Despite outrage over a proposed move, it is unlikely that Indian business houses and conglomerates will rush to set up banks given the highly regulated nature of Indian banking and the often unprofitable nature of banks according to experts.
The Reserve Bank of India's proposal to allow business houses to set up banks has been criticised by former governor Dr Raghuram Rajan and former deputy governor Viral Acharya. The recommendation was a part of a report by an internal working of the RBI on extent ownership and corporate structure in private banks in India.
In a note published on LinkedIn, Rajan and Acharya said that a corporate-backed bank would be prone to misuse and bad lending which regulators would find difficult to manage.
However, experts believe there might not be a rush among corporates to set up their own banks. "Banking business in India is very difficult and highly regulated. The economic security problems do have a huge amount of impact on a banking company," Ashvin Parekh Managing Partner of Ashvin Parekh Advisory Services told BOOM.
"By and large a universal bank today with 500 crores threshold capital is still breaking even after four and a half to five years. So, banking business, from the point of view of hardcore returns, is not as lucrative as people may perhaps think about. People are now more careful with a large number of failures that happen in businesses, there may not be floodgate of applications," he added.
Fee Only Investment Advisers LLP CEO Harsh Roongta concurred and said, "In the banking business, your raw material is money. Getting that raw material is not a problem as is attested to by the number of people who are able to raise large sums of money from the lay public. I think it is the cost that makes a difference. It is the respectability, that makes a difference.
Parekh believes that corporate-backed banks will invite more scrutiny from regulatory bodies like the RBI given the relationship the bank would have with its parent company. "There is this aspect of concentration of risk. To my mind, the regulator should be more wary or should be careful about such an application. And the reason is very simple. You are still keeping the risk somewhere within your own balance sheet," he said.
Excerpts from the interview follow
Govindraj Ethiraj: Why would a business house want to set up by a bank?
Ashvin Parekh: This is interesting. Way back in 1992, when the first set of licenses were going to be issued, I had done about five applications. Four of them were from financial conglomerates, some of them were development financial institutions. And they wanted to migrate into organizations like IDBI and UTI. So, I did those applications. One of the applications was an industrial house. And even though the regulations at that point in time weren't too clear about whether corporate houses or business houses would be allowed or otherwise. It didn't come through, of course, the other four approvals came through from the RBI. Then in 2000-01, period when they were once again going to reopen that subject, I did about three applications, one of them from a financial conglomerate, and two of them from the business houses. And then, in 2012, I did most about eight applications out of 24 overall applications for a universal bank. Only one of them materialized. That's the IDFC one. The others included business houses and NBFCs.
Why would they look at setting up a banking company? See banking business in India A, is very difficult, highly regulated, and B, sort of the cyclical problems, the economic security problems do have a huge amount of impact on a banking company. I've come to one sort of observation, this is after working in five other countries, that if you are in a position to put up a large-sized bank, if you are a good industrial house, with a very good rigid compliance and governance record, and if you really do put up a very large bank through organic or inorganic measures, but if you do put up then I suppose you are okay from the point of view of returns. By and large a universal bank today with 500 crores threshold capital, you're still breaking in after four and a half to five years.
So, banking business, from the point of view of hardcore returns, is not as lucrative as people may perhaps think about. But that's when this recommendation is be made by the RBI. I would just say that look, the idea was to look at very large corporates, and not the mid-size and the small-size basically. I think it's more of sort of getting into a banking kind of business rather than being a profitable venture at all.
Govindraj Ethiraj: Mr. Roongta, why do you feel that businesses want to set up bank if indeed, it's difficult or challenging as Mr. Parekh points out?
Harsh Roongta: I don't think any business is easy in India. Setting up a business and running a large-scale business is not easy. In a banking business or financing business, your raw material is money. Getting that raw material, I don't think is a problem as is attested to by the number of people and the kind of people who are able to raise large sums of money from the lay public. I think we've all seen that happen. I think it is the cost that makes a difference. It is the respectability, that makes a difference.
After the nationalization, or probably prior to that as well, for cooperative banks, we've not had a failure where depositors have lost money. The Reserve Bank has stepped in and has made sure that the depositors didn't lose money. And because of that respectability, your ability to access raw material, which is money, at a very reasonable cost becomes high. You are able to raise that money, as is attested to by the number of scams that have happened. But that normally comes at a high cost, much more effort. When you are a bank, properly licensed bank, it comes at a much economical cost. I think it's a simple matter: cost and respectability.
Govindraj Ethiraj: On the on the cost part, how would it matter, assuming all the ring-fencing guidelines and regulations are strong, which means that even if you own a bank, there's no way any of the money that you've taken from depositors can go to any of your own other businesses? Then why would that cost matter or make any difference?
