Banks warned on managing private pools of capital

The Reserve Bank of India (RBI) today warned that banks, which engaged in sponsoring and managing private pools of capital, were prone to high risk.

With a significant rise in the number of venture capital and infrastructure funds in the country, the central bank said banks managing these funds would be prone to risks, which are a part of these business models.

Issuing a caution to the banks, RBI quoted the recent G30 report on financial stability, which had recommended that large and systemically important banking institutions should be restricted in undertaking proprietary activities that present particularly high risks and serious conflicts of interest.

At present, a number of banks in India either have their own subsidiaries to manage private capital or have indirect exposure to such funds through other financial institutions.

These private pools of money include hedge funds, private equity funds and so on, where the bank’s own capital is often mixed with their clients’ funds.

To avoid any financial upheaval due to such activities, RBI has proposed to issue a paper, seeking public comments, on prudential issues in banks’ floating and managing private pools of capital. The central bank would frame regulatory guidelines for such activities by banks, based on public comments received by September 30, 2009.

In view of the reputational risk involved in such activities, the central bank has already mandated the maintenance of a certain level of economic capital in some cases approved in the recent past.

RBI is of the view that sponsorship and management of such assimilated private pools of capital by banks should be prohibited. Taking cues from the G30 report, on the backdrop of the financial crisis in the West, the regulator said that large proprietary trading by banks should be limited by strict capital and liquidity requirements.

Raising concerns over the risks involved, the central bank said that there is a need for the banks to have a greater awareness and limit such exposures commensurate with their risk management and available capital.

Furthermore, the central bank has proposed to prescribe a minimum lock-in-period and retention criteria to securitise the loans originated and purchased by banks.

RBI said that though the securitisation framework has been prudent and able to minimise problems pertaining to the current crisis, some banks were seen securitising loans immediately after originating or purchasing these from other banks.

The banks were passing the project implementation risks to the investors as well, by way of dividing the total loan for one project into different tranches and securitising a few tranches even before the total disbursement was complete.