LEFT PARTIES NOTE TO THE UPA GOVT

On The Proposal To Enhance The FDI Cap In Banking

THE BACKGROUND

On December 15, the finance minister, while responding to a Calling Attention notice on changes in Banking Policy in the Lok Sabha, announced the enhancement of the FDI limit to 74 per cent following the March 5, 2004 notification issued by the previous government and justified it by saying that “The revision in FDI limit will create an enabling environment for higher FDI inflows along with infusion of new technology and management practices resulting in enhanced competitiveness”. The minister also said that the RBI is in the process of considering the suggestions/feedback received on its guidelines, which was issued on July 2, 2004. It is clear by now that after its initial reservations about the move, the RBI has finally agreed to the raising of the 10 per cent voting cap in the private sector banks and make it proportional to equity holding, whose limit in turn would be raised to 74 per cent. However, it is noteworthy that the removal of the cap on voting rights would require an amendment of Section 12(2) of the Banking Regulation Act. The Left Parties are opposed to this proposed amendment.

BANK DEREGULATION: THE POSITION OF THE LEFT

The Left is opposed to the moves to further deregulate the banking sector on several counts. Deregulation of the banking sector, which is a vital component of financial liberalisation, greatly enhances the scope of speculative activities and exposes the financial system to the risks associated with volatile capital flows. This lesson was painfully learnt by several developing countries through the decade of the nineties. Far from contributing positively to economic growth, asset creation and employment generation, financial liberalisation has precipitated crises in several countries. However, the RBI’s Report on Trend and Progress of Banking in India 2003-04, talks about the appropriate timing of the entry of foreign banks into India so as to be co-terminus with the transition to greater capital account convertibility. This shows that the economic policy establishment in India, including the RBI, has not drawn adequate lessons from the experiences of the financial crisis-affected countries. Joseph Stiglitz, who was closely involved with policymaking at the international level when the spate of financial crises occurred in the late-1990s, held that “capital account liberalisation was the single most important factor leading to the crisis.” He also mentions, “all too often capital account liberalisation represents risk without a reward. Even when countries have strong banks, a mature stock market, and other institutions that many of the Asian countries did not have, it can impose enormous risks.” (He was Chief Economist, world Bank and also Chaired president Clinton’s Council of Economic Advisors, Joseph Stiglitz, Globalisation And Its Discontents, p. 99, Penguin, 2002).

Table 1

Major Financial Crises Since the 1990s

Besides, banks are the principal risk carriers in the system, taking in small deposits that are liquid and making relatively large investments that are illiquid and can be characterised by substantial income and capital risk. The observed tendency among some promoters or boards of banks to divert a substantial share of its deposits into speculative activities in which the promoter or board may be interested or into investments that are risky but promise quick returns, can increase financial fragility, lead to bank failures and if the magnitude of the failure is serious enough, can actually precipitate crisis for the entire financial system. Instances in India such as the Nedungadi Bank and the Global Trust Bank are the harbingers of what may follow if reckless deregulation of the banking sector is carried out. In fact, the experience of recurrent financial crises in the 1990s, most famously the East Asian experience, has shown how banking deregulation along with capital market liberalisation often serves as recipes for financial turmoil in developing countries like ours. (A list of major financial crises since the 1990s drawn from RBI Bulletin, October 2004 is provided in the Annexure).

It is therefore a matter of grave concern that the UPA government is continuing with the previous government’s policies with regards to financial opening. The Left Parties are of the opinion that not only are the measures to further deregulate the financial sector and raise the FDI cap in banking unnecessary from the point of view of economic and industrial growth, they would also enhance the vulnerability of the financial system to the flows of speculative capital.             