Harsh Roongta: Look at the NBFCs. The large NBFCs today are borrowing from the banks. When they borrow from the banks, obviously, the bank has a mark-up on that. I'm just making it extremely simply. If they were to directly take that from the public, and the bank is running similar risks. That's why you have systemically important NBFCs on which RBI's regulation and supervision is much, much higher. They are as important as the banks, and then it's very reasonable to expect that those NBFCs would want to move down and start raising that money themselves rather than raising it through the bank and paying a margin to the bank. I think it sounds logical. This is not a comment on what can go wrong. This is just a comment on why they want to do it.
Govindraj Ethiraj: Mr Parekh, one is the traditional model of a large bank and then there could be the newer models which are more recent. Do you feel that the reasons this time are different from maybe what they were a decade ago?
Ashvin Parekh: Let's just analyse the reasons we are talking about. One is, the banking services, the product and services. The other is the delivery mechanism. Now, what you're touching upon is a delivery mechanism. That is, let's say, the whole banking system, the delivery of banking services and products, that has undergone a radical change. And thanks to COVID now, it's undergoing even further dramatic changes. But does it really change the very core nature of the products and the services? I don't think so. Let me articulate my points. Let's say if you are a lending business, for example. Whether you lend through a FinTech kind of a platform, or you lend through, at the end of it, there is a borrower and a lender relationship. And then borrower depending upon even when he has the intention of repaying back to the lender, he has his own economic external environment to really worry about. And which is what we saw in case of auto industry. Four years ago, three years ago, two years ago, it was going through a bit of a patch, because economy wasn't performing as well as it was expected. And then suddenly now after COVID, we find a different thing altogether. But who suffers at the end? At the end of it, the lender relationship irrespective of technology, remains the same.
I suppose, you know, when we talk about differentiated banking, and this is something I always found. In fact, I personally believe that the whole experiment of differentiated banking has not taken roots in this country at all. Nine payment bank applications, nine approvals were given. About nine small finance bank approvals were given. For small finance banks, that is too small an experiment to really arrive at any judgment. But differentiated banking, did it find roots in India? I don't think so. Out of nine applications, one of them is in a in a proper shape, the other one is struggling to be in a good shape. And some of those who got the approval and started payments banks, want to become small finance banks. Now their regulators trying to pave way for that. It's a little complex thing. But I would still believe that where the economic performance related volatility is high, in that backdrop, a universal banking model is a much better model compared to a differentiated banking.
The technology part time and again, we have seen two or three prominent private sector banks, were at the upper end of technology at one point in time. I mean, the cost of their operations was benchmark even by global banks. But did that advantage continue? I don't think so. Personally, I would say the products and the delivery mechanisms have to be distinguished quite clearly.
Govindraj Ethiraj: That's a strategy that they may adopt or should be adopting. Let me pose the same question that I started with a little differently. One argument could be supposing you had an automobile company or you had a large consumer durable company, then you need a finance company or a bank, which might help you in financing products or services for your consumer. So, there is no direct benefit in terms of borrowing from that bank or that you will divert depositor money from the bank to other group companies, but surely, you may ease the delivery, or ease the selling of products and services by those companies. So, could that be a reason why some businesses house or conglomerates, who particularly have large consumer-facing businesses, are looking at banks?
Ashvin Parekh: Let's look at it this way. There is this aspect of concentration of risk. If something like this were to be one of the reasons why, let's say a large retail customer-facing conglomerate could be looking at a banking company. To my mind, the regulator should be more wary or should be careful about such an application. And the reason is very simple. You see you are still keeping the risk somewhere within your own balance sheet. In fact, you could have given credit to your customers for that matter in the normal course of your business activity.
Actually, you hit the nail on its very head. Where will the regulator draw a distinction in saying, is there an arm's length kind of relationship between borrowers and the promoters of the bank? It's going to be really difficult to my mind. Because where do you end? How much of due diligence can you really expect with some of these things?
Govindraj Ethiraj: Mr Roongta, if I were to then ask you to look at it even more plainly, is a bank just another business? As more businesses get opened up, you want to diversify your overall basket of businesses and being in finance and a bank is a good thing to have. Is that the driving motivation for many of these business houses who want to get into banks?
Harsh Roongta: As I said, they need resources. The resources could be for their own use, the resources could be for use by their suppliers or resources could be for use of their consumers. Today also this is working. Every auto company would have tie up with a series of banks and they are able to sell their product. All the top marketplaces, all the e-comm places have tie ups with banks who then fund the suppliers to those marketplaces. So, I don't think that this is missing today. The advantage-disadvantage is that it is independent of the person manufacturing or providing that service which is being funded by a third party. So, there is an independent appraisal of the credit quality. When you have a captive finance, in fact, every big consumer durable company as a captive NBFC sort of an arm.
