Rajeshwar Rao: Ownership and governance - building the edifice
for digital innovations
Remarks by Mr Rajeshwar Rao, Deputy Governor of the Reserve Bank of India, at the Mint
Annual Banking Conclave, Mumbai, 15 December 2021.
* * *
The inputs provided by Shri Navin Nambiar and Shri Pradeep Kumar are gratefully
acknowledged
Ladies and Gentlemen.
Thank you for inviting me this evening to the Mint's Annual Banking Conclave. The organisers
have quite aptly selected an extremely topical and contemporary theme, i.e.,
Future of Banking:
Navigating a Digital Opportunity for this year's conclave. During the previous edition of this
conclave, I remember Governor Shaktikanta Das speaking about digital disruptions and blurring
of boundaries between traditional banks and FinTech & BigTech. Looking at the constellation of
speakers who have been engaging with you, I am sure you all have had an extremely
enlightening discourse on several of the emerging issues during the conclave.
2. The technological and digital innovations have improved the efficiency, productivity, and
competitiveness in the delivery of financial services. Their role in furthering the financial inclusion
and reducing the cost of financial intermediation is well recognised. However, such innovations
have also given rise to newer challenges for all stakeholders. While customers face issues of
mis selling, data security and privacy as well as identity theft problems, regulators and
supervisors need to increasingly engage with issues around customer protection, ethical
conduct, regulatory arbitrage, and concerns about financial stability. In turn, the regulated entities
need to be on their toes to face up to everchanging competition and business disruptions through
technology driven innovations, requiring them to fine-tune and sometimes alter their business
plans, re-orient their strategies and manage the concomitant risks.
3. Given this backdrop, I thought I could briefly focus the spotlight on business conduct and
governance issues in financial services, which assume greater relevance in times of innovation,
change and business disruptions. These in my view are the key soft pillars which build the edifice
of a successful financial institution, more so in these challenging times. In particular, there is a
need to reflect on the role and expectations from the governance architecture viz., the Board and
its Committees, the Independent Directors and the assurance functions in banks and other
financial institutions.
4. Before I talk about governance related issues, let me briefly dwell upon the concerns around
the ownership and corporate structure for private sector banks drawing largely on the
recommendations of the Internal Working Group (IWG) constituted by the Reserve Bank to
examine these issues. The Reserve Bank has accepted 21 out of the 33 recommendations
made by the group and had announced this decision on November 26, 2021. However, there are
some issues where the recommendations have been extensively debated and therefore require
further examination.
Licensing and ownership of private banks in India
5. It is generally accepted that a deep, stable, and sound financial system contributes to
economic growth. But for growth to be truly inclusive, broadening and deepening the reach of
formal finance is a pre-requisite. Access to formal finance is especially critical for the lower
income groups as it provides them with the opportunities to save, invest, avail of credit, and grow
their incomes through productive enterprises and activities. This provides them the much-
needed insurance against future income shocks and helps them to manage emergencies. The
guidelines for licensing of new banks in the private sector issued by the Reserve Bank since the
initiation of financial sector reforms in early nineties, have been guided by the above philosophy.
In addition, the choices have also been informed by the need to instil greater competition in the
banking system to increase productivity and efficiency. So far, eight sets of licensing guidelines
have been issued by the Reserve Bank, of which four are for universal banks and four pertain to
differentiated banks.
6. After the recent IWG report, the public discourse has mostly been concentrated on their
recommendation for granting banking license to large industrial houses. However, a little
historical perspective on this issue would be helpful. In the licensing guidelines issued in 1993,
there was no explicit ban on setting up banks by large corporate/ industrial houses; The licensing
guidelines of 2001 did not allow banks to be promoted by a large corporate/ industrial house,
while in terms of the 2005 guidelines on ownership and governance in private sector banks, large
industrial houses were allowed to acquire up to 10 per cent holding in a bank with the prior
approval of the Reserve Bank. Under the licensing guidelines issued in 2013, the banks were to
be mandatorily set up through a wholly owned Non-Operative Financial Holding Company
(NOFHC). Individuals were not allowed to promote banks under these guidelines, but again there
was no bar on large corporate/ industrial houses to be promoters. The 'on-tap' guidelines of 2016
defined large industrial houses and restricted them from promoting a bank, but at the same time,
they were permitted to invest in a bank to the extent of 10 per cent. The small finance banks
(SFBs) licensing guidelines issued in 2014 and 2019 made large public sector entities and
industrial houses, including NBFCs promoted by them explicitly ineligible to set up such banks.
