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april 9 , 2011 vol xlv i no 15 EPW Economic & Political Weekly10

T T Ram Mohan (ttr@iimahd.ernet.in

) is withthe Indian Institute of Management,

Ahmedabad.

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 efciency and stability

in banking. Indias policy so far

towards foreign banks has stoodthe country in good stead. In a

review, a Reserve Bank of India

discussion paper gets the

balance right in future policy

in every way.

The 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 stam-

peded into going the way of the economies

of east Asia, Latin America and east

Europe and to have permitted free entry

to foreign banks. After all, in the liberali-

sation 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 rst prin-

ciples in evolving a framework for foreign

bank presence, as it has done in many other

areas of nancial sector liberalisation. Its

cautious approach in nancial sector liber-alisation, once criticised as being too con-

servative and inimical to efciency, has won

it plaudits consequent to the sub-prime cri-

sis. Among those falling over each other

now to lavish praise on the RBI are those

who were severely critical of its approach.

It is fair to suggest that its approach to for-

eign banks over the years too will be seen as

a distinctive contribution.

In 2005, the RBI, then under some pres-

sure to open up banking to foreign players,

came up with a policy that was intended to

have the opposite effect. It proposed a two-

stage 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 pol-

icy could be reviewed in the light of expe-

rience. The review did not occur in 2009

because, following the sub-prime crisis, itwas difcult 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 nally been conducted in January this

year, with the RBI releasing a detailed dis-

cussion paper on the policy towards for-eign banks (Discussion Paper Presence

of Foreign Banks in India).

The paper focuses on two concerns.

One, what is the appropriate degree of for-

eign 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 require-

ment of stability in the banking system and

with priority given to nancial inclusion. It

is hard to disagree with this approach.

Subsidiaries over Branches

To take up the second concern rst, the

RBI paper evaluates the pros and cons of

branches versus subsidiaries. It argues

that the latter are preferable from the reg-

ulatory point of view. Following from this,

it proposes incentives for foreign banks

that set up shop as subsidiaries or converttheir branches into subsidiaries.

Why are subsidiaries preferable? Subsid-

iaries 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 iden-

tify 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 con-

trol 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 aban-

doning their subsidiaries. In any case,

when the parent itself fails, there is little

protection for the subsidiary.It follows that ensuring that subsidiar-

ies are well capitalised and well-regulated

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april 9 , 2011 vol xlv i no 15 EPW Economic & Political Weekly12

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 cur-

rently no more than a total of 12 branch

licences every year. The objective of nan-

cial 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 subsidi-

aries is a signicant 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 computa-

tion and make the information available

so that we know what exactly is the lee-

way to foreign banks afforded by the pro-posed 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 oner-

ous as for domestic banks.

The discussion paper also stipulates

governance norms for subsidiaries, nota-

bly 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 direc-

tors at all banks be selected by non-man-

agement 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 restric-

tive. They would want a freer hand for for-

eign banks, including acquisitions of

Indian banks both in the public and pri-

vate sectors. But the experience of thesub-prime crisis has underlined the vir-

tues of caution in banking sector liberali-

sation. It has brought home the necessity

of balancing efciency 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

win-win situation: it will give them an

opportunity to grow, even while leading

to greater nancial inclusion and without

posing serious risks to nancial stability.

Many will be waiting to see whether the

prudence that informs the RBIs approach

to foreign banks is also reected in

the RBIs policy for new private banks,

which is expected to be unveiled in the

coming months.

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