Kanhaiya Singh: Bank ownership: a case for abundant caution?

A healthy banking system requires the co-existence of a variety of ownership structures for private sector banks.

The finance minister has recently emphasised wider participation of foreign banks in the Indian economy. This is somewhat at variance with the spirit of the draft "comprehensive policy framework for ownership and governance in private sector banks", prepared by the Reserve Bank of India (RBI), which intends to impose a particular ownership structure on private sector banks.

While it is true that financial institutions are different from other corporate entities, since they channel uncollateralised public funds, why should this be the reason to impose a particular ownership structure?

In fact, this difference in the nature of financial and non-financial corporations only suggests that stringent prudential norms are critical and even more so the supervision mechanism and transparency in the banking system.

The RBI's draft policy specifies that no one should hold more than 10 per cent ownership in a bank, whereas foreign direct investment (FDI) is permitted up to 74 per cent. At the same time, it also says that any bank cannot acquire more than 5 per cent share in other banks. This system by default curtails the consolidation of domestic private sector banks.

Private bank ownership across the globe can be broadly classified into four groups:

Foreign-owned banks (FOB), where invariably the ownership lies with foreign banks "" mostly having origins in developed countries.

Widely-held domestically-owned banks (WDOB), where the share holding is widely dispersed among residents.

Individual concentrated domestically-owned banks (CDOB), where a few individuals have the majority share and the rest is dispersed among other stake-holders.

Domestic industry group-owned banks (DIOB), where a few industrial groups are the majority shareholders.

Interestingly, these structures are not very different from that for other corporate entities. These structures have both advantages and disadvantages.

For instance, WDOB may have highly unstable management with minimum risk-taking capacity. CDOB could be very dynamic with tight control over the management and the motivation to take risk under profit motives.

DIOB are likely to be biased in financing promoter companies; they are likely to be exposed to poor quality of credit. On the other hand, FOB are less likely to expose themselves to these kinds of risks. Nevertheless, these problems can be taken care of with differentiated prudential norms.

Considerable research has already been done to assess the effects of structure and ownership on the efficiency and profitability of banks. Broadly, the following points emerge:

Except in a few countries, for instance, Ireland, the US, the UK, Canada, Australia and Japan, banks are not widely held, rather banks appear to be more controlled by a family or state.

Banks with higher levels of ownership concentration show higher levels of cost and profit efficiency.

Shareholder protection laws and official supervision are more important to improve banks' valuation.

Foreign shareholders demonstrate less control and, therefore, banks with high concentration of foreign share tend to be less cost- and profit-efficient.

A healthy banking environment requires the co-existence of one or more structures. The failure or success of the financial system is not because of a particular ownership structure of banks but more a result of prudential regulation, the supervisory mechanism and strict adherence to such norms, as was the case with the 1997 crisis in Indonesia.

In countries where the economy is passing through the reform process, policy makers are scared of scandals and misappropriation. In such situations, it is tempting to enact laws that could cover the inefficiency rather than eradicate the inefficiency.

Restricting the size of the holding and cross-holding, both fall under same type of policies. A better way would be to assign more weight to such assets in calculating risk-weighted capital adequacy ratio (RWCAR).

In fact, a differential RWCAR based on justifiable grounds could be proposed for different ownership structures, instead of imposing a particular structure of ownership.

In this respect, even raising the required capital should be taken as a positive step and that could be linked to the type of structure.

The benefits of economies of scale are well known and no developing country has exploited that better than the communist China "" India, unfortunately, ignored these benefits.

Consequently, India has almost lost to China in manufacturing. Further, with a democratic society, it cannot emulate the particular discipline and the commitment under which the Chinese success has flourished.

The natural course of action for India is different, its strength is the private sector, and family-owned business where market forces can set the economics right.

India can be a financial hub by allowing co-existence of large multinational institutions of Indian and foreign origin.

In the case of FDI-loaded banks, the underlying logic of keeping 26 per cent with residents also appears to be untenable and requires empirical testing. The Companies Act for the passage of any special resolution requires three votes in favour for every single vote against the resolution.

However, if this 26 per cent were widely dispersed, it would not be difficult for the majority stakeholder to convince the merits of special resolution to few individuals contributing to 1 per cent of the stake.

Therefore, if domestic influence has to be built into the FDI-loaded private sector banks, then 26 per cent should be earmarked to domestic institutions and corporations. Otherwise, 100 per cent FDI must be allowed with strict prudential regulatory norms.

(The writer is senior economist, National Council of Applied Economic Research, New Delhi. The views expressed are personal)