Foreign banks in India

Author: | Published: 1 Oct 2011
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The Indian financial system has historically been dominated by banks, with banking entities accounting for nearly 70% of the total assets of all financial institutions.

Prior to the banking and financial sector reforms in India, banks operated in a heavily regulated environment that also maintained sufficient barriers to entry. Indian banks were hence protected against too much competition, resulting in a lack of impetus to enhance efficiency and growth.

Over the last two decades, the banking system in India has seen significant reforms. This includes partial deregulation of the financial sector, and measures for increasing competition such as more liberal licensing of private banks and freer expansion by foreign banks. With a growing foreign presence in the Indian financial sector resulting in increased competition, the Indian banking industry has seen significant improvement and sophistication and is gearing up to meet the challenges of increased globalisation.

Current regulations permit foreign entry in the Indian banking sector in the following two ways: (i) investing in an existing banking entity; or (ii) setting up a banking presence in India.

Foreign investment in existing banking entities

The total foreign investment permitted in an existing private sector bank is up to 74% of the bank’s paid up capital. Once aggregate foreign investment in an existing private sector bank reaches a level of 49%, the infusion of any additional foreign direct investment requires prior regulatory approval.

Further, the FDI policy prescribes that, at all times, at least 26% of the paid up capital of a private sector bank be held by residents, except for a wholly owned subsidiary (WOS) of a foreign bank. The sub-caps for individual FII and NRI holdings is restricted to 10%, with the aggregate limit for all FIIs and NRIs capped at 24% and 10% respectively. There is the possibility of raising the cap, with approval from the board/general body, to 49% and 24% respectively.

The current ownership guidelines issued by the country’s central bank and banking regulator, the Reserve Bank of India (RBI), are framed on the policy of diversified ownership. Investment by a single entity (whether resident or non-resident) is typically restricted to 10%, except in cases where a higher level of shareholding has been specifically permitted. The transfer or acquisition of a shareholding of 5% and above requires acknowledgement from the RBI, and such significant shareholders are required to meet rigorous ‘fit and proper’ requirements.

In keeping with the principle of diversified ownership, the governing legislation for private sector banks, i.e. the Banking Regulation Act, 1969, provides that the voting rights of all shareholders, whether resident or non-resident, are capped at 10%. This is regardless of the extent of the shareholding.

In its August 2010 discussion paper on the entry of new banks in the private sector, the RBI noted that aggregate non-resident investment in these banks, including FDI, NRI and FII, could be capped at a suitable level below 50% and locked at that level for an initial 10 years. Its reasoning is to create strong domestic banking entities and a diversified banking sector that includes public sector banks, domestically-owned private banks and foreign-owned banks.

Foreign presence in India

In 2005, the RBI released its ‘Roadmap for the presence of foreign banks in India’, which proposed a twin-track gradualist approach to increasing efficiency and stability in the banking sector in India. The road map had two phases. From 2005 until 2009, the first phase would focus on consolidation of the domestic banking system while the second phase (post-2009) would focus on the gradual enhancement of foreign banks in India based on experience gained from the first phase.

In the first phase, foreign banks could establish a presence in India either through a branch, or establishment of a WOS, or conversion of an existing branch into a WOS. However, during this period, the presence of foreign banks was through branches only. The RBI’s stance on this has been that no foreign bank actually applied to set up a wholly-owned subsidiary or to convert their branches into a wholly-owned subsidiary. But this may be due to a lack of incentives.

When the time for review was due in April 2009, the financial systems around the world were adversely affected by the global economic crisis. The RBI therefore opted to postpone the review until further notice. Accordingly, the RBI indicated its intent to continue with current policy and procedures governing the presence of foreign banks in India, and to review its roadmap after due consultation with stakeholders once there was greater clarity over prospects for recovery of the global financial system. Consequently, a discussion paper on the presence of foreign banks in India was released by the RBI in January 2011 (Discussion Paper).

Key principles laid down in Discussion Paper

a) There has been no significant deviation from existing policy on the presence of foreign banks – reciprocity and single mode of presence shall continue to be underlying factors based on which the RBI will grant licences to foreign banks.

b) The Discussion Paper brings out the RBI’s clear preference on the WOS model as the form of presence, as opposed to the branch presence route.

c) However, on account of India’s commitment to the WTO, the branch route is not being disabled and the RBI has not proposed a mandatory conversion of existing branches.

d) The branch route is therefore still available (remains relevant for applicants proposing to set up a limited banking presence in India), but the onus will be on the applicant to demonstrate that the conditions for obtaining a branch licence are met.

e) Upon size of assets reaching a specified threshold (0.25% of all banking assets in India), it is the RBI’s expectation that foreign banks will voluntarily switch over to the WOS model. The Discussion Paper does not set out a clear roadmap for how the transition will be operationalised. The Discussion Paper also contemplates safeguards to ensure that foreign banks do not become dominant.

f) While clarity is yet to emerge on the exact incentives to be provided by the Government and the RBI to encourage a WOS structure, a few benefits proposed include a better chance of obtaining approval for branch expansion.

Considerations for branch presence/ WOS model

Foreign banks considering establishing a presence in India will need to satisfy the RBI that they are subject to ample prudential supervision (having regard to Basel standards) in their home country. Other factors that the RBI would look into include: economic and political relationships, financial stability of the foreign bank, its ownership pattern, its ratings by international rating agencies, and the international presence of the foreign bank.

