roadmap for take over of Indian private banks by foreign
investors will be laid out by end-December says Finance
Minister P. Chidambaram. Speaking recently at the
India Economic Summit 2004, organised by the World
Economic Forum, a global business lobby, Mr Chidambaram
said: ''The Government stands by the March 5,
2004 notification. Foreign banks can acquire up to
74 per cent equity in Indian private banks. The roadmap
for this will be unveiled by the end of this month.''
This is not the first off-the-cuff and possibly unilateral
statement that the Finance Minister has made on matters
relating to liberalisation of the prevailing regulatory
framework for banking. An inkling of the nature of
this road-map had been provided in previous such statements.
A few weeks earlier, the Finance Minister had declared
that the government was open to a process of creeping
acquisition in which foreign banks acquire a 10 per
cent stake every year in Indian private banks to enable
a buy-out in 3 to 4 years. However, potential acquirers
have been arguing that the relaxation of the cap on
foreign shareholding is not meaningful because of
the prevailing 10-per cent ceiling on voting rights
that any shareholder of a bank is entitled to exercise,
independent of the size of actual shareholding. In
response, the Finance Ministry has been pushing for
a withdrawal of that cap, which the Banking Regulation
Act of 1949 provides for.
In fact, according to reports, the Ministry of Finance
was recently asked to withdraw its Cabinet note seeking
to remove the 10-per cent voting rights cap in Indian
private sector banks. Reportedly, the note had proposed
that voting rights should be proportional to shareholding.
Senior Finance Ministry officials, however, are quoted
as saying that there was no immediate change in the
Ministry's views on the need to lift the cap on voting
On the surface all this sounds perfectly reasonable.
After having pushed through a cabinet decision to
hike the FDI stake in private banks from 49 to 74
per cent, the Finance Ministry can claim to be obliged
to facilitate the process. The difficulty is that
despite the cabinet decision the proposal has been
controversial. It is not just the unions of bank employees
and officers that have opposed the decision. It has
not been received well even by the Reserve Bank of
India and other insiders in and supporters of the
new government. This is because the proposal involves
some degree of discrimination against Indian banks
and foreign banks already in operation in the country.
In fact, the government and the central bank clearly
realise that the task of defining a road-map for foreign
acquisition does not end with permission for creeping
accumulation of shares and liberalisation of caps
on voting, because such liberalisation requires addressing
a number of other issues. The principal one relates
to the limits on shareholding of Indian promoters
of private banks and acquisition of shares by currently
operating domestic and foreign private banks in other
private banks. The Reserve Bank of India’s comprehensive
policy guidelines issued on July 2, 2004, which seeks
to integrate proposals contained in disparate notifications
into a single document, are clear on these issues.
The document lays down the following:
The RBI guidelines on acknowledgement for acquisition
or transfer of shares issued on February 3, 2004
will be applicable for any acquisition of shares
of 5 per cent and above of the paid up capital of
the private sector bank.
In the interest of diversified ownership of banks,
the objective will be to ensure that no single entity
or group of related entities has shareholding or
control, directly or indirectly, in any bank in
excess of 10 per cent of the paid up capital of
the private sector bank. Any higher level of acquisition
will be with the prior approval of RBI and in accordance
with the guidelines of February 3, 2004 for grant
of acknowledgement for acquisition of shares.
Where ownership is that of a corporate entity, the
objective will be to ensure that no single individual/entity
has ownership and control in excess of 10 per cent
of that entity. Where the ownership is that of a
financial entity the objective will be to ensure
that it is a widely held entity, publicly listed
and a well established regulated financial entity
in good standing in the financial community.
respect of a new license for private sector banks,
promoter shareholding may be allowed to be higher
to start with as at present, but will be required
to be brought down to the limit of 10 per cent in
a time bound manner normally within a period of
As per existing policy, large industrial houses
will not be allowed to set up banks but will be
permitted to acquire by way of strategic investment
shares not exceeding 10 per cent of the paid up
capital of the bank subject to RBI's prior approval.
private sector bank will be allowed to hold shares
in any other private sector bank only upto 5 per
cent of the paid up capital of the investee bank.
On the same analogy, any foreign bank with presence
in India will be allowed to hold shares in any other
private bank only upto 5 per cent of the paid up
capital of the investee bank.
the guidelines recognise that a Ministry of Commerce
and Industry notification dated March 5, 2004 had
hiked foreign investment limits in private banking
to 74 per cent. However, the guidelines seek to define
the nature and process through which the revised ceiling
is expected to work. To start with, the ceiling applies
to aggregate foreign investment in private banks from
all sources (FDI, FII, NRI). The limit of 74 per cent
will be reckoned by taking the direct and indirect
holding and at all times, at least 26 per cent of
the paid up capital of the private sector bank will
have to be held by residents.
Second, the policy already articulated in the February
3, 2004 guidelines for determining fit and proper
status of shareholding of 5 per cent and above will
be equally applicable for FDI. Hence any FDI in private
banks where shareholding reaches and exceeds 5 percent
either individually or as a group will have to comply
with the criteria indicated in those guidelines.
Third, in the interest of diversified ownership, the
percentage of FDI by single entity or group of related
entities may not exceed 10 percent. This makes the
norms with regard to FDI correspond to ceiling on
Fourth, there is to be a limit of 10 per cent for
individual FII investment with the aggregate limit
for all FIIs restricted to 24 per cent which can be
raised to 49 per cent with the approval of the Board
/ General Body.
