RBI proposal on specialised banks

It appears that the Reserve Bank of India is quietly launching a major restoration work. The Central bank has released a discussion paper on wholesale and long-term banks which proposes to set up the eponymous new financial institutions.

This is in effect bringing back to life the defunct structure of development finance institutions (DFI) which we had before. The Industrial Finance Corporation of India (IFCI), Industrial Credit and Investment Corporation of India (ICICI) and the Industrial Development Bank of India (IDBI) were the three principal DFIs which had served the country in the early years of industrialisation.

As the financial system evolved and still later with the emergence of universal banking, two of the more active DFIs converted themselves into retail banks, and they are now familiar names in India's banking. IFCI, which was the oldest but weakest of them all, remained in existence but that's about all. It is still surviving and carrying on, God knows, with what business.

Historically, what had sounded the death knell for the three DFIs was the introduction of the so-called "convertibility clause". At the height of their importance when most Indian industries had borrowed from these institutions and these institutions would provide long-term loans as opposed to working capital funding from commercial banks. It was then that the government had proposed the introduction of the convertibility clause. This allowed the lenders to convert their outstanding loans into equity shares in the companies which received the funds. This was in the late 1970s and early 1980.

The convertibility clause had scared the Indian industrialists class to no end. As loan defaults mounted, the promoters of the assisted companies were worrying about losing control as large chunks of their outstanding stood the risk of getting converted. None of that had in effect happened, though. But the industry had thought better of going to these institutions than going to the market.

By then, the interest rate scenario was also changing, and the higher costs of funds for the DFIs had altogether spooked their balance sheets. Without some government support, it became impossible for the DFIs to access low-cost funding and on-lend to industrial clients. Because their securities came to be treated as not qualified as SLR (statutory liquidity ratio) bonds, it was the last straw. Starved of cheap funds and demand for their resources dwindling for fear of convertibility, they became irrelevant.

However, the disappearance of the three DFIs came to be increasingly missed by Indian industry. After all, the industry needed long-term debt funds. It was not always practical to raise additional equity capital only and thus meet the requirements for capex. Equity capital is a permanent cost, and these cannot be easily erased. Additional equity often came at a cost: these diluted the market value of the shares.

Missing long-term debt funds, the industry has often been asking for restitution of term funding institutions.

What the RBI is now proposing is to revive these establishments in another name. The wholesale and long-term finance (WLTF) banks are suggested to be set up as an integral part of RBI's approach to building a structure of differentiated banking and financial institutions to meet the diversified funding requirements of an expanding economy.

Commercial banks overwhelmingly dominate the Indian financial system. As of June 2016, commercial banks account for about 67 per cent of the total financial sector assets in the country. Combined with cooperative banks, they account for almost three-fourths of the financial sector assets, according to the RBI discussion paper on WLTF banks. The universal banks, which are the commercial banks, operate in retail as well as corporate segments and offer varieties of financial products and services. These range from the basic deposit accounts, personal loans, and investments on the retail side to the more sophisticated services on the wholesale side such as term loans, project finance, debt syndication, investment banking, and trade finance, among others.

The justification for having a specialised wholesale long-term funding bank is given by the RBI as follows: "..with the deepening of financial sector, it may be necessary for the system to evolve towards a structure where apart from the universal banks, multiple differentiated banks also operate in their specialised domain and provide services in their areas of competitive advantage. As the niche banks develop core competency, expertise will be fostered in the banking system that could lead to enhanced efficiency in terms of reduced intermediation cost, better price and improved allocation of capital. Therefore, specialised banks could cater to the wholesale and long-term financing needs of the growing economy and possibly fill the gap in long-term financing."

Following this logic, the RBI has issued licences for a few specialised banks, including new payments banks, small business financing banks or private banks. The Raghuram Rajan Committee on Financial Sector in 2008 first presented this argument. This line of argument was further followed up by the Nachiket Mor Committee.

While there is surely the need for such specialised banks and above all a long-term wholesale funding bank, the new structure will still face the old problem. Even if everything is in favour of such institutions, the funding of these new banks would still be a problem. These banks will be highly risky ventures for one. They are being visualised as long-term financing agencies, including for the infrastructure projects and core industries. As we have seen only recently, commercial banks loans to infrastructure companies and core industries had contributed the maximum amount of bad debts to commercial banks.

Two basic requirements would be, firstly, cheap finance for onward lending and, secondly, highly qualified staff for evaluation of risks. The first problem will be resolved if the Union government decides to stand behind these banks, at least to begin with. Their securities, if given SLR status, could once again help.

What could be more intractable is these banks will require specialised officers to evaluate the risks of long-term finance for infrastructure finance. They will need engineers who should qualify as finance specialists as well. They will need technical people to assess risks of specialised projects. How do they get hold of such personnel? Where to dip their hands into such resources pool? Not a problem in a long run when their functioning will systemically generate these people. But surely would be a handicap, to begin with. Nevertheless, more the merrier. We need such specialised agencies for funding.