Rakesh Mohan: Ownership and governance in private sector banks in India
Address by Dr Rakesh Mohan, Deputy Governor of the Reserve Bank of India, at the Conference on
Ownership and Governance in Private Sector Banking organised by the Confederation of Indian
Industries, Mumbai, 9 September 2004.
* * *
I am grateful to the Confederation of Indian Industries to arrange a seminar on a subject of great
importance today. This gives me an opportunity to discuss the issues with various stakeholders.
On July 2, 2004, RBI issued draft guidelines on ownership and governance in private sector banks in
India. These guidelines were placed in the public domain for wider debate and feedback. The RBI is to
put out a second draft and then finalise the policy taking into account the feedback received. The
intention is to continue strengthening the Indian Banking System and keep moving towards
international best practice through a consultative process.
If the importance of the issue of ownership and governance in banks is to be gauged by the number of
responses received to any public document issued by RBI then I would say that it is overwhelmingly
important!
We had said in the guidelines that banks are special. Several responses have been received asking
us what we mean by 'special'. Banks are financial intermediaries critical for mobilising public savings
and for deploying them to provide safety and return to the savers. They thus have fiduciary
responsibility. The deployment of funds mobilized through deposits involves banks in financing
economic activity and providing the lifeline for the payments system. The banking system is something
that is central to a nation's economy; and that applies whether the banks are locally- or foreign-owned.
The owners or shareholders of the banks have only a minor stake and considering the leveraging
capacity of banks ( more than ten to one) it puts them in control of very large volume of public funds of
which their own stake is miniscule. In a sense, therefore, they act as trustees and as such must be fit
and proper for the deployment of funds entrusted to them. The sustained stable and continuing
operations depend on the public confidence in individual banks and the banking system. The speed
with which a bank under a run can collapse is incomparable with any other organisation. For a
developing economy like ours there is also much less tolerance for downside risk among depositors
many of whom place their life savings in the banks. Hence from a moral , social, political and human
angle, there is a more onerous responsibility on the regulator. Millions of depositors of the banks
whose funds are entrusted with the bank are not in control of their management.
Thus, concentrated shareholding in banks controlling huge public funds does pose issues related to
the risk of concentration of ownership because of the moral hazard problem and linkages of owners
with businesses. Hence diversification of ownership is desirable as also ensuring fit and proper status
of such owners and directors. At the same time with diversified ownership, there is, perhaps, even
greater concern over corporate governance and professional management, in view of this, apart from
ensuring fit and proper considerations, in order to safeguard depositors interest and ensure systemic
stability, the regulatory and supervisory framework has to ensure that banks have adequate capital to
cushion risks that are inevitable in their operations, follow prudent and transparent accounting
practices and are managed in accordance with the best practices for risk management. Seen from this
standpoint, great responsibility is imposed on the regulator.
The issue has been raised as to why now- what is new that these concerns are being raised now?
After nationalisation of major banks in 1969 and in 1980, in a sense, being government owned the
issue did not arise till recently. As part of financial sector reform and keeping in view the growth needs
of the economy it is expected that the significance and share of the private sector banks will increase
as also public shareholding in the public sector banks within the current policy framework. The banks
are expected to grow with the economy. There is also opening up of the economy and increasing
integration with the global economy. As this happens, the regulator has to ensure that the banking
system is strong, healthy and resilient to withstand shocks. We also want to ensure that transparency
improves and want to move to international best practices in regulation, supervision, risk management
while at same time calibrating the suitability to the domestic conditions and needs at the current stage
of development
Key features of the guidelines
To begin with, let me enumerate the salient features of the guidelines.
1. All shareholding of 5 per cent and above representing important shareholding will have to
meet the 'fit and proper' tests of competence, reputation, track record, integrity, satisfactory
outcome of financial vetting, source of funds and so on. Where the applicant is a body
corporate, fit and proper would include good corporate governance, financial strength and
integrity in addition to the assessment of individuals and other entities associated with the
body corporate as enumerated above.
2. In the interest of diversified ownership of banks, the objective will be to ensure that no single
entity or group of related entities have shareholding or control, directly or indirectly, in any
bank in excess of 10 per cent of the paid up capital of the private sector bank. Any higher
level of acquisition will be with the prior approval of RBI and in accordance with the
guidelines of February 3, 2004. These guidelines state that where acquisition or investment
takes the shareholding of the applicant to a level of 10 percent or more and up to 30 percent,
the RBI will also take into account other factors including but not limited to the following:
(a) source and stability of the funds for the acquisition and the ability to access financial
markets as a source of continuing financial support for the bank, (b) the business record and
experience of the applicant including any experience of acquisition of companies, (c) the
extent to which the corporate structure of the applicant will be in consonance with effective
supervision and regulation of the bank; and (d) in case the applicant is a financial entity,
whether the applicant is a widely held entity, publicly listed and a well established regulated
financial entity in good standing in the financial community. In addition as indicated in the
July draft, where the investing entity is a corporate entity, it will be seen whether there is
diversified shareholding of the investing entity. For acquisition or investment exceeding the
level of 30 percent the criteria will also take into account but will not be limited to whether
(a) the acquisition is in public interest, (b) the desirability of diversified ownership of banks,
(c) the soundness and feasibility of the plans of the applicant for the future conduct and
development of the business of the bank; and (d) shareholder agreements and their impact
on control and management of the bank.
