HT PAREKH FINANCE COLUMN
Extending Private Banking
C P Chandrasekhar
Following the reiteration in the
Union Budget of the decision of
the government and the central
bank to issue new bank licences,
the union cabinet has approved
certain amendments to the
Banking Regulation Act in order
to enlarge the influence of private
promoters. A year after the
proposal was first made and
months after the issue of a
Reserve Bank of India discussion
paper, the purpose of licensing
new private banks remains unclear.
C P Chandrasekhar (cpchand@gmail.com) is
with the Centre for Economic Studies and
Planning, Jawaharlal Nehru University,
New Delhi.
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s part of a process that started in
last year’s budget and was
  advanced through consultations
based on a Reserve Bank of India discus-
sion paper, Union Finance Minister Pranab
Kumar Mukherjee has in his 2011-12
budget speech announced the govern-
ment’s decision to issue licences for a new
set of private banks. To quote:
In my last Budget speech, I had announced
that Reserve Bank of India would consider
giving some additional banking licences
to private sector players. Accordingly, RBI
issued a discussion paper in August 2010,
inviting feedback from the public. RBI has
proposed some amendments in the Banking
Regulation Act. I propose to bring suitable
legislative amendments in this regard in
this session.
While the guidelines that would apply
are yet to be announced by the RBI, there
are pointers in the Banking Regulation
(Amendment) Bill that was ratified by the
cabinet soon after the budget, and will
now go to Parliament for approval. The
most important change the Bill seeks
to introduce is the removal of the 10%
cap on voting rights of individual share-
holders in private sector banks, independ-
ent of their shareholding. As of now, the
voting right is capped at 10% even for the
promoter of a private bank holding. This
can be a disincentive especially since
founding investors would have to bring in
as much as Rs 1,000 crore of equity. To
correct this anomaly the bill reportedly
seeks to align voting rights with share-
holding as applies outside the banking
sector. In addition, the period over which
promoters would have to reduce their
equity to some specified level to reflect
broad-based ownership is also expected
to be extended.
What is still unclear is what is sought to be
achieved through the entry of private banks.
In fact, when the process of liberalisation
of rules governing foreign banks began,
the government’s concern was to encourage
consolidation in the Indian banking space.
march 12, 2011  vol xlvi no 11  EPW   Economic & Political Weekly
The argument, often made by former
finance minister P Chidambaram, was that
compared to leading international banks
that were already present or were seeking
entry into India, domestic banks were
pygmies. What was needed, it was argued,
was the infusion of capital, through
equity issue involving dilution of the pub-
lic stake as well as government invest-
ment, to substantially expand the capital
base and operations of domestic banks.
1993 and 2004 Experience
Seen in that light, the only way the govern-
ment’s current drive can be explained is that
it expects that consolidation and expan-
sion of existing banks will be accompanied
by the entry of large new banks, so that
increase in average size is not realised at
the expense of competition. Unfortunately,
past experience does not suggest that this
would indeed occur. In the past the gov-
ernment permitted private bank entry in
two spurts. The first was in 1993, when
banks like ICICI Bank, HDFC Bank, UTI
Bank (which later became Axis Bank),
Global Trust Bank (that failed and merged
with Oriental Bank of Commerce), Times
Bank (that merged with HDFC Bank) and
IndusInd Bank were allowed to emerge
out of existing financial institutions or be
set up anew. The second was in 2004
when Kotak Mahindra Finance was per-
mitted to convert itself into a bank, and
YES Bank was granted a licence.
There were three lessons that come out
of that experience. First, the institution
concerned grew to considerable size only
if it was created out of an already large
financial institution such as ICICI Bank or
HDFC Bank. The second was that even
banks that were initially lauded for their
innovativeness, such as the Global Trust
Bank, were later found to be indulging in
activities such as increased exposure to
stock markets that rendered them fragile.
And, third, very few of the really “new”
private banks have grown adequately in
terms of size, operations and reach.
As a result, with the government once
again bitten by the private entry bug, it is
prodding the RBI to think of ways to
ensure that new private banks would also
be large. One of these was to raise the

capital requirement for entry from the
earlier Rs 200 crore to Rs 1,000 crore,
even though that fivefold increase is not as
large as it seems because of inflation in
the interim. The second was to permit the
entry of large corporates into the industry.
Not only have leading industry associations
made a case for corporate entry, but non-
bank financial companies belonging to
leading business groups such as Reliance
Capital, Aditya Birla Financial Services,
Tata Capital, M&M Financial Services, L&T
Finance and Bajaj Auto Finance are report-
edly preparing for entry into banking.
Mergers and Acquisitions
Once large private players with deep pock-
ets enter, there are likely to be pressures to
relax conditions relating to private banks.
