Should Corporates Be Allowed To Own Banks?

Recently, an internal working group came out with a report which has been criticised since then as it allows for private companies to set up commercial banks.

This criticism has come even before the RBI discusses the report in detail and forms a view about some of the recommendations contained.

The issue is a contentious one — as all issues are — with a former governor and deputy governor publishing a note describing the move as a 'bombshell'.

However, it is important to discuss the idea in detail along with its potential benefits — and its costs — before we either accept or dismiss the idea. After all, the committee that proposed the same must have some rationale behind their decision to put forth such a recommendation in the first place.

Before we go into discussions about the specific proposal, it is important to understand that the need is motivated by the desire to have greater competition by allowing for more banks.

A chronic feature of the Indian banking sector has been lazy banking, and the sector dominated by Public-Sector Banks will surely benefit from having greater competition.

To put things in perspective, nationalisation of banks was done to support India’s growth objectives by facilitating credit to priority sectors. The sectors were determined by the government and regulators (and not by prudent banking or corporate boards of the banks).

Subsequently, what we witnessed was a deadly mix of political and economic power concentrating, resulting in discretionary lending practices. This was made possible by the weak governance of the banks, even as regulatory oversight was fairly limited owing to state incapacity.

Consider this, the single largest shareholder in these public sector banks was not geared towards the objective of making profits. Thus, we ended up with a banking structure where the major banks were willing to lose money and the single largest shareholder was willing to recapitalise the bank.

The model led to a situation where political agents started to influence the lending decisions of banks, creating a toxic cocktail of crony-capitalism assisted by the state through its ownership of the banking system.

Thus, what we need to recognise here is that indeed, there is a need for having greater players in the banking sector to ensure adequate savings can be mobilised to finance investments which are needed to create non-farm job opportunities.

Therefore, the next logical question is what the ownership structure of the new entrants in India’s banking space should be. Should we allow more foreign banks or more private banks owned by domestic entities or perhaps, more government owned banks?

What we do know is that we do not need more government owned banks; if anything, we need less of them going forward, and the government should consider gradually reducing its ownership in a bulk of the existing public sector banks.

So, the choice is between foreign banks and a greater number of private banks — and perhaps, both are equally important to develop our financial system.

The proposal of allowing private corporate houses to set up banks has perhaps been done with the precise intention of allowing for greater space for private ownership of these banks.

The issue here pertains to allowing existing businesses houses to set up their banks, as many believe the model is ‘risky’ and would lead to greater concentration of economic power.

Moreover, it has been argued that a bank cannot make good loans when it is owned by the borrower.

It has, thus, been argued that a bank owned by the borrower may undertake poor lending decisions and information on loan performance will not be timely or accurate.

The fundamental problems associated with lending decisions are the problems of adverse selection and moral hazard. Typically, if we have the borrower as the owner of the bank, there will be greater access to information which should make it better equipped to evaluate the proposal in the first place.

Moreover, the assumption that a bank will be willing to lend to an unviable project using depositor’s money ignores the effect of such decisions on the viability of the bank itself.

A business group — if it owns a bank — will be geared towards ensuring that the company is viable, and maximizes shareholder wealth by generating a healthy steam of profits.

While there are concerns of banks funding other entities owned by business-houses, including evergreening of loans — a practice which was mastered by India’s public sector undertakings — however, we must realise regulations and mandatory disclosures can mitigate a major part of the risk associated with the same.

Given that the fundamental challenge in the financial world is of information asymmetry, having private corporate ownership can significantly reduce the problem, paving way for an efficient banking system.

The added advantage of the motivation for maximizing shareholder wealth and inherent incentive structures within such an ownership framework could also help in achieving several efficiently run banks.

At the same time, we must recognise the risks associated with such a move and perhaps look at ways to minimise if not mitigate these risks through our regulatory frameworks rather than dismissing the idea altogether at such a premature stage.

On the issue of frauds, more so in the financial system, we must recognise that while building roads may lead to accidents, we do not stop building them as a policy tool to prevent accidents.

Similarly, we cannot let our policies be guided by the fears of them being misused by economic agents — they must be guided by what works best for India’s development objectives and for every policy that is misused, we must proactively put in an adequate regulatory regime to prevent such instances from occurring in future.

Thus, let us not jump the gun and form too strong opinions about an idea that is still at a premature stage — it presents a solution to a challenge faced by the country even as it comes with risks.

The debate and our focus should now be on finding ways that would minimise risks rather than trying to utilise our energies solely on junking the idea.