NEW BANKING LICENSES-THE WAY FORWARD

The word “bank” was borrowed from Middle French “banque”, from Old Italian “banca”, from Old High German “banc” which means “bench, counter”. Benches were used as desks or exchange counters during the Renaissance by Florentine bankers , who used to make their transactions atop desks covered by green tablecloths. Today, Industrial and Commercial Bank of China Limited (ICBC) the world’s largest bank , has about $2.43 trillion of deposits, which is almost higher than the nominal GDP of India, Italy, Russia, France and the UK.

Section 5 (c) of the Banking Regulation Act, 1949 defines a bank as “a banking company which transacts the business of banking in India”. Further, section 5 (b) of the Act defines banking as “accepting, for the purpose of lending or investment, or deposits of money from the public, repayable on demand or otherwise, and withdrawal by cheque, draft, order or otherwise.”

Typically, the provision of deposit and loan products normally distinguishes banks from other types of financial firms. The core activity of banks is to act as intermediaries between depositors and borrowers. However, several banks have successfully leveraged this relationship with depositors and borrowers (channel) to provide all sort of financial services ranging from core services (ATM, Cards, project finance) to ancillary services (Bancassurance, Investment banking, Wealth Management, etc.) to complex & structured solutions (Mortgage Backed Securities, Collateralised Debt Obligation, etc.). For example, other income (non-funded revenues) of Axis Bank was at ~20% of total revenues in FY13.

Conversely, non-financial entities having eminent distribution networks have migrated to the role of providing banking services. For example, Japan Post Bank which is owned by Japan Post Holdings Co., has the largest public deposit in Japan ($1.81 trillion) garnered through a nationwide network of post offices. However, the bank primarily invests its money in government bonds and acts merely as a savings bank. In India, the Department of Posts has applied for a banking license and perhaps is pursuing a similar model.

Banks can create new money when they make a loan. New loans throughout the banking system generate new deposits elsewhere in the system. The money supply is usually increased by the act of lending, and reduced when loans are repaid faster than new ones are generated. In the United Kingdom between 1997 and 2007, there was a big increase in the money supply, largely caused by much more bank lending, which served to push up property prices and increase private debt. The amount of money in the economy in the UK went from £750 billion to £1700 billion between 1997 and 2007, much of the increase caused by bank lending. In fact in many European countries, bank assets dwarf the size of the local economy and are far in excess of other regions in the world as per Table 1.

Excessive or risky lending can cause borrowers to default, the banks then become more cautious, so there is less lending and therefore less money so that the economy can go from boom to bust as happened in the UK and many other Western economies after 2007. Consequently, European banks’ profits have plummeted from 46% to 1.58% in the Top 1000 bank profits list whereas Asia’s banks have increased their profits from 19% to 56%.

While global banking has seen regional disproportional growth due to country specific economic and regulatory requirements, India has its own model for financial development and its regulations. To a great extent, the conservative approach adopted by the Reserve Bank of India (RBI) has helped insulate the domestic banks from global crisis; on the other hand, none of the Indian banks have become global in size.

India has 168 Scheduled Commercial Banks (SCBs) and 82 cooperative banks. Of the 168 SCBs, 82 are Regional Rural Banks and 26 are Public Sector Banks. Thus, only 60 banks are private of which, 40 are foreign banks. According to RBI’s quarterly statistics on deposits and credit of scheduled commercial banks in March 2012, PSBs accounted for approximately 75% per cent of the aggregate deposits. This lopsided structure, where all the eggs are in the same basket, increases the risks to the economy and erodes financial stability while adding a lot of stress on the public banks to increase financial Inclusion. Further, Indian banks will have to bring in additional capital of Rs. 5 lakh crore to meet Basel III norms. The government on its part has to infuse Rs. 90,000 crore into the PSBs to maintain majority shareholding under Basel III.

RBI has as a strategy, since the economic liberalisation in 1991, has followed the cycle of permitting new bank licenses once every decade—in 1993, 2003 and 2013. This permits RBI to regulate the growth and stability of the banking system as well as the new entrants.

The key economic environment under which new banking licenses will be awarded in 2013 could be summarised as below:

•    Overall economic growth

We are in a situation where economic growth has collapsed, industrial output has stagnated for two years, jobs are being shed, consumer inflation is close to 10%, the current account deficit (CAD) in the balance of payments is nearly 5% of GDP at last count, investment is fleeing abroad, external debt maturing in the current fiscal year exceeds $170 billion and the rupee is touching new lows against the dollar each week. While the RBI and the Government are intervening with short-term measures, longer term initiatives are imperative.

As per the discussion paper on the entry of new banks into the private sector (Discussion Paper): “It is generally accepted that greater financial system depth, stability and soundness contribute to economic growth. But beyond that for growth to be truly inclusive requires broadening and deepening the reach of banking. A wider distribution and access of financial services helps both consumers and producers raise their welfare and productivity.”

There are three fundamental reasons for this cor-relation: (1) the banking system creates a more stable employment environment and provides more business opportunity, (2) it helps enlarging the per capita GDP as it brings the unaccounted sector into its fold and (3) it brings additional capital to the banking system, which has a snowball effect.

•    Financial Inclusion

As per the census of India about 59% of households had access to banking services in 2011 and the all-India average population per bank branch was 12,500 in 2012. The majority of India’s 6,50,000 villages do not have even one bank branch, and just 3.5 of every 10 Indians have access to formal banking services in the country, according to a 2011 World Bank survey. Only 37,471 branches were operational in rural India, as of March 2012, while the total banking outlets in villages (including branches, business correspondents and other modes) number just 1,81,753.

