A customer enters a branch of HDFC Bank, left, beside an advertisement for Kotak Mahindra Bank in Mumbai, India. (Photographer: Dhiraj Singh/Bloomberg)

Kotak Mahindra Bank Fracas Revives Bank Ownership Debate

BloombergQuintOpinion

When Uday Kotak proposed to reduce promoter holding in the bank which bears his name using preference shares rather than bringing down his share of common equity, banking sector watchers raised their eyebrows collectively.

What Kotak was trying to do was not just protect his interests, but also force a redefinition of the regulatory thinking on bank ownership.

His attempt failed. Within 10 days of the proposal, the Reserve Bank of India told Kotak that the non-convertible perpetual non-cumulative preference share (PNCPS) route to dilute promoter shareholding was not acceptable. While the RBI didn’t detail its view, a banking sector veteran had explained that these instruments have rights akin to creditors rather than shareholders. It’s possible the RBI saw it that way too.

It’s no surprise that the RBI turned down Kotak’s proposal. For, allowing it would have meant undermining its own publicly declared thinking on bank ownership.

But Kotak’s failed experiment may help revive a broader debate on whether the RBI needs to review its thinking on bank ownership.
Uday Kotak, vice chairman of Kotak Mahindra Bank, center right, speaks to Baba Kalyani, chairman of Bharat Forge, ahead of the World Economic Forum in Davos, Switzerland, on Jan. 22, 2018. (Photographer: Simon Dawson/Bloomberg)
Uday Kotak, vice chairman of Kotak Mahindra Bank, center right, speaks to Baba Kalyani, chairman of Bharat Forge, ahead of the World Economic Forum in Davos, Switzerland, on Jan. 22, 2018. (Photographer: Simon Dawson/Bloomberg)

This rethink is necessitated not just by Kotak’s proposal but a wider set of events, including the stories that have unfolded across private banks with diversified ownership, like ICICI Bank.

To understand the present debate, it is important to chart the regulator’s view over the last two decades.

The 2004-05 Thinking

The Banking Regulation Act restricts voting rights in a bank up to a maximum limit of 26 percent. But over the years, it has been felt that a cap on voting rights is not enough.

In 2002, then RBI Governor Bimal Jalan brought up the need to strengthen corporate governance across Indian public and private banks. Commenting on private banks, Jalan said in a speech at the Bank of International Settlements that “New private banks are generally good on accounting, but poor on accountability.”

Jalan had also noted that private banks and NBFCs follow the “insider model” of corporate governance, with families, inter-connected entities or promoters running the management.

He had added that corporate governance is highly centralised with few checks and balances on the CEO, who is generally also closely linked to the largest owner groups.
Bimal Jalan, then-Governor of the Reserve Bank of India, speaks at a bankers’ meeting at the Reserve Bank in Mumbai on April 29, 2003. (Photographer: Santosh Verma/Bloomberg News)
Bimal Jalan, then-Governor of the Reserve Bank of India, speaks at a bankers’ meeting at the Reserve Bank in Mumbai on April 29, 2003. (Photographer: Santosh Verma/Bloomberg News)

Issues raised by Jalan were debated and discussed. In 2004 and 2005, when YV Reddy was the governor, a new set of rules were put out in two tranches. The basic principle underlying the new rules was one of ‘diversified ownership and control’.

Detailing the RBI’s thinking in a speech in 2004, then Deputy Governor Rakesh Mohan had explained that banks not only hold public deposits but are also highly leveraged institutions.

The leveraging capacity of banks, means that promoters or shareholders end up being in control of very large volume of public funds of which their own stake is minuscule, argued Mohan.

