How to organise financial firms

Business Standard, 5 September 2007

Financial sector reform is critically about achieving financial firms with global competitiveness, innovation, and operational flexibility. It is imprudent for any financial firm to focus on one product line alone. In particular, given the global evolution away from a bank-oriented to a market-dominated financial system, it is imprudent for a bank to envision a future where it is a bank. The MIFC report has argued that since India has four financial regulators covering banking, securities, insurance and pensions, the sensible way to support the evolution of multi-product financial firms is to have the holding company structure where a listed holding company has a subsidiary in each of these four areas.

Finance was once synonymous with banking. Banks dominated finance. Banking was a sleepy and stable business. You took in deposits, and tried to give loans to good firms. Financial sector policy was synonymous with achieving safe and sound banking, and that involved pushing down the leverage of banks, and improving their asset quality.

That happy world is now history. Computers and communications have eroded the informational edge of banks, and the balance of power has shifted to the securities markets. The world over, finance has evolved out of bank-domination to market-domination. As an example, in India, in August 2007, the non food credit by all banks stood at Rs.19 trillion rupees (a trillion rupees is one lakh crore). In comparison, the market value of the equity of only the 2727 biggest firms (members of the CMIE Cospi index) stood at Rs.45 trillion rupees.

Improvements in technology and financial economics have taken finance from being a sleepy place to being a fast-paced hotbed of innovation and competition. In this world, banks have retreated into the niches of lending to small firms and individuals, and a role in payments. The latter may well slip away from banks through the blizzard of innovation in payments based on mobile phones and the internet which is presently underway.

In this world, what is a financial firm to do? Financial firms have to compete by becoming multi-product firms that service the broad range of financial services that are consumed by their corporate or household customers. If India primarily does financial intermediation through securities markets, no financial firm can afford to not participate in the action. Broad-spectrum firms are likely to be safer, by having diversified exposures in many markets. They are able to capture economies of scale and economies of scope. It is imprudent for a financial firm to insist it does only one thing (e.g. banking), for this will inevitably involve losing customers to competing firms which are able to offer a full spectrum of products.

In India, we have traditionally run a "silo" model. UTI was a pure mutual fund. LIC was a pure insurance company. SBI was a pure bank. Each firm did only one business. In addition, each firm talked to only one regulator. NSE has capabilities in all financial trading, but NSE is prohibited from trading currencies, bonds and commodities because these "fall under" other regulators.

This silo mentality is a fundamental flaw underlying Indian finance. We cannot achieve global competitiveness and innovative firms if the boundaries of a financial firm are thus circumscribed.

Making progress in Indian finance is critically about breaking these silos, about shifting towards a loose concept of "a financial firm" which thinks that all financial services are fair game. The analogy that comes to mind is Tata Motors, which used to make trucks. If a regulator forced Tata Motors to not make cars, this would be detrimental both to Tata Motors and to competitive conditions in India. Government needs to change itself so that financial firms think in an innovative way, trying to dream up new products to deliver into existing customers or into pockets of perceived demand.

In the UK, this problem has been solved by unifying all financial regulators into the Financial Services Authority (FSA). Everything that a financial firm seeks to do is dealt with by one regulator. In India, the emerging consensus envisages four regulators: for securities, banking, insurance and pensions.

How might financial firms be organised while we have four regulators? Sometimes, there is a hope that there can be a large financial firm and each regulator can look at the activities of the firm that fall within its mandate. Unfortunately, in India, given the weak regulatory capacity and feudal mindset of regulators, this is often impractical. Further, there is a fundamental difference between banking and insurance, where governments get involved when a firm fails, as opposed to securities and pensions, where firm failure has few repercussions.

The Mumbai International Financial Centre (MIFC) report proposes a holding company which is the corporate headquarters. This would typically be a listed company. We may have SBI Holding Company which is a listed company. This would be the owner of four subsidiaries - SBI Bank, SBI Securities, SBI Insurance and SBI Pensions. Each of these subsidiaries would talk to one regulator.

Each subsidiary would be like a division of a large multi-product firm. The most important point is that the CEO and the corporate headquarters would think like a complex multi-product financial firm, with the ability to launch any product and harness economies of scale by virtue of controlling four divisions covering all possible products. For these healthy features to hold, the holding company must not be regulated by any financial regulator; it must only obey company law and listing requirements. As an example, SBI Insurance being regulated by IRDA should give IRDA no power over SBI Holding Company.

A valuable feature of this holding company structure is that it scales up to the internationalisation of Indian financial firms, for offshore firms (similarly packaged to suit foreign regulators) can also be subsidiaries of the same holding company.

The MIFC report has pointed out five constraints which impede the transformation of Indian financial firms into this modern structure:

  1. Rules about ownership that prevent 100% ownership of SBI Bank being with SBI Holding Company;
  2. Consolidation of accounts for tax purposes is prohibited;
  3. Tax inefficiency owing to double taxation of dividends;
  4. Archaic restrictions in the Companies Act that impede leverage and
  5. Companies Act restrictions that impede intra-group transactions.
The Ministry of Finance needs to resolve these problems so that firms such as SBI or ICICI can then shift to this long-term solution for structuring financial firms in India.

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