One of the key risks posed by the bank subsidiary model is that the parent bank is directly exposed to the functioning of various subsidiaries and any losses incurred by the subsidiaries inevitably affect the bank balance sheets. Such risks can be mitigated largely by the FHC structure, the Working Group of FSLRC says

The Working Group (WG) set up by the Banking Financial Sector Legislative Reforms Commission (FSLRC), has recommended a holding company structure for banks, including state-run and private as well as for new entrants.

The WG headed by Kishori Udeshi, former deputy governor of the Reserve Bank of India (RBI), said, “...the current mode of operations of banks under bank subsidiary model (BSM) is inadequate and there should be a shift towards the financial holding company (FHC) model as a preferred model for financial sector in India. The FHC model mitigates the risks spilling over to the bank from other entities in the group. In a holding company model the banking entity will be ring fenced.”

The Banking Regulation Act does not mandate the separation of retail banking from wholesale/investment banking. However, regulated entities in the financial sector separate these activities and house them in different entities for ease of regulatory oversight, by different regulators. The model currently followed by regulated entities is BSM.

In India, banks have expanded into non-banking activities during the last two decades and have set up subsidiaries in almost all non-banking financial areas such as mutual funds, venture capital funds, pension funds, stock broking, insurance and housing finance.

Once transition to the structure, as contained in the recommendation of this WG, is achieved, subsidiaries of banks must only do such activities which banks themselves can undertake. “Subsidiaries of banks should only do business that could have been done purely within the bank. If insurance cannot be done by a bank, it should not be done by the subsidiary of a bank,” the report said.

According to the WG report, there must be ring fencing of banks vis-a-vis other non-bank entities. “Capital of banks should not be allowed to take any risks apart from banking risks, and mechanisms must be put in place through which resources from the bank does not flow up into the FHC or to sister subsidiaries in times of crisis, or otherwise,” it said.

In addition, banks must not lend to intermediaries, which are not regulated by a financial sector regulator. However, the operation of certain financial institutions such as mutual funds might require access to short-term funding and such short-term funding must be within stringent prudential regulations, the report said.

At present, banks are allowed to lend to entities that are not registered with the RBI, like insurance companies registered under the Insurance Act (1938), nidhi companies notified under Section 620A of the Companies Act (1956), stock broking companies/merchant banking companies registered under Section 12 of the SEBI Act (1992); and housing finance companies regulated by the National Housing Bank (NHB).

The Working Group said, subsidiaries of banks should not carry on activities which the parent bank themselves cannot. “If banks have subsidiaries, such as a securities brokerage house, then such subsidiaries cannot invest in products which the bank itself cannot invest in. This means that risker products which the bank cannot have in its balance sheet cannot be reflected in the balance sheet of its subsidiary,” it said.

Considering the issues and gaps in the current legal framework and drawing on the recommendations of standard-setting bodies and international best practises, this WG recommended that a sophisticated resolution corporation be set up that will deal with an array of financial firms including banks and insurance companies.

The mandate of this corporation must not just be deposit insurance. It must concern itself with all financial firms, which make intense promises to consumers, such as banks, insurance companies, defined benefit pension funds, and payment systems. A key feature of the resolution corporation must be its swift operation. It must also effectively supervise firms and intervene to resolve them when they show signs of financial fragility but are still solvent. The legal framework must be so designed to enable the resolution corporation to choose between many tools through which the interests of consumers are protected, including sales, assisted sales and mergers, the WG report said.