Ownership Structure Has Not Been Determinant Of Governance: Rashesh Shah
If you don’t allow corporate houses then where will the capital come from, asks Edelweiss Group Chairman Rashesh Shah.
Former RBI Governor Raghuram Rajan has criticised the proposal. So has S&P. But Edelweiss’ Rashesh Shah is in agreement with the recommendation of the Reserve Bank of India’s Internal Working Group that corporate houses be allowed an entry into banking.
To grow from a $3 trillion to $5 trillion economy, India needs bigger banks and more banks. Banks need capital and large business groups can provide that, is Shah’s argument. “India needs a lot of banks, we need a lot more banking penetration and banking needs capital because for every hundred rupees of loan that a bank gives, it needs about 10 to 15 rupees of equity capital. This is really long-term equity capital, India has always faced a shortage of that—of where does such long term equity capital come from? So, I think corporate houses will bring that.”
The RBI Internal Working Group proposal is predicated on necessary changes to regulatory and supervisory functions in order to prevent connected lending and exposures between the banks and other financial and non-financial group entities. Yet, the proposal poses high risk, said S&P Ratings in a note. “...RBI will face challenges in supervising nonfinancial sector entities and supervisory resources could be further strained at a time when the health of India's financial sector is weak,” the S&P note said.
A blog authored by Rajan and Viral Acharya, former deputy governor of the central bank, is blunt in its disfavour. “Why now? Have we learnt something which allows us to override all the prior cautions on allowing industrial houses into banking,” it asks.
An economy that wants to grow rapidly will require all its financial regulators to boost supervisory capacity, Shah said in an interview to BloombergQuint before the Rajan-Acharya post was published.
On the issue of connected lending and or contagion risks, he notes that large business houses are already dealing with household savings via their NBFC, mutual fund and insurance ventures. “Banking is just one more step in that direction,” said the chairman of Edelweiss Group, with interests in corporate and retail credit, asset management and insurance.
I think a lot of these large corporate houses have been in these businesses of insurance, NBFC and mutual fund for a long time and they’ve done a fairly good job. So, I think, on the whole, ownership structure has not been determinant of governance. Governance lapses can happen in any structure and its high time that we realise that.Rashesh Shah, Chairman and CEO, Edelweiss Financial Services
The RBI Working Group has also recommended that large NBFCs, with assets over Rs 50,000 crore, even if owned by a business house, be allowed to convert to a bank.
While his own NBFC business is too small to be eligible, Shah welcomed the proposal by pointing to recent crises, from the collapse of IL&FS to the pandemic, to underscore the capital concerns and asset-liability mismatch that large non banking financial companies have faced.
On the liability side, once an NBFC crosses Rs 50,000-1,00,000 crore of assets, it’s too large to be able to just roll over debt in the wholesale markets by a third every year, Shah said. “The way to think about it is...size. I think if you are below Rs 30,40-50,000 crore there are advantages of being an NBFC vis-à-vis being a bank. After a certain size, there are advantages of being a bank.”
Several others may be striking a note of caution at opening up India’s credit markets in such a fashion, Shah though is enthused by the prospect. He likened it to the transformation of India’s equity markets in the early 90s, after the Harshad Mehta scam. "We can't have very evolved and constantly growing equity markets while credit markets remain very constrained," said Shah.
“I do believe in the next three, four years there's going to be so much change in the rules and regulations and the structure of the credit markets in India that agile players will be able to capitalise on opportunities.”
Watch Rashesh Shah, chairman at Edelweiss Group, discuss the RBI Working Group proposals:
Your thoughts on the central thought of this Working Group paper, that— business houses be allowed to enter banking, as well as allow large NBFCs to convert?
If you go back and see, 25, years ago when the first set of private banks were allowed, there was no restriction on corporate houses promoting banks. So, I think in a way it's a good thing for five reasons—I think a lot of them you have enumerated, but just to put it in context I think overall, we do need a lot more banks and I think starting a bank is also very capital intensive. If you don't allow corporate houses then where will the capital come from? It won't come from only international investors or PE investors because there are caps on what foreigners can own in the banking arena. So, I think one is large corporate houses can bring capital, can bring the long term creation of institutions in India.
