The Indian banking and financial services industry has undergone a major transformation in the past 20 years. Yet, there is more to come.
The first major banking reforms happened in the early 1990s - coinciding with the onset of liberalisation. Major changes happened in supervision, capital structuring, risk coverage, and the licensing of new private banks. Since then the Reserve Bank of India, or RBI, has introduced significant changes, covering areas such as ownership structure, riskbased supervision, priority sector lending, to name some.
In response, our banking sector identified key challenges - to manage volumesled scalability issues, implement new risk models, and implement technology.
However, many strategic issues were not handled urgently - shortage of skills, greater focus on compliance by regulators, absence of a significant retail portfolio, asset-liability portfolio mismatches linked to banks' investing in infrastructure projects, the eventual lack of capital to fund future growth, among others.
| Currently Operating Major Foreign Banks...|
... that might seek or need to convert to wholly owned subsidiaries
The spotlight now is on these strategic issues. The Regulator's New Agenda
India's need to sustain its growth trajectory while managing macroeconomic challenges requires strategic banking reforms. One key reform that needs attention is The Banking Laws (Amendment) Bill 2011. Three key features of this bill are:
- Voting rights to investors as per their shareholding in private sector banks, currently capped at 10 per cent.
- Current cap of one per cent maximum investment by an investor in public sector banks is proposed to be increased to 10 per cent. However, any investor seeking more than five per cent stake in a bank will still need RBI's approval.
- Mergers and acquisitions will not need approvals from Competition Commission of India - only from the RBI. This could clear the path for consolidation in the industry.
Key reforms proposed in Banking Laws (Amendment) Bill 2011
- Voting rights in proportion to shareholding in private banks
- Investment cap of 1% in PSU banks to be increased to 10%
- M&As will need only RBI's approval
- Financial holding company needed for all financial services conglomerates
- Subsidiarisation of large foreign banks in the country
- More private sector banks to be allowed entry
- The structure and operating environment for NBFCs to be redefined
The bill also seeks to empower the RBI in multiple ways to improve stability, reduce risk of contagion, and to protect depositors and minority shareholders. The RBI will have the power to supersede a bank's board for a year and to appoint an administrator. The bill also intends to empower the RBI to exercise oversight over associate enterprises or subsidiaries of banks. It will also have the power to inspect the subsidiary or seek information from it as well as impose penalties or sanctions for violations of risk and capital guidelines. The bill also proposes other key reforms.Financial Holding Company (FHC)
Under strict ownership and governance norms, the RBI will expect all finance conglomerates, especially those with a banking entity, to convert to the FHC model. And while conglomerates, without an underlying banking entity, may choose to do so, all new entrants into banking or insurance will be mandated to set up an FHC. Cross-holdings between FHCs, and between banks and FHCs will be strictly enforced.
The RBI expects the FHC to be registered as a non-banking finance corporation, or an NBFC, which will be under the supervision of a separate unit of RBI, with supervisors from other regulators. No intermediate holding companies will be permitted. To ensure availability of capital for subsidiaries, both the FHC and the subsidiaries can be listed as per prevailing regulations and investment limits.
An FHC model will create many structural challenges for existing financial services conglomerates - creating an optimum structure, gaining agreements of existing joint venture partners for the new structures, ensuring the ability to create adequate capital infusion at FHC level, and setting up an appropriate governance structure. Seen in conjunction with emerging guidelines on new private bank licences, the FHC will also have to keep in view the non-operating holding company, or NOHC, structure proposed for new banks.
Foreign banks in India
In 2010, the RBI released a discussion paper for foreign banks to operate as wholly owned subsidiaries. Key changes envisaged are:
Systemically important foreign banks - onshore balance sheet+off balance sheet credit equivalent higher than 0.25 per cent of the industry total - and those that come from jurisdictions that guarantee higher level of protection to depositors in home countries, will need to convert to a subsidiary structure.
Will be treated on par (approx.) with a private bank - modified priority sector lending targets, branch expansion opportunity (automatic approval in Tier IV to VI locations), ability to raise subordinated debt locally, opportunity to list locally and, critically, a possibility to acquire a local bank in the future.