The only issue with the captive, is as Mr Parekh says, the job of the captive is to say sell my product. So, whether good or bad, some of the risk of the product failure gets passed on to the financial. Where it is captive, that risk obviously tends to get concentrated because a third-party independent may not take that risk. A captive will have to take that risk because that is the reason why it is in existence. So, I think, yes, banking is like any other business but it is a very vital business, it's a highway, and I think you can't afford to have your highway choked up.
Govindraj Ethiraj: Mr Parekh, let me put that question back to you. Many business houses are sometimes quite agnostic to the businesses. As they grow as a large conglomerate, they have their presence in cement, steel, infrastructure, roads, airports, and energy. Why not banking also? Is it that motivation which drives the third-party quest for a bank? Is there some icing on the proverbial cake, which we are not quite sure about?
Ashvin Parekh: I analyse this regularly. So, looking at my own experience, I thought way back in the 90s, until about 2010 I would say, there was a certain amount of psychological built up within our industrial houses, business houses and businesses per se. I would never describe as a herd mentality or club mentality, in the sense the minute you are in some kind of a corporate club, and then you find that someone is really thinking of putting up a bank. And the first question that would arise to you is, am I not well diversified? Am I not as largely reputed as the other person is? It's very difficult for someone to admit that the reputation or the diversity, or the quality of the overall financial strength of that conglomerate, may be any shade different from the others. We all start believing that we are saints in our own rights. And then it becomes difficult. Everybody wants to really jump in for that kind of license Raj sort of an approach may perhaps have played its role when it came to the applications.
But on the other hand, just to complete my thought, I suppose the on-tape, universal banking kind of licenses, which was actually started in 2016 and the guidelines were refined in 2018, but we did not have people applying. Those with 10 years of financial experience, let's say, and then not the business houses, but even they didn't apply for universal banks. There must have been herd mentality. Those have changed. People are now more careful with a large number of failures that happen in businesses, there may not be floodgate of applications.
Govindraj Ethiraj: From the regulator's side, should a bank have a private owner? Should businesses be allowed to own banks?
Harsh Roongta: Some of these risks that the banks are running, we've seen them visit, we've seen them happening. I think the fear is that the standards that we have, the general corporate governance standards that we have, it does not inspire much confidence, and I think rightly so as is attested by the fact of so many of these things regularly mentioned in the headlines. I think that lack of confidence is the issue.
And also, the fact that internationally there seems to be generally a frown on, large conglomerates, owning banks. I think generally it is not something that the environment is very friendly to. So, I think there is also a lack of precedence. Very clearly, probably what we see today is the start of a process. This is an internal working group's recommendation. I think it's good to have this debate. I don't think we can have an answer at the end of the debate. But it is good to have this debate so that these issues can be thrashed out.
Govindraj Ethiraj: It's a debate that becomes particularly interesting when you have a recent former governor and a deputy governor weighing in with full force. Mr Parekh, should a regulator be concerned? Is this environment really ready for business houses to own banks?
Ashvin Parekh: That's a very interesting question. The internal group set up by the RBI have made this recommendation and as Harsh said, it's not a regulation, it's not a law as yet. There will be comments and there'll be other filtrations and a lot of regulations also need to be changed in order to really do this. What could be the reason why the committee has made such a recommendation? If capital is the requirement, if there is a feeling an impression, and rightly so. There is a dearth of capital, and the debt-capital constraint may continue because public sector banking is not going to get the kind of dosage of capital that they actually do require. In which case, more private sector banks will have to be really opened up, more capital will have to go into the existing private sector banks. So, if that is the thought process to make sure that there is much more of resource available, capital available to the Indian banking to make sure that there is a credit flow and part of the Aatmanirbhar program and manufacturing program and so many other things, then I suppose, it's a thought that is worthy of a debate.
But at the same time, before the gates are opened, the gatekeeper will have to really work out very clear norms to make sure that only the correct candidates can get indicted. Governments come and governments go and different governments look at the regulations with different perspectives. So, it shouldn't happen that let's say we start with something and then 10 years down the road or even earlier, we start realizing that we were better off by keeping the gates closed in and we unnecessarily open them up. So, to that extent the onus will go back to the regulator. The committee has done its work. But the onus will go back to the regulator in ensuring. Banking is trust. And there has been no failure of any Indian banking. I know the amount of honest effort our regulators put into to ensure that. Now, should it really make itself more exposed to working hard to keep on doing that is a matter of discussion worthy of further debate.