The FDI threat

The RBI's decision to allow foreign direct investment in Indian banks, the lifting of sectoral caps on foreign institutional investors and a series of other policy measures could ultimately lead to the privatisation of public sector banks.

THE series of policy announcements in recent weeks promises to unleash a shakeout in the Indian banking industry. A major policy change, effected through an innocuous "clarification" issued by the Reserve Bank of India (RBI) a few weeks ago, set the stage for the increased presence of foreign entities in the industry. The RBI's move to allow foreign direct investment (FDI) in Indian banks, has been followed by the announcement in the Union Budget lifting sectoral caps on foreign institutional investors (FII). There are also reports that the RBI's forthcoming credit policy may feature more sops for private and foreign banks.

These changes are likely to hasten the process of consolidation of the banking industry. Although there is some doubt over whether the moves will have any immediate impact, there is consensus that the changes are merely a prelude to the wholesale privatisation of the public sector banks (PSBs). IDBI, the promoter of IDBI Bank, has already announced its intention to relinquish control of the bank. Foreign banks have also mounted pressure on the Finance Ministry, seeking the removal of legislative hurdles that set limits to private and foreign holdings in PSBs.

In the short term, the action is likely to be focussed on the Indian private banks. Of the 100 banks in India, 27 are PSBs (including eight in the State Bank of India group). There are 31 private sector banks, of which eight are of recent vintage (for example, ICICI Bank and HDFC Bank); and there are 42 foreign banks with branches in India.

The RBI's decision is seen as enabling foreign banks to extend their operations, primarily by acquiring other banks. Initially, foreign banks are likely to acquire control of private banks. The PSBs are likely to be put on the block after their balance sheets have been cleaned up and the workforce trimmed to meet the demands of their foreign suitors.

The private banks are a mixed bag. Many of the older private banks cater to niche markets. S.L. Shetty, Director, Economic and Political Weekly Research Foundation, points that some of these banks have played a useful role because they have adapted to local and regional requirements. "It is likely that a few of the international banks are knocking at the doors of these banks," he says. However, he reckons that takeovers may not be easy. The promoters of especially the older private banks, who have a long tradition of banking and linkages with local communities, may resist takeover bids. Shetty contends that the government's "negative attitude" to small savings and provident funds may pave the way for foreign financial institutions to extend their operations to include pension funds.

Prof. T.T. Ram Mohan, who specialises in banking at the Indian Institute of Management, Ahmedabad, says that the banking industry is likely to undergo consolidation. Some of the private banks are already wooing foreign banks. Vysya Bank, whose promoters have sold 20 per cent stake to Bank Brussels Lambert (BBL), part of the Dutch ING Group, is likely to offer a controlling stake to the foreign bank. Vysya Bank already has a tie-up with ING to sell insurance products in India. Since the International Finance Corporation, promoted by the World Bank, has a 10 per cent stake in the bank, BBL can increase its stake by only 19 per cent because of the 49 per cent ceiling on foreign stake in Indian banks. However, banking industry sources say that even if BBL has a stake of 39 per cent, it can control the private bank effectively. In fact there have been suggestions that the RBI "clarification" came mainly because BBL decided to test the regulatory regime governing FDI in banking after acquiring 20 per cent of the stake in Vysya Bank.

There is speculation that foreign banks may be interested in picking up a stake in Centurion Bank, Bank of Punjab, IndusInd bank and the Global Trust Bank. Since the RBI announcement, shares of some of these banks have been volatile in anticipation of buying interest from foreign banks. The lifting of the cap on FIIs is likely to increase further the volatility in bank stocks.

THE banking sector norms, a key feature of the financial sector reforms since the 1990s, threaten to prise open Indian banks, particularly the PSBs. For instance, the norms for capital adequacy ratio (CAR) require that capital be infused in these institutions. If banks do not have the prescribed capital base, the only course open to them is to make an offer in the market. However, this will lower the promoters' stake in these banks. This mechanism has already lowered the government stake in several public sector banks. For instance, Bank of India's recent decision to "return" equity capital to the tune of Rs.150 crores to the government will lower the government stake from 75 per cent to 67 per cent.

The RBI has directed 11 old private sector banks having an equity base of between Rs.6 crores and Rs.49 crores to increase their capital base. These banks are now under threat. Prof. Ram Mohan believes that the foreign banks, which generally have an asset base of between Rs.3,000 crores and Rs.12,000 crores, "may prefer faster growth by acquisition rather than through organic expansion". He calculates that such acquisitions will overnight imply a growth rate of 50 per cent for some of the prominent foreign banks. Besides, it provides them an established client base and access to low-cost funds, particularly in a regime in which deposit rates are glued to low levels, barely above the rate of inflation.

Some of the old private banks have the advantage of working over a long period in geographical niches in rural and semi-urban areas. And foreign banks, in their pursuit of growth, would prefer taking over such banks to the more risky option of establishing themselves in new areas. Incidentally, this has also been the route pursued by some of the new generation private banks like ICICI Bank and HDFC Bank. While ICICI Bank took over Bank of Madura, HDFC Bank bought Times Bank.

