MacroScan - Privileging FDI in Banking

The 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 rights.

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.
In 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 three years.
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.
Any 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.

Interestingly, 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 voting rights.

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 / General Body.

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 tax laws.
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 or malpractice.
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 above.

Where 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 cap meaningless.

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.