7. Many committees set-up on the subject in the past as well the IWG have acknowledged that
the large corporates/ industrial houses can be an important source of capital and can provide
management expertise and strategic direction given their pool of entrepreneurial and managerial
talent. There is also the issue of finding fit and able promoters with deep pockets to set up a large
technologically equipped universal bank. However, at the same time concerns were raised by all
of them, including the IWG, on the attendant risks which come to fore. These include - conflicts
of interest through self-dealing at the expense of bank clients and in the transactions between the
bank and its affiliates, favouring associates for extending loans and undermining the neutrality
and independence in deciding allocation of credit and constricting the flow of credit to
competitors. Caution was also warranted around issues of connected lending, complex web of
group structures, crossholding as well as presence of large number of unregulated entities in the
group, as these would stretch the RBI's regulatory and supervisory resources. Another
oftquoted argument also points to the principles of separation of banking and industry/business.
While it is an accepted fact that the relationship between financial economy and real economy is
symbiotic, de facto merger of the segments may actually aggravate the systemic risks.
8. Given that banking is a highly leveraged business dealing with public money, it makes sense to
keep Industry/ business and banking separate. This separation is expected to avoid spill over
risks - where trouble anywhere in the group entity may result in transferring risks on to the
depositors, leading in turn to claims on deposit insurance with subsequent ripple effects
cascading across the largely interconnected financial systems, creating concerns around
financial stability. These issues have been flagged by the IWG also and therefore, it is necessary
that we closely examine the related matters before thinking of permitting large industrial houses
or NBFCs owned by such houses to set up any new bank. To conclude, let me just say that the
jury is still out on the issue.
Shareholding and Structure
9. Diversification of ownership in banks is considered desirable in the long run as concentrated
shareholding may expose them to the problem of moral hazard. As such there was a regulatory
cap of 15% prescribed on promoters' holding in long run. At the same time, diversified ownership
alone is not a panacea for corporate governance concerns. The views expressed by P. J. Nayak
Committee (Committee to Review Governance of Boards of Bank in India) in 2014 was that if the
maximum shareholding for promoter investor(s) is set very low, banks could be more vulnerable
as the alignment of incentives between shareholders and management could weaken
(managements could then be primarily concerned with their own interests rather than those of
shareholders). This issue could be a greater concern than the risks emanating from
concentrated holding. Further, the shareholders, if very small can become disengaged from the
affairs of the bank. Recognising this dilemma, the IWG has recommended that the cap on
promoters' holding in long run be raised to 26% (from existing 15%). We have agreed with the
views of the IWG which have tried to strike a balance between the challenges posed by
concentration of ownership on the one hand and diffusion of ownership on the other. Even for
non-promoter holdings, lower sub limits (10 percent) for natural persons and non-financial
entities on one hand and slightly higher (15 percent) limit for well diversified financial entities
(excluding those belonging to industrial houses) has been prescribed. This stance allows for
greater flexibility for augmentation of capital even while drawing comfort from the statutory ceiling
of 26% on voting rights. Needless to mention, the Reserve Bank can also exercise its judgement
on such matters using the "fit and proper" requirements as is the case in various global
jurisdictions.
10. From the perspective of addressing the issues which may emanate from complex group
structures and opaque cross holdings, NOFHC has been considered as one of the most
appropriate structure to ring-fence a bank from the spill over effects of other entities in the group.
