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February
14, 2005 Left
Parties Note: On
The Proposal To Enhance FDI Cap In Banking THE
BACKGROUND On
15th December, the Finance Minister, while responding to a Calling
Attention notice on changes in Banking Policy in the Lok Sabha, announced the
enhancement of the FDI limit to 74% following the 5th March 2004
notification issued by the previous government and justified it by saying that
“The revision in FDI limit will create an enabling environment for higher FDI
inflows along with infusion of new technology and management practices resulting
in enhanced competitiveness”. The Minister also said that the RBI is in the
process of considering the suggestions/feedback received on its guidelines,
which was issued on 2nd July 2004. It
is clear by now that after its initial reservations about the move, the RBI has
finally agreed to the raising of the 10% voting cap in the private sector banks
and make it proportional to equity holding, whose limit in turn would be raised
to 74%. However, it is noteworthy that the removal of the cap on voting rights
would require an amendment of Section 12(2) of the Banking Regulation Act. The
Left Parties are opposed to this proposed amendment. BANK
DEREGULATION: THE POSITION OF THE LEFT The
Left is opposed to the moves to further deregulate the banking sector on several
counts. Deregulation of the banking sector, which is a vital component of
financial liberalization, greatly enhances the scope of speculative activities
and exposes the financial system to the risks associated with volatile capital
flows. This lesson was painfully learnt by several developing countries through
the decade of the nineties. Far from contributing positively to economic growth,
asset creation and employment generation, financial liberalization has
precipitated crises in several countries. However, the RBI’s Report on Trend
and Progress of Banking in India 2003-04, talks about the appropriate timing of
the entry of foreign banks into India so as to be co-terminus with the
transition to greater capital account convertibility. This shows that the
economic policy establishment in India, including the RBI, has not drawn
adequate lessons from the experiences of the financial crisis-affected
countries. Joseph Stiglitz,[1]
who was closely involved with policymaking at the international level when the
spate of financial crises occurred in the late-1990s, held that “capital
account liberalization was the single most important factor leading to the
crisis.” He also mentions, “all too often capital account liberalization
represents risk without a reward. Even when countries have strong banks, a
mature stock market, and other institutions that many of the Asian countries did
not have, it can impose enormous risks.”[2]
Besides,
banks are the principal risk carriers in the system, taking in small deposits
that are liquid and making relatively large investments that are illiquid and
can be characterised by substantial income and capital risk. The observed
tendency among some promoters or boards of banks to divert a substantial share
of its deposits into speculative activities in which the promoter or board may
be interested or into investments that are risky but promise quick returns, can
increase financial fragility, lead to bank failures and if the magnitude of the
failure is serious enough, can actually precipitate crisis for the entire
financial system. Instances in India such as the Nedungadi Bank and the Global
Trust Bank are the harbingers of what may follow if reckless deregulation of the
banking sector is carried out. In fact, the experience of recurrent financial
crises in the 1990s, most famously the East Asian experience, has shown how
banking deregulation along with capital market liberalization often serves as
recipes for financial turmoil in developing countries like ours. (A list of
major financial crises since the 1990s drawn from RBI Bulletin, October 2004 is
provided in the Annexure). It
is therefore a matter of grave concern that the UPA Government is continuing
with the previous government’s policies with regards to financial opening. The
Left Parties are of the opinion that not only are the measures to further
deregulate the financial sector and raise the FDI cap in banking unnecessary
from the point of view of economic and industrial growth, they would also
enhance the vulnerability of the financial system to the flows of speculative
capital.
