Towards consolidation

The significance of the Cabinet's approval of changes to the Reserve Bank of India Act and the Banking Regulation Act, and the proposed removal of the cap on voting rights in banks can best be gauged by the reaction of bank stocks, which rose sharply on Thursday.

The market has reason to cheer because the measures, if passed by Parliament, will be a strong signal that the reform process in the banking sector is firmly on track.

The scrapping of the statutory lower limits on the cash reserve ratio and the statutory liquidity ratio will enable the Reserve Bank of India to decide on these pre-emptions, depending on the requirements of monetary policy.

At a time when the FRBM Act stipulates a gradual reduction in the fiscal deficit, it is logical that the minimum SLR level should also be gradually reduced. The intention is clearly to equip the central bank with the flexibility to determine these ratios.

The most important change, however, is the decision to align voting rights with shareholding. This will naturally make acquiring banks far more attractive than hitherto, providing an impetus to mergers and acquisitions activity in the banking sector and paving the way for consolidation.

That, in turn, will further strengthen the banking sector. The move needs to be seen in the context of the roadmap for foreign banks issued earlier by the RBI. That roadmap essentially provided a four-year breathing space for local banks before being subject to unrestricted competition from foreign banks.

The decision to remove the 10 per cent cap on voting rights for private banks will not lead to acquisitions of Indian banks by foreign ones, because the RBI's roadmap rules that out.

But it will clear the way for M&A among local banks, strengthening them in the process and enabling them to be better equipped to take on the competition as well as the more stringent Basel norms. The new Basel norms are also the rationale for allowing banks to boost their Tier-2 capital by issuing preference shares.

At the same time, the new measures ensure that the RBI, as the banking regulator, is firmly in command. For instance, it will be mandatory for investors who buy more than 5 per cent of a bank to get prior RBI approval.

In short, while shareholding will be aligned with voting rights, the RBI will ensure that only "fit and proper" persons acquire more than 5 per cent of any bank. The RBI's hands will also be strengthened by empowering it to supersede bank boards and to direct banks to inspect and disclose the financial affairs of enterprises associated with banks.

Steps have also been taken to more effectively regulate the co-operative banking sector, the Achilles' heel of the Indian banking system. The RBI will now be able to order special audits of their accounts and license primary credit societies for carrying on banking business.

In short, the new measures are aimed at strengthening the banking system, and giving the RBI the powers to ensure that it can effectively supervise and monitor its health.