearing and selling emus. And Stockguru claimed to be making money by investing in the stock market.
Similarly Sahara is into a variety of businesses from running hotels to making films and television serials and building homes, which are all legitimate. The money raised by Sahara supposedly finances these businesses. What is questionable however is that are any of these businesses making money? Also has all the money that has been raised put to use?The film business of the company has been scaled down majorly over the years. The listed businesses of the group can’t be said to be doing terribly well either. Very little financial information regarding the group is available in the public domain to perform any reasonable financial analysis on it. (You can access some financial information regarding the group here).
Brand building is also an inherent part of a Ponzi Scheme. MMM, a Russian Ponzi scheme marketed itself very aggressively. In the 1994 football World cup, the Russian soccer team was sponsored by MMM. MMM advertisements ran extensively on state television and became very famous in Russia. Hometrade also used the mass media to build a brand image for itself. It launched a high decibel advertising campaign featuring Sachin Tendulkar, Hrithik Roshan and Shahrukh Khan. When the company collapsed, the celebrity endorsers washed their hands off the saying that they did not know what the business of Hometrade was.
Sahara is the official sponsor of the Indian cricket team. Given this the entire Indian team has been advertising the new Q shop venture of the group. So who are investors more likely to believe while parting with their hard earned money? Sachin Tendulkar, cricketing great and a Member of Parliament, or dull advertisements put out by SEBI asking investors not hand over their money to Sahara Q shop?
In an advertisement headlined “Don’t be forced, don’t be misguided” the Securities and Exchange Board of India (SEBI) had asked investors “not to yield to any pressure from any person, including Sahara or its agents, for converting or switching their existing investments in the bonds to any of the other schemes like Q-shop, etc.”
Sahara also owns the Pune IPL team. It also has a stake in an F1 racing team Sahara Force India, whose other high profile owner is Vijay Mallya.
A final point to remember about Ponzi schemes is that the finally become too big and collapse under their own weight. Let us say someone decides to start a Ponzi scheme with the intention to defraud people.
He gets 100 members to start with and each one of them contributes Rs 10,000 to become a member of the scheme. The members in turn are promised Rs 50,000 back in a period of one year. Given that the scheme is a Ponzi scheme, there is no business model to generate returns and give out the Rs 50,000 promised to each investor. So the guy running the Ponzi scheme has to take the money being brought in by the newer investors to pay off these original investors.
Now every investor has been promised Rs 50,000. To enter the scheme Rs 10,000 is required. Hence to get Rs 50,000 to pay off one original investor, five new investors have to be roped in. Each one of them pays Rs 10,000 each and thus Rs 50,000 is raised to pay off the original investor.
The point to note here is that the Rs 50,000 that each original investor gets is basically the money being brought in by five new investors. Hence, the money gained by the original investors is basically the money brought in by the five new investors. And that is what makes a Ponzi scheme a zero sum game. The original investors gained only because the latter investors were willing to pay. No new wealth has been created.
This also means that to pay off the 100 original investors 500 new investors need to be brought in.
So that’s the first level of the Ponzi.
What happens next?
After the original lot has been paid off, the 500 investors who entered the second level of the Ponzi need to be paid off, to keep the scheme going. To pay off each of these investors five new investors are required, which in total means 2500 investors. If the fraudster running the Ponzi manages to get 2500 or more investors, the scheme continues.
Let us say the fraudster manages to get 2500 investors and each of these investors pays Rs 10,000. The money thus collected is used to pay off the 500 investors of the second round. In the third round 2500 investors have to be paid, for which 12,500 investors need to invest money in the Ponzi scheme.
If the scheme continues successfully by the ninth round nearly 19.5 crore new investors need to be brought in to keep the Ponzi scheme going. India’s population as per the latest census is around 120 crore. This means that for this hypothetical scheme to continue nearly 16% of the population of India needs to invest in it.
So any Ponzi scheme if it becomes sufficiently big has to collapse because the number of people required to keep it running it simply way too big. One way to avoid this to keep get investors to reinvest their money back into the scheme and live to fight another day.
But all Ponzi schemes collapse in the end under their own weight. A mutli level marketing(MLM) kind of Ponzi scheme is a very good example of a Ponzi scheme that ultimately collapses under its own weight.
In an MLM scheme a company appoints independent distributors, who are not employees of the company. The products of the company are sold to the distributors, who not only sell these products to make a profit, but also appoint more distributors and so the cycle goes on.
The company goes about appointing distributors but the catch is that the products the distributors buy rarely get sold and is just there to build a façade of a business model.
A major part of the commission earned by a distributor comes from appointing new distributors to the company, and thus creating a new level. And so the scheme goes on, with newer levels being created. The return to the upper levels comes from creating new levels rather than the sale of the product. The wealth gained by participants at the higher levels is the wealth lost by participants at lower levels.
Like any other Ponzi Scheme there are only a finite number of people who can enter the scheme. So after some time the number of people required to keep the scheme going becomes very large and the scheme goes bust.
As Debashis Basu wrote in a recent column in Business Standard “Now they(MLM schemes) come under the garb of selling you some expensive products or some vague services: gold coins (Gold Quest), lifestyle products (QNet), surveys (Speak Asia), and so on. So, at any time, they have the fig leaf of providing some “value”. Even Amway, Oriflame and Tupperware rely on a model with recruitment and ever-expanding chain. For those at the end of the chain to get some crumbs and to sustain the whole chain, products have to be hugely expensive. Even then, most people make no money. New recruits are shown a dream — what people in the second link of the chain have achieved. But they are not told that no one beyond the top two or three layers really makes any money.”
While Ponzi schemes keep going bust newer ones keep coming and taking their place. This is sad because for the economy as whole, they are undesirable. Every time a Ponzi scheme is exposed, the confidence of the investor in the financial system goes down. Investors become reluctant to part with their money. This in turn hampers the ability of the capitalist system to raise capital for newer ventures.
The attraction of easy wealth is something that investors cannot resist. Ponzi Schemes offer huge returns in a short period of time vis a vis other investments available in the market at that point of time. With good advertising and stories of previous investors who made a killing by investing in the scheme, investors get caught in the euphoria that is generated and hand over their hard earned money to such schemes going against their common sense.
Greed also results when investors see people they know make money through the Ponzi Scheme. As economist Charles Kindleberger wrote in his all time classic Manias, Panics and Crashes “There is nothing so disturbing to one’s well being and judgement as to see a friend get rich”. In a country like India where the per capita income is low the chances of people falling for Ponzi Schemes continue to remain high.
The only way out of this menace is by punishing people who run Ponzi schemes quickly. Rather than assuming investors are knowledgeable about investment opportunities, and instead of providing investors with more information about particular investments, disseminating information about investments gone awry may be a better bet to control this problem.
As Basu writes in his column “The ministry of finance and financial regulators may like to believe that they oversee the financial sector well. They are really deluding themselves. The money people lose in pyramid schemes is a few times the size of equity mutual funds or life insurance plans, on which millions of words are written and thousands of regulatory man-hours are spent. And all the literacy workshops funded by the government and industry would seem such a joke if pyramid schemes are allowed to flourish.”
Hence, its time the government woke up to this and did something about this menace, starting by punishing some of the big boys.

The article originally appeared on www.firstpost.com on December 12, 2012.

(Vivek Kaul is a writer. He can be reached at [email protected])