Although there are 27 PSBs, in a way they are all same and the virtual monopoly of the public sector in India’s banking scene is giving rise to demands for greater competition. It is in this context that the former governor of Reserve Bank and currently chairman of the Prime minister’s economic Advisory council, Dr C. Rangarajan, observed last week that Indian banking needs greater competition. That means we need to open up the banking industry window a little more to allow fresh players. This demand is now on the way to being met with the Reserve Bank issuing draft guidelines for giving licences for new banks last week.

The idea of giving new bank licences and admitting new banks has been in the air for at least a year now. Exactly a year back, in August 2010, Reserve Bank had released its “Discussion Paper on New Bank Licences” inviting comments on the policy issues relating to allowing fresh players into banking. Easy say that after over forty years it is time to admit new banks, this is fraught with grave concerns as well. After all, banking is not like any other industry. Financial sector plays a critical role in the economy and any disruption in any part of the financial architecture of an economy can have impact on the entire economy. The recent history of financial melt-down in the developed economies once again is a grim reminder.

The draft policy resolves one of the key questions that were raised in the RBI discussion paper, that is, whether private corporate sector should be allowed to float new banks. It allows the private corporate sector to start new banks under some very strict conditions. These include stipulations that promoter groups having assets or income from real estate or broking business in excess of 10% will not be eligible to float a bank. Besides, there are provisions which seek to maintain an arms’ length relation between the promoter groups and the banks. For example, any exposure of the bank to a promoter group company in excess 10% shall not be permitted or exposure in exposure in excess of 20% to the entire group of companies will be ineligible. Similarly, half of the directors of the banks shall be independent ones.

Just before the new bank licensing policy was announced the Reserve Bank governor had expressed his reservations about “self-dealing” by private corporate promoters if they are allowed to promote new banks. There are very many other concerns as well, such as, conflict of interests between bank shareholders and depositors. While shareholders will prefer risk taking for higher gains, bank depositors will surely ask for safer investments to protect their money in the banks. The cases of some of the big banks which faced bankruptcy in course of the financial melt-down are illustrative of the dichotomy of interests between shareholders and depositors.

While the discussions paper had examined in detail the pros and cons of each of these subjects, the most sensitive issues are whether private coporates should be allowed to float new banks and what should be their voting shares. When governor Subbarao referred to possibilities of “self-dealing” he was making a pointed reference to such collusion, between a promoter group and a bank, in the event of allowing private corporate entry into banking. Currently, the provision is that a bank cannot give loans or have transactions with an entity in which any of its directors is interested. Thus, if a company does not have a common director with a bank which it is promoting, there is no bar to the bank giving it funds. This is self-dealing. This can go against the interest of say banks depositors. Capturing the essence of the problem MrSubbarao observed: “By far the biggest apprehension is about self-dealing”.

Private corporate promoters can further hide any self-dealing through an elaborate structure of cross holdings and corporate structures. The promoted banks could therefore turn into private pool of funds for corporate purposes. There would be no harm as long as things are going fine. However, in times of crisis unless funds are spread among a wide variety of private companies risks tend to get concentrated. Therefore too much funds into a single or handful of groups become vulnerable to the fortunes of these limited borrowers. Banks can fail with such corporate. This would spell disaster for the individual depositors.

At the same time, if the private corporates are debarred from floating banks, there might not be very many serious promoters who can float a really sound new bank. For one, banks cannot be floated with small core funds as equity. A new bank must start with a sufficiently large capital base –the draft policy states Rs500 crore-- to be a meaningful player. Such funds could come only from large corporate houses not from any other sources. It is well know that large houses including the Ambanis, Aditya Birla Group, Tatas are all in the running for banking licences. Of these, Tatas had at least one large bank at the time banks were taken over by the government in late ‘sixties. So also had the Birlas which had the third largest bank in their stable at the time of nationalization. Equally important, they have the talent pool to run such operations professionally and with competence.

If new private sector banks are to be allowed, it is inescapable that private corporates should be allowed to enter. Hence, what is needed is to introduce fool-proof rules and regulations for securing water-tight segmentation of banking activities from other activities of a group. The requirements of an arm’s length segregation will call for changes in the current laws and more stringent rules have to be put in place than only the bar on common directors. Besides, RBI’s supervisory powers will also have to be augmented to go into the accounts and funds flows of group companies.

In the end, the future structure of India’s banking industry will evolve as new banks start functioning. No amount of a priori moves will ensure such an healthy separation between promoter groups and India’s new private sector banks. The proof of the pudding will be in eating. Only hope is that so far the Reserve Bank of India has proved to be an eager, careful and cautious guardian of Indian banking. (IPA Service)