RBI GUIDELINES ON BANK OWNERSHIP

Subsequent to the March 5, 2004 notification issued by the ministry of commerce and industry under the NDA government, which had raised the FDI limit in Private Sector Banks to 74 per cent under the automatic route, a comprehensive set of policy guidelines on ownership of private banks was issued by the Reserve Bank of India on July 2, 2004. These guidelines stated among other things that no single entity or group of related entities would be allowed to hold shares or exercise control, directly or indirectly, in any private sector bank in excess of 10 per cent of its paid-up capital. Recognising that the March 5, notification by the union government had hiked foreign investment limits in private banking to 74 per cent, the guidelines sought to define the ceiling as applicable on aggregate foreign investment in private banks from all sources (FDI, Foreign Institutional Investors, Non-Resident Indians), and in the interest of diversified ownership, the percentage of FDI by a single entity or group of related entities was restricted to 10 per cent. This made the norms with regard to FDI correspond to the 10 per cent cap on voting rights. The guidelines allowed for an acquisition equal to or in excess of 5 per cent, so long as it was based on the RBI’s permission. The guidelines stated: “In deciding whether or not to grant acknowledgement, the RBI may take into account all matters that it considers relevant to the application, including ensuring that shareholders whose aggregate holdings are above the specified thresholds meet the fitness and proprietary tests.” These fitness and proprietary tests include the integrity, reputation and track record of the applicant in financial matters, compliance with tax laws, history of criminal proceedings if any, the source of funds for the acquisition etc. Where the applicant is a body corporate, the fit and proper criteria involves its track record of reputation for operating in a manner that is consistent with the standards of good corporate governance, financial strength and integrity. More rigorous fit and proper tests were suggested where acquisition or investment takes the shareholding of the applicant to a level of 10 per cent or more.

It is clear from the guidelines issued by the RBI in July 2004 that despite the NDA government’s decision to raise the FDI limit in banking to 74 per cent, it had chosen to remain extremely cautious about further opening up of the banking sector and allowing domestic or foreign investors to acquire a large shareholding in any bank and exercising proportionate voting rights. The RBI had strongly advocated diversified ownership of banks. RBI’s Report on Trend and Progress of Banking in India, 2003-04 (Chapter VIII: Perspectives) states, “The concentrated shareholding in banks controlling substantial amount of public funds poses the risk of concentration of ownership given the moral hazard problem and linkages of owners with businesses. Corporate governance in banks has therefore, become a major issue. Diversified ownership becomes a necessary postulate so as to provide balancing stakes.” It further states that “…in the interest of diversified ownership of banks, the Reserve Bank intends 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 banks. Any higher levels of acquisition will be with the prior approval of the Reserve Bank and in accordance with the guidelines notified on February 3, 2004.”

A more elaborate exposition of the RBI’s views on the matter came from Rakesh Mohan, the then deputy governor of the RBI. In a speech made at a Conference on Ownership and governance in Private Sector Banking organised by the CII at Mumbai on September 9, 2004 he remarked (italics added):

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.

It is evident that the RBI, which is the regulator of the banking sector, had a strong case for issuing elaborate guidelines on bank ownership to ensure diversification. If the government chooses to permit automatic acquisition of a 74 per cent stake by foreign investors, a similar facility would eventually have to be provided to domestic investors as well for the sake of ensuring a level playing field, resulting in a dilution of the RBI guidelines. That is precisely why the RBI had also specified stringent FDI acquisition norms in its guidelines.

The CMP of the UPA states that “All regulatory institutions will be strengthened to ensure that competition is free and fair. These institutions will be run professionally”. It also states that “Regulation of urban cooperative banks in particular and of banks in general will be made more effective”. However, in the present case, the government has not only disregarded the views of the RBI, which is the Regulator of the banking sector, it has forced the RBI to dilute its guidelines and thereby weaken the regulatory framework itself. Besides impairing the effectiveness of existing banking regulation, this would also create a wrong precedent whereby market players would exert undue pressure for further dilution of regulation in the future. The Left Parties therefore feel that it would be better if the UPA government abandon its move to amend the Banking Regulation Act and maintain status quo as far as the law and the RBI guidelines are concerned.

