The story so far: The Reserve Bank of India (RBI) late last month decided to keep on hold the implementation of a recommendation made by an internal working group to issue banking licences to large industrial groups. Many view the RBI’s decision as a prudent step to preserve financial stability.
What is it?
An internal working group of the RBI headed by P.K. Mohanty in November last year recommended, among other things, that the RBI allow large industrial groups to set up banks . The group’s recommendation was seen by analysts as an effort to bring more private capital into the banking system and help increase lending. The proposal was met with criticism from many experts , including former RBI governor Raghuram Rajan and former RBI deputy governor Viral Acharya .
Many countries across the world either completely ban industrial groups from owning banks or heavily restrict such ownership. The RBI has been mulling the working group’s recommendations over the past one year and has accepted some of its recommendations. However, it has decided to put on hold the major recommendation to allow industrial groups to own and operate banks.
What is the problem with allowing large industrial groups to set up banks?
Critics of the working group’s proposal argue that giving large industrialists such as the Ambanis, the Adanis and the Tatas the licence to own and operate banks will lead to misallocation of capital. They worry that the banks owned by these industrial groups would lend money to their own companies over those owned by others. For example, a bank owned by the Ambanis may prefer to lend to companies that come under the Reliance Group over those owned by the Tatas or the Adanis.
A bank owned by a certain industrial group may also be more willing to offer loans to its sister companies even if they do not meet credit standards, critics believe. Such loans are more likely to turn into bad assets and threaten the stability of the financial system. Critics also believe that India lacks the infrastructure necessary to effectively implement regulations to prevent such dangerous connected lending. The failure of many private banks in the past due to bad lending decisions too has been cited as a reason to oppose the idea of large industrial groups entering banking. Even though private banks maintain better asset quality than public sector banks, critics still fear that private banks may be more prone to making bad loan decisions.
Are the critics right?
Granting bank licences to industrial groups would give these groups easy access to capital. Remember that under the current fractional-reserve banking system, banks possess the rare privilege to create loans out of thin air without a commensurate size of deposits. So, an industrial group that owns a bank can expect an abundant supply of loans from its banking wing. This can potentially lead to serious problems.
For example, an industrial group suffering huge losses could use its banking wing to keep itself afloat for a long time. But connected lending per se does not have to be dangerous if the bank management understands that throwing good money after bad is not a wise decision. It should also be noted that banks in general are protected from going bust by the RBI usually citing the systemic risks posed by bank failures and the desire to protect depositors.
Such protection itself, however, raises the risk of moral hazard as it encourages banks to engage in poor lending practices without worrying about the consequences. In the absence of sovereign support for banks, there would be a lot more incentive for depositors who want to protect their money to oversee the lending decisions of banks and prevent over-exposure to any borrower, including a related party.