explained | Risks of allowing large industrial clusters to set up banks

the story So Far: The Reserve Bank of India (RBI) late last month decided to stop the implementation of a recommendation made by an internal working group for issuance of banking licenses to large industrial groups. Many see the RBI’s decision as a prudent move to maintain financial stability.

What is this?

An internal working group of RBI headed by PK Mohanty in November last year Recommends, among other things, that the RBI allow large industrial groups to set up banks, Analysts see the group’s recommendation as an attempt to bring in more private capital in the banking system and help increase credit. offer was received With criticism from many experts, including former RBI governor Raghuram Rajan and former RBI deputy governor Viral Acharya,

Many countries around the world either completely ban industrial groups from owning banks or impose heavy restrictions on such ownership. RBI has been considering the recommendations of the Working Group for the past one year and has accepted some of its recommendations. However, it has decided to put a hold on the key recommendation of allowing industrial clusters to own and operate banks.

What is the problem with allowing large industrial clusters to set up banks?

Critics of the working group’s proposal argue that granting licenses to own and operate banks to big industrialists such as the Ambanis, Adanis and Tatas would result in an incorrect allocation of capital. They worry that banks owned by these industrial groups will lend money to their companies more than those owned by others. For example, a bank owned by Ambani may prefer to lend to companies that come under the Reliance Group, compared to companies owned by Tata or Adani.

A bank owned by a certain industrial conglomerate may also be more willing to lend to its affiliates even if they do not meet credit standards, critics believe. Such loans are more likely to turn into bad assets and threaten the stability of the financial system. Critics also believe that India lacks the necessary infrastructure to effectively implement regulations to prevent such dangerous linked lending. The failure of many private banks in the past due to poor lending decisions has also been cited as a reason for large industrial groups to oppose the idea of ​​entering banking. Even though private banks tend to maintain better asset quality than public sector banks, critics fear that private banks may be more prone to making bad loan decisions.

Are the critics right?

Granting bank licenses to industrial clusters will provide easy access to capital to these clusters. Remember that under the current fractional-reserve banking system, banks have the rare privilege of making loans out of thin air without commensurate size of deposits. Therefore, an industrial conglomerate that owns a bank can expect abundant credit supply from its banking wing. This can potentially cause serious problems.

For example, an industrial conglomerate incurring heavy losses may use its banking wing to sustain itself in the long run. but linked credit In fact There is no need to be alarmed if the bank management understands that throwing good money after bad is not a wise decision. It should also be noted that banks are generally protected from bankruptcy by the RBI, citing systemic risks arising from bank failures and the desire to protect depositors.

However, such protection itself increases the risk of moral hazard as it encourages banks to engage in bad lending methods without worrying about the consequences. In the absence of such sovereign backing for banks, there would be a huge incentive for depositors who want to protect their money to oversee the lending decisions of banks and avoid greater risk to any borrower, including the party concerned.