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Banks: The subsidiary conundrum

Aug 31, 2007

The evolution of the banking sector in India has finally reached the stage of getting aligned to its peers in the developed world. And why not! If the regulator's (RBI's) roadmap of allowing foreign players into the sector by FY09 deserves some degree of seriousness, this seems imperative. Following this logic, the Reserve Bank of India (RBI) has proposed a new structure for the holding companies of banks in response to applications made by ICICI Bank and SBI - for setting up intermediary holding companies for their key non-bank operations. The regulator has not minced words in expressing its discomfort with regard to creating intermediate holding companies and has suggested exploring the possibility of creating banks or financial holding companies (BHC*/FHC**) on the lines of financial structure operating in the US. Currently a typical bank-centric organisation structure is followed in India (see adjacent chart). However, the proposed structure will involve a multi-layered financial conglomerate and may also have a few tiers of intermediate holding companies apart from the holding company at the top.

*BHCs are companies that own or control one or more banks. These companies can make only limited investments in the non-banking companies.

**FHCs are companies that own or control one or more banks or non-bank financial companies. FHCs can engage in activities other than banking as long as they are financial in nature. FHCs control approximately 80% of the entire banking system in USA. Other than USA, Canada, UK, Japan, France and some Asian countries such as Taiwan, Korea, Singapore and Hong Kong also have the FHC as a model of organization.

The key positive of the proposed structure is that while currently a bank's investment in its financial subsidiaries is limited to 20% of its networth, this restriction will not apply in the BHC/FHC structure. Thus, once the subsidiaries are separated from the banks, the growth of the subsidiaries/associates would not be constrained on account of capital. Further, capital adequacy for the purpose of Basel-II compliance would be applicable to the BHC at consolidated level wherever it qualifies as a 'banking group'. (If more than 50% of the group's assets are banking assets and more than 50% of the income is derived from banking activities).

The multi-layering of corporate structure is, however, not a favourable proposition from the investors' point of view as they would be ignorant about where the money invested by them will be eventually used in the complex conglomerate, as the rate of return generated would differ between the entities. Thus, it would be difficult for them to assess the true risk involved in their investments.

Further, while all the subsidiaries will be regulated by different regulators (Insurance Regulatory and Development Authority (IRDA), Securities and Exchange Board of India (SEBI) and NHB) on individual basis, as the parent is a bank, the overall supervisory responsibility for the entire group including that for the subsidiaries of the intermediate holding company will rest with RBI. The entity would therefore attract RBI's regulatory concerns and provisioning requirements thereof. These concerns will be accentuated if the holding company is unregulated, as the RBI may have difficulty in obtaining crucial information, as also in enforcing any prudential behavior required of such an intermediate holding company.

What's in it for investors?
While the RBI's discussion paper on this issue is subject to deliberation, we envisage that the immediate impact of this will not be on the regulatory norms but on the banking entities' desire to cash in on their subsidiaries. If the RBI maintains this stance, it will for the time being derail the plans of divestment of the insurance and AMC subsidiaries of both ICICI Bank and SBI. Having said that, we reiterate that this proposition does not dilute the value of the subsidiaries of the banking entities and will bear fruits for investors in the longer term.

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