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Monday, June 27, 2022

In fact: When financial institutions evolved into banks

The Narasimham Committee-II had suggested that these institutions should either convert themselves into banks or non-banking financial companies (NBFCs).

Written by Shaji Vikraman |
Updated: April 5, 2017 6:08:23 pm

By the end of the 1990s, after the first few years of opening up of the economy, the average level of bad loans reported by Indian banks rose to nine per cent. Companies that had borrowed at high rates to build plants were hit after a post-1997 slowdown and the impact of the East Asian crisis around the same time. In April 1998, the Vajpayee-led NDA government received a report of a committee, headed by former RBI governor M Narasimham, that had reviewed banking sector reforms launched in 1991.

Worried at the level of bad loans, the finance ministry and the RBI discussed how the recommendations of the Narasimham-II committee could be taken forward. Besides banks, development finance institutions or DFIs, as they were called then, such as ICICI, IDBI and IFCI too had a huge pile of bad loans. By that time, thanks to liberalisation, these institutions no longer had access to low-cost long-term funds from the government or the central bank to finance large infrastructure projects in the country. They were forced to borrow at higher rates from the market while banks began financing infrastructure projects, which they weren’t doing until then.

The Narasimham Committee-II had suggested that these institutions should either convert themselves into banks or non-banking financial companies (NBFCs). RBI governor Bimal Jalan had appointed S H Khan, who was heading IDBI, to chair a committee to look at the possible transition of these institutions into universal banks, a concept in vogue in the West. The committee recommended that DFIs could evolve as universal banks offering a range of financial services. Jalan discussed the report with his deputy governor, Y V Reddy, and given the latter’s reservations, sought the views of a retired chief economist of the Asian Development Bank on the Khan Committee report. Reddy’s argument was that the transition should be in the form of either pure commercial banks or as NBFCs. His point was that the evolutionary path for each of these institutions ought to be towards emerging as banks.

After that, a discussion paper was unveiled by the RBI in December 1999, and a policy on transition of FIs into banks announced in 2000. ICICI was then at the top of the league in disbursing funds to projects and firms but like other financial institutions, it too was feeling the pressure. One of its subsidiaries, Shipping Credit and Investment Corporation of India (SCICI), which funded shipping firms, had to be merged with the parent company, ICICI, due to downturn in the sector. As a financial institution, it had secured a banking licence just as IDBI had in 1994, having formed a subsidiary, ICICI Bank. Sensing the directional shift in the financial sector, ICICI approached the RBI with a proposal to convert into a bank and sought a waiver on mandatory norms such as setting aside a minimum portion of deposits as cash reserves with the central bank, known as CRR, and Statutory Liquidity Ratio, or SLR, which required investing a fixed proportion — then 25 per cent — of deposits in government securities or bonds besides providing loans to priority sectors. However, the banking regulator wasn’t ready to ease the rules though it agreed for a rethink on lending to priority sectors such as agriculture over time. Officials recall that Jalan may have been more receptive to the idea, but his deputy, Reddy, wasn’t so, saying that the day ICICI converted itself into a bank, it had to follow all the prudential requirements just like other banks, instead of being half a bank. Interestingly, Jalan who had worked with ICICI as a young economist in the 70s, backed Reddy.

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Several meetings took place in New Delhi in 2001 at the finance ministry’s banking division, as public financial institutions were then controlling ICICI, which was headed by KV Kamath at the time. Frustrated by delays, the ICICI management would often meet the joint secretary in charge of financial institutions in the ministry, U K Sinha. A meeting was convened by then finance secretary Ajit Kumar to sort out the issue but the central bank had given enough signals that it wasn’t willing to ease the rules, prompting the government to step back. Subsequently, at a meeting in Mumbai, the ICICI top brass was told that issues such as SLR were non-negotiable. One of the worries expressed by the ICICI chief was the repercussions of buying huge quantities of government securities from the market. Reddy had suggested that this hurdle could be surmounted by entering into a deal to swap bonds with India’s largest bank, the SBI, which had excess securities on its portfolio. Meanwhile, other issues had to be sorted out including properties — for instance, one of the buildings of its old subsidiary, SCICI, was sold to the Income Tax department.

In March 2002, the reverse merger — of the old development financial institution with its subsidiary, ICICI Bank, came into effect. Over a decade later, the new entity is now India’s largest private bank as progressively, the ownership of state-owned institutions got diluted. Its other peer, IDBI, had to be first corporatised given that the institution was governed by a statute, the IDBI Act, which had to be repealed. The slow conversion of IDBI into a bank and its transition have clearly reflected in its ranking in the pecking order of Indian banks.

A couple of years after ICICI became a bank, there was a significant withdrawal of deposits in some parts of the country, which forced the central bank to issue a statement, endorsing that the bank was sound. Soon after, it was the turn of a senior bank official to acknowledge to a top central banker the wisdom of the central bank’s decision not to ease prudential norms. That was when it truly sunk in — the importance of such capital buffers in a crisis.

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