3. The main difference between the February guidelines and the July draft is that the latter
requires prior approval for shareholding above 10 per cent and is also applicable for existing
shareholding above such level. The criteria laid down in the guidelines will be applicable
equally for higher level of acquisitions as also for time bound plan for continuance or
reduction in cases where the limits exceed those indicated.
4. Minimum of Rs 300 crore of net worth is perceived as being desirable on grounds of optimal
operations and systemic stability. Banks with net worth lower than Rs 300 crore will be
encouraged to increase it to this level through organic or inorganic growth within a
reasonable period.
5. In case of new licenses, promoter's shareholding will normally be expected to be brought
down to 10 per cent in a period of three years even if higher to begin with.
6. Large industrial houses as per existing policy will be permitted strategic investment in banks
up to 10 per cent subject to fulfilling the other criteria.
7. While guidelines have already been issued to banks and Fis in India to minimize cross
holding to 5 per cent, symmetrically, the draft guidelines require foreign banks operating in
India to restrict their acquisition (either directly or through any entity in the group) of
shareholding in Indian banks to 5 per cent .
8. The maximum limits for portfolio investment through stock exchanges by individual NRIs and
FIIs at 5 per cent and 10 per cent respectively and aggregate limits at 10 per cent (can be
raised to 24 per cent through special resolution of general body) and 24 per cent (can be
raised to 49 per cent through special resolution of general body) respectively, currently
permissible, as reiterated in the GOI press note of March 5, 2004, have been retained in the
draft guidelines. These will be subject to government's policy in this regard. All cases of
acquisition or holding of 5 per cent and above, in case of FIIs, will require acknowledgment
by RBI as per February 3, 2004 guidelines. Where the investing entity is a 'sub account', full
details of the investor/s and other particulars required for due diligence will be called for.
9. While most of the elements of the draft guidelines in case of directors have been
implemented already, the provision relating to the desirable practice of having not more than
one member of family close relative or associate on the Board of a bank is yet to be
introduced.
10. All transition arrangements for compliance with the guidelines for existing holdings will be
subject to submission of time bound action plans by the concerned banks. The intention as
already indicated will be to move towards the desired objectives in as non-disruptive a
manner as possible.
11. Continuing compliance of 'fit and proper' criteria for shareholders and directors will have to
be ensured by the bank on an ongoing basis subject to independent verification by RBI
where felt necessary.
How did we come to devise these guidelines? Apart from an internal review, we scanned international
practice.
International approaches
Internationally, the regulatory/supervisory approach has been evolving into cohesive and inclusive
regulatory paradigm involving three different monitoring perspectives on the overall functioning of
banks -
• an enabling and proactive regulatory and supervisory oversight,
• internal control through a vibrant and professional Board and
•
market discipline
All three in isolation have their limitations and are effective differentially based on the overall systemic
contexts such as the level of maturity of the economy, and hence the markets, the efficacy of the legal
system and the resolution mechanisms in place, the prevalent business culture etc. Market discipline
may not be very effective till transparent disclosure requirements are put in place. Even then the ability
of the market to discipline the constituents would depend on its own structural strength as well as the
economic setting in which it operates. Therefore a significant level of reliance has to be placed on
internal control effected through Board oversight.
An important factor, in this context, that defines the business culture is what has come to be termed as
"corporate governance". It is a nebulous concept whose essential elements were part of the business
ethos in all societies but which has in recent times come under sharp focus and acquired a heightened
significance partly due to the process of globalization and the increasingly overarching role of business
on the society at large.
From a banking industry perspective, corporate governance involves the manner in which the
business and affairs of individual institutions are governed by their boards of directors and senior
management, affecting how banks1:
•
set corporate objectives (including generating economic returns to owners);
• run the day-to-day operations of the business;
•
consider the interests of recognised stakeholders;
•
align corporate activities and behaviours with the expectation that banks will operate in a
safe and sound manner, and in compliance with applicable laws and regulations;
• protect the interests of depositors.
The two major concerns that arise in context of corporate governance in banks and need to be
addressed are (i) the concentration of ownership and (ii) the type of people who control the bank.
Diversified ownership becomes a necessary postulate as it provides balancing stakes which may not
be possible otherwise, even in the case of voting right limits. A related concern is the 'quality' of control
over the functioning of banks manifest in the credentials of the various stakeholders.
