NIIT UNIVERSITY

Holding Company Concept

An perspective from Indian Banking Sector

Prasanna Narayanan
P301412CMG401

Presently Indian banks are organized under the subsidiary model, where each bank acts as the parent of all the subsidiaries. Under this model, the bank floats subsidiaries under them to undertake the non-banking financial activities. The universal model undertakes all the financial activities within a single entity. The concept of Financial Holding Company (FHC) has evolved as a preferred model drawing lessons from the global financial crisis. The design of an FHC is such that it acts as a financial institution engaged in non- banking activities that offers customers a wide range of financial services, including the opportunity to purchase insurance products and invest in securities. This paper aims to provide an understanding of Holding Company Concept in Indian Banking perspective.

Table of Contents
Introduction ........................................................................................................................................ 3 Holding Companies in Banking Groups................................................................................................. 3 International experience regarding Financial Holding Companies (FHCs)/ Bank Holding Companies (BHCs) ................................................................................................................................................. 4 Major types of financial holding companies structures ........................................................................ 4 Need for Holding Company Concept in Indian Banking Sector .............................................................. 5 Legal Issues for FHCs/ BHCs for India ................................................................................................... 6 Regulatory issues relating to FHCs/BHCs .............................................................................................. 7 Supervision Framework for Financial Groups in India ........................................................................... 8 Conclusion ........................................................................................................................................... 8 References .......................................................................................................................................... 9

Introduction
Indian financial services sector has also been witnessing a rise in the emergence of financial conglomerates. With the enlargement in the scope of the financial activities driven by the need for diversification of business lines to control the enterprise-wide risk, some of the players are also experimenting with structures hitherto unfamiliar in India. In this context, it is considered timely to take a review of some of the conglomerate structures, assess their suitability for the country given the prevailing legal, regulatory and accounting framework, and highlight the regulatory and supervisory concerns for the Reserve Bank emanating from such structures. The subject of the type of corporate form embraced by financial groups in India for undertaking a range of financial activities has gained significance from two distinctive, inter-related, perspectives. The first being efficient corporate management within the groups meeting the growth and capital requirements of diverse entities. The second is the degree of regulatory comfort with diverse models, especially about the concerns relating to contagion risks. Banks, at present, in India are organized

under the Bank-Subsidiary Model (BSM) in which the bank is the parent of all the subsidiaries of the group. The need and feasibility of introducing a financial holding company model in the Indian context is necessitated from the lessons drawn from the global financial crisis.

Holding Companies in Banking Groups

In many countries, deregulation and financial consolidation have led to the development of Financial Holding Companiesallowing commercial banking, insurance, investment banking, and other financial activities to be conducted under the same corporate umbrella There are several ways of conducting different financial services in the same organization: The Universal Bank as currently practiced in Germany, where all financial services are done within the bank. The Bank Subsidiary Model, where non-banking activities are done in separately constituted subsidiaries of the bank. The Bank Holding Company model, where non-banking activities are done in firms owned by a parent company that also owns the bank. Transforming into a bank holding company makes it easier for the firm to raise capital than as a traditional bank. The holding company can assume debt of shareholders on a tax-free basis, borrow

money, acquire other banks and non-bank entities more easily, and issue stock with greater regulatory ease. It also has a greater legal authority to conduct share repurchases of its own stock.

International experience regarding Financial Holding Companies (FHCs)/ Bank Holding Companies (BHCs)
Internationally there are mainly two holding company models for bank related conglomerates viz, BHC Model and FHC Model. BHC Model: BHCs are companies that own or control one or more banks. In USA these are regulated by the Federal Reserve. These companies were first introduced in Bank Holding Company Act of 1956. These companies can make only limited investments in the non-banking companies. FHC Model: FHCs are companies that own or control one or more banks or non-bank financial companies. In USA, FHCs were created by the Gramm-Leach-Bliley Act as a way to expand the financial services activities of BHCs. GLB permits banks, securities firms and insurance companies to affiliate with each other through the FHC structure. FHCs can engage in activities other than banking as long as they are financial in nature. The most important of these are securities underwriting and dealing, insurance underwriting, insurance agency activities and merchant banking. The requirement to have bank in the financial group is pre-requisite for qualifying as an FHC in USA.

