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Home > Blogs > Ian Fraser > India opens door to foreign banks in bid to reinvigorate economy

India opens door to foreign banks in bid to reinvigorate economy

Opening of door to foreign banks could create India's subprime crisis Ian Fraser

Raghuram Rajan, the governor of the Reserve Bank of India, believes he’s found a silver bullet that will transform India’s banking sector. Rajan, who took over as governor of the Mumbai-headquartered RBI on 4 September, wants to roll out the red carpet to foreign banks and to ease the regulatory regime for domestic players. He believes this will reinvigorate India's staid banking market; accelerate the flow of credit around the Indian economy; and address inequality. Rajan's bold plan is part of what the Financial Times describes as:

"[...] a wide-ranging and potentially radical agenda to curb inflation, boost competition and challenge corporate vested interests throughout India’s fast-developing financial sector."


Rajan -- a former IMF chief economist and  former professor of finance at Chicago University’s Booth School of Business -- made his name by questioning the tenets of the ‘Greenspan doctrine’. In a seminal speech he gave at Jackson Hole, Wyoming, in August 2005, he warned of an impending financial collapse and would-be securitization. He said that bankers had become "investment managers" who, instead of evaluating credit risk, the traditional core skill for bankers, had become primarily concerned with whether debt could be bundled up and palmed off on others.

The central plank in Rajan's plan for reforming India's banking system, elaborated in a hard-hitting speech on 16 November, is that the country should open its doors to long-term investors from outside India -- including banks, private equity investors and other providers of long-term capital. If foreign banks are prepared to establish separately-capitalized subsidiaries in India, the RBI said it will reward them by permitting them to open branches, to provide trade finance and to compete directly with domestic lenders.

The three foreign banks with significant operations in India – HSBC, Standard Chartered and Citigroup – currently operate as branches, which implies more regulation and greater restrictions than they can do as wholly owned subsidiaries (WOS). Between them, these three foreign players currently have less than 4.3 per cent of deposits between them in India.

Other strands to Rajan's plan to kickstart lending in India include making banking licenses available to a wider range of ventures and ownership structures, and lighter touch regulation which will mean established Indian banks no longer have to seek RBI permission whenever they wish to open a new branch. He intends to issue licenses to new domestic banks from January 2014. He told the Financial Times:

"We could have wholesale banks, we could have mobile [phone] companies doing some banking activities, within certain constraints. We could have small banks, which we currently don’t allow, and we could allow co-operative banks [...] I see over the next few years a dramatic remaking of the banking landscape. Both from the  new banks which are going to come on board and the foreign banks which are going to be allowed to expand more freely. It will be a multiplier in terms of competition.”

One negative for banks considering WOS conversion is they would have to channel 40 per cent of their lending to India's so-called “priority sector”, which includes agriculture and the 700 million Indians – more than half the country's population  -- who currently have no bank account, the so-called “unbanked". This could be a disincentive and -- if it isn't -- there would be a danger that the requirement, coupled with a sudden inflow of new lenders, could give rise a subprime lending crisis in India. Under the RBI's statutory liquidity requirement (SLR), banks that convert to WOS status would also be required to hold 23% of their total assets in Indian government securities.

Other measures Rajan unveiled include a crackdown on the "extend and pretend", "delay and pray" policies that are so prevalent among India's state-owned banks when borrowers default. The RBI wants them to be considerably more open, honest and transparent about provisioning and bad debts. He anticipates that pressures arising from greater competition from overseas players will force change. To ensure that the domestic banking sector doesn't get swamped, the RBI said it would cap the market share of foreign banks operating as WOS in India -- but only if the combined share of foreign banks in the Indian market exceeds 20%.

Macquarie Securities’s Ismael Pili was a bit sniffy about Rajan's vision. He told the Wall Street Journal's Livemint:

"Many foreign banks have frequently said in the past that ambiguity in tax laws discourages them to get converted into a subsidiary model. This may partly explain the reason for the cold responses. The biggest issue before had been the branch licensing regime, as expansion of branches for foreign banks had been very tightly regulated. Now that they’ve been brought on a par with other banks, foreign banks can expand more rapidly and be more competitive, assuming the foreign bank decides to go head to head with the domestic players. Increased competition usually leads to lower profitability for the incumbents."

And a commenter on the Financial Times' interview with Rajan, who signs himself as "Bugbear", doubted whether Rajan’s plan would bear fruit any time soon:

“For all the talk, the sad truth is that a corrupt and intellectually bankrupt government requires India's vast savings network to be its piggy bank, crowding out the private sector. A high 23% of reserves have to be maintained in government securities and another 4% with the RBI for which no interest is payable (CRR). I don't see foreign banks embracing these terms any time soon"

However Rajan, who has twice raised Indian interest rates since becoming RBI governor, and seen off the currency crisis that was brewing at the end of August, is aware that the SLR would be a deterrent to overseas players considering WOS conversion. Speaking in his inauguration speech as governor on 4 September, Rajan said: "We need to reduce the requirement for banks to invest in government securities in a calibrated way." He pledged to unwind the requirement gradually as more and more new players enter the Indian banking market.

Tags: bad debts , bank regulation , banks , deregulation , distressed assets , emerging market banks , financial regulation , financial regulations , government bonds , India , Indian banking system , Indian banks , Indian economy , liquidity cushion , liquidity requirement , Mumbai , Raghuram Rajan , RBI , Reserve Bank of India , tax law , transparency
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