Then as you said, if you already have large NBFCs, with more than Rs 50,000 crore of assets, they are anyway interconnected to the banking system because a lot of them would be borrowing from the banks, would be borrowing from the markets and from the retail investors. So I think the time has come to revisit that. I think the working group has done a good job of highlighting.
I think there's still a lot of clarity required on NOHFC and other things...but in principle, most of the recommendations of the working group are very good.
India needs a lot of banks, we need a lot more banking penetration and banking needs capital because for every hundred rupees of loan that a bank gives, it is about 10 to 15 rupees of equity capital. This is really long term equity capital, so India is always faced a shortage of that—of where does a long term equity capital come from? So, I think corporate houses will bring that. Also we should keep in mind that the crisis of the last two-three years in the NBFC sector has shown that as NBFCs become larger and larger, there is a rollover required because an average NBFC’s borrowing tenure is about three years. So, if you are an NBFC which has one lakh crore of assets, you have to borrow Rs 30-35,000 crore a year just to roll over your debt and that can create an even larger systemic risk. So in any case, I think large NBFCs either needed some backstop or access to customer deposits and needed a much stronger regulatory oversight. So given all of that, allowing them to convert into banks I think a good idea.
There is considerable consternation on allowing for large business houses to enter the banking space. That the RBI’s supervisory functions are not up to scratch in being able to limit conflict and contagion. Especially after what we've seen in the recent past with IL&FS and DHFL. Do you think that's a hurdle that can be overcome in a short period of time let's say 3, 4-5 years or do you think that's something that will continue to be a problem and the pushback will be too hard?
I think, first of all, using the supervisory capacity as a constraint should not be a starting point because I think all institutions have to build their supervisory capacity and RBI has done a great job over the years. The same held true when you introduced private sector banks, the same when you introduced small finance banks and the same is also true with NBFCs. Because, RBI’s oversight of NBFCs, especially the systemically important NBFCs, has also ensured that RBI had to increase their supervisory capacity. So I think that we should take it as given if your economy is growing.
I would say, a lot of the corporate houses are already in the insurance industry, they are already in NBFCs, they are already in the mutual fund industry where also they are channellising household savings into long term investments. If you've allowed corporate houses into insurance, into mutual funds and into NBFCs also, in a way they are already part of the financial ecosystem. I think banking is just one more step in that direction.
Banking is slightly more intense from a consideration point of view because as you said it involves customer deposits but so does in a way mutual funds, so does NBFCs who do bond issues and so do insurance companies, it's the same. I think a lot of these large corporate houses have been in these businesses of insurance, NBFC and mutual fund for a long time and they've done a fairly good job.
So, I think, on the whole, ownership structure has not been a determinant of governance. Governance lapses can happen in any structure and it’s high time that we realise that.
Regarding NBFC conversion to bank - while those NBFCs owned by large corporate houses have been restricted, the on-tap bank license is available for others, yet we haven’t seen takers. If these recommendations were to become a reality, given what has happened in the past couple of years, do you think some NBFCs would have changed their mind?
So, I think NBFCs’ constraint was allowing corporate houses to be in banks. Because larger NBFCs, more than Rs 50-60,000 crore of assets are all owned by corporate houses, because even to be a large NBFC you needed borrowing capacity from banks, from bond markets. Firms like ours which are not part of a business house are NBFCs of about Rs 20-25,000 crore after 10-15 years of existence. So, in order to build a large NBFC you needed to be having access to capital and liquidity, the larger business houses have it. So that was the first constraint. Allowing corporate houses to be a bank will allow the larger (NBFCs) guys to do that (apply for a bank license).
Also, if you do the analysis of the pros and cons of banking versus NBFC and that's I think at the heart of what you're asking—what are the pros and cons of being a bank versus a NBFC. There are clear pros and cons and they change overtime. I think in the last few years being an NBFC had its own cons which got highlighted a lot more but over the years we have seen that there are definite advantages of both and I believe the both need to coexist.
I think as a general rule of thumb, the problem with either banking or NBFCs is not the opportunity to lend or the opportunity to build assets, it is the liability challenge. On the liability side, once you cross Rs 50,000-1,00,000 crore of assets you become too large to be able to just roll over your debt in the wholesale markets, a third every year. It becomes too bulky, too cumbersome and in a bad year where something like IL&FS happens, the markets freeze up and then the rollovers become either hard to get or very expensive and can pose a clear systemic risk. As a result of that I think after a certain size, being a bank does give you liability stability, though they have more constraints on what you can do on the asset side.
