The foreign threat in banking

The clearance granted for a major expansion of foreign bank presence in India will hit priority sector lending overall, reduce the Reserve Bank of India's regulatory authority over banks and lead to a situation where the banking sector will be left vulnerable in the face of an economic shock.

INDIA'S banking sector is set to witness a major expansion of foreign bank presence. The clarification recently issued by the Reserve Bank of India (RBI) regarding the cap on foreign direct investment (FDI) in private and public sector banks, set now at 49 and 20 per cent respectively, finally makes clear the implications of a Cabinet decision taken in May last year. The ceiling on FDI applies to all forms of acquisition of shares (initial public offers or IPOs, private placements, American depository receipts and global depository receipts, and acquisitions from existing shareholders). The clarification also makes clear states that even foreign banks with a branch presence in India can make FDI investments in private and public sector banks subject to approval from the RBI. This provides the basis for an expansion of the reach of existing banks through equity-enabled tie-ups with Indian entities. With the mushrooming of private banks promoted by Indians in recent years and the more recent trend towards merger of these entities with larger strategic partners, the new clarification sets the stage for an expansion of foreign bank presence in India.

There remain two other hurdles. Though the regulations that were recently clarified ensure that the equity stake of foreign partners can rise to levels which allow for foreign control, interference by the foreign stakeholder will be tempered by the stipulation under the Banking Regulation Act, Section 12 (2), that in the case of private banks the maximum voting rights per shareholder will be 10 per cent of the total voting rights.

It will not be long before this provision is diluted: foreign and private sector banks are already lobbying with the RBI to have it changed. A senior official in a foreign bank is quoted as having said: "We should be given more leeway and majority shareholders must have a say in the management of the bank. The 10 per cent cap is interfering with our right to manage our affairs. This cap on voting rights should be increased, to be proportionate to the shareholding."

The other hurdle is the lower cap of 20 per cent share of FDI in equity in the case of public sector banks, which clearly dominate the banking business in India. Here again, the lower ceiling has been necessitated by the fact that diluting the government's shareholding to less than 33 per cent would require legislative changes. The lower cap appears to be a temporary measure pending such changes. Given the desperate desire of the Bharatiya Janata Party-led government to push ahead with neo-liberal reform in general and financial sector reform in particular, it can be expected soon to make an effort to institute the changes necessary to allow for foreign bank takeover of public sector banks as well.

ONCE these changes are instituted, a fundamental restructuring of the organisational basis of India's banking sector is inevitable. Foreign banks, which are permitted to bring in capital that can be accessed at extremely low costs abroad, have pockets deep enough to buy their way to dominance. With liberalisation there has been a significant increase in foreign bank interest in expanding operations to India. However, for a number of banks the prospect of setting up a wholly new operation, building goodwill and then establishing a permanent presence appeared to be too expensive a proposition relative to the prospect of developing a profitable business. The new option of testing the waters with a small acquisition in an existing private sector bank and then, as liberalisation proceeds further, garnering a controlling interest in the bank concerned if the operations warranted it, is a far better. Thus an increase in FDI flow to the banking sector is extremely likely.

In fact, a number of foreign banks have evinced interest in acquiring a stake in Indian banks. Bank Brussels Lambert, a subsidiary of the Dutch ING Group, has expressed its intent to take control of Vysya Bank. BBL currently holds a 20 per cent stake in Vysya Bank. The promoters of Global Trust Bank are believed to have approached ABN Amro Bank, to sell the more than 26 per cent stake held by them in the bank. Citibank and ABN Amro are reportedly negotiating for a stake in Bank of Punjab. And, Citibank, ABN Amro and HSBC have been eyeing a stake in Centurion Bank.

Developed country governments, especially the U.S. government, have backed this interest and have been pressuring the RBI to make clear the nature of the liberalised rules regarding foreign bank expansion. Interestingly, the RBI clarification on FDI in banks issued on February 16 came days after U.S. Treasury Secretary Kenneth Dam met with the RBI Governor and the head of Citibank's South Asia operations. According to reports, Dam, who was in Mumbai ostensibly to discuss money-laundering rules, had taken up the issue of opening up foreign investments in local banks.

THERE are a number of implications of such an expansion of foreign presence. To start with, even with the diluted regulation that is currently in place, it is clear that private banks in general and foreign banks in particular have been lax in meeting the regulatory norms. The takeover trend would result in a sharp reduction in the extent of regulation of banking sector operations by the RBI. The implications of this for the priority sectors, especially agriculture, can be quite damaging.