RBI
GUIDELINES ON BANK OWNERSHIP Subsequent
to the 5th March 2004 notification issued by the Ministry of Commerce
and Industry under the NDA government, which had raised the FDI limit in Private
Sector Banks to 74% under the automatic route, a comprehensive set of policy
guidelines on ownership of private banks was issued by the Reserve Bank of India
on 2nd July 2004. These guidelines stated among other things that no
single entity or group of related entities would be allowed to hold shares or
exercise control, directly or indirectly, in any private sector bank in excess
of 10 % of its paid-up capital. Recognising
that the 5th March notification by the Union Government had hiked
foreign investment limits in private banking to 74%, the guidelines sought to
define the ceiling as applicable on aggregate foreign investment in private
banks from all sources (FDI, Foreign Institutional Investors, Non-Resident
Indians), and in the interest of diversified ownership, the percentage of FDI by
a single entity or group of related entities was restricted to 10%. This made
the norms with regard to FDI correspond to the 10% cap on voting rights. The
guidelines allowed for an acquisition equal to or in excess of 5%, so long as it
was based on the RBI’s permission. The guidelines stated: “In deciding
whether or not to grant acknowledgement, the RBI may take into account all
matters that it considers relevant to the application, including ensuring that
shareholders whose aggregate holdings are above the specified thresholds meet
the fitness and proprietary tests.” These fitness and proprietary tests
include the integrity, reputation and track record of the applicant in financial
matters, compliance with tax laws, history of criminal proceedings if any, the
source of funds for the acquisition etc. Where the applicant is a body
corporate, the fit and proper criteria involves its track record of reputation
for operating in a manner that is consistent with the standards of good
corporate governance, financial strength and integrity. More rigorous fit and
proper tests were suggested where acquisition or investment takes the
shareholding of the applicant to a level of 10% or more. It is clear from
the guidelines issued by the RBI in July 2004 that despite the NDA
government’s decision to raise the FDI limit in banking to 74%, it had chosen
to remain extremely cautious about further opening up of the banking sector and
allowing domestic or foreign investors to acquire a large shareholding in any
bank and exercising proportionate voting rights. The RBI had strongly advocated
diversified ownership of banks. RBI’s Report on Trend and Progress of Banking
in India, 2003-04 (Chapter VIII: Perspectives) states, “The
concentrated shareholding in banks controlling substantial amount of public
funds poses the risk of concentration of ownership given the moral hazard
problem and linkages of owners with businesses. Corporate governance in banks
has therefore, become a major issue. Diversified ownership becomes a necessary
postulate so as to provide balancing stakes.” It further states that “…in
the interest of diversified ownership of banks, the Reserve Bank intends to
ensure that no single entity or group of related entities have shareholding or
control, directly or indirectly, in any bank in excess of 10 per cent of the
paid up capital of the private sector banks. Any higher levels of acquisition
will be with the prior approval of the Reserve Bank and in accordance with the
guidelines notified on February 3, 2004.” A more elaborate
exposition of the RBI’s views on the matter came from Dr. Rakesh Mohan, the
then Deputy Governor of the RBI. In a speech made at a Conference on Ownership
and Governance in Private Sector Banking organised by the CII at Mumbai on 9th
September 2004 he remarked (italics added): The banking system is
something that is central to a nation’s economy; and that applies whether the
banks are locally- or foreign-owned. The owners or shareholders of the banks
have only a minor stake and considering the leveraging capacity of banks (more
than ten to one) it puts them in control of very large volume of public funds of
which their own stake is miniscule. In a sense, therefore, they act as trustees
and as such must be fit and proper for the deployment of funds entrusted to
them. The sustained stable and continuing operations depend on the public
confidence in individual banks and the banking system. The speed with which a
bank under a run can collapse is incomparable with any other organisation. For a
developing economy like ours there is also much less tolerance for downside risk
among depositors many of whom place their life savings in the banks. Hence from
a moral, social, political and human angle, there is a more onerous
responsibility on the regulator. Millions of depositors of the banks whose funds
are entrusted with the bank are not in control of their management. Thus,
concentrated shareholding in banks controlling huge public funds does pose
issues related to the risk of concentration of ownership because of the moral
hazard problem and linkages of owners with businesses. Hence diversification of
ownership is desirable as also ensuring fit and proper status of such owners and
directors. It is evident that the RBI, which is the regulator of the banking sector, had a strong case for issuing elaborate guidelines on bank ownership to ensure diversification. If the government chooses to permit automatic acquisition of a 74% stake by foreign investors, a similar facility would eventually have to be provided to domestic investors as well for the sake of ensuring a level playing field, resulting in a dilution of the RBI guidelines. That is precisely why the RBI had also specified stringent FDI acquisition norms in its guidelines. The CMP of the UPA states
that “All regulatory institutions will be strengthened to ensure that
competition is free and fair. These institutions will be run professionally”.
