Rajan makes a case for small banks

Rajan makes a case for small banks

The honorary economic adviser to Prime Minister Manmohan Singh, Raghuram Rajan, is against industrial houses being allowed to run banks as the central bank is engaged in the process of drawing up the guidelines for allowing more entrants into the industry.

According to Rajan, the Indian central bank should allow about 20 new, professionally managed, small banks with a minimum capital of 50 crore. Well-managed, small non-banking financial companies (NBFCs) as well as microfinance institutions (MFIs) that are in the business of giving tiny loans to poor people should be allowed to convert their firms into banks, he has recommended. Finally, while the majority of the new entrants should have local promoters, foreign players should also be allowed to set up banks, provided they meet the fitness criteria.

Also See The Rajan Prescription (PDF)

Rajan, the Eric J. Gleacher Distinguished Service Professor of Finance at the University of Chicago’s Booth School of Business, made the confidential comments to the Prime Minister on the Reserve Bank of India (RBI) discussion paper that deals with the proposal to allow more private sector banks.

The note, a copy of which was reviewed by Mint, was written by Rajan in his capacity as Singh’s honorary adviser. He declined to comment to Mint on this issue, saying, “Any reports I send are meant to be confidential."

Finance minister Pranab Mukherjee in his February budget had said the banking regulator will allow more new entrants to allow Indians greater access to banking services. About 40% of the country’s 1.2 billion people don’t have such access now. RBI in August released a discussion paper on new bank licences and asked for feedback by 30 September. It is expected to release draft guidelines at the end of January for public comments.

The August discussion paper focused on capital, ownership structure, foreign shareholding norms and the business model of new private banks, but stayed away from taking any position on the profile of the new entities that will be given licences to run such banks. It also said all applications will be examined by an external group and “a limited number of licences" will be given, based on the group’s recommendations.

The RBI paper has proposed that the minimum capital requirement could be anything between 300 crore and 1,000 crore, and a higher minimum capital norm will ensure “banks operate on a strong capital base", and such banks would be able to take part more meaningfully in the financial inclusion drive through their ability to invest in technology.

Licences to industrial houses, according to the paper, ensure important sources of capital, management expertise and strategic direction, but a conflict of interest could arise as the firms may misuse the bank for their own needs and restrict credit flow to competitors.

RBI has explored the option of allowing industrial houses to take over regional rural banks (RRBs) before setting up banks. RRBs are currently 50% owned by the Union government, 15% by the respective state governments and 35% by sponsored commercial banks.

Among other things, the RBI paper discussed at length the issue of converting NBFCs into full-fledged banks.

Rajan, a former chief economist of the International Monetary Fund, who now has the rank of secretary, government of India, in his capacity as adviser, said, “RBI could allow the entry of small banks, but not restrict their growth or geographical spread." In the past, India has experimented with a concept known as local area banks that operated with small capital and a tiny geographical area.

The 20 new entrants Rajan is in favour of should have a capital to asset ratio of not less than 15%, he has suggested.

“Restrict their activities in initial years to more traditional banking activities…and maintain close supervision," the note said. “Remove restrictions as supervisors gain confidence in the banks and allow a full-fledged banking licence not less than three years after commencing operations and once certain criteria are met."

According to him, a minimum entry requirement of 1,000 crore would ensure that only large corporate houses can get a banking licence and with the capital to asset ratio at 10%, such banks will have an asset base of 10,000 crore at the outset. “A bank of such size is unlikely to be effective at local lending or at promoting financial inclusion… Finally, untried management handling 10,000 crore in assets is a risk RBI should worry about."

A sound track record on financial services and higher capital to asset ratio should be the focus rather than higher capital as the cost of information technology systems is not prohibitive. “There are very few well-managed small NBFCs and MFIs that could well be entrusted with a banking licence," he said.

Pandora’s box

Rajan is worried about the risks posed by the entry of large industrial groups as such banks could tend towards lending to related entities, with such loans increasing when a house runs into trouble. “India already has a concentrated wealth structure, which influences political decisions. Allowing industrial houses to own banks will exacerbate the concentration of economic power and political influence. We should not open this Pandora’s box," he said.

On the other hand, Rajan has suggested an experiment with a dual-licensing structure. For instance, a few industrial houses whose integrity is above reproach could be given restricted small bank licences that can be upgraded depending on their performance and “supervisory comfort". Based on this experience, RBI can open the doors to big industrial houses in phases.

Foreign financial firms, according to him, have expertise and hence “while most of the approved licences will be for more domestic promoters, there is no reason why foreign promoters should have very different requirements imposed on them".

Finally, Rajan does not see much merit in branch expansion. With the growth of mobile banking, the advent of the unique ID programme, and a liberalized business correspondence rule, he sees no reason in linking inclusion to branch expansion. “We should write our regulations such that branchless banks are also possible."

Rajan’s suggestions could influence RBI’s thinking when it frames the draft guidelines for new bank licences in January.

Earlier, a Planning Commission panel on financial sector reforms, and headed by him, had suggested the separation of debt management from RBI’s mandate and sowed the seeds for the Financial Stability and Development Council that the government has set up.

Photo by Ramesh Pathania/Mint