Context: An internal working group had recommended allowing corporates in the banking sector but the 'bombshell' proposal doesn't find a mention in the list of suggestions accepted by the RBI on November 26?.
Key Points

• The suspense that began in November 2020 ended today. In November 2020, an Internal Working Group (IWG) appointed by the Reserve Bank of India (RBI) whetted the appetite of conglomerates and equity enthusiasts alike when it recommended that corporate houses be allowed to get a bank licence and that NBFCs owned by corporates also be allowed to become banks if they otherwise qualify. 
• The RBI today did not accept these recommendations. It didn't reject them, but probably diplomatically, has put them under a "held for further examination" category.

If implemented then

• Large corporate/industrial houses may be allowed as promoters of banks only after necessary amendments to the Banking Regulation Act, 1949 (to prevent connected lending and exposures between the banks and other financial and non-financial group entities); and strengthening of the supervisory mechanism for large conglomerates, including consolidated supervision.

Issue

• The recommendation that will make the market sit up is that promoters of banks may hold a maximum of 26 percent paid-up equity shares in the bank, which is up from 15 percent earlier. 
• The other notable recommendations that have been accepted include allowing promoters of new banks to bring down their stake to 26 percent by the 15th year. There will be no intermediate targets to bring down the stake to 40 percent as now exists. 
• However, new promoters have to submit a roadmap to bring down their stake to 26 percent, at the time of accepting their licence.

Former RBI Governor Raghuram Rajan and former RBI Deputy Governor Viral Acharya have criticised the suggestion by the IWG, describing it a “bombshell”.

• They observed, it would be ‘penny wise pound foolish’ to replace the poor governance under the present structure of these (public sector/government-owned) banks with a highly conflicted structure of ownership by industrial houses.
• Moreover they say, If sound regulation and supervision were only a matter of legislation, India would not have an NPA (non-performing assets) problem.
• More specifically, here in this case, the main concern in allowing large corporates to open their own banks is a basic conflict of interest, or more technically, “connected lending”.

What is connected lending?

• A situation where the promoter of a bank is also a borrower and, as such, it is possible for a promoter to channel the depositors’ money into their own ventures.
• Connected lending has been happening for a long time and the RBI has been always behind the curve in spotting it.
• The recent episodes in ICICI Bank, Yes Bank, DHFL etc. were all examples of connected lending.
• The so-called ever-greening of loans (where one loan after another is extended to enable the borrower to pay back the previous one) is often the starting point of such lending.

Pros of Allowing Corporates To Own Bank

• Plugging Capital Gap: The biggest pro will be that India’s banks need capital. Currently, the government keeps picking money from the taxpayers pocket and funding the public sector banks. Hence, by allowing the big corporates into the banking sector the capital requirement can be fulfilled.
• Facilitating Financial Inclusion: As a lot of people do not have access to banking in the country, the entry of corporates into the banking sector would mean the opening of more branches and subsequently bringing more people into the banking net.
• Improving Competition: Privatization of banks has been a long-proposed reform in the Indian banking industry. Allowing corporates into the banking sector will further pressurize Public sector banks to become competitive.

Cons of Allowing Corporates To Own Bank

Connected Lending & Moral Hazard: A bank with no connections to business houses can effectively screen loan applicants and thus ensure efficient allocation of funds to accelerate the overall growth of the economy.

• Industry-group-owned banks, on the other hand, will be under constant pressure to favour group companies, at the expense of more deserving ones, which can be labelled as connected lending.
• Connected Lending can effectively transfer the project risks from the business group to the banks, with the costs finally being borne by the other shareholders of the bank or even by the taxpayers in the case of a bank collapse.
• In economic terms, it may deter efficient fund use and affect profitability & solvency.
• In ethical terms, this will erode the bank’s role as an effective financial and create a moral hazard or conflict of interest situation.

Circular Lending & Difficulty In Regulation: Another risk associated with banks owned by industry groups is circular lending.

• Under circular lending, corporate bank X funding projects of an industry group, which owns corporate bank Y, and corporate bank Y funding projects of an industry group owning bank Z, and finally, corporate bank Z funding projects of industry group owning bank X.
• With available legal structures and the proliferation of shell companies, makes it hard to track such lending on a real-time basis.

Inequality & Concentration of Wealth: Corporates owing banks will add more muscle to big industry groups, which already dominate many important sectors of the economy, including telecom, organised retail, aviation, software and e-commerce.

• Their tie-up with banks, which is the core of the financial sector, will not only jeopardise the interests of smaller players but also help them leverage their strength into other new markets.
• This will further accelerate the concentration of wealth and increasing inequalities.
• This may lead to the emergence of new big power centres that would soon throttle the government’s ability to steer the economy in the right direction.

Contradicting the Previous Ruling: The banking sector in India has been in trouble for the last few years, keeping that in mind the RBI in 2016 had created new guidelines on the limit of lending to a single company.

• The rationale behind this ruling was that if a bank lends too much to one company only then it risks losing that money if the company sinks.
• Therefore, the recommendation of allowing the entry of industry groups in the banking sector is in contraction with the above-said ruling in 2016.

Road Ahead

• The pros and cons analysis of mixing industry and finance indicates that the move may not be conducive to growth, public finance and the future of the Indian economy itself. So rather than concentration of too much economic power in the hands of corporates, it will be wise to carry out the long-pending banking reforms and strengthen the functional autonomy of RBI.