It also states that “Regulation of urban cooperative banks in particular and
of banks in general will be made more effective”. However, in the present
case, the Government has not only disregarded the views of the RBI, which is the
Regulator of the banking sector, it has forced the RBI to dilute its guidelines
and thereby weaken the regulatory framework itself. Besides impairing the
effectiveness of existing banking regulation, this would also create a wrong
precedent whereby market players would exert undue pressure for further dilution
of regulation in the future. The Left Parties therefore feel that it would be
better if the UPA Government abandon its move to amend the Banking Regulation
Act and maintain status quo as far as the law and the RBI guidelines are
concerned. BANKING SECTOR REFORMS: SOME CRITICAL OBSERVATIONSThe Finance Minister said
in Parliament on 15th December 2004, that the hike in the foreign
equity cap in banking would create an “enabling environment” for higher FDI
flows, leading to “infusion of new technology and management practices”
resulting in “enhanced competitiveness”. However, the Left Parties feel that
neither does raising of the equity cap ensure higher FDI inflows, nor does
higher FDI inflow necessarily imply infusion of such technology and management
practices that are beneficial to the economy and the people. What is more, it
can curb rather than enhance competitiveness, especially when a regulatory
framework meant to ensure diversified ownership is diluted to pave the way for
foreign banks acquiring private Indian banks within three to four years through
creeping acquisition. The Finance Minister, in the course of his response to the Calling Attention notice on 20th December 2004 referred to the Narasimham Committee Report on Banking Reforms and posed a question for every Member of Parliament: “Has our banking sector become stronger, thanks to the reforms or not?” To buttress his point, he gave figures for the declining proportion of net NPAs of the public and private sector banks. He also mentioned about the enhanced profitability of the banks in the post-reforms period, attributing it to the successful implementation of the reforms recommended by the Narasimham Committee in 1991 and said that the UPA Government was taking “this reform process forward”. These claims are contentious. The figures for Non Performing Assets that the Finance Minister has quoted in Parliament are ratios. While it is true that the gross and net NPAs as a percent of total assets or as a percent of gross or net advances have shown a gradual decline over the last few years, the absolute values of gross or net NPAs have continued to rise for almost all categories of banks. (Table of NPAs of Scheduled Commercial Banks provided in Annexure). This cannot be interpreted as a sign of growing strength of the banking sector. Moreover, if one further considers the fact that the trend towards window dressing balance sheets in the name of NPA management has grown considerably among all banks, including those in the public sector, the claim of growing efficiency and strength of the banking sector becomes even more suspect. If disaggregated figures of loan write offs on the one hand and cash recoveries, compromises and upgradations on the other are provided, if not for individual banks then at least the total figures for the different categories of scheduled commercial banks, it can throw more light on the true picture of the banking sector in the post-reform period. Because if loan write offs are driving the observed decline in the net or gross NPAs to net or gross advances ratios respectively, or if the banks are inflating their advances portfolio at the end of the year in order to throw up favourable ratios in order to gratify the capital markets, then it cannot be seriously considered to be symbolizing enhanced efficiency. Such ‘ever-greening’ can be financially innovative; however, such innovations serve little purpose as far as the objectives of an efficient banking system are concerned. As far as the increased
profitability of the banking sector is concerned, the RBI Report on Trend and
Progress of Banking in India, 2003-04 (Chapter VIII: Perspectives) states: Over the past few
years there has been a steady decline in interest rates largely reflecting
sustained reduction in inflation rates and inflationary expectations. Such
reductions in interest rates occurred in an environment where credit growth
remained sluggish. Consequently, there was a favourable impact on banks’
balance sheets in terms of increased operating profits from treasury operations
given the asset concentration in favour of Government securities in excess of
the requirement of statutory liquidity ratio (SLR). For example, treasury income
of the banking sector increased from Rs.9,541 crore in 2001-02 to Rs.19,532
crore in 2003-04 and constituted 32.0 per cent and 37.1 per cent of operating
profit in the corresponding years. This in turn enabled banks to make larger
loan loss provisions. Consequently, the net NPA ratio has declined from 5.5 per
cent in 2001-02 to 2.9 per cent by 2003-04. While a declining interest rate
scenario has positive spin offs for the banking sector, given that interest
rates had touched historically low levels by 2003-04, there does not appear to
be any further scope for similar trends to be observed during 2004-05. In
future, therefore, an increasing proportion of banks’ income would emanate
