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Opinion | Banking regulations are not cast in stone

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The Mumbai High Court will hear Kotak Mahindra Bank’s petition against the Reserve Bank of India (RBI) after the latter rejected its plan to reduce promoter shareholding by issuing perpetual non-cumulative preference shares (PNCPS). It would not be an exaggeration to say that the case’s outcome may change the face of India’s banking industry. A win for Kotak will prompt a much-needed review of regulation and will bring in new banks, increased competition and hopefully better services.

The case before the High Court

The high court’s task is not easy. First, there is no precedent; this is the first time that the RBI has been taken to court on policy matters, a domain where its writs run large. Among all financial sector regulators, RBI has the maximum power to frame and enforce regulations. If you ask a banker, he will jokingly tell that he needs the permission of RBI even to sneeze.

Second, the court will have to define the scope of the case. If the court limits its examination to determining whether the dilution method adopted by Kotak is within the law or not, this will solve only Kotak’s problem and not that of the ecosystem. Therefore, the court must examine the law as it was applicable to Kotak, its evolution over time, look at the objective behind these regulations and risks being mitigated.

Law and interpretation

When Kotak got a banking license in 2003 under RBI’s 2001 guidelines, it was required to maintain a minimum 49 percent promoters’ contribution in paid-up capital. Not equity but paid-up capital. Any excess over 49 percent was to be diluted within a year after the start of operations. For restricting foreign shareholding, however, RBI used the word ‘equity’ in the same license. The license also stated RBI’s power to impose additional conditions and interpretations. Thus, when examined strictly under licensing conditions Kotak has complied with the letter of the law, unless RBI takes shelter under residual powers.

It’s also pertinent to examine what the Banking Regulation Act has to say about this. Section 12 of the Banking Regulation Act defines both equity and preference shares as capital. It does not cap capital holding but restricts voting rights at 26 percent (earlier 10 percent was amended to 26 percent in 2013). Clearly, Parliament realised that governance risks emanate from voting rights and not economic rights. On the contrary, higher economic rights reflect higher skin in the game without proportionate political or voting rights.

RBI has done the opposite by capping economic rights at 15 percent while the law permits 26 percent voting rights. Can RBI guidelines be contrary to the intent of Parliament?

Section 12B of BR Act details the power of RBI to approve the transfer of more than 5 percent paid up capital (once again it is not equity) or voting rights, under certain conditions. The paramount importance is that the person be fit and proper. The interesting point to note is that even when anyone holding more than 5 percent shares is found not fit and proper, the only right RBI has is to freeze voting power and that too after giving an opportunity to the aggrieved person. Therefore, if the RBI cannot force a person who is found not fit and proper to part with its shares, can RBI force Kotak, who is fit and proper to sell his shares?

Can the foundation of an enterprise be shaken?

At least in the Indian context, promoter skin in the game is an important parameter to measure the stability of an enterprise. The RBI too recognises this. That’s why all throughout it has insisted on minimum promoter contribution of 49 percent. Somewhere and somehow without any empirical evidence, it dawned upon RBI that a high promoter stake is risky. The regulator capped the maximum stake at 10 percent and later 40 percent in case the bank was promoted by a diversified NOHC (Non-Operating Holding Company). However, as late as May 2016, it said that promoter’s equity even after the lock-in period will be governed by licensing conditions.

The point here is that listed companies in India have strong foundations because of promoters’ commitment. A reduction in promoter involvement is viewed negatively by investors. Other financial sector regulators, in fact, specify minimum promoter equity. Empirical evidence suggests that whenever a promoter dilutes equity, the enterprise loses its value. RBI has no means to check what would be the impact of its diktat on Kotak Bank. Bandhan Bank’s merger with Gruh Finance is a good example that shows how regulatory diktat can destroy shareholder value.

While regulators keep on making regulations, it is the market place which is the real judge of risk and governance. The market rewards good governance and this is manifested mainly by the price-to-earnings multiple. If that theory is accepted, then Kotak must a well-governed bank. Note also that higher economic rights mean that the promoter will also be the biggest loser of bad governance and failure. (Admittedly, that’s not true in cases where promoters have conflicting and competing businesses. In Kotak’s case, there is no conflict.)

In any case, evidence suggests that higher promoter equity is warranted. A case in point is IL&FS, where no one was in the saddle and then RBI wanted SBI and LIC to increase equity. Catholic Syrian Bank is another example where higher equity is needed to bring the bank back to health.

That said, promoter capture of an enterprise is equally dangerous and can derail governance. Therefore, a fine balance between the two extremes is what is required. The real danger is from potential conflicts of interest, which can arise if promoters are forced to dilute and develop other business interests.

Regulations and objective

Regulations are framed with an objective and certain logic. Past events lead to reactions in the form of new regulations. Most regulations are aimed at preventing any future negative happenings. A fine balance is required while making regulations so that neither risks are ignored nor are they exaggerated. This requires continuous debate.

As far as bank ownership norms are concerned, this is an opportune time. Note the fact that there is not a single applicant to set up a new bank under the on-tap bank licensing policy introduced in 2016. Today, there are dozens of non-banking financial companies (NBFCs), which easily meet all conditions and have larger asset sizes than many state-owned and private lenders, yet not a single one is coming forward. Why should a promoter who can do almost the same business as an NBFC (with lower regulations, risks, and higher shareholding) want to become a bank? In effect, RBI guidelines nip entrepreneurship in the bud.

Kotak has an option of selling his entire equity to the likes of JP Morgan or Morgan Stanley and starting all over again with seed capital of Rs 75,000 crore as an NBFC. That would be a shame and is a perfect recipe for killing entrepreneurship and the concept of free enterprise.

The current regulations are neither logical nor they serve their objective. Regulations are not cast in stone. The fact that one of the best-governed banks has taken the regulator to the court is reason enough to review regulations, independent of the regulator and the regulated.


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