Corporate cos in banking is recipe for crony capitalism: Experts

The RBI’s Internal Working Group (IWG) recently made a radical recommendation: it proposed to allow Indian corporate houses into banking. The proposal has invited all-round criticism from banking experts on the ground that it would lead to crony capitalism and eventual financial instability.

The IWG recommendations talked about necessary amendments to the Banking Regulation Act before allowing corporate into banking. The IWG was set up to review extant ownership guidelines and corporate structure for Indian private sector banks. The RBI panel had proposed that large corporations may be permitted to promote banks, as well as raising the cap on promoters’ stake in private sector banks to 26%, from 15% at present.

‘Connected lending’

In scathing observations, three lead economists Ahankar Achrya, Vijay Kelkar and Arvind Subramanian have said permitting industrial houses to own banks can undermine economic growth and democracy. Kelkar is former finance secretary and Acharya and Subramanian are former chief economic advisors.

In a joint article in The Indian Express, they said the problem with banks owned by corporate houses is that they tend to engage in connected lending. “This can lead to three main adverse outcomes: over-financing of risky activities, encouraging inefficiency by delaying or prolonging exit; and entrenching dominance,” they wrote.

“First, lending to firms that are part of the corporate group allows them to undertake risky activities that are not easily financeable through regular channels,” they said. “Since these activities are risky, they often do not work out,” they said, adding, ultimately it’s the tax payer who has to foot the bill.

“In principle, connected lending can be contained by the regulatory authority. Indonesia tried to do this, but it banned the practice,” they wrote. “But the authorities there found to their dismay that no matter how often they tightened the definition of connected lending, conglomerates were always able to find loopholes,” they said. “It is also why Indian policy makers have consciously and wisely drawn a Lakshman Rekha between banking and industry,” the three experts wrote.

Also read: Lakshmi Vilas Bank’s collapse highlights lack of RBI supervision

‘Why now?’

Former RBI governor Raghuram Rajan and former RBI deputy governor Viral Acharya said the proposal is a “bad idea”. Rajan is currently Katherine Dusak Miller Distinguished Service Professor of Finance at The University of Chicago Booth School of Business and Acharya is a professor at the Stern School.

In a note published on Monday on Linked, they asked: Why now? “Have we learnt something that allows us to override all the prior cautions on allowing industrial houses into banking?” they asked.

As in many parts of the world, banks in India are rarely allowed to fail – the recent rescue of Yes Bank and of Lakshmi Vilas Bank are examples. For this reason, depositors in scheduled banks know their money is safe, which then makes it easy for banks to access a large volume of depositor funds. The rationale for not allowing industrial houses into banking is then primarily two.

First, industrial houses need financing, and they can get it easily, with no questions asked, if they have an in-house bank. The first question is: how can the bank make good loans when it is owned by the borrower? Even Regulators in such cases can succumb to either political pressure or the urgency of the moment, they said.

The second reason is that it will further exacerbate the concentration of economic (and political) power in certain business houses. Even if banking licences are allotted fairly, it will give undue advantage to large business houses that already have the initial capital that has to be put up. Moreover, highly indebted and politically connected business houses will have the greatest incentive and ability to push for licences. That will increase the importance of money power yet more in our politics, and make us more likely to succumb to authoritarian cronyism, the two former top RBI officials said.

Former chief economist of World Bank Kaushik Basu said on Thursday the RBI working group’s proposal is a ‘good-looking’ step in a ‘bad direction.’ Basu, who was also chief economic adviser during the UPA period, said at first sight, this may look good because the close connection between industrial corporations wanting to borrow and banks wanting to lend speeds up lending activities and makes the banking sector look more efficient.

“But such connected lending is almost invariably a step towards crony capitalism, where a few big corporations capture the business space in the country, slowly edging out the smaller players. “Also, connected lending can lead to eventual financial instability,” he argued.

‘Skepticism lingers’

S&P Global Ratings on Monday (November 23) too expressed skepticism over the recommendation. The American credit rating agency said that it is fraught with risk given India’s weak corporate governance in the wake of large corporate defaults over the past few years.

The agency further added that the RBI’s internal working group’s concerns regarding the concentration of economic power, as well as financial stability in permitting corporate houses to own banks, are some of the potential risks.

The agency believes the RBI will be faced with several challenges in supervising non-financial sector entities at a time when the health of financial sector is weak.

“We are, however, skeptical of allowing corporate ownership in banks given India’s weak corporate governance amid large corporate defaults over the past few years,” S&P said in a statement.

“In our view, the working group’s concerns regarding conflict of interest, concentration of economic power, and financial stability in allowing corporates to own banks are potential risks. Corporate ownership of banks raises the risk of intergroup lending, diversion of funds, and reputational exposure. Also, the risk of contagion from corporate defaults to the financial sector increases significantly,” S&P said.

The performance of India’s corporate sector over the past few years has been weak with large corporate defaults, it said adding that non-performing loans (NPLs) for the corporate sector stood at around 13% of total corporate loans as of March 2020 (around 18% as of March 2018), highlighting the more pronounced risk in India compared with other countries.

Also read: Giving banking licenses to corporate houses retrograde: CPI

The US-based rating agency, however, said RBI panel’s recommendations on awarding new licences to well-managed Indian non-bank financial companies (NBFCs) could improve financial stability.

S&P said the recommendation to harmonise licensing guidelines for all banks, new and old, will help restore a level playing field for all players.

Brokerages too believe that while it may take time for corporate-promoted banks to be set up, some of the other proposals could take effect relatively sooner.

Macquarie Securities said at a time when bank failures are increasing in India, the decision to distribute licences could be controversial. “We expect RBI to exercise caution in this regard,” it said.

Investec said the RBi recommendation could be the most sweeping regulatory change if enacted in present form. “We believe that RBI will be cautious in awarding banking licenses to corporates with no experience in financial services. In failing to become a bank, large NBFCs might face more stringent regulations. This is generally negative for large NBFCs.”