India's Aspiring Banks Line up for LicensesPublished: January 17, 2013 in India Knowledge@Wharton
India's Finance Minister, P. Chidambaram, wants more banks. So does the country's banking community and the financial sector. And the regulator in charge of authorizing new financial institutions -- the Reserve Bank of India (RBI) -- seems to be finally ready to open the floodgates.
Floodgates are an exaggeration, however. Though the number of serious aspirants for a bank license could number more than 20, the RBI is not likely to issue more than four; the smart money is actually on just two. (In 1993, when the RBI licensed some private banks, it received 113 applications. Nine got the green light.)
More than 40% of the adult population in India does not have access to banking services so the need to expand coverage is obvious. A large part of the sector is government-owned; most major banks were nationalized in 1969. But a significant jump in coverage means large investments and the government doesn't have the money. Nor is it ready to dilute its stake. New banks are therefore a must. The process was started by former Finance Minister Pranab Mukherjee in his February 2010 Union Budget. But the RBI has been dragging its feet: It issued draft guidelines in August 2011, invited comments and the matter has rested there ever since.
The RBI's major objection was that it didn't have enough powers to regulate the new banks. The agency could remove an errant director, but if an entire bank board connived in a fraud, it was helpless. Now Chidambaram has taken away that excuse: The Banking Laws (Amendment) Bill, which gives the RBI more teeth, was cleared by the Lok Sabha (the lower house of Parliament) in December 2012, as a part of the government's new reforms package. The RBI's reluctance stems from one major reason: large industrial groups are now allowed to acquire banking licenses. One of the key reasons for the nationalization of banks was that many were controlled by large business groups that used public deposits to finance their own businesses. There were no Chinese walls and widespread allegations of misuse of funds.
And the RBI is not alone with its reservations. "One of the real problems in the financial sector is that there are issues of conflict of interest," Nobel Laureate Joseph Stiglitz said while delivering the C.D. Deshmukh Memorial Lecture in Mumbai recently. "And when you have corporates owning their own banks, you are opening up a venue for corporate conflicts of interest." C. Rangarajan, chairman of the Prime Minister's Economic Advisory Council, has also advised the RBI to put licenses for conglomerates on the backburner. The first choice should be applicants that are not part of big groups, and only when these aspirants are found wanting should the RBI look at corporate, Rangarajan told the Press Trust of India. The International Fund has also warned the RBI against allowing corporate entities into this area.
A Mixed Record
The winners in the earlier round of bank license issuances have had a mixed record. There are successes like ICICI Bank (which converted from a development financial institution), HDFC Bank and Axis Bank. But two new banks -- Centurion Bank and Bank of Punjab -- merged and were later acquired by HDFC Bank. Global Trust Bank was taken over by Oriental Bank of Commerce after a major scam that saw its net worth practically wiped out. Times Bank also merged with HDFC Bank.
The big business conglomerates that want a piece of the action include the Aditya Birla Group (Aditya Birla Financial Services), the Tatas (Tata Capital), the Ambanis (Reliance Capital), Bajaj (Bajaj Finserv) and the Mahindras (M&M Financial Services). Others include engineering giant Larsen & Toubro (L&T), SKS Microfinance (the only listed microfinance company), Life Insurance Corporation and Infrastructure Development Finance Company (IDFC). "We will consider applying for a banking license," Ajay Srinivasan, head of the Aditya Birla Group's financial services initiative told the media recently.
The draft RBI guidelines give some criteria for eligibility, including that the entity applying for a license must have "diversified ownership, sound credentials and integrity" and a successful track record of at least 10 years. Groups with significant interests in real estate and capital market activities, which, according to the RBI, "apart from being inherently riskier, represent a business model and business culture [that] are quite misaligned with a banking model," will not be entertained.
The guidelines put the initial minimum paid-up capital at Rs. 500 crore (US$92 million) and restrict foreign shareholding in any form to 49% for the first five years. (Private banks in India can have up to 74% foreign shareholding today.) The guidelines also stipulate that 25% of the branches must be opened in unbanked rural centers.
The Problems of Going Rural
That regulation in particular makes matters more difficult. As businesses penetrate the rural areas, the personnel costs become too high compared to the business generated. As fast-moving consumer goods (FMCG) companies have discovered, the salary of one person is often higher than the profits generated by a whole cluster of villages.
"If the new banks are expected to do business with a client segment that is much less remunerative, it is going to put a larger burden on them," notes Shinjini Kumar, director of PricewaterhouseCoopers (PwC) India. "As it is, there is a lot of competition and stress on the system where the larger players are concerned. The private-sector banks cannot afford to have a financial inclusion piece that does not lead to a profitable business model. They have to put the two pieces -- financial inclusion and profitability -- together. It cannot be one at the cost of the other -- which is how public-sector banks have always functioned."
Rajesh Chakrabarti, executive director of the Bharti Institute of Public Policy at the Indian School of Business (ISB), says that "financial inclusion can only go up, though it is hard to predict by how much and who will be the most suitable player on that front. Even if a new entrant is not a direct inclusion player, increased competition in the regular business among banks will force them to seek niches and, eventually, inclusion will increase."
Kumar suggests that unbanked consumers are not the only place where banking can spread. "There is a space in India today -- the emerging middle class -- which is between the middle class and the financially excluded," she says. "This is a space where most of the new bank license aspirants are already present (by way of different businesses). They have cracked the code of doing business in this segment. They understand this segment and its dynamics."
In terms of game-changing potential, Kumar adds that this segment is where new banks can have a maximum impact. "This space is also a priority area for policy makers today, so new entrants eyeing this space are likely to find a supportive climate," she notes. "If the new players can pull this off, it will change the banking landscape completely for the sub-middle class segment, similar to how ICICI changed the retail banking landscape for the middle class when it entered the sector."
According to Chakrabarti, an expansion of the banking sector will likely be a mostly positive development. "New banking licenses are a good idea," he says. "More players will create more competition and the net effect, I think, will be positive. It is possible that some new entrants or incumbents may not be able to survive the competition. But as long as they can exit through a takeover without hurting the depositors -- and we can have enough faith on the RBI to ensure that -- the effect will be mostly positive. The only conceivable downside can be a rush to the bottom for loan quality. But once again RBI's monitoring of NPAs [non-performing assets] is likely to prevent that."
"I do not anticipate any problems," he continues. "RBI and Basel guidelines on capital adequacy will ensure that new entrants are solidly capitalized and our existing prudential norms give enough protection against lending to a single business conglomerate. So this will infuse greater competition in the sector and perhaps a little volatility. It may make life slightly more difficult for a few not-so-well-performing public sector banks. But on the whole, it will increase efficiency in the sector."
But who are the new entrants likely to be? Given the RBI's reluctance to issue licenses to big business houses, those firms may not make the cut this time. The frontrunners appear to be IDFC and L&T Finance, according to a report by Credit Suisse. The stock markets seem to agree. IDFC is now close to Rs. 180 (around US$3.29) against a 52-week low of Rs. 94 (US$1.72). L&T Finance has more than doubled to reach Rs. 95 (US$1.74).