Risks of allowing large industrial groups to set up banks

Syllabus: General Studies Paper 3

Context:

• The Reserve Bank of India (RBI) late last month decided to keep on hold the implementation of a recommendation made by an internal working group to issue banking licences to large industrial groups. Many view the RBI’s decision as a prudent step to preserve financial stability.

More on the news-

An internal working group of the RBI headed by P.K. Mohanty last year recommended, that the RBI allow large industrial groups to set up banks.

• The group’s recommendation was seen by analysts as an effort to bring more private capital into the banking system and help increase lending.
• The proposal was met with criticism from many experts, including former RBI governor Raghuram Rajan and former RBI deputy governor Viral Acharya.
• International practices -Many countries across the world either completely ban industrial groups from owning banks or heavily restrict such ownership.

RBI decided to put on hold the major recommendation to allow industrial groups to own and operate banks.

Risks associated with allowing large industrial groups to set up banks

• It is argued that giving large industrialists the licence to own and operate banks will lead to misallocation of capital.
• The banks owned by these industrial groups would lend money to their own companies over those owned by others.
• A bank owned by a certain industrial group may also be more willing to offer loans to its sister companies even if they do not meet credit standards. Such loans are more likely to turn into bad assets and threaten the stability of the financial system.
• India lacks the infrastructure necessary to effectively implement regulations to prevent such dangerous connected lending.
• Past precedence-The failure of many private banks in the past due to bad lending decisions too has been cited as a reason to oppose the idea of large industrial groups entering banking.

Analysis

Granting bank licences to industrial groups would give these groups easy access to capital.

• Under the current fractional-reserve banking system, banks possess the rare privilege to create loans out of thin air without a commensurate size of deposits. So, an industrial group that owns a bank can expect an abundant supply of loans from its banking wing. This can potentially lead to serious problems.

For example, an industrial group suffering huge losses could use its banking wing to keep itself afloat for a long time.

Connected lending per se does not have to be dangerous if the bank management understands that throwing good money after bad is not a wise decision.

• Banks in general are protected from going bust by the RBI usually citing the systemic risks posed by bank failures and the desire to protect depositors.

Such protection itself, however, raises the risk of moral hazard as it encourages banks to engage in poor lending practices without worrying about the consequences. In the absence of such sovereign support for banks, there would be a lot more incentive for depositors who want to protect their money to oversee the lending decisions of banks and prevent over-exposure to any borrower, including a related party.

The Hindu link-

https://www.thehindu.com/business/Industry/explained-risks-of-allowing-large-industrial-groups-to-set-up-banks/article37921352.ece

Question- What are the risks involved with allowing large industrial groups to set up banks?