The current market capitalisation (market value of a company's stock) of the 11 private banks whose shares are listed is about Rs.1,600 crores. The under-capitalised old private banks are clearly vulnerable. A 49 per cent stake in each of these banks can be bought by foreign banks at a total cost of less than Rs.800 crores. A 49 per cent stake in Dhanalakshmi Bank would cost Rs.13 crores; in Nedungadi Bank Rs. 21 crores; in Lakshmi Vilas Bank Rs.28 crores; in United Western Bank Rs.32 crores; in City Union Bank Rs.27 crores; and in Federal Bank Rs.73 crores. Although the CARs of many of these banks are higher than the RBI-stipulated norm, Prof. Ram Mohan argues that this alone does not offer them protection. He says that private banks are "certainly easy takeover targets" owing to the fact that the money required for such takeovers is "piffling amounts, by the standards of foreign banks". However, he says that foreign banks will examine the quality of the targeted banks' assets before making their moves.

Prof. Ram Mohan argues that although the minimum CAR of 10 per cent may be the norm, in reality banks may need to maintain it at about 12 per cent to enjoy some measure of comfort. He points to the case of Vysya Bank. It maintains a CAR of 15 per cent, nevertheless its promoters did not want to put in more funds. Instead "they have sought to hand over a stake to a foreign bank". Apart from maintaining CAR norms, banks need capital to grow. "This," says Prof. Ram Mohan, "may force them to dilute their holdings in the banks." He believes that the foreign banks will seek full control of the banks, that is, the "ownership will change". He feels that initially they may be more interested in the new private banks - apart from HDFC Bank, ICICI Bank and Vysya Bank.

Shetty prefers to look at financial sector reforms in terms of how they address the question of economic development. He argues that ten years of reforms have failed. "Every indicator of banking," he claims, "suggests that there has been a serious setback." Foreign capital, he argues, has a "certain management culture, a certain method of operation and certain types of customers that they would like to cultivate". Shetty says: "Rural and urban employment cannot be sustained without credit. Economic development needs institutional instruments. Neither the foreign banks nor the private banks are likely to be the right instruments for the objective of development." He argues that the structure of the Indian economy and its needs dictate a different approach to banking. Foreign banks, he argues, are not increasing their share of deposits. Instead, their profits are mainly on account of "playing in the money market and external transactions". He observes that although the new private banks have increased their deposits, their influence is limited.

THE real significance of the RBI announcement is widely perceived to be in terms of what is in store for the PSBs, which are at the core of Indian banking. The financial sector reforms have had a pincer effect on the PSBs. They have been under pressure to carry the burden of another era - one in which banks were seen as essential infrastructure in the task of economic development. A perverse result of that era was the parasitism of Indian industry, which siphoned off funds on a massive scale from these publicly-owned institutions. Since liberalisation, banks have been forced to set aside a large proportion of their profits to cover the losses arising out of the banks' devalued assets, euphemistically termed non-performing assets (NPA).

Liberalisation also forced the PSBs to generate quicker profits, compelling them to behave like clones of their private counterparts. The reorganisation of banking operations has effectively reduced the spread of the activity of these banks. The recent statement by a senior RBI official that banks need to concentrate on their main areas of business - in terms of geographical coverage as well as profitability - bears the imprint of this mindset. V. Easwaran, deputy general secretary of the All India Bank Officers' Confederation, says the new regime, with its emphasis on "virtual banking, instead of brick-and-mortar banking", has caused banks to indulge in "mindless downsizing".

Despite this, the 27 PSBs account for 81 per cent of all bank deposits; the 31 private banks account for 13 per cent; and the foreign banks 6 per cent. The position is almost similar in the case of advances by banks. The profitability of PSBs is lower not merely because of higher wage costs, but because of their lower per-branch business. This, in turn, is largely on account of the extensive reach of their business, particularly in the rural areas.

Banking statistics reveal several disquieting trends in the last few years. For instance, the credit-deposit (CD) ratio in the rural areas has declined significantly. The combined CD ratio of the rural branches of all banks in India has declined from about 65 per cent to 40 per cent between 1996 and 2001. This implies that a diminishing proportion of rural deposits is being ploughed back as credit in rural areas. This tendency is particularly adverse in States like Bihar, Uttar Pradesh and Madhya Pradesh.

The sharp decline in interest rates on bank deposits implies adverse consequences for rural savings. There is evidence to show that rural and agricultural credit, and lending to small-scale industries, have suffered seriously since the 1990s. The evidence from diverse sources indicates that the squeeze on rural credit has forced rural borrowers to seek credit from money lenders and other informal sources of finance. In short, while high-street urban banking has been on the rise, aimed at skimming the cream of the market, the use of rural credit as a lever for economic development has been seriously undermined. Prof. Ram Mohan avers that the entry of foreign banks is likely to have serious implications for balanced regional development and also widen the rural-urban divide. "Small people are likely to be cut out of the credit market," he says. Both Shetty and Ram Mohan argue that small-scale industrialists, the "most dynamic of entrepreneurial talent" in the country, are also likely to suffer as a result.

The new private banks and the foreign banks have focussed on "retail banking", which critics say is a euphemism for "high-street banking". Ram Mohan believes that the government is "nudging events" in the direction of opening up the PSBs to foreign ownership. "There is also pressure from foreign banks and governments," he says.