Reserve Bank of India Governor Raghuram Rajan set tongues wagging when on a recent trip to the US he announced that the central bank might finally allow foreign banks to take over Indian banks. It was, in his words (and as reported by Press Trust of India): “...going to be a big, big opening because one could even contemplate taking over Indian banks, small Indian banks and so on.”

Foreign banks have been demanding for many years that they be allowed to acquire local banks. Many visiting ministers and politicians have lobbied with the government and the RBI without much success. HSBC did acquire a stake in one of the new private banks — UTI Bank, renamed later as Axis Bank — but was curtly told by the RBI to lay off.

Governor Rajan’s open invitation, extended on October 13, should sound like music to foreign banks. Unfortunately, there may not be many foreign banks queuing up, given not only the existing policy environment but also the fact that the the Governor’s exhortations may actually lie beyond the realm of business logic.

However, the statement has provided a fresh impetus to the continuing debate on status of foreign banks. It has, thus, become imperative to examine the conditions prompting the Governor’s statement, as well as weigh that against existing policy landscape.

Onerous model The first factor influencing the Washington proclamation seems to be the surprise sprung on India policy-makers by three foreign banks; Goldman Sachs, Morgan Stanley and UBS AG surrendered their banking licences early this year. Till now, banking licences were highly coveted and the decision by these institutions seemed counter-intuitive.

This raised questions about India’s banking model and whether the playing field had got so unviable that it even justified surrendering banking licences, in the full knowledge that it might become difficult to re-obtain another one at a later date.

It could well be that they chose to opt out because their parents were faced with capital famine. But, at a time when the country is battling perceptions about corruption, mounting bureaucratic hurdles, a difficult business environment and a slowing economy, news of these banks expressing no-confidence in the Indian banking system has further reinforced prevailing impressions.

It didn’t help matters when some Indian finance companies — such as Mahindra Finance Ltd (and later Tata Sons) — also withdrew their applications for a banking licence. To that extent, the RBI Governor’s statement seems designed to instil confidence among foreign investors.

The three heavyweights apparently threw in the towel because of India’s onerous banking model, which docks around 27 per cent of a bank’s lendable resources through mandatory reserve requirements and forces banks to lend a percentage of their loans to specific sectors, such as agriculture.

It may be argued that these three banks knew what they were getting into: these regulations have been around for many years. However, what seems to be changing is the shape of the playing field.

‘Near-equal’ treatment This brings us to the second point. The RBI has been examining the prospects of converting the status of foreign banks in India. Currently, all foreign banks are present in India legally as “branches” of their parent banks. This was necessitated when the RBI felt that, in the event of a foreign bank failing in India, the branch status would make it legally contingent on the parent bank to make good any losses.

This thinking was stood on its head in the aftermath of the 2008 financial crisis, when parents themselves had to scrounge around for capital to survive the meltdown. Therefore, the central bank felt it made abundant sense to convert foreign banks in India to wholly-owned subsidiaries, so that the bank’s local capital (provided originally by the parent) could be ring-fenced during a financial emergency.

Whether this impending shift influenced the exits is not known. But, what is definitely known is that the status conversion does change playing conditions.

The policy document spelt out unequivocally that foreign banks starting operations after August 2010 (and meeting some other conditions) have to convert to wholly-owned subsidiaries which would invariably involve a higher capital commitment (Rs 500 crore versus $25 million, or Rs 153 crore), allocation of a larger percentage of funds for directed lending (40 per cent compared with 32 per cent now), among other things. In return, they would get “near-equal” treatment with Indian banks, or enjoy the same freedom in opening branches.

Currently, foreign banks’ branch expansion is circumscribed to the extent of India’s multilateral and bilateral agreements. Converting to a wholly-owned subsidiary would surely afford foreign banks a modicum of freedom but, on the other hand, would also require them to mandatorily open 25 per cent of their branches in unbanked rural areas.

Deal-breaker This leads us to the third issue: a small proviso tucked away in the Governor’s message. His open-door announcement included one small condition: reciprocity.

Rajan said that foreign banks would be welcome provided their home countries also accorded Indian banks a similar status. This is a potential deal-breaker.

Indian central bank governors have repeatedly made the point that the RBI’s policies for foreign banks are not only compliant with India’s WTO commitments but also far more generous than other countries when seen through the lens of reciprocity. The RBI’s Report on Trend and Progress of Banking in India for 2012-13 states: “As at end-March 2013, there were 43 foreign banks operating in India with 331 branches. As against this, there were 24 Indian banks with 171 branches abroad.” However, the argument of reciprocity is not very transparent because scant details are available in the public domain.

But, beyond these three pillars of argument, there exists a fourth undercurrent, which perhaps provides a better key to decoding the Governor’s message.

Back in Washington DC when Rajan made his statement on October 13, he was part of a delegation accompanying Finance Minister P. Chidambaram to the annual Fund-Bank meetings. Interestingly, this delegation’s visit to Washington was preceded by Prime Minister Manmohan Singh’s trip.

The Manmohan met US President Barack Obama on September 27 and both are believed to have discussed a host of issues — including India’s foreign investment climate — amid mounting apprehensions that a chill had frozen trade and diplomatic relations.

A fortnight later, as part of his itinerary, P. Chidambaram met US Treasury Secretary Jacob Lew on October 13 for the fourth annual meeting of the India-US Economic and Financial Partnership. A joint statement stated: “We discussed the importance of investment for driving economic growth and job creation in our economies and ways to improve our enabling environments to mobilise investment, especially for the financing of infrastructure.

We noted that President Obama and Prime Minister Singh have reaffirmed their commitment to concluding a high-standard Bilateral Investment Treaty that will foster openness to investment, transparency, and predictability, and thereby support economic growth and job creation in both countries. “

Clearly, the Governor’s declaration on the same day looks like an attempt to talk up the policy environment and alter existing perceptions. So will foreign banks bite the bait? Going by reports, it seems they will wait for some clarity on the next government at the Centre.

(The author is Senior Geoeconomics Fellow at Gateway House: Indian Council for Global Relations.)

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