Why RBI May Bar Banks From Holding Subsidiaries With Similar Functions

An internal working group of the Reserve Bank of India has recommended that banks and their existing subsidiaries or associates be prevented from engaging in “similar activities”, especially those that banks can undertake “departmentally”.“The bank and its existing subsidiaries/JVs/associates should not be allowed to engage in similar activity that a bank is permitted to undertake departmentally,” the report released on Friday stated, adding that the term “similar activity” must be defined clearly.If a group entity desires to continue undertaking any lending activity, the same shall not be undertaken by the bank departmentally, the report said. “...the group entity shall be subject to the prudential norms as applicable to banks for the respective business activity.”Defining ‘Similar’ ActivitiesEven as the working group report steered clear of defining what would be considered as “similar activity” between a bank and its existing subsidiary, there could be some hint available in the Banking Regulation Act, said R Gandhi, former RBI deputy governor.As per Section 6 of the Banking Regulation Act, 1949, besides banking, scheduled commercial banks can engage in business activities, including:Lending or advancing of money either upon or without securityCollecting and transmitting of money and securitiesBuying bonds and other securities on the behalf of customersCarrying on and transacting every kind of guarantee and indemnity businessContracting for public and private loans and negotiating and issuing the sameExecuting and undertaking of trusts“The Banking Regulation Act does provide with some framework on what could be considered as ‘similar activities’, but the final regulation may or may not include all of them,” Gandhi said.At this point, it’s difficult to give a precise answer, Suresh Ganapathy, banking analyst at Macquarie Capital Securities, told BloombergQuint. “Unless it’s made clear as to what the working committee group means by ‘similarity’, or what it considers as “similar businessses”, it’s very difficult to give a precise answer.”Disruptive Move?Any move to disallow subsidiaries of banks from engaging in businesses similar to that of the bank could be potentially disruptive for a number of lenders, which have such structures.For instance, HDFC Bank Ltd. has a non-bank lender in HDB Financial, which offers retail loans albeit to a different set of customers. Similarly, Kotak Mahindra Bank Ltd. has an auto lending non-bank lender in Kotak Mahindra Prime, Axis Bank Ltd. holds Axis Finance, among others.Many of these were licensed in years when there were no restrictions on bank-led NBFCs..Also Read: RBI Working Group Suggests Allowing Large NBFCs To Convert Into Banks.Fundamentally, this is being done as the regulator wants to dissolve the regulatory arbitrage between NBFCs and banking businesses, and discourage banks from running parallel businesses with similar functions, said Abizer Diwanji, head-financial services at EY India..Based on the wording of the proposal, the banking subsidiaries or associates involved in business activities for which the banking license has been granted (to them), such as lending businesses—the housing finance and non-banking financial subsidiaries, and credit/debit card issuance business, those will need to either get consolidated into the bank or carved out completely.Abizer Diwanji, Head-Financial Services, EY India..The move, however, wouldn’t impact units such as insurance, broking or asset management.“Since a bank isn’t allowed to carry out insurance, retail and institutional equities broking, portfolio management services, investment banking and asset management business as a department, the recommendation may not apply to those entities,” Diwanji said..A Wider DebateThe recommendation to bring together similar businesses under the umbrella of a bank is part of a wider debate on the structure through which banking entities should operate.In its 2013 guidelines for licensing of new banks in the private sector, the banking regulator had mandated the promoter and/or promoter group to set up a bank only through a wholly-owned non-operative financial holding company. Now, the proposal recommends that banks with no other group entities can exit from the NOFHC structure, but makes this model mandatory for those with other group entities.For the new ones there will be no exception, but banks that got licenses before 2013 must move to the NOFHC structure within five years from announcement of tax-neutrality, the report said.“What this (RBI’s requirement for banks to move to the NOFHC structure) effectively does is make it crystal clear that if you are a bank and you want to own any of these (financial services) institutions, you cannot do that unless you set up a NOFHC kind of structure and then separate out your non-lending businesses or even those businesses in which you are lending into a separate NBFC category and put it into a NOFHC kind of structure,” said Ganapathy.Agreed Saswata Guha, director and team head of financial institutions at Fitch Ratings. The second reason, he said, was to bring systematically important NBFCs to convert into banks so that they can come under greater regulatory purview. “I suppose it (the proposed regulation) would be applicable to the existing NBFC subsidiaries of banks but the regulatory stance on that is unclear. The underlying philosophy though boils down to the regulator’s desire to have greater control over systemic risks.”A third possible reason, pointed Gandhi, could be to reduce bank’s liability towards stressed fnancial services subsidiaries. “If a bank directly holds a financial services subsidiary, legally it becomes liable to provide capital to that particular entity if it goes under or faces liquidity constraints,” he said. “The RBI has observed such examples in the past and does not want the subsidiary’s problems to get translated into the bank’s problems.”.A Complex TaskWhile such a proposal, if turned into regulation, will ensure greater regulatory supervision, it would be complex to execute.“It’s a huge process that banks will need to go through, if these regulations do become effective, starting from demerging the operations of bank subsidiaries and then, subsidiarising them to the NOFHC,” said Diwanji.Presently, holding financial services subsidiaries under a NOFHC structure is not mandatory for banks that secured licenses before the 2013 licensing guidelines. But, if that was to change and the NOFHC structure eventually becomes mandatory, it would lead to “obstruction of capital flow and lesser synergies between the bank’s promoters and shareholders of subsidiaries.”.Presently, there is a two-way shareholder value creation, at the level of the subsidiary and at the bank level, which brings about more synergies. Now, if the NOFHC structure was to be enforced, the promoters will be the primary shareholders of the NOFHC and every time the capital has to flow from a subsidiary, it will have to flow via NOFHC, which will make it a much more complicated structure for capital flow leading to cash-leakages, making it a highly inefficient model from the shareholders’ perspective.Abizer Diwanji, Head -Financial Services, EY India.But from a regulatory point of view, it makes life easier for RBI as it can exercise complete control over the NOFHC, while independent entities such as insurance and asset management companies can also continue being controlled by their respective regulators, he said.

Why RBI May Bar Banks From Holding Subsidiaries With Similar Functions

Some of the biggest private banks in the country have large non-banking financial companies as subsidiaries.

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