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New Banking Licenses: Red Herring Or Real Deal?

Published on Sat, Mar 02,2013 | 12:29, Updated at Tue, Apr 02 at 12:31Source : 

By: Nishant Parikh- Partner & Rohan Ghosh Roy- Senior Associate, Trilegal

On 22 February, 2013, the RBI released the much-anticipated guidelines for licensing of new banks in the private sector, which lays down the criteria and process for the RBI to consider and grant banking licenses to new private sector banks.  Among other things, the RBI guidelines specify a new holding structure for these banks, stipulate that at least 25% of their branches have to be in unbanked rural areas, and require them to be promoted by Indian entrepreneurs and corporates with a 10-yr successful track record in running businesses.

Given that a number of new banks licensed in the previous rounds of bank licensing have either merged with larger banks or failed, the RBI was keen to ensure that the experience was not repeated this time.  The stringent requirements laid down by the RBI, to minimize that risk, may, ironically, lead to increased transaction costs and reduced profitability for the new banks and the groups that promote them – in turn, threatening their business prospects and survival. 

The NOFHC model

The RBI has proposed that promoters’ stake in all new banks be held through a wholly-owned non-operative financial holding company (NOFHC).  The origins of this structure can be traced to the recommendations of the 2011 working group constituted by the RBI on introduction of financial holding structures in India.  However, the RBI has taken the working group’s recommendations a step further and introduced several new requirements.

Shareholding– At least 51% of the voting equity capital of the NOFHCs needs to be held by a promoter-group listed company in which the public shareholding is at least 51%.  Individuals within the promoter group, along with their relatives and associated entities cannot hold voting equity shares in excess of 10% in the NOFHC.  Shares of the NOFHC cannot be transferred to any entity outside the promoter group and group restructuring as a result of which a shareholder acquires 5% of more of the NOFHC requires the RBI’s prior approval.

Holding company–The NOFHC shall act as the holding company for the promoter group’s stake in the bank as well as all other regulated financial services entities/businesses in which the promoter group has ‘significant influence’ or control.  This is intended to ‘ring fence’ the financial services businesses within the group from the other business activities of the promoter group, and also ring fence the bank from the activities of the other financial services entities.  The NOFHC will be licensed and regulated by the RBI as a non-banking finance company (the regulations for this are still awaited) and will not be permitted to set up a new financial services entity for at least three years from the date of commencement of business. 

NBFCs – The RBI has permitted existing NBFCs to ‘convert’ into a bank, but all existing lines of business that a bank is not permitted to undertake (for instance, banks are generally not allowed to engage in share financing) must be transferred to a separate entity.  Similarly, for groups that have existing NBFCs and have applied for a banking license, all lines of business that can be undertaken by a bank are to be transferred to the bank. 


Most large corporate houses with interests in the financial services sector (who will most likely be the frontrunners in applying for new licenses) have a fairly diversified holding structure.  The requirement that all regulated financial services entities be held under an NOFHC and 51% of the NOFHC be held by a non-financial services listed company (in which the public shareholding is at least 51%), the RBI is asking most of these groups to engage in what could be an expensive and messy group restructuring.  

To illustrate, let us consider an atypical holding structure where a flagship listed entity (Company A) in which the promoters hold at least 51%, holds 100% of the group’s downstream holding company (Company B) and 74% of the group’s insurance venture (Company C).  Company B, in turn, holds 5-6 different companies engaged in regulated financial services and non-financial services businesses. 

For Company B to be able to act as the NOFHC for the group (the most logical choice), firstly the promoters would have to divest their stake in Company A and bring it down to a maximum of 49%; secondly, Company C (being a regulated financial services entity) would have to be transferred from Company A to Company B; thirdly, the subsidiaries of Company B that are engaged in non-financial businesses would have to be transferred out to a new company owned directly by the listed company; fourthly, the financial services businesses carried on by the subsidiaries of Company B that can also be carried out by a bank, would have to be transferred to the banking entity through a business transfer; and fifthly, the capital available at Company B would have to be ramped up significantly since it now holds a new insurance venture (Company C) and will be promoting a new bank. 

The entire process will be expensive (each share sale and business transfer may attract capital gains tax and/or stamp duty) and could be complex, depending on group structure (for instance, if any of the subsidiaries of Company B are also listed, it could require share swaps to preserve shareholder value).

Further, since (a) all regulated financial services businesses within the promoter group are to be held under the NOFHC, (b) all existing financial services businesses that can be undertaken by a bank are to be transferred to the new bank, and (c) the NOFHCs are prohibited from establishing any new financial services entity for 3 years, the RBI has effectively tied the fortunes of the group’s financial services businesses to the fortunes of the new bank sought to be promoted by it.  If the bank fails, so will the largest chunk of the group’s financial services business. 

Banks, in general, need scale and outreach to be profitable.  The RBI guidelines do not make it any easier for the new banks to achieve scale and be profitable in the initial phase.  New banks have to open at least a quarter of their total branches in unbanked rural areas (with a population of up to 9,999 as per the latest census, and therefore, most likely to be loss making branches). Existing domestic scheduled commercial banks have to open only a quarter of the new branches they open each year in such areas, and newer private sector banks have to maintain a quarter of their branches in semi-urban and rural areas on an ongoing basis.  This puts the new banks at a relative disadvantage as compared to the existing players –they should ideally have had a relative advantage to go through their nascency. 

To add to the quandary, the RBI has rejected calls to allow local players to team up with strategic foreign partners, which could have given them access to relatively cheaper capital and sectoral expertise.  The RBI guidelines have restricted aggregate foreign investment in the newly licensed banks to 49% for the first 5 years (the cap for existing banks is 74%) and imposed a limit of 5% on foreign investments by a single entity/group – all but ruling out the possibility of a strategic alliance with a foreign group.

In conclusion, it would appear that the guidelines were prepared keeping industrial houses in mind.  Financial services-focused groups may find it more difficult to reorganize themselves in the manner contemplated under the guidelines. 

(Disclaimer: The contents of this article are intended for informational purposes only and do not constitute legal opinion or advice. Readers are requested to seek formal legal advice prior to acting upon any of the information provided herein.)


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