The Experience of Trying to Reform India’s Banking Sector – Money Perception

Loknath Das August 11, 2017 Banking

Our efforts to improve the financial system had mixed results. With public sector banks we tried, but we failed. With private sector banks, we tried, and we succeeded. Similarly, with rural cooperatives, we failed, and with urban cooperatives, we succeeded.

We explored specific strategies for improvements in each of the components. Public sector banks dominated our thinking, but the RBI’s manoeuvrability was limited by legal provisions that empowered the government. Private sector banks required improvements in governance and we in the RBI had the scope to achieve results. Foreign banks had few branches, but were keen to penetrate deeply into our system. However, we successfully resisted premature onslaught. The cooperative system was relevant for a large number of people, but it suffered from several weaknesses arising out of politicisation of the system. Non- banking financial companies was a large but nebulous segment within the jurisdiction of the RBI. Two of them with large public deposits posed problems that we could resolve. There was a large segment of the semi-formal financial system that was undertaking banking-like activities. These included chit funds, trusts, non- governmental organisations, and self-help groups. They were out of our jurisdiction. In brief, we in the RBI had to be conscious of the scope for and limits to our contribution to the financial system. But reforming, regulating, and supervising such a diverse segment has been a fascinating personal and professional experience.

The overall performance of the financial system depended on the functioning of the public sector banks which accounted for more than two-thirds of banking business. The standards of governance depended on the manner in which the government exercises its powers under the legislative provisions by which several banks were nationalised. The RBI’s oversight of public sector banks was focused on prudential regulation.

Public sector banks had some strengths as well as some weaknesses. They had a large network of branches. They had a large workforce, which at the time of recruitment was skilled. Their familiarity with the society and local businesses was unparalleled. Their functioning in a modern competitive environment was constrained by several factors. The officers and staff were lacking in incentives to perform. They were subject to parliamentary oversight, to the jurisdiction of the CBI and the Central Vigilance Commission, which should ideally concentrate on those issues which arise in performing sovereign functions and not commercial activities. Also, accountability to Parliament and influence of individual parliamentarians and bureaucrats are often indistinguishable.

The nominations to the boards of the banks were governed, to a significant extent, by political affiliations. The official nominee of the government on the board represented both the sovereign and the shareholder and thus exercised disproportionate power.

The chances of privatisation of public sector banks or similar reforms were, in our judgement, very dim. Their medium- term future was unclear for the entities themselves. A budget announcement to reduce government shareholding below 51 per cent by Finance Minister Yashwant Sinha had not been followed up. The government had no specific strategy on the future of public sector banks. I did not expect either a dilution of public ownership or an end to dual control by the government and the RBI over them. We made some attempts to improve their standards but with disappointing outcomes. I will narrate them to show how the system works.

We wanted the directors nominated by the government to the public sector banks to satisfy the ‘fit and proper’ criteria on par with those prescribed by the RBI for private sector banks. The government was not averse at a formal level to the RBI recommending or commenting on the ‘fit and proper’ aspects of the proposed nominee directors from the government. In practice, it did not welcome our intense due diligence. A proposal to create a roster of competent professionals who could be nominated on bank boards was made but was never responded to. After a while even the formality of a reference to the RBI when the government nominated non-officials to bank boards was done away with.

The chief executives of banks were appointed by the government, as per the legal requirement. However, a committee headed by the governor recommended the names. The committee had representation of the government and an expert nominated by it. My contention was that a regulator could accept or reject a choice but could not recommend to an owner who ought to be appointed. The government’s nominee is involved both in the process of recommending and approving. We pleaded for total exclusion of the RBI’s role in recommending chief executives by exempting the bank from participation in the process of selection. At the same time, we sought the government’s voluntary acceptance of the RBI’s role in giving clearance to CEOs selected by the government. This was in consonance with procedure in respect of private sector banks. Our proposal was not accepted by the government.

Y.V. Reddy
Advice & Dissent: My Life in Public Service
HarperCollins, 2017

An important issue in governance is conflict of interest. Hence, we did not want our officials to be on the boards of public sector banks. We proposed amendments to the relevant laws which mandated such nomination. However, I was informed by the nance secretary that the parliamentary standing committee was keen to continue to have RBI official in the boards. I suggested that, as a compromise, the law could provide for nomination of a person with experience in financial regulation. The suggestion was accepted. So, the legal amendment did not bar the nomination of RBI officials while removing the mandated nomination of RBI officials. During my tenure, I proposed the names of retired officials of the RBI.

