Who should start a bank in India?

Economic Times, 4 July 2013

How should RBI choose amidst the applicants for new banks? A key guiding principle should be professional management, that is not dominated by one family or one entrepreneur or one CEO. Banks with dispersed shareholding, where managers don't have enough skin in the game, have many problems. But banks with high-powered incentives are worse.

In most fields in India, there are no entry barriers. Anyone can setup a steel mill. What is special about banking that makes us worried about entry? The typical bank has Rs.5 of equity capital plus Rs.95 of borrowing from the public adding up to a balance sheet of Rs.100. This presents many kinds of problems.

The simplest get-rich-quick scheme involves setting up a bank, giving loans to cronies that will not be repaid, and walking away. It is not hard to put in Rs.5 to start a bank and walk away with Rs.20, thus yielding a four-times return on equity in (say) four years. More complicated versions of this deal involve setting up a ponzi scheme where deposits grow rapidly and bad loans are given out on a much bigger scale.

Ever since R. K. Hazari worked on this in the 1960s, we have been very conscious of one subset of this problem: banks setup by industrial houses that give bad loans to their own group companies. This is a relatively easy problem as it is not that hard to write and enforce regulations that block lending to group companies. The real problem lies with entrepreneur-dominated banks -- whether or not they are in a business house.

An entrepreneur running a bank is given a great opportunity to roll the dice with 20x leverage, take as much risk as possible, and dump the problem on taxpayers if things go wrong -- as the government will never allow innocent depositors to lose their money.

The government is supposed to block this at two levels. First, regulation and supervision is supposed to prevent and detect such behaviour. Second, when a bank becomes fragile, the `Resolution Corporation' (e.g. the US FDIC) is supposed to seize control of a bank, and either sell it off or shut it down while it is still solvent. In India, we have problems on both fronts. Banking regulation and supervision is weak as the RBI is beset with an array of problems. The resolution corporation does not exist.

The problems of ownership, governance and compensation should be seen as one unified question. A bank CEO who has stock options which yield a payoff of Rs.1000 crore upon success is not that different from a promoter of the bank. Whether high-powered incentives come about through stock options, bonuses or high shareholding by an entrepreneur / family / promoter, the results are the same.

We in India have had a remarkable experience on these questions with the first two waves of entry by private banks. In most cases, professionally run banks (where the CEO has low-powered incentive) have done well. Most of the time, family run banks have done badly.

The defining question that we should ask, in envisioning new banks created by the 26 applicants, is about the extent to which the bank will look like a professionally run bank with low-powered incentives. As an example, if the house of Tata will create a bank that is similar to TCS in terms of being professionally managed, this would work well even though it is a part of an industrial house. Conversely, many of the applicants are problematic in promising to create entrepreneur-led banks, even though they are not part of an industrial house.

This is not to say that banks with dispersed shareholding and professional managers are a panacea. Dispersed-shareholding corporations have numerous problems. As Infosys has reminded us, succession planning can be a challenge. Managers can be lazy, pay themselves too much, and steal. The delicate checks and balances between shareholders, managers and the board of directors are hard to create. Dispersion of power in the corporation requires complex institutional machinery -- much like the complexity of dispersion of power in a democracy.

While recognising that there are genuine pitfalls on this path, we must walk it, and grapple with the problems that arise. The challenge of learning to build dispersed shareholding corporations is as important for India's future as the challenge of learning to operate a democracy. Autocratic family- or entrepreneur-dominated banks are likely to create quite a mess, as long as we have not established the proper legal and institutional foundations of a Resolution Corporation, and sound regulation and supervision in banking. Until the draft Indian Financial Code is enacted as law, it would be wise to stick to banks with dispersed shareholding and professional managers.

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