Wednesday, August 31, 2011

RBI’s Draft Guidelines for Private Sector Banks

Following the Finance Minister’s announcement in his budget speech for 2010-11 and a discussion paper published by the Reserve Bank of India (RBI) in August 2010, the RBI has now released draft guidelines for licensing new banks in the private sector. The draft guidelines lay down the conditions on which corporate groups will be permitted to set up banks in India.
While the RBI seems keen to tap into the potential (financial and managerial) of the Indian corporate groups in establishing and managing banks so as to benefit the financial sector, the stringent conditions imposed by RBI in the regulations are an indication of the tight control that RBI wishes to retain over the process. In that sense, RBI seems unable to exorcise the demons from the pre-nationalization era where the nexus between corporates and the banking sector resulted in improper management of banks that put investors and depositors at grave risk.
The key proposals in the draft guidelines are as follows:
Eligible Promoters

Both objective and subjective criteria have been laid down to determine the eligiblity of promoters to set up a bank. The subjective elements include “diversified ownership, sound credentials and integrity”. Curiously, RBI has demonstrated some uneasiness with reference to other businesses that prospective promoters may be carrying on. Here are some extracts:
Banking is essentially based on fiduciary principles as depositors’ money is involved. It therefore becomes imperative that the fit and proper assessment framework for bank promoters is much more comprehensive in scope as compared to other sectors. Any such framework also needs to look into the nature of activities the promoter group of the bank is predominantly engaged in. There are certain activities, such as real estate and capital market activities, in particular broking activities which, apart from being inherently riskier, represent a business model and business culture which are quite misaligned with a banking model. Post-crisis, there are concerted moves even internationally to separate banking from proprietary trading. More importantly, in India, past experience with brokers on the boards of banks has not been satisfactory. It will therefore be necessary to ensure that any entity/ group undertaking such activities on a significant scale is not considered for a bank licence. Otherwise there will be real risks of the same business approach getting transmitted to the banks as well and it will be difficult to address this only through regulations. Accordingly, entities/groups that have significant (10% or more) income or assets or both from/ in such activities, including real estate construction and broking activities taken together in the last three years, shall not be eligible to promote banks.
It is not clear if tainting all players in a specific type of business activity with the same brush is a prudent approach. For example, as these comments observe, stock broking activity is a regulated industry subject to fitness norms and may not deserve the type of blacklisting treated meted out by the RBI.

Corporate Structure

RBI has specified the structure that corporates must be used while setting up banking activity. Promoters must set up a non-operative holding company (NOHC) through which they will hold the bank and all other regulated financial activities within the group. As the draft guidelines note, this is to “ring fence the regulated financial services activities of the group” from other non-financial activities. Depending on existing structures of corproate groups, successful licensee may need to restructure their group holdings to comply with the proposed structure.

Minimum Capital

An initial minimum capital requirement of Rs. 500 crores has been imposed. There are very specific requirements on shareholding limits of the NOHC in the bank. For instance, there is a lock-in of 40% shares of the NOHC in the bank for 5 years. Although the NOHC may start with a higher shareholding, it has to be pared down to 40% within 2 years from the date of licensing, to 20% within 10 years, and to 15% within 12 years. The bank will have to be listed on a stock exchange within 2 years, which is quite a short time frame. Hence, the establishment of the bank as well as its initial business operations must provide for early listing.

Foreign Shareholding

To begin with, a private sector bank can raise only up to 49% from foreign investors. It is only after 5 years that the prevailing policy of foreign investment in banking will become applicable, which is that foreign investment is allowed up to 74%. To that extent, RBI has followed a phased approach for the new private sector banks by not making the general foreign invstment policy applicable to them at their initial stage. This would mean that a private bank conducting an IPO in the first 2-year period will have to largely rely on the domestic supply of capital.

Corporate Governance

The draft guidelines provide some broad indication of the type of governance norms to be followed by private sector banks. The emphasis is on ring fencing all regulated activities under the umbrella of the NOHC. Moreover, the draft guidelines call for a separation of ownership and management in promoter companies that own or control the NOHC. This might be somewhat difficult to comply with, especially in the case of banks to be established by traditional family corporate groups. The only specific governance norm is that “at least 50% of the directors of the NOHC should be totally independent of the promoter / promoter group entities, their business associates, and their customers and suppliers”. In that sense, RBI appears less concerned with governance issues at the level of the bank itself, but more with the corporate group estaiblishing it, as these norms extend to both the NOHC as well as the promoters.

The draft guidelines set out several other operational conditions for grant of banking licences, including priority sector targets, mandate on core banking solutions, and the like. Other conditions include those relating to relationships between the bank and the promoter group entities, and how they are to be regulated.

Overall, while the RBI has taken the bold step of further opening up the private banking sector, it is treading with utmost caution. In terms of timing, it is unlikely that the regime for private banking licences will be in place anytime soon. As the draft guidelines themselves suggest, they will be finalised “and the process of inviting applications for setting up new banks in the private sector will be initiated only after the Banking Regulation Act is amended” to include various matters that are presently under consideration for legislative amendment, including removal of restriction on voting rights and RBI’s approval for change of shareholding beyond 5% in a bank. It is difficult to hazard a guess as to the timeframe within which the legislative amendments would be effected.

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