The way to think about it is to think about it as size. I think if you are say below Rs 30, 40-50,000 crore there are advantages of being an NBFC vis-à-vis being a bank. After a certain size, there are advantages of being a bank.
The other way of looking at it, in a bank there are restrictions on what you can do in terms of the asset side - the loans you give, priority sector lending etc..- but you have a lot more stability on the liability side. As an NBFC, you have a lot of constraints on the liability side but you have a lot of freedom on the asset side. So, I think at a smaller scale, NBFCs will have certain advantages, at a larger scale banks will have certain advantages. Also there are a lot of other nuances banks can sell transaction services and foreign exchange, credit cards and all that. So, I think there are advantages of cross sell, of size, of liability, of asset side freedom for both the models. If you look at the performance of NBFCs or the banks, I think most good banks make 2 – 2 ½% ROA and most good NBFCs make 2-3% ROA. A lot of the bad banks make hardly any ROA and a lot of the bad NBFCs also hardly make any ROA. If you look at the actual universe of banks and NBFCs, the profitability has been almost in the same spectrum in that sense. I think the more determinant will be size, strategy and all of that.
On a consolidated basis, would Edelweiss be eligible? Would you be interested in a banking license and if not, why?
We are very small. Everybody thinks that we are large in the credit space. If you look at Edelweiss we are more of a diversified group. If you look at our total assets, in ARC, wealth management, asset management we are closer to three lakh crore rupees, but our NBFC assets are about Rs 25,000 crore. So, we are much smaller. In fact, we've always been a very small NBFC - though in the last few years that part of the business got highlighted.
I think we are still very small and we are still a lot farther away. I think in the next five-seven years we have a very good plan on what we can do on the NBFC model itself. And as I said, being a bank is also very capital intensive and we are a first-generation entrepreneur company. The one thing we don't have is excess is capital. We have an equity capital base of eight and a half thousand crore rupees but this is split across all the businesses.
I do feel that there are a lot of opportunities for firms like ours in credit but as an asset manager. So, in the last few years we've raised a lot of funds, we have close to Rs 30,000 crore in credit funds that we have raised from international investors, and on the mutual fund side we have the Bharat Bond ETF and all that we have raised. So, we think ultimately credit will have various opportunities - as a bank, as an NBFC, as a housing finance company, even as an asset manager. And, we would rather do it as an asset manager, that has been our stated strategy. Because that doesn't require a lot of capital and that doesn't have ALM risk. In India, I think whether you are a bank or an NBFC, the larger problem has not been credit risk. Credit risk - you can price it in, your underwriting standards can become stronger. Instead of 2% NPA you might end up with 4 or 5% NPA. It hurts your earnings but it won't kill you. ALM risk is a big one. If you have to pay somebody hundred crore and you can arrange only Rs 99 crore and you can’t arrange that extra one crore, you still default. So, I think ALM risk is a bigger one and we've been very careful about that. So even in the last many years we held a lot of liquidity, we made sure that we are always well capitalised. So for us, I think it's more important to make sure from a capital efficiency point of view - an asset management model for the same credit opportunities is important.
You view on shortening the timelines for payments banks to convert into small finance banks.
I think the payment banks were really envisaged as pure transaction-oriented banks and maybe five seven years ago there was an opportunity in that. But the way the telecom industry and the payment space has gotten disrupted, we have now you know UPI and BHIM and you have obviously all this Amazon Pay and Google Pay... So given the payment space has completely changed in the last five years with the players like PayTm and all of them being there, I think a pure transaction bank may not have a business model and that is what we are hearing and that is what we are seeing. So, allowing a payment bank to convert into a small finance bank and eventually allowing small finance banks to convert into universal banks, I think gives them a range of options for scaling up and building a viable business model. So, I think RBI has been very pragmatic.
Pragmatism has also crept in into the NOHFC structure where again the working group seems to have changed stance a little bit and said that if you don't have other businesses in the group then you don't necessarily need to adopt this structure.