Thus, during 2001, one of the observed effects of financial sector reform was a shortfall in private sector banks' advances to the priority sectors, which stood at 38.7 per cent of the total as compared with the required 40 per cent. On the other hand, despite a marginal fall in public sector bank advances to these areas, its overall tally in terms of share of advances stood at 43 per cent. The sector most affected was agriculture, in whose case private bank lending amounted to just 9.6 per cent of net credit, which was far short of the stipulated 18 per cent.

Within the private sector, the foreign banks were the major defaulters. According to the Annual Report of the RBI, advances provided by foreign banks to the priority sector came down from 35 per cent as of March 2000 to 31 per cent during 2001. Here again, agriculture was the prime area of neglect. Foreign banks' performance in the matter of credit to small scale industries and export sectors was much better, with lending to these sectors accounting for 10 and 19 per cent, respectively, of the net bank credit against the sub-sectoral targets of 10 per cent and 12 per cent. Clearly, even to the extent that priority-sector lending targets had been met, the choice was in favour of the more cost effective and profitable sectors. Overall, 60.8 per cent of the priority sector lending by foreign banks was directed towards export credit.

Second, the expansion in foreign bank presence will subject public sector banks to unfair comparisons with regard to "profitability" and "efficiency", and this would force these banks to change their lending practices as well. Thus, though the overall performance of the public sector banks in terms of priority-sector lending was satisfactory during 2001, total agricultural advances of public sector banks as a share of net bank advances fell by 2.3 per cent to 15.7 per cent, as compared with the norm of 18 per cent. Yet, it must be said that advances to agriculture and small-scale sector units accounted for the bulk of the public sector banks' advances to the private sector.

The RBI reports that the aggregate outstanding priority sector advances of the public sector banks increased by Rs.18,739 crores (14 per cent) to Rs.1,46,546 crores during 2001. This would have affected public sector bank income, relative to the private sector in general and foreign banks in particular.

IN the net, public sector banks are less profitable than private banks. Public sector banks,that account for 79.5 per cent of total assets of all commercial banks, earn only 67.2 per cent of aggregate net profits, whereas the older private sector banks with 6.5 per cent of total assets earn 8.1 per cent of aggregate net profits, the new private sector banks with 6.1 per cent of assets obtain 10 per cent of aggregate net profits and foreign banks with just 7.9 per cent of total assets garner 14.7 per cent of aggregate net profits.

Among the factors that account for this differential in profitability, there are two that are important. One is that the operating expenses for a given volume of business tends to be higher with public sector banks. The other is that income generated out of a given volume of business tends to be lower in their case of the public sector banks. These are the two areas in which changes are being made as part of the effort of the public sector banks to "match up" the performance of private domestic and foreign banks. The expansion of foreign presence would only accelerate this tendency.

The effort of the public sector banks to trim operating expenses has taken many forms. They are seeking to reduce the wage bill by reducing employment through the twin mechanisms of retrenchment under the voluntary retirement scheme and simultaneous computerisation. They are also seeking to reduce costs by limiting branch expansion and even reducing the number of branches. The full implications of the former for organised sector employment are yet to be gauged. The latter, which affects the rural areas first, reduces access to credit in such areas that were well-served by the post-nationalisation branch expansion drive, and worsens the tendency towards reduced provision of credit to the agricultural sector.

While this is occurring, public sector banks are working to increase income generated from a given volume of business. This not only leads to reduced interest in priority sector lending but also encourages diversification to more risky high-profit lending as well as to investments that yield incomes other than interest income. One form of high-profit lending is lending to stock market players, in the form of credit for share purchases and guarantees to brokers. And the principal form of investments that yield non-interest income is investment in shares. Recent experience, such as the stock market collapse in the wake of the Ketan Parekh affair, point to the dangers inherent in such diversification, which increases bank fragility substantially. This increase in fragility is all the more disturbing since it occurs in a context where mergers and acquisitions involving foreign and Indian banks are resulting in consolidation and increasing the size of entities that could be adversely affected.

Thus, the RBI's eagerness to rush through with reform of a kind that reduces its own regulatory authority and power can find India's banking sector displaying weaknesses of a kind that, in the face of any economic shock, can destabilise the system.