Major types of financial holding companies structures

BHC/FHC

Main Banking Subsidiary Other Banking Subsidiaries

Insurance

Securities

Asset Manageme nt

Others

Fig.1 A typical bank-centric organization structure

BHC/FHC

Main Banking Subsidiary

Insurance

Securities

Asset Management

Others

Other Banking Subsidiaries

Fig 2. A Financial conglomerate with holding company at the top

BHC/FHC

Main Banking Subsidiary

Intermediate Holding Company

Housing Finance

Others

Other Banking Subsidiaries

General Insurance

Asset Management

Life Insurance

Fig 3. A Financial conglomerate with holding company at the top as well as an intermediate holding company

Need for Holding Company Concept in Indian Banking Sector

In India, the financial sector reforms have witnessed an upsurge in banking, capital markets and insurance industries leading to formation of conglomerates with complex structures. RBI constituted the working group in June 2010, headed by Smt. Shyamala Gopinath, the then Deputy Governor of RBI to examine the feasibility of introducing a Financial Holding company Structure in India. RBI wanted the Working Group to address the issues of conflict of interest and safety considerations for banks venturing in non- banking financial activities. The post crisis reform proposals do not specify preference for any particular model. The focus, as far as structure was concerned, was on strengthening capital

requirements at the consolidated level; reducing complexity of structures to enable efficient resolution of financial institutions; and separation of investment banking from commercial banking. In terms of existing instructions, a banks aggregate investment in the financial services companies including subsidiaries is limited to 20% of the paid up capital and reserves of the bank. However, in a FHC/ BHC structure, this restriction will not apply as the investment in subsidiaries and associates will be made directly by the FHC/ BHC. As the subsidiaries are separated from the banks, their growth of the subsidiaries/associates would not be constrained because of capital. In the case of public sector banks, the Government holding through a FHC/ BHC will not be possible in the existing statutes. However, if statutes were amended to count for effective holding then, the most important advantage in shifting to FHC/ BHC model would be that the capital requirements of banks' subsidiaries would be de-linked from the banks capital.

Legal Issues for FHCs/ BHCs for India

Need for a separate law: Some countries have a separate legislation for regulating FHCs/ BHCs. If we have to have only BHCs, the purpose could be achieved perhaps even by amending the BR Act, 1949. However, in case it is decided to go for FHCs by expanding the scope of permissible financial activities by including all possible financial services, a separate Act on the lines of GLB in USA may be required. Minimum threshold for recognizing a BHC for regulatory purposes: In USA, a BHC is a company which directly or indirectly or acting through one or more other persons owns, controls, or has power to vote 25 percent or more of any class of voting securities of a bank and or controls in any manner the election of a majority of the directors or trustees of the bank. A suitable threshold will have to be incorporated in the proposed statute in the Indian context too. Permissible activities of FHCs/BHCs: Internationally, there are restrictions on the activities of BHCs or FHCs. While BHCs are not allowed to invest in non-banking related activities, subject to certain exceptions, restrictions in the case of FHCs mostly relate to investments in non-financial commercial enterprises. Further, the BHCs and FHCs are required to be non-operating in nature. Appropriate, restrictions on these lines will have to be prescribed by us.

Cross holdings among FHCs/BHCs: Cross holdings among BHCs would create intractable regulatory problems. Some limits would be necessary in this regard.

Regulatory issues relating to FHCs/BHCs

Capital adequacy framework Capital adequacy framework for FHCs/BHCs would be governed as per Basel-II norms. The capital adequacy framework would be applicable to the BHC at consolidated level wherever the entire group would qualify as the banking group. (If More than, 50% of the groups assets are banking assets and more than 50% of the income is derived from the banking activities). In other cases, the capital adequacy would be applied at the banking subsidiary level. Ownership of Banking FHCs In India, the ownership norms are not the same for the public and private banks. While the provisions of the respective statutes govern the ownership structure of public sector banks, in the case of private sector banks, the ownership and governance framework put in place by RBI regulates it. The exodus by a banking group to the FHC structure would result in the bank becoming a subsidiary of the FHC. As by definition, an FHC will control a bank, keeping with the spirit behind the legal provisions and the ownership and governance framework, therefore, it would be essential to apply the same ownership and governance framework for the banks to their respective FHCs. For example, in order to remain consistent with the provisions of the Nationalisation Acts, in the case of nationalized banks, it would entail Government of India retaining a minimum stake of 51% in the FHC and foreign investment not exceeding 20%. Similarly, in the case of a FHC controlling a private sector bank, it would entail the acknowledgement for acquisition or transfer of shares for any acquisition of shares of 5 per cent and above of the paid up capital of the FHC. Need for a Separate Act A dedicated Act has been enacted for regulation of FHCs in most of the countries. In the US, FRB is the regulator of BHCs and FHCs. In Australia, Canada, Cayman Islands, Colombia, Japan, Korea, Singapore, Sweden, and United Kingdom a single regulator oversees the activities of all financial conglomerates as a whole. In the case of India, RBI Act of 1934 is not deemed adequate to regulate and supervise the