I think they are making one very big fundamental change - if you read this report and the approach of RBI in the last five seven years. Earlier, the approach was that the bank is a topmost entity, everything is underneath the bank. You can have an insurance company, you can have a mutual fund, you can have an even an NBFC-- all underneath the bank. So, a lot of the older banks have that structure - that there is a parent bank and there are a lot of other financial services businesses underneath that. Now what RBI want to do is they want to invert this. They want to keep the bank completely insulated at the lower most and any other financial services should be held by the Non operating Holding Finance Company independently.
Now this is a good structure to ringfence risk from the banks because RBI does want the bank not to have any other ancillary/associated implicit risk which can be there when you have a lot of other subsidiaries and businesses. However in India, this kind of structure from a capital raising point of view, NOHFCs have not been able to raise capital. In fact the whole concept of holding company in India is still being debated. And there are large corporate houses which are trying to figure out what should the value of a holding company. So I think, Indian equity markets have not been friendly to holding company structures. So, the cost of capital, cost of equity may go up as a result of that and that will also be an important consideration in people setting up business.
If the broad thrust of this paper becomes reality, how do you see the competitive landscape in financial services changing? Do you expect M&A activity if some of these doors are opened?
Actually whenever you have a structural change like this, there will always be a lot of M&A opportunities. Even last time, 25 years ago when RBI gave the first private sector banks, a lot of M&A happened after that and we saw at least for 10 years, between 1995 to 2005, there was a lot of banking M&A, until 2007-08. But after that there has not been as much M&A as you would have thought. What is required is constant churn, we need a lot more banks.
It’s a very paradoxical situation - where you need a lot more banks but you also want consolidation and M&A in the banking sector at the same time because we need a lot more financial inclusion and especially access to credit.
Financial inclusion is not just about opening a bank account. It is also ability to get credit and the ability to get credit is still very small. So even if about 500 million people in India have a bank account, not more than 40-50 million people have been able to get credit on a regular basis, and we need at least 200-300 million people in India to be able to access credit. So, the real financial inclusion in India is not about savings and it's not about investments. It's about credit. And I think a lot more banks will allow it and a lot more NBFCs will allow it. So I think we need a long tail, a lot experimentation required. Like what happened in telecom in the early days.
I think we need the same thing in the banking sector. Obviously, innovation will come with certain amount of risks and all that...so a lot of countries have allowed smaller players and sandbox and new business models and all. But, I do believe that credit markets in India need a lot of innovation.
About 25-27 years ago, we had the equity market crisis with Harshad Mehta. If you remember, at that time, there was no SEBI, no NSE. I think between 1992 to 1996, in those four years we got SEBI, we got NSE, we got the BSE which got automated. We got a lot of the private sector mutual funds coming in, we allowed FIIs to invest in equity markets. And those five, seven years of reforms including futures and options, we used to have a settlement cycle that was T+30, now, it is T+2, dematerialisation was a big point in that. So, in those five seven years, equity markets completely got transformed. That has actually resulted in 20 years of good growth in the markets, equity markets, equity market participation, companies’ ability to raise capital. Unfortunately, our credit markets opened up but opened up a little bit and every time there was a crisis, there was a feeling that we gave to close it. I think this approach that we have for the next 10 years—opening up credit markets is going to be transformative. Because, in any economy, equity is so important but credit is so much more important. Equity impacts only about 40-50 million people but credit impacts 300-400 million people if not more. We need to really expand our credit markets and along with that, as I said, from NBFCs to banks to funds we also need a lot more products, we need interest rate futures, we need credit default swaps, we need repo market for corporate bonds.
The post IL&FS crisis has been really a good time to think through what do we need to reform the credit market. Because, we can't have very evolved and constantly growing equity markets while credit markets remain very constrained. The need of the economy is more credit and unless credit starts flowing, our growth aspiration will not get met. So, I think all this is part of that. I do believe in the next three, four years there's going to be so much change in the rules and regulations and the structure of the credit markets in India that agile players will be able to capitalise on opportunities. There’ll be a lot of M&A, there will be new entrants coming in, the older ones getting consolidated and we're going to see a fair amount of churn.
It's going to be very exciting, because this, like equity markets from 1992 to 1998, is from now to 2025 for credit markets. I hope so, I do think that all the stars are lined for that.