Recognising this fact, RBI has made NOFHC structure mandatory for the banks licensed since
2013. However, the transition of banks, which were licensed before 2013 and have other entities
in the group, to NOFHC structure is another challenge that needs to be addressed due to various
complex issues involved. These issues too need careful examination.
11. Finally, the overwhelming number of responses/ comments on the report of IWG gave us a
very diverse set of views from a wide spectrum of stakeholders. This corroborates the
importance and complexities of the issues around ownership, control, and corporate structure of
private banks. It is precisely for these reasons, we have decided that some of the
recommendations of the IWG need wider stakeholder consultation, deeper examination from
various angles, including legalities, and may also require engagement with various other
agencies and regulators.
Let me now discuss on the important issue in current milieu - corporate governance.
Importance of Governance in Financial Institutions
12. A sound, efficient and robust financial intermediation structure facilitates optimal allocation of
financial resources in the economy. For this, the trust of all stakeholders, especially of depositors
in case of banks, is a pre-requisite. While legal and regulatory architectures provide a broad
framework to maintain this trust, the trust needs to be grounded in good governance and ethical
conduct of the institutions and their functionaries. The banks tend to be well regulated and are
intensively supervised but any erosion of public trust in financial institutions cannot be countered
with regulatory prescriptions or supervisory rigours alone. Therefore, to mitigate the 'risk of
failure' emanating from governance issues, the standards expected of banks are always higher
than those from other entities. The same principle would apply to other regulated entities
engaged in financial intermediation, albeit in varying degrees.
13. For ensuring sound corporate governance, we need to be mindful of two key challenges.
First, dominant shareholders exercising relatively more control may not optimise the interest of
all stakeholders. Second, a self-serving management may have perverse incentives to take
advantage of the diversified, diffused, or passive nature of other stakeholders. While separation
of ownership from control must be a dominant response to address the first challenge, in order
to address the second challenge, it is important to ensure that the incentives of the management
are aligned with the interest of depositors and other stakeholders.
14. In the domestic context, growing size and complexity of India's financial system highlights the
need to strengthen the governance standards in banks by increasing scrutiny of the role of
promoter(s), major shareholder(s) and senior management vis-a-vis the role of the Board. To
this end, Reserve Bank issued a discussion paper on 'Governance in Commercial Banks in
India' in June 2020, the intention of this Discussion Paper was to enhance governance standards
in banks and to align the current regulatory framework with global best practices albeit with the
domestic contextualisation. Based on the suggestions made in the Discussion Paper and the
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public feedback on these suggestions, the Reserve Bank issued instructions earlier this year
regarding the Chair and meetings of the board, composition of certain committees of the board,
age, tenure and remuneration of directors, and appointment of the whole-time directors (WTDs).
15. In the parlance of regulation, prudential regulation and conduct regulation denote what is
commonly known as twin peaks. In RBI, we are looking at these two important aspects through
the prism of governance with equal emphasis on conduct of business besides prudence, which I
suppose would have been visible to you by now. It's no doubt essential for the management to
deliver good performance but more importantly this should be achieved by adhering to
acceptable customer and market conduct and best corporate governance practices. RBI has
also taken some initial steps for direct interface with board or board/ committee chairs when
there are concerns to show its seriousness or when there is a need for direct dialogue.
Roles and Expectations from the Board and its Committees
16. The overall responsibility of fostering a culture of good governance in banks rests with their
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Board of Directors. The Board should set the "tone at the top" and oversee management's role
in fostering and maintaining a sound governance, compliance, and risk culture. This
responsibility has been bestowed on the Board and its Directors irrespective of the fact that who
appoints them. The Board is expected to ensure that the bank is run by professionals with
integrity, complies with all regulatory and legal requirements, and conducts its business in
accordance with high professional and ethical standards.
17. For the Board to gain deeper insights to engage with the management in a credible and
constructive manner, it would be necessary.
For the committees of the board to have directors with the necessary specialist knowledge
or practical experience consistent with the mandate given to various committees.
To ensure the presence of majority of independent directors on board and various
committees, to increase the probability of credible critique of the management proposals.