Finally, there is a limit of 5 per cent for individual
NRI portfolio investment with the aggregate limit
for all NRIs restricted to 10 per cent which can be
raised to 24 per cent with the approval of Board /
It must be noted that the RBI’s guidelines do allow
for an acquisition equal to or in excess of 5 per
cent, so long as it is based on the RBI’s permission.
The guidelines merely state that: ''In deciding
whether or not to grant acknowledgement, the RBI may
take into account all matters that it considers relevant
to the application, including ensuring that shareholders
whose aggregate holdings are above the specified thresholds
meet the fitness and proprietary tests.''
The nature of these fitness and proprietary tests
are of relevance. In determining whether the applicant
(including all entities connected with the applicant)
is fit and proper to hold the position of a shareholder,
RBI may take into account all relevant factors, as
appropriate, including, but not limited to
The applicant’s integrity, reputation and track
record in financial matters and compliance with
Whether the applicant has been the subject of any
proceedings of a serious disciplinary or criminal
nature, or has been notified of any such impending
proceedings or of any investigation which may lead
to such proceedings.
Whether the applicant has a record or evidence of
previous business conduct and activities where the
applicant has been convicted for an offence under
any legislation designed to protect members of the
public from financial loss due to dishonesty, incompetence
Whether the applicant has achieved a satisfactory
outcome as a result of financial vetting. This will
include any serious financial misconduct, bad loans
or whether the applicant was judged to be bankrupt.
The source of funds for the acquisition.
Where the applicant is a body corporate, its track
record of reputation for operating in a manner that
is consistent with the standards of good corporate
governance, financial strength and integrity in
addition to the assessment of individuals and other
entities associated with the body corporate as enumerated
acquisition or investment takes the shareholding of
the applicant to a level of 10 percent or more and up
to 30 percent, the RBI stated that it will also take
into account other factors including but not limited
to the following: (a) the extent to which the corporate
structure of the applicant will be in consonance with
effective supervision and regulation of the bank; and
(b) in case the applicant is a financial entity, whether
the applicant is a widely held entity, publicly listed
and a well established regulated financial entity in
good standing in the financial community.
Finally, acknowledgement of acquisition or investment
exceeding the level of 30 percent will be considered
keeping the above criteria in view and also taking into
account but not limited to the following (a) whether
the acquisition is in public interest, (b) the desirability
of diversified ownership of banks, (c) the soundness
and feasibility of the plans of the applicant for the
future conduct and development of the business of the
bank; and (d) shareholder agreements and their impact
on control and management of the bank.
It should be clear that the Finance Ministry’s eagerness
to welcome foreign investors in banking notwithstanding,
the RBI is still cautious about allowing domestic or
foreign investors acquiring a large shareholding in
any bank and exercising proportionate voting rights.
The reasons are obvious. Banks are the principal risk
carriers in the system taking in small deposits that
are liquid and making relatively large investments that
are illiquid and can be characterised by substantial
income and capital risk. Any tendency to divert a substantial
share these deposits into activities in which the promoter
or board is interested or into investment that are risky
but promise quick returns can increase fragility and
lead to failure. And instances such as Nedungadi Bank
and Global Trust Bank illustrate that when that happens
the problem is no more only that of the promoter but
of the central bank and the government. Given that,
preventing a problem is more important that resolving
them through mechanisms such as forced mergers. As the
RBI puts it rather euphemistically: “Banks are ''special''
as they not only accept and deploy large amount of uncollateralized
public funds in fiduciary capacity, but also they leverage
such funds through credit creation. They are also important
for smooth functioning of the payment system.”
It should be clear that if the government chooses to
permit automatic acquisition of a 74 per cent stake
by foreign investors, a similar facility would have
to be provided to all acquirers, resulting in a dilution
of the RBI guidelines. This is the source of the RBI’s
fears, which have resulted in FDI acquisition norms
specified in its guidelines that render the 74 per cent
But there are other reasons why FDI in banking is in
itself not appropriate, resulting in stringent controls
on foreign acquisition in other countries as well. A
year back, South Korea's central bank called for curbs
on foreign ownership in the country's financial sector
and urged the government to slow the pace of bank privatisation
until local buyers could be found. South Korea has received
billions of dollars of overseas investment in its financial
industry since the country's 1997-98 financial crisis.
The central bank said the level of foreign ownership
in South Korea's banking sector - 38.6 per cent including
direct and stock investment - was higher than 19 per
cent in Malaysia, 15 per cent in the Philippines and
Thailand, and 7 per cent in Japan. In the central bank’s
view, foreign-owned banks were undermining the economy
by focusing lending on consumers. It said: ''Such
a tendency could lead to lower corporate lending . .
. and therefore weaken the country's economic growth.''
Eastern Europe too has seen substantial increases in
foreign investment in recent years as a result of which
in Poland, the Czech Republic and Hungary foreigners
own and determine credit policy in respect of some 80
per cent of banking assets. However, studies by the
European Bank for Reconstruction and Development reveal
that the result has been over-cautious lending to indigenous
firms, notably small and medium-sized enterprises.
In the circumstances the RBI’s caution is warranted.
But, under pressure from the Finance Ministry, it has
chosen to treat its comprehensive guidelines note, which
merely documents law and practice as they stand, as
a discussion note. It has invited feedback from banks
and has not set a timetable to implement the proposals.
Clearly, the Finance Minister is using the opportunity
to open up the banking sector, even if pleasing foreign
and domestic investors results in greater fragility
and lower investment.