S&P Global Ratings says that the recommendations of the Reserve Bank of India (RBI)'s working group on awarding new licences to well-managed Indian non-banking financial companies (NBFCs) could improve financial stability. However, it says it is sceptical of allowing corporate ownership in banks, given India's weak corporate governance amid large corporate defaults over the past few years.
"In addition, RBI will face challenges in supervising nonfinancial sector entities and supervisory resources could be further strained at a time when the health of India's financial sector is weak," the ratings agency says.
In the ratings agency's view, the working group's concerns regarding conflict of interest, concentration of economic power, and financial stability in allowing corporates to own banks are potential risks.
It says, "Corporate ownership of banks raises the risk of intergroup lending, diversion of funds, and reputational exposure. Also, the risk of contagion from corporate defaults to the financial sector increases significantly."
The performance of India's corporate sector over the past few years has been weak with large corporate defaults. Non-performing loans (NPLs) for the corporate sector stood at around 13% of total corporate loans as of March 2020 (around 18% as of March 2018), highlighting the more pronounced risk in India compared with that in other countries.
The working group has recommended that corporates should be allowed to control banks 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. In addition, the group proposed strengthening of the supervisory mechanism for large conglomerates.
The recommendation to harmonise licensing guidelines for all banks, new and old, will help restore a level playing field for all players, S&P says, adding the RBI's proposal to raise the minimum net worth for all universal banks to Rs10 billion will also ensure better capitalisation and that only promoters with deep pockets can enter the banking sector.
In addition, it says, the recommendations would limit the size of shadow banking in India and ensure stronger supervision. RBI proposes that only well-managed NBFCs with over 10 years of experience and Rs500 billion of assets will be allowed to convert to a bank.
S&P says, "We believe the NBFCs have numerous strengths that will give them a head start in their entry into banking. These include their existing client bases, distribution networks, brand and risk management systems. Conversion to a banking entity could provide more stable funding, in particular low-cost deposits."
"Still, we do not expect the competitive banking environment in India to deteriorate with these new licenses. This is because the finance companies that are converting into banks will have huge upfront regulatory costs. They will incur additional costs in terms of cash reserve ratio and statutory liquidity ratio requirements; priority sector lending; and adjusting their existing portfolios to reduce concentration in one segment," it added.
The performance of new banks set up in India over the past three decades has been mixed. Of the 14 new universal bank licences issued by RBI since 1993, Global Trust Bank and Yes Bank Ltd had to be bailed out by government-owned banks. In addition, three banks were eventually acquired by HDFC Bank Ltd, while ICICI Bank Ltd and IDBI Bank Ltd merged with their parents.
Nevertheless, S&P says, the RBI has adopted a very calibrated approach in awarding new licences. "A change in regulation by itself would not lead to RBI liberally allowing corporates to start a bank. The RBI's fit and proper criteria for banks give it large latitude in decision-making. Also, most importantly, it remains to be seen how many of these recommendations become law," the ratings agency added.