To ensure that the channels of information to the specialised supervisory committees of the
Board are independent of the influence of the risk takers.
18. These measures could significantly enhance the quality of decisions by the Board and its
committees, especially the key committees viz., the Audit Committee, the Risk Management
Committee and the Nomination and Remuneration Committee. There is often a fine balancing
act to be played by the Board in response to the complex interplay between dominant
shareholder(s), minority shareholders and management. The ability of steer through this
distinguishes an effective Board from an ordinary one.
'Independence' of Independent Directors
19. Independent Directors are necessary to counterbalance interests that are well represented
on the Board with those who do not have representation or are inadequately represented on the
board. Independent Directors help to bring in clarity regarding responsibilities and also enhance
accountability of the management to the stakeholders. The most effective Boards are the ones
that can overcome the challenges of the 'principal-agent' relationship and resolve the information
asymmetry conundrum. The degree of this asymmetry is bound to increase in large and complex
entities. To resolve this challenge, the independent directors need to recognise that they are the
ones who must overcome the information asymmetry. Remember, it is the management which
functions under the superintendence, control, and direction of the board. Why else would a board
need to exist? Of course, for this to happen, the Independent Directors need to be truly
independent in form and in substance.
Compensation practices
20. Remuneration policy forms an integral component of internal governance structure of the
bank which enables the Board to reward good performance and acceptable risk-taking
behaviour. It also gives a tangible tool in the hands of the Board (or by delegation to Nomination
and Remuneration Committee of the Board) to align risk taking behaviour of the key risk takers
with the approved risk appetite and strategic direction. Within this perimeter, it is the
entrepreneurial spirit of various risk takers which drives the entity towards achieving its
objectives.
21. While existing guidelines for private sector banks in India require that compensation of CEOs,
whole time directors, control function staff and material risk takers (MRTs) shall be adjusted for
all types of risks and is sensitive to the time horizon of the risks, we often see misalignment in
the performance of the entity and compensation proposals recommended to the NRC/ Board.
Let me emphasize- the last thing RBI would like to do is to decide remuneration of individual bank
executives which is essentially a board / NRC function. But there are at times situations where
the internal and external equity of such compensation is not adequately justified in the proposal.
We need to remember that perverse incentives may lead to reckless behaviour or higher risk
taking which may manifest itself over a period. The compensation practices, where employees
were often rewarded for increasing short-term profit without adequate recognition of the risks and
long-term consequences amplified excessive risk taking that severely threatened the global
financial system in 2008.
Concluding thoughts
22. Covid has all of us taking a new perspective of everything in our life. In the beginning of the
first wave of the epidemic, everybody was scrambling for 'immunity boosters' in whatever form it
could be sold to them. Corporate Governance to banks during tough times is what immunity is to
an individual at times of health scare. The development of immunity is complex and takes lifelong
ingestion of healthy and positive practices. Like human longevity, the sustainability of banking
business comes from the healthy corporate governance practices.
23. As we collectively aspire for an efficient financial intermediation with positive spill over to the
real sectors, we need to remind ourselves that these aspirations are set in an increasingly
competitive, diverse, interconnected and market driven ecosystem. It is important in this context
to gain and retain the trust of other stakeholders such as depositors and various providers of
financial resources. This is best ensured by the governance, control, and assurance functions in
financial institutions. Governance frameworks can be pictured of as a complex mesh of nuts and
bolts holding the financial pillars of capital, assets, deposits, and investments in place and
keeping the structure of the bank upright. As we strive to recover from the pandemic, financial
institutions will need extraordinary amounts of financial resources to support growth to realise our
visions for a brighter tomorrow. Raising these resources would not be a constraint for financial
intermediaries with robust governance frameworks as they can command a governance
premium. This premium in turn will be driven by expectations from the leadership at the top. After
all, it only takes a few to make a difference.
My best wishes for you to get the governance right as you get ready to navigate through the
digital opportunities that lie ahead!
Thank you.
1
www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12078&Mode=0
2
BCBS (www.bis.org/bcbs/publ/d328.pdf)