The Reserve Bank's proposal to cap foreign investment in new banks below 50 per cent is aimed at maintaining the diversity of the Indian banking sector by avoiding a repeat instance of local banks losing their Indian -owned tag.
Recently, the country's two leading private sector banks -- ICICI Bank and HDFC Bank -- lost their "Indian-owned" status, as foreign investment in them went over 50 per cent due to changes in the way foreign direct investment is calculated.
The government changed the way foreign direct investment is calculated and included ADRs, GDRs and convertible bonds in the category.
"The Press Notes 2, 3 and 4 issued by the government of India in February, 2009, indicate that banks with foreign shareholding of more than 50 per cent would be treated as non -resident-owned banks," RBI said in its discussion paper on entry of new private sector banks.
To ensure that these new banks, if allowed, do not lose their Indian-owned status, the RBI proposed capping foreign investment, including FDI, FII and NRI holdings, below 50 per cent.
"Since the objective is to create strong domestic banking entities and a diversified banking sector... Aggregate non- resident investment... In these banks could be capped at a suitable level below 50 per cent," the RBI said.
At present, the sector can attract foreign investment up to 74 per cent.
The central bank categorically stated the need for a diversified sector "which includes public sector banks, domestically owned private banks and foreign owned banks".
Though the 'foreign-owned' ICICI Bank and HDFC Bank remain 'Indian-controlled', they are not 'domestically owned private banks', which form a major pillar for the diversity that the Reserve Bank is looking for in the banking sector.
"Diversity helps infusing more competition, with a different management style and operating philosophy benefiting the end-customers," said Ernst & Young India Director Viren Mehta.
PricewaterhouseCoopers Associate Director Robin Roy said, "The thrust in the paper is on financial inclusion and Indian banks have a deep understanding of rural areas, not outsiders. It will help local banks get foreign capital."
At present, India has 27 public sector banks, 22 private banks, 31 foreign banks, 86 regional rural banks, four local area banks, 1,721 urban cooperative banks, 31 state cooperative banks and 371 district central cooperative banks.
"Foreign banks will not be permitted to have more than a 50 per cent stake for the first 10 years. This may be largely to protect the Indian banks from the heavy competition of the huge foreign banks," said SMC Capitals Equity Head Jagannadham Thunuguntla.
With a route already available for foreign banks to enter the domestic market with a wholly-owned unit and thereafter divest 26 per cent to comply with the cap, the RBI is considering telling foreign banks that this route will not be available in case of acquiring local banks.
In addition, as there cannot be two different policy sets within a sector, over time, the proposed cap of below 50 per cent could also hold true for existing banks, possibly bringing ICICI Bank and HDFC Bank back into the 'Indian-owned' fold.
The discussion paper did not say whether the 50 per cent cap on foreign investment in private sector banks is for new units only, or will it hold true for existing ones as well. Industry experts have differing views on it.
"It is not clear. However, it is possible that even the existing banks will have to comply with the new cap over a period of time for a level playing field," said KPMG Financial Services Tax Leader Punit Shah.
"It must be only for new licences, otherwise it will be very difficult for many existing banks. It is too remarkable a change to be in a discussion paper... (it) should have been clarified if meant for all," E&Y India's Mehta said.
A senior RBI official, however, said, "It's a discussion paper. However, we cannot have two different policies. In another section, the paper does... (say) any change would also have to be implemented for other existing banks."
However, doubts are being raised whether foreign players would be interested in something which they cannot control, especially when there is a provision for foraying into the Indian banking business with a wholly-owned subsidiary.
"Suggestion to reduce FDI cap below 50 per cent is restrictive and would discourage foreign investment in the banking sector," KPMG's Shah said.
While there are some who see it as a constraint, others still see it as attractive enough for foreign players that do not want to take a 100 per cent risk, who may see it as a way to test the water before taking the plunge.
"Foreign banks could be interested, as they might want to experiment with less investment before putting in full money for the banking business in India," said E&Y's Mehta.