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Global experience in allowing corporate groups to set up banks reveals that stringent regulation is the best defence against malpractice.

The Reserve Bank of India (RBI) appeared un-consulted when Pranab Mukherjee, the then finance minister, invited new players to set up banks in his Budget speech in February 2010. It surprised many in the central bank because consolidation in the banking sector was the most debated topic in those days.

Now, three years on, it is more or less certain that a new set of players will be allowed to open banks. In contrast to a decade ago when large corporate houses were not permitted to open banks, some groups are widely expected to win licences in this round.

As things stand, the finance ministry clearly wants more banks to showcase its reform drive. It has already indicated that the final guidelines on new bank licensing will be announced, though the precise date is not clear yet.

But it is the RBI that still looks hesitant. Why?

The central bank’s dilemma stems from the fact that industrial groups, if allowed, could undermine the independence of banks. Many, including Nobel laureate Joseph Stiglitz recently, supported this argument and suggested the RBI continue with its practice of not granting banking licences to corporate groups.

Globally, however, it is fairly common to allow industrial houses in the banking business. Only 12 per cent of countries restrict the mixing of banking and commerce, the RBI notes in its discussion paper on new bank licensing (August 11, 2010). All the same, the Indian banking regulator is known to be conservative, and has often been described as “a different BRIC in the wall” when compared to its peers in Brazil, Russia and China. Maybe it has reasons to be different, since the track record in other comparable countries that have allowed industrial groups to float banks is not encouraging.

Consider this: Several banks in Brazil, which permits industrial groups to own banks, appeared vulnerable in the mid-1990s. A study on the Brazilian central bank Banco Central do Brasil’s website reveals that nearly 40 per cent of the banks operating in Brazil in December 1988 did not survive until 2000. Almost half of them withdrew from the national financial system for reasons of liquidation. Even those banks that survived had to cope with serious problems, the study says.

Korea, on the other hand, decided to ban industrial houses from promoting banks after the Asian crisis weakened its financial system.

To be sure, not allowing corporate groups in banking does not necessarily ensure that a crisis can be averted. For instance, the financial crisis of 2008-09 required bailouts of many banks in the US, where industrial companies are not permitted to own banks.

Clearly, the question is not whether corporate groups should own banks or not, but whether the regulatory framework is strong enough to minimise risks of bank failures. In that context, the RBI is justified in demanding more power before allowing industrial groups in the banking business. Parliamentary approval for amending the banking laws is certainly a move in this direction.

Indeed, strict regulations have ensured that Brazilian banks are now less prone to failures. “Banking supervision, which already had a high degree of compliance with Basel Core Principles in 2002, has been strengthened further; it is risk-based, intrusive, and sophisticated, and leverages strong off-site analytics,” the International Monetary Fund (IMF) noted in its assessment of Brazil’s financial system stability in July 2012.

Those deft policy responses and built-in financial system buffers allowed Brazil’s financial system to weather the global crisis of 2008-09 remarkably well, it added.

Several developed nations around the globe do not restrict entry of industrial companies in the banking sector. In Canada, small banks can be owned by single owners and commercial enterprises. Global retailer Tesco has set up a bank in the UK. Industrial groups in Australia, Germany and France are also allowed to set up banks.

But the rules are fairly stringent across most of these countries – caps on voting rights and maximum shareholding, controls on governance, and minimum capital requirements – to restrict concentration of economic power and malpractices.

In Taiwan and Hong Kong, there are standard restrictions on related-party transactions. The regulator in South Africa focuses on the quality and reputation of shareholders, while allowing corporate groups in banking.

Even so, bankers agree that it is a complex task to supervise banks if the promoter is involved in several other businesses where a banking regulator has no jurisdiction. Indeed, arguments among regulators of different sectors (banking and insurance, for instance) are not unknown in India.

So, it is not surprising that the IMF has expressed concerns that the risks of allowing industrial houses in Indian banking sector may outweigh the benefits. But the RBI can draw comfort from the fact that it has been fairly successful in regulating banks and ensuring that the Indian financial system emerged from the global banking crisis relatively unscathed.

Also, by its own admission, experience suggests that large business groups will probably fare better in running a bank profitably than individual investors and banking professionals. “Banks promoted by individuals, though banking professionals, either failed or merged with other banks, or had muted growth. The experience with small banks has not been encouraging. Out of the six local area banks licensed [between 1999 and 2001] only four remain… The remaining two are functioning satisfactorily but their growth has been restrained due to inadequacies of the small bank model,” the RBI admits.

The big question, of course, is whether the deeper pockets of large corporate groups will achieve the financial inclusion that Indian policy-makers crave. It is ironical that despite four decades of bank nationalisation in India, more than 40 per cent of the population still do not have bank accounts.

All in all, there is no doubt that the RBI will ensure that a corporate group meets its “fit and proper” criteria before offering new bank licences. But the central bank must see that applicants that meet the requirements are not made to wait on the pretext of a weak regulatory framework.

Via : Business Standard