Banking Sector Reforms

Mistake in allowing industrial houses to own banks

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Not much

Mains level : Paper 3- Challenges in allowing industrial houses to own an operate banks

The article analyses the risks involved in allowing the corporate houses to own and operate the banks.

Context

  • An internal working group of the RBI has recently made a recommendation to permit industrial houses to own and control banks.

Encourage bank but not owned by banks

  • According to the report, the main benefit is that industry-owned banks would increase the supply of credit, which is low and growing slowly.
  • Credit constraints are indeed a real problem, and creating more banks is certainly one way of addressing the issue.
  • But this is an argument for encouraging more banks but it is not an argument for creating banks specifically owned by industry.
  • The other powerful way to promote more good quality credit is to undertake serious reforms of the public sector banks.

Problems in allowing industrial houses in banking

  • The problem with banks owned by corporate houses is that they tend to engage in connected lending.
  • This can lead to three main adverse outcomes:

1) Over-financing of risky activities

  • Lending to firms that are part of the corporate group allows them to undertake risky activities that are not easily financeable through regular channels.
  • Precisely because these activities are risky, they often do not work out.
  • And when that happens, it is typically taxpayers who end up footing the bill.
  • In principle, connected lending can be contained by the regulatory authority.
  • However, experiences in other nations show that regulating connected lending is impossible convincing most advanced countries that regulating connected lending is impossible.
  • Indonesia tried to regulate the practice: It banned the practice.
  • The only solution is to ban corporate-owned banks.
  • Regulation and supervision need to be strengthened considerably to deal with the current problems in the banking system before they are burdened with new regulatory tasks.

2) Lack of exit

  • The economic landscape is littered with failed firms, kept alive on life support, making it impossible for more efficient firms to grow and replace them.
  • While some progress was initially made under the Insolvency and Bankruptcy Code (IBC), this had stalled even before the pandemic, largely because existing promoters and owners mounted a stiff resistance.
  • If industrial houses get direct access to financial resources, their capacity to delay or prevent exit altogether will only increase.

3) Increasing dominance

  • The Indian economy already suffers from over-concentration.
  • We not only have concentration within industries, but in some cases the dominance of a few industrial houses spans multiple sectors.
  • If large industrial houses get banking licences, they will become even more powerful, not just relative to other firms in one industry, but firms in another industry.

Impact on regulator and government

  • The power acquired by getting banking licences will not just make them stronger than commercial rivals, but even relative to the regulators and government itself.
  • This will aggravate imbalances, leading to a vicious cycle of dominance breeding more dominance.

Impact on quality of credit

  • Indian financial sector reforms have aimed at improving not just the quantity, but also the quality of credit.
  • The goal has been to ensure that credit flows to the most economically efficient users, since this is the key to securing rapid growth.
  • If India now starts granting banking licences to powerful, politically connected industrial houses we will effectively be abandoning that long-held objective.

Impact on economy and democracy

  • Indian capitalism has suffered because of the murky two-way relationship between the state and industrial capital.
  • If the line between industrial and financial capital is erased, this stigma will only become worse.
  • Corporate houses that are already big will be enabled to become even bigger allowing them to dominate the economic and political landscape.
  • A rules-based, well-regulated market economy, as well as democracy itself — will be undermined, perhaps critically.

Consider the question “What are the challenges and opportunities in allowing the industrial houses to own and operate the banks.”

Conclusion

The conclusion is clear. Mixing industry and finance will set us on a road full of dangers — for growth, public finances, and the future of the country itself.

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