A recent internal working-group paper of the Reserve Bank of India (RBI) on the ownership of private banks in India suggested, "Large corporate/industrial houses may be allowed as promoters of banks only after necessary amendments to the Banking Regulation Act, 1949 (to prevent connected lending and exposures between the banks and other financial and non-financial group entities); and strengthening of the supervisory mechanism for large conglomerates, including consolidated supervision." This has set the proverbial cat among the pigeons. Many commentators, in particular those who have been in senior positions in the RBI, have jumped up to decry the move, calling in question the RBI's ability to manage risks that will arise due to undetected related-party transactions - risks thought serious enough to destabilise the financial system as a whole.
Current status of bank ownership
The banking system in India remains largely government-owned, with some private-sector ownership. In principle, the RBI does not allow large industrial groups to own and manage banks. This restriction arises out of a fear that industrial ownership will induce banks to lend to group companies without adequate risk management and risk pricing - to the detriment of depositors - and will lead to systemic instability.
There are two issues that arise here. As the discussion paper suggests, the Banking Regulation Act needs to be amended to restrict related-party lending. Reporting and surveillance mechanisms need to be enhanced to enable the RBI to detect violations quickly. Is it therefore the case of naysayers that this is not possible in terms of today's technology and reporting requirements?
The other issue is the counterfactual. By not allowing non-financial ownership of banks, has the system become more robust and has it delivered on its objectives of making adequate credit available to the economy to grow without needlessly drawing on bailouts from taxpayers?
There is considerable literature that attempts to analyse performance of banks and financial systems operating under varying ownership regimes. Looking at the conclusions of some of these can throw some light on whether the fears are justified.
A paper on this subject is titled 'Banking Systems Around the Globe: Do Regulation and Ownership Affect Performance and Stability?' - by James R. Barth, Gerard Caprio, Jr., and Ross Levine (1999). The paper goes to the heart of the question we are examining.
"This paper (1) collects and reports cross-country data on commercial bank regulation and ownership in more than 60 countries and (2) evaluates the links between different regulatory/ownership practices and both financial sector performance and banking system stability in these countries." In its conclusions, the paper states (emphasis mine):
"We find no positive effects from restricting the mixing of banking and commerce. We evaluate indicators of (1) the ability of banks to own and control nonfinancial firms and (2) the ability of nonfinancial firms to own and control commercial banks. There is not a reliable relationship between either of these measures of mixing banking and commerce and the level of banking sector development.
While restricting nonfinancial firms from owning commercial banks is unassociated with financial fragility, restricting banks from owning nonfinancial firms is positively associated with bank instability. We find that those countries that restrict banks from owning nonfinancial firms have a robustly higher probability of suffering a major or, even systemic, banking crisis. Thus, one of the major reasons for restricting the mixing of banking and commerce - to enhance financial fragility - is not supported by the evidence presented in this paper."
Government ownership of banks
The same paper quoted above suggests: "On average, greater state ownership of banks tends to be associated with more poorly operating financial systems". La Porta et. al. (2002) find government ownership of banks negatively correlated with financial development and growth. While this has been subsequently challenged, for instance by Svetlana Andrianova et.al (2012), public ownership is not without its issues.
In a paper titled 'The impact of government ownership on bank risk', Giuliano Iannottaa, Giacomo Nocerab, Andrea Sironic (2009) conclude: "First, government-owned banks (GOBs) have lower default risk but higher operating risk than private banks, indicating the presence of governmental protection that induces higher risk taking. Second, GOBs' operating risk and governmental protection tend to increase in election years. These results are consistent with the idea that GOBs pursue political goals and have important policy implications for recently nationalized European banks."
This corroborates an earlier study. Dinc (2005), using evidence from 36 countries, shows that government banks lend more, relative to private banks, in election years.