BANKING SECTOR REFORMS: SOME CRITICAL OBSERVATIONS

The finance minister said in Parliament on December 15, 2004, that the hike in the foreign equity cap in banking would create an “enabling environment” for higher FDI flows, leading to “infusion of new technology and management practices” resulting in “enhanced competitiveness”. However, the Left Parties feel that neither does raising of the equity cap ensure higher FDI inflows, nor does higher FDI inflow necessarily imply infusion of such technology and management practices that are beneficial to the economy and the people. What is more, it can curb rather than enhance competitiveness, especially when a regulatory framework meant to ensure diversified ownership is diluted to pave the way for foreign banks acquiring private Indian banks within three to four years through creeping acquisition.

The finance minister, in the course of his response to the Calling Attention notice on December 20, 2004 referred to the Narasimham Committee Report on Banking Reforms and posed a question for every Member of Parliament: “Has our banking sector become stronger, thanks to the reforms or not?” To buttress his point, he gave figures for the declining proportion of net NPAs of the public and private sector banks. He also mentioned about the enhanced profitability of the banks in the post-reforms period, attributing it to the successful implementation of the reforms recommended by the Narasimham Committee in 1991 and said that the UPA government was taking “this reform process forward”. These claims are contentious.

The figures for Non Performing Assets that the finance minister has quoted in Parliament are ratios. While it is true that the gross and net NPAs as a per cent of total assets or as a per cent of gross or net advances have shown a gradual decline over the last few years, the absolute values of gross or net NPAs have continued to rise for almost all categories of banks. (Table of NPAs of Scheduled Commercial Banks provided in Annexure). This cannot be interpreted as a sign of growing strength of the banking sector. Moreover, if one further considers the fact that the trend towards window dressing balance sheets in the name of NPA management has grown considerably among all banks, including those in the public sector, the claim of growing efficiency and strength of the banking sector becomes even more suspect. If disaggregated figures of loan write offs on the one hand and cash recoveries, compromises and upgradations on the other are provided, if not for individual banks then at least the total figures for the different categories of scheduled commercial banks, it can throw more light on the true picture of the banking sector in the post-reform period. Because if loan write offs are driving the observed decline in the net or gross NPAs to net or gross advances ratios respectively, or if the banks are inflating their advances portfolio at the end of the year in order to throw up favourable ratios in order to gratify the capital markets, then it cannot be seriously considered to be symbolising enhanced efficiency. Such ‘ever-greening’ can be financially innovative; however, such innovations serve little purpose as far as the objectives of an efficient banking system are concerned.

As far as the increased profitability of the banking sector is concerned, the RBI Report on Trend and Progress of Banking in India, 2003-04 (Chapter VIII: Perspectives) states:

Over the past few years there has been a steady decline in interest rates largely reflecting sustained reduction in inflation rates and inflationary expectations. Such reductions in interest rates occurred in an environment where credit growth remained sluggish. Consequently, there was a favourable impact on banks’ balance sheets in terms of increased operating profits from treasury operations given the asset concentration in favour of government securities in excess of the requirement of statutory liquidity ratio (SLR). For example, treasury income of the banking sector increased from Rs 9,541 crore in 2001-02 to Rs 19,532 crore in 2003-04 and constituted 32.0 per cent and 37.1 per cent of operating profit in the corresponding years. This in turn enabled banks to make larger loan loss provisions. Consequently, the net NPA ratio has declined from 5.5 per cent in 2001-02 to 2.9 per cent by 2003-04. While a declining interest rate scenario has positive spin offs for the banking sector, given that interest rates had touched historically low levels by 2003-04, there does not appear to be any further scope for similar trends to be observed during 2004-05. In future, therefore, an increasing proportion of banks’ income would emanate from the traditional business of lending. (emphasis added)

The only point, which remains to be added in this context, is that the lure of high profits from treasury operations is attracting foreign banks towards India today; which has dovetailed with the possibility of making quick gains by the promoters of private Indian banks by selling off their stakes to foreign banks and FIIs while their balance sheets look good; to create a pressure group which wants further opening up of the banking sector. There is no good reason why the UPA government should frame policies to cater to the needs of such pressure groups.