Concentrated shareholding in banks controlling huge public funds does pose issues related to the risk of concentration of ownership because of the moral hazard problem and linkages of owners with businesses. Hence diversification of ownership is desirable as also ensuring fit and proper status of such owners and directors.   
Rakesh Mohan, Then RBI Deputy Governor, In 2004
Yaga Venugopal Reddy, left, governor of the Reserve Bank of India, consults with Rakesh Mohan, deputy governor of the Reserve Bank of India, in Mumbai, India, on April 18, 2006. (Photographer: Santosh Verma/Bloomberg News)
Yaga Venugopal Reddy, left, governor of the Reserve Bank of India, consults with Rakesh Mohan, deputy governor of the Reserve Bank of India, in Mumbai, India, on April 18, 2006. (Photographer: Santosh Verma/Bloomberg News)

2013 And Beyond

In subsequent years, whenever the RBI has reviewed bank ownership and shareholding rules, it held on to that basic thinking of ‘diversified ownership and control’. While there were some differences in specific conditions attached to licences given out at different points in time, the broad thinking remained the same.

In 2013, when the RBI issued a fresh set of regulations governing licencing of new banks, it introduced the concept of non-operative financial holding companies (NOFHC). However, it continued with the requirement that the stake of the NOFHC would be brought down over a period of time.

The initial NOFHC equity would need to be at least 40 percent for five years, and no more than 20 percent within 10 years and 15 percent within 12 years, said the 2013 guidelines.

In May 2016, the RBI issued revised guidelines related to ownership in private banks.

As part of the new rules, some tweaks were introduced on the permitted shareholding for financial institutions. For instance, diversified financial institutions were allowed to hold upto 40 percent. However, no change was made in the promoter shareholding rules and the RBI said that conditions at the time of licencing of each individual bank would continue to apply.

Later in 2016, when the guidelines for on-tap bank licencing were released, the promoter shareholding view was once again re-iterated.

Promoters shall hold a minimum of 40 percent of the paid-up voting equity capital of the bank which shall be locked-in for a period of five years from the date of commencement of business of the bank. The promoter group shareholding shall be brought down to 15 percent within a period of 15 years from the date of commencement of business of the bank.
RBI Guidelines For ‘On Tap’ Licensing of Universal Banks, In August 2016.
Raghuram Rajan, then governor of the RBI, centre, with then deputy governors R Gandhi and Urjit Patel, in Mumbai, India, on Aug. 9, 2016. (Photographer: Dhiraj Singh/Bloomberg)
Raghuram Rajan, then governor of the RBI, centre, with then deputy governors R Gandhi and Urjit Patel, in Mumbai, India, on Aug. 9, 2016. (Photographer: Dhiraj Singh/Bloomberg)

Time For A Review?

Anyone familiar with the above history of banking regulation knew that Kotak’s move was unlikely to pass muster with the RBI. However, with the Kotak incident now behind us, it is certainly worth asking whether the RBI needs to change that prevailing view.

The PJ Nayak committee of 2013 had recommended that promoter shareholders be allowed to hold upto 25 percent equity stake in a bank. The committee had argued that a promoter stake of 15 percent is too low.

The committee noted: It must be observed that if the maximum shareholding for promoter investors is set very low, the alignment of incentives between shareholders and managements could weaken, and banks could be more vulnerable, as managements could then be primarily concerned with their own interests rather than those of shareholders.

The committee had also suggested that a category of ‘Authorized Bank Investors’ be created, which can be allowed to hold upto 20 percent in a bank. The thinking behind this recommendation was that an investor who holds a large block of equity would be more inclined towards ensuring sound practices and governance at a bank.

Indeed, the recent allegation of weak governance at a institution like ICICI Bank does raise the question of whether diversified ownership has the opposite effect of what is intended.

Incidentally, Uday Kotak had raised this issue in the bank’s annual report this year.

As reflected by events around us, it is naïve for policy makers to believe that diversified ownership/state ownership is the way to good governance in banking. Banks deal with other people’s money. The issue is directors and managers with no skin in the game are taking decisions on lending and writing off thousands of crores!
Uday Kotak In Kotak Mahindra Bank’s FY18 Annual Report

It was fully justified for Kotak to bring that issue to the table for a debate. Perhaps, he would have done well to push that debate towards an eventual conclusion, rather than trying to side-step it.

Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.

Corrects an earlier version reflecting a change in voting cap to 26 percent, as per a July 21, 2016 gazette notification.