The government expressed policy preference to bring about consolidation in the public sector banks. Our view in the RBI was that consolidation should not be an end in itself. It should be driven by appropriate assessment of synergies by the enterprises concerned. Experience showed that many cases of consolidation of banks had failed globally. My view was that increasing size through consolidation would not solve the basic problems of the public sector, namely, standards of governance. We suggested that the government, as owner, should assess overall bene t to it as a result of the proposals for consolidation of individual cases or consolidation should be part of an overall well-worked-out strategy. Despite our advice, divestment, and consolidation were considered by the government in parallel, without much progress.

In contrast, we had excellent support from the government in improving the private sector banks, which were a mixed lot of good and bad ones. The old private sector banks were relatively small, and in the nature of community banks. Some of them had been captured by investors with doubtful credentials. The newly licensed private sector banks started off well, embracing new technologies and modern banking practices. Over time the segment became a mixed bag, with a couple of super-performers, and some causing discomfort. Two of the super-performers, ICICI Bank and HDFC Bank, were promoted and incorporated in India, but the majority of ownership was foreign.

There were several small private sector banks which did not satisfy the minimum capital adequacy requirement prescribed under the new guidelines. Several stratagems were adopted to ensure that either they increase the capital within a specified time or they get merged with a healthier bank on a voluntary basis. The RBI actively encouraged consolidation in the private sector banking system, mostly through voluntary mergers or acquisitions. Consolidation happened mainly due to enforcement of t and proper criteria on ownership and governance. In one case, however, merger was imposed, and it was a challenging task.

Soon after I joined as governor in September 2003, I had to take a view on cleaning up of the balance sheet of GTB for the financial year 2002-03. The inspection by the RBI in previous years found that there was significant misclassification of assets and other accounting irregularities to understate losses significantly. After making the corrections, the financial statement for 2002-03 showed an overall loss, but a small operating profit for the year. The balance sheet had to be in the public domain before the end of September. The proposal before me was that the RBI should issue a statement welcoming the clean-up of the balance sheet by GTB which, no doubt, was at the instance of the RBI. The danger of issuing a statement was that markets might treat it as a certificate of sound health and good conduct, which certainly was not true. At the same time, the case for issuing a statement was to ensure that there was no serious loss of confidence and consequent run on the bank as a result of the disclosure of the significant misclassifications made in the past. We issued a statement of assurance just in time, on 30 September, so that we could consider a line of action in due course, at a time of our choice. However, GTB continued to be on the list of problem banks to be carefully monitored by the Board for Financial Supervision.

In this background, the RBI was keen that the bank should be adequately capitalised and the governance in the bank improved. The GTB was not in a position to attract additional capital, but there was an offer to inject capital from a private equity rm. However, the offer sought some temporary relaxation of regulatory prescriptions. We felt that we could not start rebuilding trust and confidence in a bank with relaxations in regulations. Hence, we sounded leading private sector banks if they could take over GTB. Surprisingly, they did not evince interest. We decided to act before it was too late, and at our request, the government imposed a moratorium on withdrawal of deposits on 24 July 2004, a Saturday evening. I was con dent that once we put a moratorium on encashing of deposits, the interested parties would be emboldened to express their interest in a merger. We had in parallel identified banks which might have synergies for a merger. In the process, we had to handle an unprecedented challenge: to restrict the withdrawals from ATMs dispersed all over the country, in addition to making available sufficient cash in all branches spread over the country. These required extensive logistical efforts, but in total secrecy.

By Monday, 25 July forenoon, we could choose one of the two banks that were interested in a merger – the Oriental Bank of Commerce. The message to the banking community was loud and clear – the RBI would be prompt, severe, and effective in corrective actions in respect of any bank or banker that came to our adverse notice.

There were several criticisms of our action. One view was that shareholders suffered, but I was clear in my mind that depositors’ interests were foremost. Some complained that it was over a weekend, but then it was deliberate. A third criticism was that the public sector bank was informally forced to merge. That simply was not true. In fact, Finance Minister Chidambaram, on being informed over phone minutes ahead of public disclosure of successful identification of the bank that was to merge, said: ‘Is it with the State Bank of India?’ That was the expectation on the basis of precedents, but it was the Oriental Bank of Commerce.

Suggestions were made that we should consider the issue of new banking licences as a means of strengthening the banking system. Our stand was that the emphasis should be on improving the large number of private sector banks already existing and also consolidating them as vibrant units. Additionally, we insisted that issuing of new bank licences could be considered after amendments that we had proposed to the existing Banking Regulation Act were approved. They were meant to strengthen the RBI’s capacity to enforce appropriate t and ownership criteria and governance. New banking licences could not be approved during my period, pending passage of the relevant laws.

