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Foreign Banks: RBI Gets the Balance Right

T T Ram Mohan

The experience of the sub-prime crisis has underlined the virtues of caution in banking sector liberalisation. It has brought home the necessity of balancing efficiency and stability in banking. Indias policy so far towards foreign banks has stood the country in good stead. In a review, a Reserve Bank of India discussion paper gets the balance right in future policy in every way.

T T Ram Mohan (ttr@iimahd.ernet.in) is with the Indian Institute of Management, Ahmedabad.

he role of foreign banks in the Indian system is one of the most important issues the Reserve Bank of India (RBI) has had to grapple with in the post-liberalisation scenario. It would have been easy enough for the RBI to be stampeded into going the way of the eco nomies of east Asia, Latin America and east Europe and to have permitted free entry to foreign banks. After all, in the liberalisation era, there is no dearth of advocates of the view that more competition is good and that large international banks are as good for the Indian economy as any other form of foreign direct investment (FDI). To its credit, the RBI has eschewed this easy option and thought through first principles in evolving a framework for foreign bank presence, as it has done in many other areas of financial sector liberalisation. Its cautious approach in financial sector liberalisation, once criticised as being too conservative and inimical to efficiency, has won it plaudits consequent to the sub-prime crisis. Among those falling over each other now to lavish praise on the RBI are those who were severely critical of its ap proach. It is fair to suggest that its approach to foreign banks over the years too will be seen as a distinctive contribution. In 2005, the RBI, then under some pressure to open up banking to foreign players, came up with a policy that was intended to have the opposite effect. It proposed a twostage road map for foreign banks. In phase I, up to 2009, the policy on foreign banks would be in conformity with existing norms. The focus, in this phase, would be on strengthening the domestic banking sector in various ways, including consolidation. In phase II, consequent to 2009, the policy could be reviewed in the light of experience. The review did not occur in 2009 because, following the sub-prime crisis, it was difficult to take a view on regulation of foreign banks and also partly because

any entry of foreign banks was largely notional given the unsettled conditions in the large international banks. The review has finally been conducted in January this year, with the RBI releasing a detailed discussion paper on the policy towards foreign banks (Discussion Paper Presence of Foreign Banks in India). The paper focuses on two concerns. One, what is the appropriate degree of foreign presence in the banking system? Two, what is the appropriate organisational form for foreign banks operating in India? To put the RBIs approach in a nutshell, it is willing to allow foreign banks a greater role than in the past, provided such a role is consistent with the overriding requirement of stability in the banking system and with priority given to financial inclusion. It is hard to disagree with this approach.

Subsidiaries over Branches

To take up the second concern first, the RBI paper evaluates the pros and cons of branches versus subsidiaries. It argues that the latter are preferable from the regulatory point of view. Following from this, it proposes incentives for foreign banks that set up shop as subsidiaries or convert their branches into subsidiaries. Why are subsidiaries preferable? Subsidiaries are locally incorporated entities, and this is advantageous from the regulatory point of view for a number of reasons. One, it ensures that the assets and liabilities of the local entity are delineated from those of its parent and provides for ring-fenced capital within the host country. It is easier to identify which laws of jurisdiction apply. Local incorporation makes the subsidiary more amenable to direction from its own board of directors. It makes for more effective control over foreign banks in a banking crisis. There is, however, no assurance that the parent will support the subsidiary in a crisis, any more than it will support a branch. The paper cites the examples of banking crises in Malaysia and Argentina when parents had no qualms about abandoning their subsidiaries. In any case, when the parent itself fails, there is little protection for the subsidiary. It follows that ensuring that subsidiaries are well capitalised and well-regulated

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alone can protect the host country in situations where the parent or the parents home banking system is caught up in a crisis. For all its limitations, however, the subsidiary form wins out over the branch in terms of regulatory comfort. In order to minimise systemic risk, it is not enough to ensure that foreign banks operate mainly through subsidiaries. A significant contribution of the RBI paper is to highlight the need to limit overall foreign banking presence itself in a given system. In other words, an enlarged foreign bank presence is not an unambiguous good and cannot be justified on grounds of increasing competition or efficiency in the system.

Downside of Foreign Banks

The RBI paper highlights a downside risk to rapid growth of foreign banks, namely, the risk of disruption in the event of a crisis in the home economy. The crucial issue is liquidity. Foreign bank expansion in the host country is often driven by borrowings from the home country. Very often, foreign bank growth in the host country occurs at a rapid pace and at the expense of domestic banks. When there is a banking crisis in the home country, the parents liquidity needs become paramount. Funds tend to get withdrawn from the host country. This leads to a liquidity crunch there if foreign banks are dominant in the banking system. Thus, foreign banks turn out to be fair weather friends, growing rapidly and prospering when the going is good and withdrawing at the first sign of trouble in the home country. This is precisely what happened in east Europe, where foreign banks have a dominant presence, during the sub-prime crisis. The countries in the region ended up paying a heavy price. The RBI paper notes that there was evidence of such behaviour in India as well during the sub-prime crisis. The paper observes,
Indian experience in this regard even with branch mode of presence has been no exception as the foreign banks had withdrawn substantially from the credit markets in India to the extent that y-o-y growth of credit was -7.1% (as on 3 July 2009) and -15.9% (as on 9 October 2009).