FHCs by RBI, as the legal powers are required to regulate comprehensively and exercise consolidated supervision on the FHCs are not provided for in the provisions governing NBFCs contained in the RBI Act. In particular, RBI Act do not confer powers to change the management of the holding company or give direction as to the kind of other subsidiaries etc., collect information from and inspect the subsidiaries of the FHCs and the application of bank-like ownership restrictions on the FHCs.

Supervision Framework for Financial Groups in India

To address these broad issues the three major financial sector supervisors in India (RBI, SEBI and IRDA) established a special monitoring system for Systemically Important Financial Intermediaries (SIFI). The Financial Conglomerate monitoring framework was put in place in June 2004 following the acceptance of the report of an inter-regulatory Working Group . The FC monitoring framework has been revised in phases in order to enhance its effectiveness. The current practices being followed in regulation with SIFIs /FCs are: Off-site surveillance through quarterly Returns aimed at tracking the following: Ensure compliance of arms length principle in intra-group transactions and exposures (ITEs); Identifying entities with deteriorating financials and large risk concentrations; Large intra-group transactions and risk concentrations manifesting in major markets viz. equity, loans, debt, repo, inter-bank, call money, derivatives, etc. carried out for any purpose (trading or investment); Build-up of any disproportionate exposure (both fund based as well as non-fund based) by a regulated entity to other group entities; Any group-level concentration of exposure to various financial market segments and counterparties outside the group Information on adverse events such as fraud, penalty/strictures etc., levied/passed by regulators/ courts/ administrative agencies.

Conclusion
Financial conglomerates have evolved predominantly over the second half of the twentieth century, and have become exceptionally significant in recent years. The major economic benefits from conglomerates are the suitability to realize potential economies of scale and scope and to gain synergies across complementary business lines. These economies result in enhanced operational

efficiency and effectiveness owing to lesser costs, reduced prices, and enriched innovation in products and services. Though the empirical benefits of such financial conglomerates are uncertain, of late these organizations indeed have gained in prominence. Yet, there seems to be a steady trend towards increasing conglomeration in several countries. Indian banking sector is passing through another crucial phase in its evolution with the Reserve Bank of India proposing the formation of holding companies in banking groups. RBI has suggested that a financial holding company (FHC) or a banking holding company (BHC) will offer considerable advantages as the banks will be much better protected against possible adverse effects from the activities of their non-banking financial subsidiaries. In view of the above, the financial holding company (FHC) model ought to be pursued as a preferred model for the financial sector in India. In addition, the FHC model can be extended to all large financial groups irrespective of whether they contain a bank or not. Therefore, there can be Banking FHCs controlling a bank and Non-banking FHCs, which do not contain a bank in the group.

References
RBI, (2011), REPORT OF THE WORKING GROUP ON INTRODUCTION OF FINANCIAL HOLDING COMPANY STRUCTURE IN INDIA, RESERVE BANK OF INDIA, 4TH MAY. SIB STUDENTS ECONOMIC FORUM THEME NO. 244 : FINANCIAL HOLDING COMPANY RBI DISCUSSION PAPER ON HOLDING COMPANIES IN BANKING GROUPS, 26TH AUGUST 2007 APPLYING FOR NEW BANKING LICENSES: A GUIDE TO NON-OPERATIVE FINANCIAL HOLDING COMPANIES, VINOD KOTHARI, NIDHI LADHA, 25TH FEBRUARY 2013.