Two of these relaxations, in the form of
removal of the voting rights cap and the
extension of the period required for dilu-
tion of promoters’ stake, have already been
referred to. But speculation in the media
suggests that matters could be taken further.
For example, it is expected that private
banks would be permitted to resort to
mergers and acquisitions without “exces-
sive” restrictions. This would help them
to grow in size without relying on the
cumbersome process of establishing new
branches and expanding their branch net-
work themselves. To facilitate this, merg-
ers and acquisitions activity in the bank-
ing sector may be kept out of the purview
of the Competition Commission of India
(CCI), to reduce oversight and ease expan-
sion through that route.
That is not all. There are reports that
the government may give the regulator
(the RBI) the power to allow banks to lend
to companies in which the banks’ direc-
tors have a direct or indirect interest. This
move is being advocated on the grounds
that failing such regulation it would be
difficult for private banks to find com­
petent independent directors. But past
experience indicates that the reason for
preventing such “insider lending” is dif-
ferent. In the years preceding nationalisa-
tion, when leading banks were part of
business groups, an excessively large and
disproportionate share of advances by
these banks went to firms in which direc-
tors had such an interest. An official com-
mittee found that two-thirds of advances
Economic & Political Weekly  EPW   march 12, 2011  vol xlvi no 11
by banks were being directed either to firms
belonging to the same business group as
the bank itself or to firms in which directors
of the bank had an identifiable connec-
tion. Influence rather than project screen-
ing was clearly determining lending and
leading to overexposure to a few clients.
Neither of these was a positive develop-
ment from the point of view of ensuring
stability, let alone of fair use of depositors’
money. Nor was it inclusive, since a corol-
lary was that a minuscule share of total
credit was going to the agricultural sector.
Thus the purpose of permitting lending to
companies in which bank directors have
an interest could only be to encourage cor-
porate groups to enter banking to garner
public resources for private investment.
In what seems to be an effort to conceal
these potential consequences of permit-
ting private entry into the banking space,
the official justification for permitting pri-
vate entry revolves around: (i) the need to
increase competition in the banking sec-
tor to reduce intermediation costs and
improve service quality; and (ii) expand
the geographic coverage of banking and
increase access to banking services to all
sections, to ensure “inclusiveness”. The
RBI’s discussion paper was quite explicit
about the first of these objectives declar-
ing that it is considering providing licences
to a “limited number” of new banks
because: “A larger number of banks would
foster greater competition, and thereby
reduce costs, and improve the quality of
service”. The paper had also asserted that
private entry “would promote financial
inclusion, and ultimately support inclu-
sive economic growth, which is a key
focus of public policy”. More recently,
after the budget was presented, the gover-
nor of the RBI went on record that one of
the criteria for evaluating applications for
new bank licences would be their business
plan for financial inclusion.
Likely Outcome
Our discussion above makes clear that the
first of these outcomes is unlikely to happen.
Rather, if corporate groups with deep
pockets are allowed to enter banking, we
are likely to see an unbridled merger and
acquisitions wave, as these players seek
to quickly expand their branch network.
This tendency would be even more dramatic
HT PAREKH FINANCE COLUMN
if, aided by bilateral, plurilateral and global
agreements, foreign banks are also provided
relatively free entry and national treat-
ment in the banking space. Consolidation
is likely to be accompanied by greater
concentration in credit allocation, aided
in this case by regulatory forbearance.
The second of the justifications pro-
vided for encouraging private entry is sur-
prising to say the least, inasmuch as the
record of extant private banks in terms
of meeting priority sector lending targets
and offering services to geo­graphically
dispersed and underprivileged populations
has been poor. Even to the extent that they
have approached priority sector targets it
has been because the government has
redefined priority sector credit to include
forms of “indirect finance”. In the case of
agricultural credit for example, priority
lending can include housing finance of cer-
tain kinds and lending to input providers
such as seed companies.
This shortfall on the part of the private
banks is not surprising, since lending to
rural producers in a manner that is inclu-
sive involves lending relatively small sums
to a large number of remotely located bor-
rowers. This inevitably raises transaction
costs and profits tend to be low. The result
would be lower profits on average, which
public sector banks may be persuaded to
accept, but private banks, domestic or for-
eign, are unlikely to tolerate. Hence the
inherent tendency among the latter is to
circumvent norms with regard to lending
to the priority sectors. Hence, suggesting
that allowing entry of new private sector
banks would make the financial system
more inclusive is to go against both logic
and experience.
Thus, whether we look at it in terms of
enhanced competition or in terms of
financial inclusion, easing the terms of
private entry would deliver results quite
contrary to what the government expects.
So its eagerness to persist with this move
remains unclear.
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