these are not mentioned in the RBI paper. Given their strengths, foreign banks may be able to cherry-pick the best borrowers in the host country, leaving domestic banks weaker. Regulatory capacity for monitoring foreign banks, especially the cross-border activities of these banks, may not be adequate and can develop only slowly. Foreign bank expansion must necessarily be constrained by the ability of regulators to supervise and monitor them effectively. Foreign banks may weaken monetary policy transmission because they have access to a large pool of funds beyond the control of the monetary authority. In a crisis, foreign banks are less amenable to moral suasion on the part of the central bank than domestic banks. For all these reasons, the benefits of foreign bank presence must always be weighed against the downside risks they pose.

Domestic Priorities
There is a third consideration that the RBI has to keep in mind in the Indian context. Any foreign bank expansion at this point must mesh with our priorities. One priority now is financial inclusion, reaching banking services to what the RBI designates as tier 3 to tier 6 centres. Foreign banks would, no doubt, be more keen on having branches in the metro politan centres, which are the biggest markets for deposits as well as loans. But, these markets are now well-served by domestic banks, public and private. Foreign banks would not expand the market by setting up branches there; they can, at best, take away market share from domestic banks. Foreign banks are well-placed to take away the best corporate borrowers

because of their superior strengths in cross-border products. If foreign bank expansion is to be dovetailed with the interests of the economy and the stability of the banking system, then it is best that it happens in underbanked areas. That is an area that has been neglected by domestic banks, including public sector banks in the deregulated area for the simple reason that the more lucrative and easily targeted markets are in the metropolitan areas. It is in under-banked areas that we need financial innovation in the form of low-cost business models. Since foreign banks claim innovation as their big strength, it makes sense to let them into the under-banked areas. It was foreign banks that opened up the market for retail finance in India. A similar challenge and opportunity awaits them in under-banked areas. It is a classic bottom-of-the-pyramid challenge, one that is potentially attractive in commercial terms. As microfinance firms have shown, lending to the poor can be extremely lucrative. Think of what a bank could achieve with lower costs and a wider portfolio of products. Foreign banks that can crack the challenge may also find that they have developed a model that could be exported to advanced market countries, as the late management guru, C K Prah alad, had indicated. The RBI discussion paper outlines a policy that factors in the three considerations outlined above: a preference for subsidiaries as the organisational form for foreign banks, prudential limits on foreign bank presence, and financial inclusion. There are clear incentives for foreign banks that opt for the subsidiary form, whether by converting existing branches

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There are other reasons why regulators in emerging markets would be wary of a large foreign bank presence, although
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into subsidiaries or for entering the market through subsidiaries. They will be given full national treatment, that is, for branch licensing they will be subject to the same treatment as domestic private banks. They will also be subject to the same minimum capital requirements as domestic banks.

WTO Commitments
Foreign banks that operate as branches will be allowed to expand strictly in accordance with Indias commitments under the World Trade Organisation (WTO), which is currently no more than a total of 12 branch licences every year. The objective of financial inclusion is sought to be fostered by issuing new branch licences to foreign bank subsidiaries only in tier 3 to tier 6 centres. Going beyond our WTO commitments for foreign banks that operate as subsidiaries is a significant piece of liberalisation and would count as an important piece of unilateral liberalisation but it comes with a caveat. Foreign banks (subsidiaries and branches) will not be allowed to expand beyond a total of 25% of capital in

the Indian banking system. It needs to be evaluated how many branches this would roughly translate into at the current level of the banking system. The RBI might make a rough computation and make the information available so that we know what exactly is the leeway to foreign banks afforded by the proposed policy. Since subsidiaries would get more generous treatment than branches, the priority sector norms for the former are proposed to be made more onerous than for the latter, although not as onerous as for domestic banks. The discussion paper also stipulates governance norms for subsidiaries, notably that at least one-third of members of the local board should be independent directors. This raises the question of how independent the independent directors under the existing norms are, whether directors chosen by management can ever be truly independent. The RBI must ask that at least 50% of all independent directors at all banks be selected by non-management shareholders. This is a larger

reform that is required not only for banks but all listed companies. Conventional advocates of reform will view the RBI papers approach as restrictive. They would want a freer hand for foreign banks, including acquisitions of Indian banks both in the public and private sectors. But the experience of the sub-prime crisis has underlined the virtues of caution in banking sector liberalisation. It has brought home the necessity of balancing efficiency and stability in banking. The RBI paper gets the balance right in every way. If foreign banks accept the challenge thrown to them, it could result in a w in-win situation: it will give them an opportunity to grow, even while leading to greater financial inclusion and without posing serious risks to financial stability. Many will be waiting to see whether the prudence that informs the RBIs approach to foreign banks is also reflected in the RBIs policy for new private banks, which is expected to be unveiled in the coming months.

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