Ring-fencing banks

Y.V. Reddy, the RBI Governor, with chiefs of Indian banks. A file picture. - PAUL NORONHA

The RBI expresses serious reservations about the new kinds of corporate structures planned by banking institutions.

Y.V. Reddy

WHEN banking institutions venture beyond plain vanilla banking, regulators usually sit up and take note. Recent moves by two leading banking groups the ICICI and State Bank of India (SBI) groups to hive off their insurance and mutual fund businesses into specially created corporate structures of the kind yet unfamiliar in India have provoked the Reserve Bank of India (RBI) to come out with a discussion paper on the matter. While ICICI Bank is the biggest private bank in India, the SBI, a public sector bank, is the biggest player in the Indian banking industry.

The discussion paper, issued on August 27, sets out the issues at stake and highlights the RBIs concerns. Both the SBI and ICICI Bank had recently sent proposals to the RBI for creating intermediate holding companies to facilitate the expansion of operations in their insurance and mutual fund businesses. Outlining its concerns, the central bank pointed out that some players are experimenting with structures so far unfamiliar in India. It observed that there were regulatory and supervisory concerns, given the prevailing legal, regulatory and accounting framework. The RBI has fixed October 8 as the deadline for those who wish to respond to the discussion paper.

The Indian Banks Association, representing bank managements, met on September 13 to discuss the issue. Media reports indicate that the managements of both public sector and private banks favour the intermediate holding company model. Under this structure, a bank, acting as the parent company, floats a holding company, which would in turn act as the parent for various entities operating in different lines of financial business. ICICI Bank has suggested that the RBI allow banks to float an intermediate holding company that would be categorised as a Non-Banking Finance Company (NBFC), which will conform to the prescribed capital adequacy ratio. Apparently, ICICI Bank has suggested that the NBFCs borrowing would be backed by the equity in the company. Reports indicate that the SBI has suggested that the RBI initially allow banks to have an intermediate holding structure; after some time, banks can move towards a full-fledged holding company structure.

What are the motives for this kind of restructuring? Why does the RBI appear concerned about these innovations? And most importantly, what are the implications of these moves?

In order to answer these questions, one needs to appreciate why regulators all over the world are so touchy about regulating banks. The defining feature of banking activity, as opposed to all other lines of financial business, lies in what a bank does. All banks, even private ones, have a public interest because they accept deposits from the public. This sets them apart from the other lines of financial business stock markets, for instance. Historically, the question of fiduciary responsibility, and the public interest identified with it, has meant that regulators around the world shudder at the prospect of letting a bank collapse. This is the reason that even full-blown collapses of stock markets do not evoke comparable dread among regulators as a bank collapse does.

In the past two decades, banks have been increasingly diversifying their portfolios, venturing into various kinds of activities. Banks are into housing finance; they have their own insurance business, mostly in alliance with foreign companies; they have promoted mutual funds; they have established investment-banking arms; and they are involved in the securities markets in a variety of ways.

These are all very different from old-style banking operations involving raising deposits and lending to borrowers. It is significant that there are different regulators for the different kinds of subsectors within financial markets.

Existing laws do not permit a commercial bank to invest more than 20 per cent of its capital and reserves in its subsidiaries offering financial products. The SBI and ICICI Bank have argued that the new kind of holding companies proposed would enable their insurance wings, for instance, to raise capital from private sources to back the risks in the insurance business. The proposed intermediate holding company is thus akin to a special purpose vehicle located between the bank and its subsidiary offering insurance products.

Although the RBI is sceptical about the moves, reports in the financial media indicate that the Finance Ministry has decided to give in-principle approval to the two banks proposals. The recent amendments to the SBI Act have enabled the government to acquire the RBIs 59.7 per cent stake in the SBI. Despite the amendment, the governments stake in the SBI cannot fall below 51 per cent because it would then lose its public sector status. SBI officials have pointed out that the SBIs valuation would go up if the proposed subsidiaries are slotted into an intermediate holding company.

The SBIs proposed holding company is to operate SBI Life, which is a joint venture between the SBI and Cardiff SA of France. The SBIs mutual fund subsidiary, SBI Funds Management Ltd., is also a joint venture, in partnership with Societe Generale Asset Management. The SBI also plans a similar joint venture for its non-life insurance business.

There are also plans to list the subsidiaries in the next financial year. It appears that the formation of such a structure will enable the SBI to pretend to be a public sector company even as large swathes of its business, organised within subsidiaries, would largely be in private hands. In effect, the move appears to be a smart way of avoiding the more difficult route of privatising the bank, which would surely ruffle many feathers.

