Evaluating the risks in opening up the banking sector
(20.12.19 to 21.12.19)
Dr. Kembai Srinivasa Rao, Former Director, NIBSCOM
The RBI (Reserve Bank of India) has accepted some of the key recommendations of the Internal Working Group (IWG) to Review Extant Ownership Guidelines and Corporate Structure for Indian Private Sector Banks and provided some leeway for new entrants in the banking sector. In this post, K Srinivasa Rao discusses these recommendations, and contends that these recommendations will strengthen entry norms, while laying a stronger foundation for the expansion of the banking network.
When considering the strategic role of banks in making India “atmanirbhar” 1 (self-reliant), the size and scope of activities of banks needs to be expanded and accelerated by creating a compatible and energised ecosystem – one that is flexible, but also rigorous enough to tackle underlying risks. In a recent speech on the creation of synergies for seamless credit flow and economic growth’, Prime Minister Narendra Modi categorically stated that banks should move from being ‘loan approvers’ to proactively ‘partnering with loan seekers’ to develop a base of wealth-creating entrepreneurs who can potentially create employment opportunities, and help build a self-reliant country.
While the existing network of banks are contributing in a big way towards building the economy, new entrants to the banking system can add a diversified value proposition to the new genre of entrepreneurs, unicorns, and start-ups with innovative business models. The RBI (Reserve Bank of India) has accepted some of the key recommendations of the ‘Internal Working Group (IWG) to Review Extant Ownership Guidelines and Corporate Structure for Indian Private Sector Banks’, and has provided some leeway for new entrants (RBI, 2020, 2021). ‘On-tap’ bank licensing norms, which NBFCs (non-banking financial companies) eligible to convert to banks are required to abide by, are driven by certain important parameters for ensuring financial stability and customer protection. Norms related to minimum initial seed capital, promoter stake, fit and proper criteria, permissible period for listing of the entities, holding company model to keep ownership, and risks associated with conflict of interest, are some of the well-balanced measures. The new norms will provide a safe basis for the entry of new banks, help increase outreach, and make financial inclusion deliver better value to society.
These recommendations will strengthen entry norms and lay a stronger foundation for the expansion of the banking network. Though the aspirations of corporate sector to enter into banking are currently not viewed very favourably, they are also not being outrightly dismissed. Corporate sector entry into banking is still under systemic risk evaluation by the IWG, considering its potential domino impact on the risks to the financial system. Granting bank licences to the corporate sector may lead to a conflict of interest due to the likely diversion of bank funds to their own entities. This would put the financial system at risk, and hence, adequate systemic control will have to be built to mitigate the domino impact of spillover risks to the banking system. No concrete decision has been taken by the RBI so far in allowing corporate sector into banking.
In terms of the recommendations of the IWG, the RBI accepted that the promoter’s stake – currently capped at 15% – could be raised to 26% of paid-up ‘voting equity share capital’ in 15 years but if it is already diluted, it cannot be raised back to 26%. It will apply to those that are in the process of diluting or to new entities. No change has been made to initial lock-in requirements that continue to be a minimum of 40% of the paid-up ‘voting equity share capital’ of the bank for first five years. There are no intermediary limits between 5 and 15 years.
The new norms will make the stakeholding pattern more attractive for new promoters. However, it has been made mandatory for new entities to submit a 26% stake dilution schedule down from 40%, and this dilution process will be monitored by RBI. It will make the new entities more disciplined and shall avoid the kind of litigations that were witnessed earlier.
However, non-promoter shareholding will be capped at 10% of the paid-up voting equity share capital of the bank in case of natural persons and non-financial institutions or entities, and at 15% in case of all categories of financial institutions or entities. The pledge of shares as stake by promoters, while acquiring loans from banks, during the lock-in period, which essentially amounts to bringing the unencumbered promoters’ shares below the prescribed minimum threshold, should be disallowed. Voting rights of such pledgees shall be restricted to 5% till the pledgee obtains the RBI’s permission to regularise the acquisition of these shares. It will prevent entities from seeking outside funds and shall discourage pledging of shares.
From ‘shadow banks’ to banks
Based on the accepted IWG recommendations, NBFCs will be permitted to set up universal banks and small finance banks (SFBs) to enlarge the scope of their operations, and more importantly, access low-cost resources, that is, savings and current deposits. As part of improving risk management architecture in NBFCs, the RBI has prescribed tighter, bank-like regulatory framework for large NBFCs under the new scale-based supervisory dispensation. Under this framework, NBFCs need to have at least 10 years of experience to set up universal banks, and five years for setting up SFBs. The recommendation of the IWG to reduce the minimum experience requirement for converting payment banks into SFBs to three years has not been accepted, and this shall continue to stand at five years along with other conditions. The RBI can impose better regulatory risk management norms but the real challenge is to imbibe appropriate risk management skill-sets among employees of the NBFCs, who will be responsible for handling banking operations after the conversion. Finetuning the employees’ competency to manage risks that a bank will encounter will be a huge challenge for aspiring NBFCs.
