The fall of unfathomable financial institution Lehman Brothers in August 2007 as a prelude to deep financial crisis that gripped the world in the last few years was a wake-up call for central banks. In August 2007, the Reserve Bank of India (RBI) came out with a discussion paper on holding companies in the banking group, where the central bank suggested to have financial holding company or a banking holding company to protect banks against possible adverse effects from the activities of their non-banking financial subsidiaries.
In the meantime, some enthusiastic banking groups, especially the private sector ones, had made their first moves to create ‘intermediate holding companies' by creating layers within their corporate structure, which would have made the central bank's job more difficult in monitoring them. While these discussions were almost concluded without making any headway, the RBI had set up another working group under the chairmanship of Deputy Governor Shyamala Gopinath in June 2010 to examine the feasibility of introducing a Financial Holding Company (FHC) structure.
The issue of the nature of corporate form adopted by financial groups for undertaking various financial activities has acquired relevance from two distinct perspectives — one, efficient corporate management within the groups addressing the growth and capital requirements of different entities, and two, the degree of regulatory comfort with different models, particularly in regard to the concerns relating to contagion risks.
Banks, at present, in India are organised under the Bank-Subsidiary Model (BSM) in which the bank is the parent of all the subsidiaries of the group. The working group was mandated to examine the need and feasibility of introducing a FHC model in the Indian context, including by drawing lessons from the global financial crisis.
The formation of FHCs should be seen in the background of the global financial crisis. The RBI says: “The recent global financial crisis can be said to be model agnostic as far as the form of conglomeration is concerned. ....... The post crisis reform proposals do not specify preference for any particular model. The focus, as far as structure is concerned, is on strengthening capital requirements at the consolidated level; reducing complexity of structures to enable efficient resolution of financial institutions; and separation of investment banking from commercial banking”.
From a regulatory perspective, one of the key risks posed by the BSM is that the parent bank is directly exposed to the functioning of various subsidiaries and any losses incurred by the subsidiaries inevitably impact the bank balance sheet. It therefore becomes imperative that the bank regulator has an interest in the health of all subsidiaries under the banks, even as each subsidiary is under the jurisdiction of the respective sectoral regulators.
The most obvious risk from affiliation of banks with non-banks is the risk of transference to non-bank affiliates of a subsidy implicit for banks in the safety net, deposit insurance, access to central bank liquidity and access to payment systems, with the attendant moral hazard. This subsidy is more readily transferred to a subsidiary of a bank and can, to a certain extent be reduced through the holding company structure. The other risk posed by this model is the difficulty in resolution if the bank, or any of its subsidiaries, is in trouble.
The working group felt that a holding company structure may enable a better supervision of financial groups from a systemic perspective. It would also be in consonance with the emerging post-crisis consensus of having an identified systemic regulator responsible inter alia for oversight of systemically important financial institutions (SIFIs). “A holding company model would provide the requisite differentiation in regulatory approach for the holding company vis-à-vis the individual entities.”
Suitable model?
On balance, a holding company model may be more suited in the Indian context. It, however, was conscious of the fact that regardless of the organisational forms, banks cannot be totally insulated from the risks of non-banking activities undertaken by their affiliates. It also recognised that there are divergent ownership and governance norms for various sectors and also entities within the sectors. The divergences primarily reflect regulatory and public policy objectives. There are also legacy issues concerning the existing conglomerates. “Any framework to harmonise them at the level of the FHC would be a challenge and therefore the FHC as a preferred model will need to be phased in gradually”.
While emphasising the view that the FHC model should be a preferred model for all financial groups, irrespective of whether they contain a bank or not, the working group said the ‘intermediate holding companies' within the FHC should not be permitted “due to their contribution to the opacity and complexity in the organisational structure”.
In the post-crisis analysis, the financial groups without banks could also be of systemic importance particularly if they are large and undertake maturity and liquidity transformation. This would be particularly relevant in the case of large conglomerates coming under the existing financial conglomerate supervision framework. So it was recommended that there can be Banking FHCs controlling a bank and Non-banking FHCs which do not contain a bank in the group.
Paving the way for a holding company structure for financial entities, the RBI has introduced two important caveats — the apex bank has sought to be the sole regulator of FHCs, irrespective of a bank's presence in the holding company or not and it has also sought a separate regulatory framework with a new Act.
The working group considered various possible options in this regard and concluded that a separate regulatory framework for FHCs, overarching the existing functional regulation for various segments, would be the most desirable alternative.
Firewall provisions
While firewall provisions can be important safeguards in preventing potential conflicts of interest and protecting insured deposits, in reality, the firewalls may not hold up, the working group felt.
Such a framework would also ensure that there is no ‘product arbitrage' across different functional regulatory regimes. However, the working group was very clear that the role of the financial holding company regulator would be supplementary to the role of existing functional regulators.
As regards the legal framework for separate regulation of FHCs, it has recommended that the enactment of a separate Act for regulation would be the most efficient alternative. It will avoid any legal uncertainties that could be there if FHCs were to be governed by amending the RBI Act or Banking Regulation Act. It will align the regulation of FHCs with the objectives of systemic oversight and it will enable design of a regulatory framework for FHCs different in scope and focus from entity regulation.
Further, the RBI has recommended that the amendments should also be simultaneously made to other statutes/Acts governing public sector banks, Companies Act and others, wherever necessary. Alternatively, in order to avoid separate legislation for amending all individual Acts, the provisions of the new Act for FHCs should have the effect of amending all the relevant provisions of individual Acts and have over-riding powers over other Acts in case of any conflict.
While strengthening the sense of responsibility in ownership, the RBI's efforts are in the right direction to avoid a systemic failure in the financial system in future, thus protecting the interest of all stakeholders.