A survey of the regulatory regimes in major countries brings out that most of the regimes address
these two concerns through a set of restrictions on the ownership of bank stock on the following
parameters:
• quantum of ownership by single person/associated persons
• ownership restrictions for domestic entities based on nature of entity
•
non-bank financial firms
•
non-financial entities
•
other banks
•
ownership restrictions for foreign entities
Major inferences that can be drawn from the international practices are as follows :
In most of the countries, ownership concentration is regulated through a layered threshold
structure as per which any person wishing to acquire/increase shareholding in a bank beyond those
thresholds would be required to seek regulatory approval . The qualifying threshold level in most
countries is 10%. Most of the countries though do not have an explicit cap on the maximum
shareholding by a single person/entity. The above structure applies to direct as well as indirect
control by a person singly or jointly through a group of associates or related parties.
The regulators give approvals on a case to case basis subject to a number of considerations
including the overall sectoral impact of the transaction and the satisfaction of 'fit and proper'
principles by the person(s) acquiring the stake.
Acquirers of shares beyond thresholds need to provide comprehensive information to the
authorities for their approval including the intent of purchase, terms and conditions, if any, manner of
acquisition, source of funds etc.
In terms of the nature of the entity, non-banking financial firms and non-financial firms are
permitted to acquire shares in banks subject to the overall ceilings in respect of single entity in most
countries albeit with regulatory approval in most cases. The non-discriminative treatment of the two
classes of entities is reflected in dovetailing of the restrictive clauses, wherever applicable, with the
norms on ownership by single entity.
Crossholding amongst banks i.e., acquiring shares in a bank by another bank, directly or indirectly,
is subject to regulatory approval in most of the regimes and the thresholds, in some cases, are lower
than those for non-bank entities.
Background for the draft guidelines
Having dealt with the international approaches , I would like to highlight some facts and developments
which should serve as a background information for this seminar.
• Unlike in many other countries, the various laws relating to banking in India [Banking
Regulation Act 1949, Banking Companies (Acquisition and Transfer of Undertakings Act,
1970 and 1980, the State Bank of India Act 1955, the State Bank of India (Subsidiary Banks)
Act 1959] do not provide for prior approval of the regulator for acquisition of significant
ownership in banks - either in the public sector or in the private sector. There is, therefore, a
need for an articulation of policy in public interest and depositor's interest.
•
On February 3, 2004, the Reserve Bank came out with the guidelines for acknowledgment
for acquisition and transfer of shares in private sector banks. These guidelines took into
account the emerging trends in banking and international practices. For the first time, it was
spelt out that the term 'holding' will refer to both direct and indirect, beneficial or otherwise
and will be computed with reference to the holding of the applicant, relatives and associates.
•
On 5 March 2004, press note 4 was issued by Government of India covering foreign
investment in banking. The operational guidelines are yet to be issued. Hence the draft
guidelines do not cover the policy in regard to investment by foreign banks or form of
presence of foreign banks for which there will be separate guidelines. Before issuing these, it
is felt necessary to streamline the national policy for ownership, domestic and foreign, and
governance.
•
On June 25 2004, 'fit and proper' criteria for directors of private sector banks were spelt out
by RBI based on qualification, expertise, track record and integrity of persons to be
appointed as directors of banks. The process of due diligence is to be undertaken by the
bank at time of appointment and renewal.
• On July 6 2004, banks / FIs were advised that they should not acquire any fresh stake in a
bank's equity shares, if by such acquisition, the investing bank's/FI's holding exceeds 5 per
cent of the investee bank's equity capital.
Why are the guidelines being made applicable for existing banks?
The banking sector is already quite large and widespread. There are several banks of varying sizes,
composition of shareholding and directors. The issues of size and governance are extremely important
from point of view of financial stability. This draft policy is in consonance of treating banks as special
and is setting upfront a road map in a transparent manner for the existing investors to align their
policies and potential investors to make informed decisions. The intention of the policy is to ensure
adequate capital and consolidation in the banking industry with the regulator being aware of the
intention of existing and potential shareholders. Since one of the fundamental presumption in the
policy is that any shareholding above 10 per cent would have to satisfy the regulator of the fit and
proper status and sound governance principles on a continuing basis, it is necessary that the same
principles are applicable to existing owners but done so in a non-disruptive and consultative fashion.
In regard to banks permitted recently or rehabilitated recently on the basis of specific approvals, the
commitments made as part of the approval process would undoubtedly be taken into account as also
continuing compliance with 'fit and proper' and sound governance. The same criteria as applicable for
higher level of ownership as articulated in the February 3, 2004 would form the basis for dealing with
the cases under transition as well.
The discussion paper is an illustration to the consultative process that has been increasingly adopted
in the policy making by the Reserve Bank. As far as banking business is concerned, we appreciate the
role of promoters in general and strategic investors in particular; although the distinction between them
is often blurred in practice. The comments on the first draft of this discussion paper will definitely
enable us to fine tune the policy for the better.