Higher capital levels
Bearing in mind the elevated complexity of risks in the banking business, entry-level capital norms have been revised upwards. Higher entry-level capital needs prescribed by the IWG have been accepted. Accordingly, the initial ‘paid-up voting equity share capital’ or the net worth required to set up: (i) A new universal bank, is increased to Rs. 1,000 crore (from the present Rs. 500 crore). (ii) For SFBs, from Rs. 200 crore to Rs. 300 crore. In the context of the convertion of urban cooperative banks into SFBs, the capital requirement has been increased from Rs. 100 crore to Rs. 150 crore (and shall be gradually increased to Rs. 300 crore in five years after convertion).
Higher capital is a known cushion for risk management as is evident from the Basel-III norms2 that imposed an additional 2.5% capital conservation buffer (mandatory from 1 October 2021). The 2008 Global Financial Crisis clearly outlined the linkage of capital with the risk appetite of financial entities. Hence, the new banks will have to proactively maintain capitals levels, preferably higher than the minimum to not only manage the risks of today, but to prepare the bank for future contingencies.
The listing of banks has disclosures as a risk mitigation tool. Once, the entities comply with Regulation 49 of the listing agreement prescribed by SEBI (Securities and Exchange Board of India), it works as a disciplined risk management tool, with transparency and shared information. Taking a cue from the Basel–II norms that works on three pillars – minimum capital adequacy ratio, supervisory review process, and market discipline, the listing norms have been rightly aligned to the capacity of new banks. According to the RBI, SFBs should enlist within eight years from the date of commencement of operations, instead of the IWG recommendations of six years, thus granting them more time. Providing the banks with sufficient time to gain listing capacity is more important than pressurising them to list early. The cap of eight years for mandatory listing will provide time to build resilience for stabilisation, consolidation of operations, and to gain investors’ confidence. But, as per the RBI, universal banks shall continue to be listed within six years of commencement of operations because they need to be better equipped compared to SFBs.
These norms will apply to new applicants after 26 November 2021, and old applications will be processed based on earlier norms. A roadmap for raising the capital levels for existing banks and those to be considered prior to the cutoff date will be prescribed. Thus, old applicants are given the benefit of the entry-level capital requirements that were in force at the time their application was made.
The IWG found the criteria used to assess the “fit and proper” status of promoters and major shareholders, as prescribed in the earlier guidelines, appropriate and these shall continue to be in force. There is no change in these criteria as they are already sturdy to weed out unsuitable applicants.
As far as corporate structure is concerned, while non-operative financial holding companies (NOFHC) are the preferred mode of the corporate structure of a bank, it is made mandatory only for entities where the individual promoters, promoting entities, or converting entities have other group entities. Banks currently under NOFHC will be allowed to exit from the structure if they do not have other group entities under their fold. The new norms clearly state that the NOFHC model need not be followed when the new bank does not have other interconnected entities triggering conflict of interest.
Way ahead: Towards uniformity
As a sustainable step to ensure uniformity, a comprehensive document encompassing all licensing and ownership guidelines will be put in place. If new rules are tougher, legacy banks should also conform to new tighter regulations and transition paths may be finalised in consultation with the affected banks to ensure compliance with the new norms in a non-disruptive manner. This is a correct and timely step to sequence the entry of new universal banks/SFBs with a better capital base so that lending can be activated. The cooperative banks that are brought within the regulatory ambit of the RBI should take a cue from the relaxed criteria to transition into SFBs. They can play a more significant role in shaping up the financial sector by becoming SFBs. With this move, based upon the significant work of IWG, new entities will get the opportunity to be part of the banking business. The new universal banks/SFBs coming from NBFCs, or those being converted from corporative banks can potentially bring diversification. Given their experience of working as NBFCs, when turn into banks, they can bring in different practices in lending operations and recovery of loans, and micro-procedures in customer treatment, that can provide a different experience to customers. This can potentially increase the flow of credit to various sectors of the economy, and can help revive the economy in the short run and contribute to the growth on a durable basis. Thus the new genre of technology-driven capital-intensive banks can play a constructive role in collaborating with the existing players to bring about better synergy – provided the inherent risks are better managed.
But in its new form, capacity-building in risk management in banks – old and potential entities – will assume greater significance to ensure the creation of a larger banking network supported by a stable, sound, and sustainable, integrated banking system. But, this requires capacity-building in NBFCs in line with increased operational freedom. The point of concern is not the lack of regulatory risk-related norms, but creating capacity at the grassroots level to imbibe risk management practices in handling day-to-day business, for pursing a risk-adjusted, sustainable business model. This calls for precision in establishing standard operating procedures at the line-management level, to fine-tune risk management.
In May 2020, Prime Minister Narendra Modi announced a Rs. 20 lakh crore package as part of the Atmanirbhar Bharat Abhiyan to support the country in the time of pandemic and to make India more self-reliant.
Basel-II norms are the international norms for maintaining minimum capital in banks.
Bank of International Settlements (2015), ‘R Gandhi: Future and new thoughts on co-operative banks’.
Reserve Bank of India (2020), ‘Report of the Internal Working Group to Review Extant Ownership Guidelines and Corporate Structure for Indian Private Sector Banks’, Report.
Reserve Bank of India (2021), ‘Recommendations of the Internal Working Group to Review Extant Ownership Guidelines and Corporate Structure for Indian Private Sector Banks’, Report.