RBI’s proposal on banks fires up NBFC stocks, but former head Rajan worried

On November 20, the Reserve Bank of India released the Report of the Internal Working Group to Review Extant Ownership Guidelines and Corporate Structure for Indian Private Sector Banks. As markets opened the following Monday (November 23), shares of non banking finance companies (NBFC) shot up spectacularly, obviously buoyed by the expectation that such companies stood a better chance at obtaining a license to function as full fledged banks.

It would appear that this is the deliverance that the NFBCs were expecting, after a bruising two-year run in which they have been under severe pressure to muster liquidity for their operations. The Working Group, which was constituted at the height of the pandemic, submitted its report to the central bank on October 26. The five-member group was headed by P. K. Mohanty, a member of the RBI’s Central Board.

Even as shares of NBFCs — among them even beleaguered ones — flared, a warning shot was fired by two recent helmsmen at the central bank, former Governor Raghuram Rajan and Viral Acharya, former deputy Governor.

In a statement issued on Monday on the professionals’ platform LinkedIn, the duo warned that the move to grant banking licences to NBFCs affiliated with industrial conglomerates would “exacerbate the concentration of economic (and political power) in certain business houses.” While agreeing with some of the Working Group’s suggestions, the duo, however, urged the central bank to keep the proposal to allow industrial houses with interests in the NBFC segment to turn into banks “on the shelf.” “India,” they warned “has seen number of promoters who passed fit and proper test at the time of licensing but then turned rogue.”

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Ever since the collapse of the IL&FS in 2018 triggered a crisis in the Indian NBFC industry, these “shadow banking” companies have scrounged for liquidity. The explosive growth the NBFC industry till then was, in turn, spurred by the collapse in lending by Indian banks in the last few years. Bank lending to industry has been moving at a snail’s pace because they have turned risk averse following the pile up of non performing assets (NPA) in their balance sheets. The withdrawal of this space was filled by the NBFCs.

On Monday, shares of not only the larger NBFCs such as Bajaj Finance, Mahindra and Mahindra Financial Services, and L&T Finance Holdings increased sharply, but even smaller ones such as Shriram Transport Finance and Cholamandalam Finance moved up smartly.

The speculation that NBFCs were particularly likely to be favoured in the grant of fresh banking licenses has been fuelled by the report’s suggestion that large NBFCs be issued licenses. However, it needs to be appreciated that it is not by any means certain that the RBI has approved the recommendations of the group.

Licenses have been issued by the RBI to private banks in three rounds since the first one commenced in 1993, soon after economic liberalisation commenced. There was one round in 2001 and then in 2013. In 2016, the RBI decided to issue licences for private universal banks “on tap”.

The wave of speculation about NBFCs turning into banks lies has been obviously sparked by the Working Group’s recommendation that “well run” large NBFCs with a minimum asset size of ₹50,000 crore “may be considered for conversion into banks.” The only other qualification is that they ought to have been in business for at least 10 years, a condition that would be easily satisfied by the larger ones in the industry.

The Group has also suggested that the cap on promoters’ stake in banks be raised from the current level of 15 per cent to 26 per cent of the voting equity capital in these institutions. Non-promoter shareholding, it suggested, should be subject to a single and inform cap of 15 per cent of voting stock. The Group has also recommended that payments banks with a minimum track record of three years be allowed to convert into small finance banks. It has also suggested that all universal banks function under a non-operative financial holding company. It has also suggested that the minimum net worth for all universal banks be set at ₹1,000 crore to ensure better capitalisation.

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NBFCs have played a vital role, lending primarily to the infrastructure, real estate and auto industry. However, the cascading crisis that started with the fiasco at IL&FS revealed that their collapse could expose the entire financial system to grave danger. The NBFC crisis in 2018, for instance, engulfed not only these companies, but soon enveloped credit rating agencies (which were again shown to have been negligent in their practices), mutual funds and the audit firms that had turned a blind eye to sharp practices in the industry.

There are good reasons why NBFCs, especially the larger ones, would like to turn into banks. One major attraction is the low interest rates on bank deposits, which are in fact currently at a historic low. Unlike banks, NBFCs access to liquidity is at much higher rates of interest, which automatically translate into lower margins in a competitive market. Although it is true the bar for regulation is much higher for banks, which also impose costs on operations, the advantage of scale that a pure banking operation offers is attractive to many of these prospective entrants.

But from a regulatory perspective, the arrival of the new entrants could add to the supervisory burden on the RBI. This is especially significant because there has been criticism that the RBI has been found wanting in quickly checking malpractices and violations of regulations in the banking sector. Critics point to the string of banking frauds and wrongdoing in banks to assert their case. They point out that both the RBI as well as the finance ministry have been negligent in playing their oversight role as. The Finance Ministry — acting through its nominees in bank boards — has proved inept at providing corrective action and the central bank has been found wanting in its key task, that of supervision of banks’ performance. To add more banks, especially those that arise from a suspect pedigree — indicated by the NBFC crisis that is yet to blow over fully — would swell the task of the RBI, they aver.

In fact, although S&P (Standard & Poor’s) Global Ratings said it expected the move to further financial stability, it pointed out that it is “sceptical” of allowing corporate ownership in banks. It explained its apprehension by referring to “India’s weak corporate governance record amid large corporate defaults over the past few years.”

The fact that most of the large Indian conglomerates — from the Tatas and Reliance to the Mahindras — also have an NBFC under their control poses additional systemic risks to the stability of the financial sector. Allowing a large industrial  corporation access to a captive bank would violate a basic premise of banking — maintaining an arms length distance between the owners of funds and their borrowers. The proposals mark a departure from this “conservative” stance in banking regulation. It remains to be seen whether the RBI accepts these proposals.

Rajan and Acharya pointed out that there are good reasons why the arms length formula is regarded as prudential all over the world. Industrial houses, which are periodically scouting for funds, would obviously turn to one that is available in-house as a captive source of finance. The two former central bank officials asked: “How can a bank make good loans when it is owned by the borrower?”

Moreover, Rajan and Acharya pointed out that the RBI in 2016 had prescribed caps on banks’ exposure to industrial groups, which “have been relaxed recently.” The duo also questioned the timing of the move. “Committees,” they pointed out, “are rarely set up out of the blue.” “Is there some dramatic change in perception that it is responding to?” they asked. They also pointed out that all the “experts” that the Group consulted, barring one, were of the view that large industrial houses and corporates ought not be allowed to promote banks. Yet the Group went right ahead and recommended exactly the opposite of what the “experts” had advised it!

The bonhomie that has been characteristic of relations between the RBI and the finance ministry in since the departure of the previous Governor, Urjit Patel, also indicate that much would also depend on how North Block views the significant change of course proposed.