Foreign banks had a small share of the banking business, but had significant, in fact, critical presence in select segments of nance, such as forex markets and government debt markets. They were keen to expand their presence in India through inorganic growth, that is, by taking over control and management of existing private sector banks. They operated across borders, and across markets, through multiple organisational layers within a conglomerate. They had a network of non-banking arms operating in parallel in India. Operations in India accounted for a major source of profits for many of them for a variety of reasons, one of them being their expertise in and access to modern technology. They had a special place in financial markets, in addition to skills and competitive strengths. Cross-border presence gave them an opportunity to move financial assets across the border to take advantage of differences in regulation, taxes, and interest rates. They were also important for ow of investments that public policy seeks. In brief, the branches of foreign banks did a lot of good to public policy, but they could also undermine public, policy, especially regulation, without necessarily breaking the law.

The most important issue at the time I joined related to increasing the presence of foreign banks and raising the limits to foreign ownership in our banks to 74 per cent. Such a policy was announced in the budget speech of the finance minister. I was uncomfortable with giving priority to larger presence of foreign banks in advance of reforming the domestic banking sector. We had to work with the government on resetting priorities. We succeeded in convincing the government to defer immediate increased presence of foreign banks and to adopt a gradual approach through a roadmap.

In effect, we reset the priorities and that is a long story.

In September 2003, when I joined as governor, I found that there was only one important item in the agenda for reform before the government. That concerned increasing the permissible share of foreign ownership in Indian banks, and permitting foreign banks to acquire Indian private sector banks. The government was keen to implement the policy and was in readiness to process the legislation in the budget session of 2004 in fulfilment of the announcement in the February 2003 budget speech. The existing legislation did not deter foreign banks from setting up 100-per-cent-owned subsidiaries, though a policy to facilitate them was not in place. To acquire existing private sector banks, or to have subsidiaries with less than 100 per cent of ownership, amendment to the law was needed to allow for foreign banks to exercise voting rights in proportion to the ownership.

I opined that policy constraints on our banks should be addressed urgently, before opening them up for deep presence of foreign banks. Hence, my preference was to increase the number of branch licences of foreign banks well beyond the commitment made by us to the WTO for the present. However, the government made it clear that it wanted to implement the decision announced. The task before us was to find a way of fulfilling the commitment made in the budget speech of 2003, but ensure that in the actual sequencing of reform in banking, improvements in domestic banks took precedence.

On the basis of consultations with us, the government issued a press note, on 5 March 2004. The FDI limit in private sector banks was raised to 74 per cent under the automatic route, including the investment made by foreign institutional investors. The major input that we gave to the government was that a foreign bank should be permitted to have only one form of presence. Foreign banks, according to the press note, would be permitted to have either branches or subsidiaries, not both. They could operate in India through only one of the three channels – (a) branch/es; (b) a wholly owned subsidiary; or (c) a subsidiary; further aggregate foreign investment up to a maximum of 74 per cent in a private bank was permissible. The press note mentioned that the guidelines in this regard would be issued by the RBI. We were required to issue guidelines on liberalising foreign investment, as per the press notification in March.

As a first step, I focused on governance in our banking system. So, the Annual Policy Statement of 18 May 2004 indicated that keeping in view the special nature of banks it was necessary to articulate in a comprehensive manner the policy in regard to ownership and governance of both public and private sector banks. We put in public domain a draft with three elements, namely, (a) criteria for significant shareholding, that is, beyond 5 per cent; (b) for being a member of the board, and (c) additional requirements for chief executive. The guidelines were equally applicable for foreign investors under the liberalised regime announced in March 2004. We provided for transition arrangements where the existing ownership structure in any bank did not satisfy the requirements specified. The guidelines asserted the RBI’s intention to undertake independent verification of ‘fit and proper’ test conducted by banks. We did not have specific legislative provisions to enforce these guidelines, so we formally invoked powers conferred by Section 35A of the Banking Regulation Act, 1949, and gave directions ‘in public interest’. We got our point of view on the reforms in banking sector, in a draft form, in public domain, so that our view became the starting point for feedback from the stakeholders and consultations with the government.

The professionals in RBI worked closely on several drafts in consultation with market participants and the government. In the final stages, I had detailed discussions with Chidambaram. The result was a comprehensive agenda for reform and development of the banking system in India. This was set out in the budget speech of 2005-06. It said: ‘the RBI has prepared a roadmap for banking sector reforms and will unveil the same. While most proposals will be implemented by the RBI on its own authority, some legislative changes would be required to be made.’ (Para 82)

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