Will banks become risk-averse in the quest to seek a governance premium?

India Inc will have to pencil in Mint Road's stress on the governance premium in bank lending

The Reserve Bank of India (RBI) has reset the corporate governance template for banks during its twin interactions with the boards of state-run and private banks last month. Boards are to be more vigilant and the scope for chief executive officers to impose their writ is to be curtailed. The issues highlighted by Governor Shaktikanta Das, and Deputy Governors Rajeshwar Rao and M K Jain, will almost certainly act as a guide in Mint Road’s next inspection cycle.

“Governance premium”, therefore, is in the spotlight. Raising financial resources would not be a constraint for banks with robust governance frameworks because they can command a governance premium. “This premium, in turn, will be driven by the quality of leadership at the top,” said Das. Rao put it in context: “As we strive to become a developed country by 2047, financial institutions will need extraordinary amounts of financial resources.”

Which raises the question: will banks become risk-averse in the quest to seek a governance premium?

Senior bankers think there is no way to fool-proof board decisions from going awry; it requires “a different kind of touch-and-feel expertise” as the variables are many. Often, dud loans are not the result of vested interests or poor underwriting skills — they also arise from sectoral policy changes or lack of it, such as the “policy paralysis” seen during the last years of United Progressive Alliance.

Another long-standing peeve — of bankers being held accountable for decisions long after their serving days — holds. The marked shift towards retail lending in recent years may be because of this; not just the higher margins on offer. Now, this too appears to be under the scanner. The RBI’s Trend and Progress of Banking in India (2021-22) made a reference: “In recent years, Indian banks appear to have displayed ‘herding behaviour’ in diverting lending away from the industrial sector towards retail loans. Empirical evidence suggests that a build-up of concentration in retail loans may become a source of systemic risk.”

Extrapolating from the same “herding behaviour”, it’s possible that banks privilege “governance” — why take risks at all? What, then, is an ideal business model? Who is to sit in judgment on this?

The next cycle of board-level appointments — whether to corner rooms or whole-time and independent directors — will be keenly watched. It is clear with Mint Road spelling out what it expects of boards, deliberations can only turn intense. Sign-offs at bank boards, which in the past may have been driven by a genuine need to help businesses tide over a difficult cycle, may become hostage to “governance bureaucracy”.

Large and the better-run companies have the management bandwidth to pencil in the changes emanating from the “governance reset” by RBI, but many at the bottom of the credit food chain could be adversely affected. What if, in their enthusiasm to secure a better governance premium, banks were to turn shy from lending to infrastructure (the government has taken the lead for funding it now, but the private sector will have to take on the load at some stage); or for that matter, financial inclusion. Co-lending between banks and non-banking financial companies (NBFCs) could turn itchy. Then you have environment, social and governance (ESG)-based lending — an evolving area. How is the governance framework to incorporate this?

The immediate impact from RBI’s spell-out of the governance template will be on private banks. It has ramifications for consortium lending — private banks could refuse to buy the line of state-run banks on large credits. Recall what Governor Y V Reddy said on corporate governance (December 16, 2005). That some of the governance aspects of state-run banks, though they have a bearing on prudential aspects, are exempt from applicability of the relevant provisions of the Banking Regulation Act (BR Act, 1949) as they are governed by the respective legislations under which they were set up. Though RBI’s approach has been to ensure to the extent possible uniform treatment of state-run and private banks in terms of prudential regulations on governance, “the RBI prescribes its policy framework for private banks while suggesting to the Government, the same framework for adoption, as appropriate, consistent with the legal and policy imperatives”.

All this is set for change.

Mint Road’s “Discussion paper on governance in commercial banks in India” released on June 11, 2020, said the objective was “to align the current regulatory framework with global best practices while being mindful of the context of the domestic financial system”. Though it had qualified saying “except in so far as what is prescribed is not inconsistent with provisions of specific statutes applicable to them or in case where the major shareholder/promoter viz., Government of India retains its instructions”. This has to be read along with Finance Minister Nirmala Sitharaman’s proposal for amending key Acts in the Union Budget for FY24 for improving governance and investor protection in banks. She was for amendments to the RBI Act (1934), BR Act, and the Banking Companies (Acquisition and Transfer of Undertakings) Act (1970).

India has a bank-led financing system. If operational flexibility is hindered (as is being whispered by bankers), it can affect credit flow given the trade-offs involved. The road to 2047 has to take into account the aspiration to be an economy in multiples of $5 trillion.

What need may be in store

A balance between ticking boxes on corporate governance and operational flexibility

Large swathes of India Inc will grapple to factor in changes imposed by RBI’s new focus on governance

Lower-rated firms may be particularly hit; green taxonomy can cause hiccups

The next round of board appointments will give a peep into how banks are reading RBI