While the impact of the implementation of the banking reforms in the 1990s in terms of increasing the efficiency and strength of the banking sector remain suspect, what has been unambiguous is its immediate, direct, and dramatic effect on rural credit, which the Left considers to be one of the key parameters to judge the efficacy of the banking system. There has been a contraction in rural banking in general and in priority sector lending and preferential lending to the poor in particular. The share of rural bank offices in total bank offices, which had jumped from 17.6 per cent in 1969 to 36 per cent in 1972 and then rose steadily to attain a peak of 58.2 per cent in March 1990, gradually declined to below 50 per cent in 1998 and thereafter. In fact, there was an absolute contraction in the number of rural bank offices in the 1990s: 2,723 rural bank offices were closed between March 1994 and March 2000. The credit-deposit ratio in rural areas fell from about 66 per cent in 1990 to about 56 per cent in 2002.

The target of 40 per cent set by the RBI for priority sector lending, which was over-achieved by the scheduled commercial banks between 1985 and 1990 fell from 1991 onwards to reach at only 33 per cent in 1996. While the share of priority sector lending shows an apparent increase to about 36 per cent since then, this was on account of the inclusion of sectors like IT and agro processing in the definition of priority sectors. Loans to multinationals involved in agribusiness like Pepsi, Kelloggs, Hindustan Lever and ConAgra now count as priority sector advances! More recently, loans to cold storage units, irrespective of location, have also been included in the priority sector. However, the most important fact is that the share of outstanding advances to agriculture in total outstanding advances of scheduled commercial banks fell steadily from about 15 per cent in 1989 to 10.5 per cent in 2000.

The distress, which characterises the Indian countryside today and the agrarian crisis that lie beneath, was to a significant extent caused by the policies of banking reforms throughout the 1990s that led to a sharp fall in rural and agricultural credit. This grim reality of rural India has to be kept in mind during discussions on banking reforms. While the Left had wholeheartedly welcomed the announced target of adding 50 lakhs institutional borrowers within one year by the finance minister on June 18, 2004, such statements of intent needs to be backed by concrete efforts towards ensuring that the private sector and foreign banks meet their priority sector lending targets, especially to agriculture. The share of priority sector credit in the total outstanding net credit of foreign banks was 34.2 per cent in 2002, well below the 40 per cent norm. Of this, about 17.7 per cent was export credit and 11.6 per cent was credit advanced to small sector units. All the other priority sectors, including agriculture, accounted for the remaining 4.9 per cent of the outstanding credit of foreign banks. The CMP of the UPA states, “…the social obligations imposed by regulatory bodies on private banks and private insurance companies will be monitored and enforced strictly”. Can the government abide by this commitment if the foreign and private ownership norms of banks are further diluted?

CONCLUSION

The proposal to dilute stakes of Public Sector Banks upto 33 per cent, which was recommended by the Second Report of the Narasimham Committee, had failed to gain Parliamentary approval. It was because the Parliament felt at that time that the process of banking deregulation and financial liberalisation has already gone too far in India. The RBI itself has found through its empirical studies that there is no observable link between ownership and efficiency or profitability, as far as the Indian banking sector is concerned. The Left believes that the job of the government is well cut out as far as the banking sector is concerned; increasing the efficiency of the banking system within the existing regulatory framework and gear it up for much increased flows of credit to the credit-starved rural areas, particularly into agriculture. There is no justifiable case for another fresh dose of bank deregulation at the present juncture, especially vis-à-vis raising the foreign equity and voting rights cap in private banks.

As has been mentioned earlier, the Left Parties are not in favour of any amendment of the Banking Regulation Act, which would do away with the existing cap on the exercise of voting rights by shareholders of a bank and make it proportional to equity holding, which in turn would be allowed to a maximum of 74per cent for FDI through the automatic route. Therefore the UPA government should refrain from adopting the notification route to allow acquisition of shares by foreign investors above the existing guidelines and subsequently presenting the Amendment in the Parliament as a fait accompli.

  Table 2

Bank Group-wise Gross and Net NPAs of Scheduled Commercial Banks

(as at end March)

(Amount in Rs. Crore)

Source: Report on Trend and Progress of Banking in India, 2002-03