The policy mandate for single mode of presence together with the threshold for systemically important foreign banks could lead to some of the existing foreign banks (with a large presence in India) being compelled (when they seek approval for new branches) to convert into a WOS model.

It is unlikely that existing branches will be allowed to maintain their status quo (i.e. the branch model), and be permitted to open new branches, if a foreign bank hits the 0.25% threshold in terms of its asset size relative to that of the total asset size of all commercial banks in India. The RBI may even prescribe WOS conversion as a condition precedent for any additional branch approvals in such a situation. The RBI’s policy to strictly comply with its WTO commitments (in terms of permitting new branches under the branch model) is also likely to influence existing foreign banks in India to reorganise their presence in India as a WOS.

For new entrants, banks falling in the following categories may be mandated entry only under the WOS model:

a) Banks incorporated in jurisdictions that provide for home country protectionism (inter alia, precedence in bankruptcy to local depositors vis-à-vis depositors of offshore branches);

b) Banks with unsatisfactory home country regulations, including disclosure requirements;

c) Banks with complex structures and which are not widely held;

d) The RBI’s discretion – if it is not satisfied with the supervisory arrangements and market discipline in the home country of the foreign bank.

Further, given that the RBI has specifically referred to home country protectionism for local creditors/depositors in jurisdictions such as the US, Canada and Australia, applicants from these countries would need to evaluate the option of applying through the WOS route.

National treatment

The RBI’s view appears to be that allowing full national treatment to foreign banks (which are incorporated in India) could lead to unintended consequences. It is therefore neither ‘possible nor desirable’ to provide full national treatment to WOS’s of foreign banks.

Having said the above, while a WOS would not be treated at par with domestic banks, the WOS would be placed in a much better position than branches of foreign banks.

The pros and cons

The WOS model comes with better chances of success in being able to establish a banking presence in India. In addition, a WOS will have the ability to obtain permission for additional branches (since the Discussion Paper suggests that branch expansion will be granted to WOS over and above the WTO quota of 12 branches a year). The WOS model will also have access to local funds for raising non-equity capital.

On the flipside, the WOS model comes with additional corporate governance related compliance (including 50% resident India board composition), and significantly higher capital adequacy and priority sector lending requirements. Further, exposure norms will apply on the basis of the WOS’s balance sheet and not that of the parent entity and the WOS cannot use its parent’s credit ratings or avail of parent guarantees (except issuance of letter of comfort by the parent to the RBI for meeting the WOS’s liabilities).

Establishment of a WOS may, in the future, bring with it a requirement to dilute at least 26% of its ownership to Indian residents. In addition, a WOS will need to comply with the same requirements as domestic banks (including under company law) before it can distribute dividends to its parent. Further, a WOS would be categorised as a ‘foreign-owned and controlled company’ in terms of the FDI Policy of India. As and when the subsidiary route is operationalised, downstream investments by foreign bank subsidiaries would clearly need to comply with the requirements of the FDI Policy. There is ambiguity in relation to the extent to which exchange control norms (such as pricing, etc) are also extended to their operations. Exchange control restrictions, if applied, will have an adverse impact on the operations of WOS and place it at a competitive disadvantage.

Others

The Discussion Paper indicates: (i) the RBI’s discomfort in relation to the possibility of regulatory arbitrage between banks and their affiliate NBFCs, and that (ii) the presence of an NBFC in the group will be factored into the WOS’ bank application. However application of principles of consolidated supervision should address the RBI’s concerns adequately, and it is unlikely that a bank and NBFC co-existing within the same group will be disallowed by the RBI. Banks would however need to be mindful of the existing restriction on holding over 10% of the paid up equity of a deposit taking NBFC.

Although the RBI has, on several occasions in the past, indicated that differential licensing goes against the more fundamental goal of financial inclusion, a reiteration of its position in the Discussion Paper could result in greater resistance for granting bank licences to applicants with a niche banking model. The resistance would be more for applicants seeking to undertake niche banking through the branch route, since the RBI is unlikely to grant more than 12 approvals annually going forward.

Conclusion

To summarise, in our view, the permission to get a banking licence itself (notwithstanding the preferred mode of operations) hinges on (i) reciprocity; (ii) single mode of presence; (iii) ability to encourage financial inclusion by, inter alia, overcoming the inherent regulatory bias against ‘niche banking’.

Biography
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Cyril S Shroff
Managing partner
T: +91 22 2496 4455
E: cyril.shroff@amarchand.com

Cyril S Shroff is managing partner of Amarchand & Mangaldas & Suresh A. Shroff & Co. He has over 25 years of experience in the securities market and a range of other areas including corporate laws, banking and infrastructure.

Shroff is regarded and has been consistently rated as India’s top corporate, banking and project finance lawyer by several international surveys including those conducted by International Financial Law Review (IFLR), Euromoney, Chambers Global, Asia Legal 500 and Asialaw among others.

Shroff has authored several publications on legal topics. He is also a visiting lecturer of securities law at the Government Law College. He is a member of the advisory board of the Centre for Study of the Legal Profession established by the Harvard Law School, and a member of the advisory board of the National Institute of Securities Markets (NISM).

His recent experience includes:

  • Advised Axis Bank on the acquisition of Enam Securities investment banking, capital markets and stock broking units.
  • Advised Standard Chartered PLC in the first ever issuance of Indian Depository Receipts on the BSE and the NSE.
  • Advised Essar Energy PLC in relation to pre-IPO corporate reorganization and listing on the London Stock Exchange.