Report of internal working group of the RBI

Report of Internal Working Group of the RBI

Why in News

• A recent report by an Internal Working Group of the Reserve Bank of India has attracted a lot of attention as well as criticism.
• The IWG was constituted to “review extant ownership guidelines and corporate structure for Indian private sector banks” and submitted its report last week.

What led to Criticism?

• The IWG submitted several recommendations, but one, in particular, has raised a lot of concern.
• This had to do with allowing large corporate/industrial houses to be promoters of private banks.

Why the IWG constituted and what was were its recommendations?

• The banking system in any country is of critical importance for sustaining economic growth.
• India’s banking system has changed a lot since Independence when banks were owned by the private sector, resulting in a “large concentration of resources in the hands of a few business families”.
• To achieve “a wider spread of bank credit, prevent its misuse, direct a larger volume of credit flow to priority sectors and to make it an effective instrument of economic development”, the government resorted to the nationalisation of banks in 1969 (14 banks) and again in 1980 (6 banks).
• With economic liberalisation in the early 1990s, the economy’s credit needs grew and private banks re-entered the picture.
• However, even after three decades of rapid growth, “the total balance sheet of banks in India still constitutes less than 70 per cent of the GDP, which is much less compared to global peers” such as China, where this ratio is closer to 175%.
• Moreover, domestic bank credit to the private sector is just 50% of GDP when in economies such as China, Japan, the US and Korea it is upwards of 150 per cent.
• In other words, India’s banking system has been struggling to meet the credit demands of a growing economy. There is only one Indian bank in the top 100 banks globally by size.
• Clearly, India needs to bolster its banking system if it wants to grow at a fast clip.
• In this regard, it is crucial to note that public sector banks have been steadily losing ground to private banks.
• Private Banks are not only more efficient and profitable but also have more risk appetite.
• It is in this background that the IWG was asked to suggest changes that not only boost private sector banking but also make it safer.
• For the most part, the IWG’s recommendations are unexceptionable in that they bolster prudential norms so that the interests of the depositors are secure and banks and their promoters are not able to game the system.

Why is the recommendation to allow large corporates to float their own banks being criticised?

• Historically, RBI has been of the view that the ideal ownership status of banks should promote a balance between efficiency, equity and financial stability.
• A greater play of private banks is not without its risks. The global financial crisis of 2008 was a case in point.
• A predominantly government-owned banking system tends to be more financially stable because of the trust in government as an institution.
• Moreover, even in private bank ownership, past regulators have preferred it to be well-diversified — that is, no single owner has too much stake.
• More specifically, the main concern in allowing large corporates — that is, business houses having total assets of Rs 5,000 crore or more,
  • • where the non-financial business of the group accounts for more than 40% in terms of total assets or gross income —
    • To open their own banks is a basic conflict of interest, or more technically, “connected lending”.

What is connected lending?

• Connected lending refers to a situation where the promoter of a bank is also a borrower and, as such, it is possible for a promoter to channel the depositors’ money into their own ventures.
• Connected lending has been happening for a long time and the RBI has been always behind the curve in spotting it.
• The so-called ever-greening of loans (where one loan after another is extended to enable the borrower to pay back the previous one) is often the starting point of such lending.
• Unlike a non-bank finance company or NBFC (many of which are backed by large corporates), a bank accepts deposits from common Indians and that is what makes this riskier.
• Simply put, it is prudent to keep the class of borrowers (big companies) apart from the class of lenders (banks).
• Past examples of such mingling — such as Japan’s Keiretsu and Korea’s Chaebol — came unstuck during the 1998 crisis with disastrous consequences for the broader economy.
• In the past, RBI has always frowned upon this suggestion.
• In fact, when the IWG reached out to its set of experts, it found that barring one, all of them “were of the opinion that large corporate/industrial houses should not be allowed to promote a bank”.

Then why recommend it?

• The Indian economy, especially the private sector, needs money (credit) to grow.
• Far from being able to extend credit, the government-owned banks are struggling to contain their non-performing assets.
• Government finances were already strained before the Covid crisis.
• With growth faltering, revenues have plummeted and the government has limited ability to push for growth through the public sector banks.
• Large corporates, with deep pockets, are the ones with the financial resources to fund India’s future growth.

IE