FDI In Banks: The RBI Suggests Restraint

 Jayati Ghosh

THE UPA government has in recent times been pushing to increase the role of multinational banks in Indian banking, despite the concerns expressed by the Left and their own promises with respect to the Common Minimum Programme. The Cabinet raised the cap on FDI in banking some time ago, and since then the finance minister has been putting pressure on the Reserve Bank of India to declare the guidelines which would allow foreign banks to enter and acquire Indian banks.

A DISASTROUS MOVE

There are several reasons why such a move is fraught with danger. When domestic or foreign investors acquiring a large shareholding in any bank and exercising proportionate voting rights, it creates potential problems not only of excessive concentration in the banking sector, but also can expose the economy to more intensive financial crises at the slightest hint of panic.

Banks are the principal risk carriers in the economic system, since they take in relatively small deposits that are liquid and make relatively large investments that are not so liquid and typically can have substantial income and capital risk. Any tendency to divert a substantial share of these deposits into activities in which the promoter or board is interested or into investment that are risky but promise quick returns can increase fragility and lead to failure.

We already have experience of how this can become a problem when private banks find that they are not in a position to pay their depositors and therefore fail. In such cases, if small depositors are to be rescued and the life savings of ordinary people who put their trust in the bank are to be recovered, the bank has to be bailed out by the central bank (and therefore indirectly by the government).

Instances such as much-publicised failures of the Nedungadi Bank and the Global Trust Bank illustrate that when this happens, the problem is no more only that of the promoter but of the central bank and the government. In such a situation, it is probably more important for the government and the central bank to think of strategies that would ensure that such instances are prevented, rather than resolving them after the event through mechanisms such as forced mergers. But if the government chooses to permit automatic acquisition of a 74 per cent stake by foreign investors, a similar facility would have to be provided to anyone who acquires shares in the bank.

There are other reasons why FDI in banking is in itself not appropriate or desirable. This is why there are still stringent controls on foreign acquisition in other countries as well. And in countries where such controls have not been exercised, the role of foreign banks in a period of crisis is often dubious. In Argentina, for example, where the banking system is thirty per cent under the control of foreigners, foreign banks have been accused of adding to the currency crisis of 2000 when they funnelled out huge amounts of dollars just before the collapse of the currency in what has been called “insider trading” on a massive scale.

There are other tendencies which foreign banks show that are undesirable. Foreign Banks tend to concentrate in the most profitable and high value-added segments of the market, and on certain types of lending such as credit cards in urban markets, rather than pursue any development agenda.

CURBS ON FOREIGN OWNERSHIP

One year back, South Korea's central bank called for curbs on foreign ownership in the country's financial sector and urged the government to slow the pace of bank privatisation until local buyers could be found. South Korea has received billions of dollars of overseas investment in its financial industry since the country's 1997-98 financial crisis. The central bank said the level of foreign ownership in South Korea's banking sector - 39 per cent including direct and stock investment - was higher than 19 per cent in Malaysia, 15 per cent in the Philippines and Thailand, and 7 per cent in Japan. In the central bank’s view, foreign-owned banks were undermining the economy by focusing lending on consumers. It said: ''Such a tendency could lead to lower corporate lending . . . and therefore weaken the country's economic growth.''

Eastern Europe too has seen substantial increases in foreign investment in recent years as a result of which in Poland, the Czech Republic and Hungary foreigners own and determine credit policy in respect of some 80 per cent of banking assets. However, studies by the European Bank for Reconstruction and Development reveal that the result has been over-cautious lending to indigenous firms, notably small and medium-sized enterprises.

LEFT’S OPPOSITION TO RAISING FDI CAP

These are among the reasons why the Left has opposed raising the cap on FDI in banking, since it is a form of financial liberalisation which is not only unnecessary but also undesirable and can have negative effects over time. It is interesting that even the Reserve Bank of India (RBI) apparently shares these concerns. Since the RBI is responsible for the overall management and supervision of banking in the country, it must necessarily be concerned with anything that will increase the fragility and concentration of the banking system.

RBI’s GUIDELINES

That is why the guidelines that the RBI has recently issued, at the finance minister’s prodding, reveal a degree of caution and awareness of the many threats of opening up this sector without adequate safeguards. In the recently issued “Road map for foreign banks in India”, the RBI makes it clear that foreign presence must be considered only in two phases. The first phase is to last from March 2005 to March 2009.

In the first phase, the RBI has made it clear that the acquisition by foreigners of shareholding in Indian private sector banks can only relate to certain very specified banks who are in very bad shape already. The guidelines state that “In order to allow Indian Banks sufficient time to prepare themselves for global competition, initially entry of foreign banks will be permitted only in private sector banks that are identified by RBI for restructuring. In such banks, foreign banks would be allowed to acquire a controlling stake in a phased manner.”

Therefore, until 2009, foreign acquisition of Indian banks is to be limited to those that are anyway about to collapse and have been vetted by the RBI for restructuring. Thereafter, “In the second phase, after a review is made with regard to the extent of penetration of foreign investment in Indian banks and functioning of foreign banks, foreign banks may be permitted, subject to regulatory approvals and such conditions as may be prescribed, to enter into merger and acquisition transactions with any private sector bank in India subject to the overall investment limit of 74 per cent.”

These are eminently sensible guidelines, which clearly indicate that the RBI is being forced by the finance ministry even to entertain such an idea against its will and contrary to its own assessment of the requirements of the Indian banking system. It has come to the point where even monetarist technocrats are more aware of the perils of financial liberalisation than those in the Cabinet who should know better.