In another paper 'Financial Development, Bank Ownership, and Growth. Or, Does Quantity Imply Quality? Shawn A. Cole (2008)', the literature survey describes: "Sapienza (2004) and Khwaja and Mian (2004) use micro-level data to compare public and private sector banks in Italy and Pakistan, respectively. Sapienza finds that public sector banks lend at lower interest rates, and with a bias towards poorer areas, compared to private banks, and that some lending appears to be politically motivated. Khwaja and Mian find that government-owned banks are more likely than private banks to lend to firms whose directors or executives have political affiliation, and less likely to collect on these loans.
Cole (2006) demonstrates that government-owned banks in India are subject to substantial government capture, lending more in election years, and targeting these loans to "close" constituencies."
Clearly, government ownership of banks is no guarantee against cronyism. A corporate intent on 'looting' the banking system may be tempted to pay a rent to appropriate managers and controllers of public banks to take loans, without subjecting itself to regulatory oversight and reputational loss by attempting to set up and then loot its own bank.
Commenting on the economic effect of bank nationalisation in India, Cole concludes: "Bank nationalization had no effect on lending growth in the decade following nationalization. This contrasts greatly with estimates from the natural experiment, which show that nationalization led to a 5-10 percent increase in the annual rate of credit growth between 1980 and 1990. This positive effect on financial development was not sustained.
Government ownership did have a lasting effect on the sectoral allocation of credit, leading to increased lending to agriculture and rural areas. It also had a substantial effect on the price and quality of intermediation: markets with more government-owned banks had much higher delinquent loan rates, and lower average interest rates... this increased lending (to agriculture) did not affect agricultural investment, and increased the share of non-performing loans substantially.
The final analysis thus rejects a development view of government ownership of banks.
Government ownership initially increased the quantity, and substantially lowered the quality, of financial intermediation."
If anyone still doubts that government ownership leads to toxic lending, one has only to see the performance of government-owned banks in India over the past 15 years, where almost a third of the corporate book had to be written off.
Following a policy of licensing either professionals or financial companies for setting up private banks has not proven to be a great success. The past three decades are littered with corpses of failed banks - Centurion, Times, Global Trust, to name a few. The ones that survived too have had a chequered history, for example, Yes Bank, where the RBI had to organise a bailout.
On the other hand, several NBFCs that have grown at a rapid clip over the past decade or two have managed to build up large books without compromising quality of lending. A group like Bajaj, where the industrial concern is cash surplus, or the Murugappa group, which is lightly leveraged, has presence across financial services that includes large lending operations. If allowed to convert to banks (with requisite regulatory forbearance to compensate for the increased liquidity requirement), it is unlikely that they will resort to lending that will mar the reputation of the parent companies that have been nurtured over generations.
The RBI has power to select licensors that it considers 'fit and proper'. While it has not shown a great ability to discriminate between those that should be considered 'fit and proper' and those that should not, it does allow the regulator to keep undesirable industrial entities away from banking. On the other hand, allowing those that have a proven record of prudence and good corporate governance can provide the capital and managerial bandwidth to increase credit availability in the system.
The RBI has no issue with foreign capital but somehow seems to not trust Indian entrepreneurs. At a time when the government is promoting 'Atmanirbhar Bharat', perhaps it is time to examine possibilities of an 'Atmanirbhar' banking system. Surely, when India can develop technology tools to identify and execute a direct bank transfer to a migrant labourer, it is not difficult to trace related-party transactions.
Asset-management companies and insurance companies, many of which are owned by industrial houses, too have large lending books that extend corporate loans. These too are required to follow restrictions on related-party investment and SEBI seems to have done a reasonable job of monitoring it. If such monitoring is beyond the ken of the RBI, as the former RBI managers seem to suggest, it may be time to separate banking supervision from the RBI and hand it over to another regulator, perhaps SEBI? The fears of an incompetent regulator cannot surely be reason enough to practise untouchability in bank ownership.
Anand Tandon is an independent analyst.