Why there may not be too many takers for new banks

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Ousted Citigroup Inc. chief executive officer Vikram Pandit ’s return to banking is creating excitement in the Rs. 75 trillion Indian banking industry, but there may not be too many takers for permits because of regulatory reasons and some licensing norms that many companies say will come in the way of creating value. The Indian central bank is set to open up the sector for a bunch of private entities as well as state undertakings a decade after it allowed two new banks to start business.
Famed investment banker Nimesh Kampani’s financial services firm, JM Financial Ltd, is nominating Indian-born Pandit, 56, as non-executive chairman of its proposed banking company. Pandit and his business partner Hari Aiyar, who had worked with him at Morgan Stanley and Old Lane, the hedge fund that was sold to Citi when Pandit joined the Citigroup, are making a strategic investment by taking a 3% equity stake in JM Financial. Both will have the right to purchase shares up to the amount prescribed by the Reserve Bank of India (RBI) in the proposed bank. Under the licensing norms, an entity or an individual can buy less than 5% in a bank. On Thursday, at a stock exchange filing after market hours, JM Financial said it would apply for a banking licence. On Friday, its stock rose 13.38%.
Till recently, every man and his dog wanted to set up a bank as it gives one status and access to cheap money, but many large conglomerates are now holding brainstorming sessions on whether it’s worth entering the banking business in Asia’s third largest economy where around 40% of the adult population still does not have access to banking. Indeed, the opportunity is enormous as the expanding middle class in India has ambitions to buy houses and cars, and corporations see huge consumer demand in many pockets of the economy, but regulatory requirements are making many aspirants rethink their strategy. And, at least some of them have started feeling that it’s just not worth entering the segment. Those who want to float a bank need to put in their applications by 1 July.
The list of aspirants at this point includes large conglomerates such as the Tatas, Birlas, Mahindras, Bajajs, the Videocon group and the Reliance Group; non-banking financial companies such as Religare Enterprises Ltd, L&T Financial Holdings Ltd, LIC Housing Finance Ltd, Magma Fincorp Ltd, Shriram Transport Finance Co. Ltd, SREI Infrastructure Finance Ltd; brokerages such as India Infoline Ltd and Edelweiss Financial Services Ltd; microfinance institutions such as Bandhan Financial Services Pvt. Ltd and Janalakshmi Financial Services; and state-run India Post, Power Finance Corp. Ltd and Rural Electrification Corp. Ltd.
All of them have existing assets and want to convert themselves into a bank. And there lies the catch. The licensing norms say that the new banks must have 40% of the loan portfolio in the so-called priority sector, or small loans, as soon as they start operations. Besides, they need to maintain the statutory government bond holding—currently 23% of deposits—and cash reserve ratio (CRR), currently 4%. CRR refers to the portion of deposits that commercial banks need to keep with the central bank. This means, if an entity has an asset book of, say, Rs.10,000 crore, it must have Rs.4,000 crore worth of small loans. Besides, it needs to keep Rs.400 crore with RBI in the form of CRR and invest Rs.2,300 crore in government bonds to fulfil the target of statutory liquidity ratio or SLR.
In the past, when the development financial institution, the erstwhile Industrial Development Bank of India, became a bank through a reverse merger with its banking subsidiary, RBI gave it seven years to achieve these targets, but it did not relax the norms when another such institution, ICICI Bank Ltd, became a bank.
This time around, RBI is not willing to relax the norms as the objective behind opening up the sector is the so-called financial inclusion, or expansion of banking services. It is also insisting that one-fourth of the branch network of a new bank must be in unbanked pockets where the population is less than 9,999.
So, there is a clear disincentive to a group that has an existing loan portfolio and wants to start banking. Even if RBI gives a few years to achieve the targets for priority sector loans and investment in government bonds, for such banks the sole business in the first few years will be only giving small loans and buying government bonds. Or they will have to pay the penalty for not meeting the targets. So, it will be difficult to make profits in initial years.
And, by the time a bank starts making a profit, its promoters would have to pare their stakes. Going by the licensing norms, the proposed new bank will have to be listed within three years and the promoters’ shareholding must come down to 40%. Within 10 years, it must be pared to 20%, and by the 12th year 15%.
Within these stipulations, how would a promoter create value? Even though the initial capital requirement is Rs.500 crore, the serious aspirants will have to pump in more capital as the capital adequacy ratio for the new banks has been kept at 13%. For the existing banks, it is 9%. This means, for every Rs.100 worth of loans, a new bank needs Rs.13 capital. In other words, their capability to leverage will be less than the existing banks and they would need more capital if they want to expand their asset base. Besides, they would need to spend money on technology, branches and employees.
So, those who have an existing asset book would need to spend heavily to achieve the targets for priority sector loans and mandatory government bond holding, and others who want start with a clean slate would need to make heavy investments but cannot reap the harvest as they would need to divest and bring down their stakes. In big conglomerates, I am told, other business divisions have been making pitches to the senior management against getting into banking, saying they can generate better returns if the money is invested in their businesses.
On top of these, any corporation that enters banking also runs a big reputation risk if anything goes wrong in the business of money. This is not the case with other businesses. For instance, the Tata Finance scandal has affected the group much more than, say, its investment in Corus Group Plc turning sour or Ratan Tata’s battle with the four satraps in the Tata empire—Russi Mody, Darbari Seth, Ajit Kerkar and Nani Palkhivala—after he took over the mantle in the 1990s.
Then there are other technical issues. For instance, banks’ liabilities—deposits—are unsecured, while the bulk of a non-banking financial company’s liabilities such as loans from banks and money raised from corporations and wealthy individuals through bonds are secured. RBI norms do not allow a bank to have a secured liability on its books. So, those banking aspirants who want to start business by transferring their assets and liabilities of the existing business will need to seek a relaxation of the norm from the regulator.
Similarly, what will they do with their bad loans? If they transfer such loans along with good loans—however small the bad loans may be—the bank’s asset book will have a blot from Day 1, but if they do not transfer these, they will find it difficult to recover money, as unlike banks, non-banking financial companies cannot move on the fast-track recovery lane under the Sarfaesi Act, or the Securitization and Reconsutruction of Financial Assets and Enforcement of Securities Act, 2002.
All these complexities may prompt the aspirants, particularly the big business conglomerates, to explore new models while applying for bank licences. One could be an alliance with a microfinance firm as that will help them achieve the priority loan and rural branch network targets.
Despite all issues, many of the non-banking financial companies need to become banks as otherwise they may not survive. The first set of new banks that got licences in 1994 had taken away business from then staid public sector banks and foreign banks in urban areas in India. The banks that will set shop now will attack the non-banking financial companies to generate business.

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