Draft rules raise benchmark for potential entrants

Author: | Published: 1 Aug 2012
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The new benchmark for potential entrants to the Indian banking sector reflects the Reserve Bank of India's (RBI's) intention to control the risks of the Indian banking sector more effectively following the global financial crisis of 2008. The draft guidelines, which lay down the criteria for corporate groups to secure permission for establishing banks in India, were released on August 29 2011. The subjective elements towards eligibility of the promoters include, 'diversified ownership, sound credentials and integrity'. The final guidelines will be issued after the RBI has reviewed feedback, comment and suggestions on the draft version.

The guidelines state that entities having more than an aggregate 10% income or assets in real estate, construction and capital market activities, in particular broking activities, are not allowed to promote banks in India. The objective is to prevent risks from these activities spreading to the banking sector, which is based on fiduciary principles as depositors' money is involved.

Another strong objective of the guidelines is to regulate the risks of banks more effectively by ring-fencing all regulated activities under the umbrella of a non-operative holding company (NOHC). New banks will be set up only through a wholly-owned NOHC to be registered with the RBI as a non-banking finance company (NBFC), which will hold the bank as well as all other financial companies in the promoter group. This might have implications for the existing structure of corporate groups, as a successful licensee may need to restructure its group holdings in order to comply with the proposed structure.

In addition, there is a minimum capital requirement of Rs 5 billion (US$88 million). The NOHC shall hold a minimum 40% of the paid-up capital of the bank for a period of five years from the date of licensing of the bank. The NOHC could start with a higher shareholding, but it has to be brought down to 40% within two years, to 20% within 10 years, and to 15% within 12 years from the date of licensing. The aggregate foreign shareholding in the new bank shall not exceed 49% for the first five years after which it will be as per the extant policy.

On the corporate governance side, the guidelines state that at least 50% of the directors of the NOHC should be totally independent of the promoter/ promoter group entities, its business associates, and its customers and suppliers.

Under the guidelines, new banks will have to open 25% of their branches in rural areas

The guidelines also state that exposure of the bank to any entity in the promoter group shall not exceed 10%, and the aggregate exposure to all the entities in the group shall not exceed 20% of the paid-up capital and reserves of the bank.

Finally, the bank shall open at least 25% of its branches in the unbanked rural centres (population up to 9,999 persons). This is expected to make banks more accessible to less populated places.

Many legal practitioners from the banking sector find the new regulations to be overly protectionist. In particular, they find the capitalisation requirement to be hard to follow, and they also find the requirement to establish 25% of branches in rural areas to be unreasonable.

Akil Hirani, managing partner at Majmudar & Partners, says: "There are not enough considerations on market reality as the government intends to set up these new banking rules. Some of the requirements have significant impact on the profitability of the banks. For example, the requirement for potential entrants to set up 25% of their branches in rural areas is unviable to some investors."

He adds: "The banking activities in these areas are mostly taken care of by domestic banks, as they normally have agendas aligned to the central government. However, the private banks do not have such agendas, nor do they have specialties in taking care of businesses in rural areas. For many of the newcomers, such requirements are difficult and unviable."

Others, such as Kotak Mahindra Capital chief legal and compliance officer Ajay Vaidya, believe that the requirement for 25% rural branches was always a likely response to criticism received over microfinance institutions. They argue that the benefits include bringing institutionalised banking systems to less populated centres around the country.

One concern is that the Indian government's new rules might prevent it from realising its objective of attracting more foreign players, says Hirani, particularly when the capacity of local banks is insufficient to finance India's fast growing economy. "The Indian government has strong incentives for attracting more investment from foreign banks as they tend to offer better financial products, and at lower cost, in order to compete with protected local banks," he says. "So despite the fact that the new banking rules appear to raise the benchmark for incoming banks, it doesn't mean that the government is reluctant towards the entrance of foreign banks."

Hirani adds: "It is purely a regulatory effort to better control banking-related risks in India. However, they are just doing that in the wrong way without comprehensively balancing the interest between establishing an investment-friendly environment for the banking sector and introducing more regulations to control risks."

The RBI's new set of draft guidelines for licensing new banks has certainly caused a stir among the legal fraternity, but they are unlikely to be implemented anytime soon as they are still under amendment and discussion. Various matters, such as the removal of restrictions on voting rights and RBI's approval for change of shareholding limitations, remain under RBI consideration.

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