In the discussion paper, the RBI has expressed its reservations about the intermediate holding structure on the grounds that regulating such entities would be difficult. This is partly because the RBI feels that under existing laws the intermediate company would not fall within its regulatory ambit.

Although it accepted that the holding company model would enable a parent company to deliver non-banking services while also owning a bank, the RBI pointed out that regulating an intermediate layer would be difficult. This is because a different regulator would govern each of the holding companys subsidiaries operating in a different segment of the financial market. The Insurance Regulatory and Development Authority (IRDA) would govern the insurance business; operations of the mutual funds and securities business would be governed by the Securities and Exchange Board of India (SEBI); and housing finance would be regulated by the National Housing Bank, an arm of the RBI.

In effect, the intermediate holding company, under whose umbrella these subsidiaries would operate, would not be governed by a single regulator. The RBI fears that the multiplicity of regulators will enable entities to indulge in regulatory arbitrage. It also pointed out that it may have difficulty in obtaining crucial information from the intermediate holding company as also enforcing prudential behaviour.

Instead, the central bank has suggested the formation of a banking holding company or a financial holding company at the apex of the structure (see chart). This would ensure that the parent holding company is held responsible for the conduct of its offspring. Banking holding firms can own more than one bank and can make limited investment in non-banking companies, while financial holding firms can own banks as well as non-banking business.

However, the formation of financial holding companies would require fresh legislation on the lines of the Gramm-Leach-Bliley Financial Services Modernisation Act of the United States. The RBI pointed out that if non-banking entities were to be held directly by the bank holding company, the contagion and reputation risk on account of affiliates for the bank is perceived to be less severe as compared with the present. It also pointed out that the U.S. law could not be replicated in its entirety because several segments of the financial operations of such entities remained unregulated in the U.S. The RBI has suggested that it be entrusted with the task of regulating banking holding companies and financial holding companies.

The RBI pointed out that the device of intermediate holding companies had been mainly used by multinationals to take tax advantage by setting them up in tax havens. Moreover, such structures were key building blocks for achieving a multi-layered corporate structure, it said. The central bank noted that governments and regulators had always regarded these kinds of structures, built through a web of special purpose vehicles and intermediate holding companies, as an impediment to effective supervision.

Multilayered corporate structures are like boxes within boxes, not easily amenable to regulatory oversight. The problem of regulators becomes accentuated if the intermediate companies do not fall within the regulatory ambit, observed the RBI.

In passing, the RBI also referred to possible complications such structures could have in the context of regulatory provisions governing specific sectors such as the insurance business, which have caps prescribed for the extent of foreign direct investment (FDI).

On August 21, the Finance Minister cleared a proposal from ICICI Banks investment holding company, ICICI Financial Services, to sell 24 per cent stake to foreign investors. ICICI Bank owns 74 per cent each of ICICI Prudential Life Insurance and ICICI Lombard General Insurance, but the bank is 70.88 per cent owned by foreign investors. This means the effective FDI in the insurance subsidiaries is about 78.56 per cent, against the FDI norm of 26 per cent.

If and when ICICI Bank transfers its stake in the insurance companies to ICICI Financial Services and the holding company in turn sells a 24 per cent stake to foreign investors, then the effective Indian shareholding in both insurance companies will further fall to about 15.62 per cent; FDI would then be 84.36 per cent.

Seven years ago, the National Democratic Alliance government eased FDI regulations on the insurance sector by allowing ICICI Bank, the Housing Development Finance Corporation (HDFC) and the SBI to form insurance ventures with foreign strategic partners. In fact, HDFC is in a position similar to ICICI Bank. HDFC is owned to the extent of 78.71 per cent by foreigners. Given the fact that HDFC owns 81.9 per cent of HDFC Standard Life Insurance Company, the effective FDI in HDFCs insurance subsidiary is about 82.43 per cent. Foreign holding in the SBI is capped at 20 per cent, which implies that the effective foreign ownership of SBI Life Insurance Company is above the 26 per cent cap.

It is evident that the RBI and the Union Finance Ministry have almost diametrically opposite views on what kind of structures are prudent for financial players. It would appear that the countrys central bank prefers a more conservative approach. But the language of liberalisation is such that it distorts the economic lexicon. In finance, unlike in most other realms, a conservative approach may be more progressive than a liberal one.