Controlling the ownership of banks

A credible board, an independent management and recruiting the best talent are better mitigants of control than regulation

The financial sector today represents the foundation of an economy and its smooth functioning is crucial to help industry achieve its full potential. Recent developments such as exchange rate fluctuations, rising non-performing assets, and upcoming loan repayments have eroded the liquidity balance in the Indian financial markets. For industry, strains in liquidity result in non-availability of credit and higher interest costs, curbing investments at a time when demand is set to pick up in the economy.

The Reserve Bank of India (RBI)’s 2016 guidelines on ownership and governance in private sector banks has been the focus of much debate in recent months. So what are the key issues and how do the RBI guidelines measure up?

Regulations on the ownership of banks have evolved since 2003 when two new banks were given licences and promoter’s ownership was locked at 49 per cent for the first five years with no guidelines for further dilution. With the fall of Global Trust Bank in 2004 and an attempt by HSBC to acquire a stake in UTI Bank (later Axis Bank), RBI introduced norms that permitted shareholdings above the various thresholds to be based on a specified criteria without any numeric cap on these shareholdings. An advisory committee was also envisaged under the rules, which never got formed. These were modified in 2005 with the introduction of the guidelines on the ownership and governance of banks that required an approval of shareholding equal to or above 5 per cent and required shareholdings of 10 per cent  and above to be brought down to levels as decided by the RBI. However, all these were mere notifications and the act was never amended to cap any form of promoter shareholding though some promoters of banks were directed to bring shareholdings over time.

Illustration by Ajaya Kumar Mohanty

That said, RBI’s discretionary powers on the ownership of banks is in line with most countries (with Indonesia being an exception), where successive increase in promoter shareholding (controlling shareholding) requires an approval of the regulator. The Banking Regulation Act, 1949, was amended in 2013 to introduce section 12B, which gave RBI the powers to grant a prior approval for acquisition of shares and voting rights. Till date, nowhere in the Act is there a mention of capping promoter shareholding, except for RBI directions and in licensing rules. An unrelated though important amendment to voting rights was notified in 2015 increasing the voting rights from 10 per cent to 15 per cent  and further again in 2016 from 15 per cent  to 26 per cent.

However, the new on-tap licensing guidelines for universal banks require promoters to reduce their voting equity capital holdings to 40 per cent  within five years, 30 per cent  within 10 years and 15 per cent  within 15 years of commencement of business. This is based on a thinking that the more diversified the ownership, the better is the governance within the banks.

But is diversified shareholding an effective governance tool?

A pertinent observation was made by the Organisation for Economic Co-operation and Development (OECD) while discussing the corporate governance principles and I quote, “Where shareholdings are dispersed, the principal/agent problem which emerges is between shareholders as a class and the management of the company. No matter what the formal governance rights of the shareholders may be, their collective action problems may make it, in practice, impossible or very difficult for the shareholders to exercise effective control over the management of the company. In consequence, management may give priority to non-shareholder interests, including the interests of the managers themselves. The question for company law, therefore, is what contribution it can make to reduce the costs of diversified ownership and the principal/agent problem generated by such a diversification. On the other hand, where a single or small number of shareholders hold a substantial block of shares in the company (say, in excess of 25 per cent of the voting rights), securing managerial accountability to the shareholders (or at least to the controlling shareholders) through the traditional governance mechanisms of the company law will not usually be difficult. What, however, emerges in such a situation is that the principal/agent problem between the controlling shareholders and the non-controlling (or minority) shareholders.”

Our current banking system seems to address this effectively given the supervision and discretionary powers enshrined in the Banking Regulation Act, 1949, to selectively ask the bank promoters to reduce the shareholdings where it finds governance systems to be weak, banks board ineffective, performance deteriorated or good managers not being attracted to the bank. The balance that controlling shareholders can have over the management given their so called “skin in the game” is the best form of control one could envisage especially in a regulated industry like banking. In any case, the Banking Regulation Act gives enough powers to the RBI to dismiss management and board if not fit and proper.

On the 15 per cent maximum shareholding levels for promoters over a period of time, I would say that there is a risk of managements getting too strong and undermining foreign shareholdings who control bank boards through proxy firms on the other. Given that our stock market is predominately invested in by foreign institutional funds, we see that most of our large banks have in excess of 51 per cent held by foreigners. We have also seen managements going unaccountable until the regulator steps in. But that has been seen only in diversified banks. As the OECD paper suggests, a predominant shareholder holding 25 per cent or more could effectively control management. I find it as a co-incidence that the P J Nayak Committee has recommended 25 per cent  as a threshold for promoter shareholding. So is the Sebi and CCI-defined control as 25 per cent  now as against 15 per cent earlier.

I would reiterate that regulated industries like banks where external supervision is paramount and the regulator has discretionary powers, ownership of banks should be based on an individual bank’s conduct.Also, there is no ceiling on holding in areas like insurance, mutual funds or even NBFCs, which deal with public and retail money. More focus should be on the independence of the board and the culture of the bank to attract, retain and brew talent so that over time, the bank grows independent of its promoter. Capital, the raw material for banks, would in the normal course of business bring in dilution with growth but let that be a business decision rather than a regulator-imposed one.

The author is partner and national leader, financial services, EY India