Monday, 15 August 2011

Financial Holding Companies: Implications for India

“Consolidation alone will give banks the muscle, size and scale to act like world class banks. We have to think global and act local and seek new markets, new classes of borrowers.”

P. Chidabaram

The wake-up call for central banks around the world came in Aug- 2007 when the world saw unfathomable fall of financial institution Lehman Brothers. With the introduction of discussion paper on holding companies in the banking group, in 2007 itself, RBI gave a clear signal that it wants to safeguard banks against adverse effects from non-banking activities of subsidiaries.

There are different models of conducting banking and non-banking financial services under the same umbrella:

All these models can have one or more layers of intermediate holding companies.

Financial Holding Companies allows commercial banking and non-banking activities viz. insurance, investment banking and other financial activities to be conducted under the same corporate umbrella. To lead the consolidation even further RBI is also mooting to extend FHC Structure to all large financial groups irrespective of whether they contain a bank or not. Therefore, there can be a banking FHC and non-banking FHC as a result of which there is a need of a separate regulatory framework for FHCs.

However, the conversion from Bank Subsidiary Model to FHC is not easy because of the following two reasons:

1.      Amendments to existing regulations

2.      A consolidated supervision mechanism is to be enacted through MoU between regulators.

The principal economic benefits from conglomerate are the ability to capture potential economies of scale and scope and to capture synergies across complementary financial services business lines. These economies result in improved operational efficiency and effectiveness due to lower costs, reduced prices, and improved innovation in products and services. Regulatory authorities have encouraged consolidation in the financial services industry in order to facilitate enhanced diversification, capitalization, and investments in banking information technology, and to lessen the supervisory burden where banking organizations are larger and more visible.

Financial Holding Structures

A typical bank subsidiary model (BSM), by taking ICICI Bank Ltd as an example is shown below:

In a financial group, a holding company can be the parent of the group or an intermediate holding company. A multi-layered financial conglomerate may also have a few tiers of intermediate holding companies apart from the holding company at the top. For e.g. it can be clearly in the organization structure of Bank of America Corporation (Shown below) that retail banking is separate business unit taken care of which holding company is NB Holdings Corp. whereas Merrill Lynch & Co., Inc takes care of the Investment banking and other financial services. And, Bank of America Corporation is the Holding company i.e. FHC.

Recently, some banking groups, especially private sector banks, have taken steps to form intermediate holding companies by creating layers within their corporate structure, this has made RBI’s job more difficult in monitoring them. Thereby RBI is mooting that Intermediate Holding Companies within FHC should not be permitted as they make organizational structure more complex and opaque. FHC Structure with a holding company in between is shown below:

Major Motivations for FHCs in India

Currently, a bank’s aggregate investment in the financial services companies including subsidiaries is limited to 20% of the paid up capital and reserves of the bank. In a FHC structure, this restriction will not apply as the investment in subsidiaries and associates will be made directly by the FHC. Once the subsidiaries are separated from the banks, their growth of the subsidiaries/associates would not be constrained on account of capital. But the investment in subsidiaries might also be capped up to a certain limit as deemed by the RBI.

In case of Public Sector Banks, the Government holding through a FHC will not be possible in the existing statutes. However, if statutes are amended to count for effective holding then, the most important advantage in shifting to FHC model would be that the capital requirements of banks' subsidiaries would be de-linked from the banks’ capital.

Since the non-banking entities within the banking group would be directly owned by the FHC, the contagion and reputation risk on account of affiliates for the bank is perceived to be less severe as compared to the present structure as BSM.

All these subsidiaries in the FHC Structure can be listed and raise money and make themselves more sustainable as compared to the existing Bank Subsidiary Model.

Issues Regarding Introduction of FHCs in India

A.     Legal Issues

                                I.            Need for a Separate Law: - In case the RBI decides to go for FHC Structure in India by expanding the scope of permissible financial activities by including all possible financial services, a separate Act on the lines of GLB in the US is required.

                             II.            Permissible Activities of FHCs: - Internationally, restrictions in case of FHCs mostly relate to investment in non-financial commercial enterprises. Appropriate restrictions have to be prescribed, which will make them more transparent and make them appear to be less risky.

                           III.            Cross Holdings among FHCs: - Cross holdings among FHCs would create intractable regulatory problems. Therefore, some limits would be necessary in this regard.

B.     Regulatory Issues

                                I.            Capital Adequacy Framework: - Entire group if classified as Banking Group - if more than 50% of the group’s assets are banking assets and more than 50% of the income is derived from the banking activities - then capital adequacy framework would be applicable to the FHC at the consolidated level. In other cases it will be applicable to banking subsidiary level.

                             II.            Presence of Unregulated entities within the FHC: - The presence of any unregulated entity within the FHC structure especially an unregulated intermediate holding company may prove to be a weaker link in the entire structure providing scope for regulatory arbitrage. Therefore, it needs to be ensured that the FHCs are, by law, not permitted to invest in any unregulated entity.

C.     India Specific Concerns

                                I.            The banks will be able to avoid the present 20% regulatory limit on investment in the  financial services companies, RBI's regulatory concerns on account of the over extension of the bank group and increase in corresponding reputation risk, will continue. Moreover, these concerns will be accentuated if any unregulated holding is present in the Group.

                             II.            In insurance companies, the direct or indirect foreign holding cannot exceed 26%. However, when the Indian promoter company is a banking company, the proportion of foreign holding in such a banking company would not be taken into account for the purpose of calculating 26% cap of foreign holding in Indian insurance company in view of IRDA Regulations. In the FHC Structure, the insurance company would be an independent subsidiary of the FHC therefore the above exemption would not be allowed.

Banks would be in a much better position to have FHC Structure as they would be much better protected from the possible adverse effects from the activities of their non-banking financial subsidiaries. In fact, it may also be possible to consider allowing non banking subsidiaries under the FHC structure to undertake riskier activities hitherto not allowed to bank subsidiaries such as commodity broking.

A big advantage of the FHC model does is that the FHC does not have any operations on its own – it does nothing other than own share in each of the operating subsidiaries. Each operating subsidiary can be independently regulated by its own sectoral regulator. That is a lot easier to do than consolidated supervision of an entity, which is also an operating financial company.

In the above context, it will be useful to explore the possibility of adopting a FHC Model. However, a proper legal framework needs to be created before such structures are floated and it is ensured that no unregulated entities and intermediary holding company are present within the structure.