from the traditional business of lending. (emphasis added) The only point, which remains to be added in this context, is that the lure of high profits from treasury operations is attracting foreign banks towards India today; which has dovetailed with the possibility of making quick gains by the promoters of private Indian banks by selling off their stakes to foreign banks and FIIs while their balance sheets look good; to create a pressure group which wants further opening up of the banking sector. There is no good reason why the UPA Government should frame policies to cater to the needs of such pressure groups. While the impact of the implementation of the banking reforms in the 1990s in terms of increasing the efficiency and strength of the banking sector remain suspect, what has been unambiguous is its immediate, direct, and dramatic effect on rural credit, which the Left considers to be one of the key parameters to judge the efficacy of the banking system. There has been a contraction in rural banking in general and in priority sector lending and preferential lending to the poor in particular. The share of rural bank offices in total bank offices, which had jumped from 17.6% in 1969 to 36% in 1972 and then rose steadily to attain a peak of 58.2 % in March 1990, gradually declined to below 50 % in 1998 and thereafter. In fact, there was an absolute contraction in the number of rural bank offices in the 1990s: 2,723 rural bank offices were closed between March 1994 and March 2000. The credit-deposit ratio in rural areas fell from about 66% in 1990 to about 56% in 2002. The target of 40% set by the RBI for priority sector lending, which was over-achieved by the scheduled commercial banks between 1985 and 1990 fell from 1991 onwards to reach at only 33% in 1996. While the share of priority sector lending shows an apparent increase to about 36% since then, this was on account of the inclusion of sectors like IT and agro processing in the definition of priority sectors. Loans to multinationals involved in agribusiness like Pepsi, Kelloggs, Hindustan Lever and ConAgra now count as priority sector advances! More recently, loans to cold storage units, irrespective of location, have also been included in the priority sector. However, the most important fact is that the share of outstanding advances to agriculture in total outstanding advances of scheduled commercial banks fell steadily from about 15% in 1989 to 10.5% in 2000. The
distress, which characterizes the Indian countryside today and the agrarian
crisis that lie beneath, was to a significant extent caused by the policies of
banking reforms throughout the 1990s that led to a sharp fall in rural and
agricultural credit. This grim reality of rural India has to be kept in mind
during discussions on banking reforms. While the Left had wholeheartedly
welcomed the announced target of adding 50 lakhs institutional borrowers within
one year by the Finance minister on 18th June 2004, such statements
of intent needs to be backed by concrete efforts towards ensuring that the
private sector and foreign banks meet their priority sector lending targets,
especially to agriculture. The share of priority sector credit in the
total outstanding net credit of foreign banks was 34.2% in 2002, well below the
40% norm. Of this, about 17.7% was export credit and 11.6% was credit advanced
to small sector units. All the other priority sectors, including agriculture,
accounted for the remaining 4.9% of the outstanding credit of foreign banks. The
CMP of the UPA states, “…the social obligations imposed by regulatory bodies
on private banks and private insurance companies will be monitored and enforced
strictly”. Can the Government abide by this commitment if the foreign and
private ownership norms of banks are further diluted?
CONCLUSION The
proposal to dilute stakes of Public Sector Banks upto 33%, which was recommended
by the Second Report of the Narasimham Committee, had failed to gain
Parliamentary approval. It was because the Parliament felt at that time that the
process of banking deregulation and financial liberalization has already gone
too far in India. The RBI itself has found through its empirical studies that
there is no observable link between ownership and efficiency or profitability,
as far as the Indian banking sector is concerned. The Left believes that the job
of the government is well cut out as far as the banking sector is concerned;
increasing the efficiency of the banking system within the existing regulatory
framework and gear it up for much increased flows of credit to the
credit-starved rural areas, particularly into agriculture. There is no
justifiable case for another fresh dose of bank deregulation at the present
juncture, especially vis-à-vis raising the foreign equity and voting rights cap
in private banks. As
has been mentioned earlier, the Left Parties are not in favour of any amendment
of the Banking Regulation Act, which would do away with the existing cap on the
exercise of voting rights by shareholders of a bank and make it proportional to
equity holding, which in turn would be allowed to a maximum of 74% for FDI
through the automatic route. Therefore the UPA Government should refrain from
adopting the notification route to allow acquisition of shares by foreign
investors above the existing guidelines and subsequently presenting the
Amendment in the Parliament as a fait accompli. |
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