Universal banking

Print edition : May 09, 1998

THE S.H. Khan Committee set up by the Reserve Bank of India to harmonise the roles of development finance institutions (DFIs) and banks has come up with the concept of universal banking, which allows them to compete with one another in all areas of business.

In its interim report, submitted to RBI Governor Bimal Jalan, the committee argued that distinctions between commercial and investment banking have become increasingly blurred with banks providing both working capital and term loans to corporates and DFIs competing with commercial banks for deposits (although they cannot accept short-term deposits). Therefore, the committee argues, DFIs should be given banking licences eventually and until then they should be allowed to establish 100 per cent banking subsidiaries while they continue to play their present role.

"Size, expertise and reach are now deemed crucial to sustained viability and future survival in the financial sector," the report says, and recommends that managements and shareholders of banks and DFIs be allowed to explore the possibility of gainful mergers not only of banks but also of banks and DFIs. "However, such restructuring and consolidation... should be led by viability and profitability considerations alone," it says.

The Khan panel believes that the synergies unleashed by such consolidation will help Indian institutions compete in the international financial market. Interestingly, the panel suggests that since DFIs in India are increasingly operating on commercial as opposed to developmental considerations, the Government/RBI should provide appropriate levels of financial support if they are to assume any developmental obligations.

DFIs were set up with the objective of taking care of the investment needs of industries. They have, over time, built up expertise in merchant banking and project evaluation. Yet they have also backed bad investments and, as a result, become equity holders in defaulting enterprises through conversion of loans into equity. Despite DFIs holding huge chunks of equity, their directors on company boards have looked the other way when companies mismanaged their affairs and incurred losses. Instances of DFI nominees on company boards being unaware of violations of law by the company managements are not unheard of. ITC's violations of the Foreign Exchange Regulation Act are a case in point.

Nevertheless, DFIs have developed core competence in investment banking. They take a lot of risks to prop up industries. They finance industries such as infrastructure industries, which have long gestation periods and have contributed significantly to the country's industrialisation process. Instead of asking DFIs to improve their asset portfolio by exiting from the boards of companies which they finance and asking them to concentrate on their core competence, the Khan Committee has recommended a free-for-all where banks and DFIs will compete with one another for deposits and loan accounts.

The panel recommended that the regulatory discrepancies between foreign and local entities must be smoothened and that the regulatory burden must be determined solely by systemic efficiency and risk-management concerns. The panel also suggested the establishment of a super regulator to supervise and coordinate the activities of the multiple regulators in the financial system.

The panel called for a revamp of the 1993 Act on recovery of debts, legal reforms, a reduction in the cash resereve ratio (CRR) to international levels and the abolition of statutory liquidity ratio (SLR) and the statutory minimum of advances to certain sectors. It has called for modifications in the definition of priority sector by excluding all infrastructure loans from the net bank credit for the priority sector. It has suggested the creation of an alternative mechanism to finance the priority sector.

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