Global Trust Bank, along with Times Bank and Centurion Bank, were awarded licences in the early 1990s but either merged or collapsed. RBI could now have discretionary powers to avoid a similar situation
These changes will have significant impact since large global banks operating in India have always sought an even playing field, specifically around branch expansion.Licences for new private sector banks
In 2010, the RBI released draft guidelines on licences for private banks and opened doors for the following aspirants: existing financial services companies, mostly large NBFCs, with financing and other financial services businesses; and large corporate houses or conglomerates, with or without a captive NBFC, with an ability to invest in a bank. The RBI has, in its model, eliminated entities with high exposures to real estate, construction and capital market investments.
Key features include stringent ownership rules of the NOHC and the underlying bank - fit and proper criteria for promoters, ring fencing the NOHC's capital, and bringing the NOHC, the bank and other financial services businesses into a single regulatory oversight model. While the NOHC must be held entirely by the promoter group, NOHC ownership in the new bank must be at least 40 per cent at the start and reduce to 20 per cent within 10 years. FDI investments in the underlying bank cannot exceed 49 per cent and no one party can hold more than five per cent stake.
Dual presence - bank and NBFC - will not be encouraged. All activities in an NBFC that can be done in a banking department will need to be transferred. New licensees must open 25 per cent branches in Tier V and VI locations, and meet priority sector lending targets, including rural obligations. Exposure to any promoter group entity shall not exceed 10 per cent and aggregate exposure to all group entities shall not exceed 20 per cent of paid-up capital and reserves of the bank. All credit facilities to promoters, their business associates, major suppliers and customers should have minimum security cover of 150 per cent. The bank has to maintain a minimum capital adequacy ratio of 12 per cent for the first three years of its operations.
The guidelines will create a dilemma for financial services groups that are anchored around their financing NBFCs. To convert or not will be decided by issues around the structure, capital requirements, ease of restructuring portfolio, ability to leverage the current base of customers in the bank, capability of the existing organisation to fit into a banking model, among others. The RBI will also use its discretionary powers to prevent situation similar to the early 1990s. Of the seven bank licences issued then, only four survive - HDFC, ICICI, Axis and IDBI. The rest - Times Bank, Centurion Bank and Global Trust Bank - either merged or collapsed.
These guidelines will only be implementable once the Banking Amendment Act is passed in Parliament - to enable the proposed ownership structure to be aligned with the amended act.Redefining the NBFC Structure
Also important is a set of draft recommendations for NBFCs. Key highlights include - any change in control or transfer of an NBFC-ND (non-deposit taking NBFC) or NBFC-D (deposit taking NBFC) beyond 25 per cent of paid-up capital will need RBI approval, while NBFCs-ND with assets of less than Rs 50 crore will be encouraged to deregister. Minimum capitalto-risk weighted assets ratio to move to 15 per cent, while classification and provisioning norms to be made similar to banks; additionally NBFCs to benefit from SARFAESI, or Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest, Act and an increase in their single party and group exposure limits.
Captive NBFCs must focus on financing the parent company's products - minimum 90 per cent - and risk assessment of the NBFC will consider the risk of parent company. The RBI will have powers with reference to management and will seek additional disclosures, including liquidity ratio, asset-liability profile, exposure to parent company, etc. NBFCs with assets of more than Rs 1,000 crore will be subject to comprehensive supervision, including inspection at predetermined levels.
The RBI will achieve key objectives with these guidelines - dramatic reduction in the number of inactive NBFCs, very low scope of arbitrage between a bank and its NBFC, reduction of systemic risks, and a better reporting and supervisory framework for the sector.
The next phase of India's growth will get a fillip if these amendments or structural changes are enacted. Whether they manifest themselves in the form of deeper financial inclusion or better risk containment, India's financial services sector is poised to grow.Diwanji is Partner and Head of Financial Services, KPMG India; Trivedy is Partner, KPMG Advisory Services; and Makhijani is Partner, KPMG India. The views and opinions in the article are those of the authors and do not necessarily represent the views of the organisation