While the existing banks also function as per the same mandate (one rural branch out of every four branches), the entry of new players, with a specific and deeper financial inclusion as a license condition, should augment the overall rural presence.

•    Efficiency and Competition

While the overall efficiency of banks in India is increasing, there exists a lot of scope to improve the efficiency of the public sector banks. Net impaired assets (net NPAs + restructured assets) have increased rapidly in FY12 and FY13. Net impaired assets to net worth ratios are now at alarming levels, particularly for PSU banks. Barring BOB and SBI, for all other PSU banks, net impaired assets are almost equal to or even more than 1Q14 net worth. However, for private sector banks, stress levels are very much under control and manageable. Net impaired assets as a percentage of net worth is ~10% for private sector banks (except for Axis Bank at 14% and ICICI Bank at 12%).

Even for private banks, bringing in fresh competition from well-managed business houses, having proven track record in both profitability and setting up pan-India networks (e.g. telecom), will improve the competition and bring in innovation into the system which will only benefit the consumer. Currently, since there are only 3-4 private banks which have pan-India presence, entry of larger business houses will provide competition and much required depth to the financial system in India.

3.    New banking license guidelines

RBI granted licenses to 10 private players between 1993 and 2003. The players were ICICI Bank, HDFC Bank, UTI Bank (now Axis), Global Trust Bank (GTB), IDBI Bank, Times Bank, Centurion Bank, Bank of Punjab, IndusInd Bank, and businessman CR Bhansali, who was accorded an in-principle approval but the bank never materialised. Of the 10, four were promoted by financial institutions and the remaining six by individual banking professionals. As it turned out, all those promoted by individuals either failed or merged with other banks, (viz., GTB with Oriental Bank of Commerce and Times Bank, Bank of Punjab and Centurion Bank with HDFC Bank).

The central bank become more cautious, and be-tween 2004 and 2010 granted licenses only to Kotak Mahindra Bank and Yes Bank.

The failures/mergers were essentially due to (1) weak corporate governance/frauds (CR Bhansali and GTB) and (2) lack of promoter interest or deep pockets (Times Bank, Bank of Punjab and Centurion Bank). RBI also noted that the experience of the Local Area Banks have also not been encouraging due to small size and concentration risk. Similar is the situation with RRBs.

The discussion paper thus notes: “The experience of the Reserve Bank over these 17 years has been that, only those banks that had adequate experience in broad financial sector, financial resources, trust-worthy people, strong and competent managerial support could withstand the rigorous demands of promoting and managing a bank.”

Further, Indian regulators have also learnt that during the 2008 crisis, it was the strength of the Indian JV partner which helped sustain the business, for example, an entity like Tata AIG. Further, RBI also learnt that only domestic banks (unlike foreign banks) have been able to penetrate the country and support financial inclusion.

In light of the macroeconomic situation and experiences both domestically and internationally (Lehman Brothers collapse, etc), RBI has come out with guidelines for issuance of new banking licenses. The table below attempts to summarise the key conditions of the guidelines and rationale for the same:

While the objective tests have been laid down as above, RBI has retained subjectivity in the allotment of banking license to give itself flexibility in decision making. It is expected that the RBI may consider the following and perhaps more, while evaluating each of the applications:

•    Industrial and business houses having a long history of building and nurturing new businesses in highly regulated sectors such as Telecom, Power,

•    Background of promoter, directors and top executives. No objection certificate of the promoter’s credentials, integrity and background will probably be taken from banks, other regulatory agencies and also from investigating agencies.

•    Corporate governance standards in the corporate entity, extent of financial activities carried out by the industrial/business house, comfort with the corporate structure within the group, whether ownership is diversified and separate from management and the source of promoters’ equity.

4.    Applicants and way forward

Unlike an NBFC License, a banking license is controlled with an occasional window which opens briefly, once in a decade. Essentially, some sort of excitement is expected over the number of applicants. In 1993, 13 applications were received out of which 10 were awarded the license. In 2003, 100+ applications were received out which license was awarded only to two. When the current guidelines of 2013 were announced, media reports expected over 100 applications to be received by RBI before the cut-off date of 1st July, 2013. To everyone’s surprise, only 26 applicants were received. Expected big names like Mahindra & Mahindra Financial Services Ltd opted not to apply citing that the new rules may be too hard for businesses to implement.

Of course, each applicant would have done his cost benefit analysis before applying. The apparent benefits, amongst others, would be

(1)    Scalability and stability of business,

(2)    Better cost of capital due to access to public deposits,

(3)    Distribution network so as to improve the fee based income (eg- Bancassurance), and

(4)    Return on investments. Table 2 indicates the share price performance of new banks commenced since 1993.

The key challenges for setting up the bank would, amongst others, be

(1)    Stringent regulations, not just for the bank, but for all financial regulated entities in the Applicant group and

(2)    Cost on account of priority sector lending, branch expansion and financial inclusion.

The bigger issue arises from the fact that the conditions are expected to be complied with from day one of the commencement of the bank business. RBI has emphasised that it will not deviate from the guidelines while allotting licenses and thus, will not grant any exemptions.

The list of applicants along with a possible classification, and RBI’s potential key consideration for that bucket is tabled below.

Of the number of applicants, RBI will now be required to address several critical questions, including:

•    How many banking licenses should be issued, assuming the industry is likely to consolidate?

•    Will players with pan-India focus be given preference over regional players? Or whether both the categories of applicant will be considered?

•    Whether large industrial houses with experience in setting up pan-India networks like telecom, automobiles, etc., will get preference?

* The authors are senior officials of a well-known financial company. The views expressed in the article are their personal views.

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