Pre-empt Regulatory Arbitrage

The Reserve Bank of India’s reputation as a regulator is rock-solid in the global financial system. It now has to ensure that its regulation on NBFCs has the life span of a turtle

SOMEONE once gave regulation one-fifth the life span of a chimpanzee. India has seen numerous examples where the regulator tries to erect walls around a particular sector, only to find that business has found a way around. Some of these sidesteps can be labelled as criminal, but most of these instances can be clubbed into what is now known as “regulatory arbitrage”, which means utilising gaps in the existing regulatory framework without violating the law of the land. There is a regulatory arbitrage occurring right now, which has the Reserve Bank scrambling to plug the loopholes. This involves nonbanking finance companies (NBFCs), especially those promoted by foreign banks or even those sired by international financial giants. The central bank is now planning to come out with regulation that endeavours to eliminate the NBFC-spawned arbitrage.  

Foreign banks are keen to expand their footprint, and given India’s growth rate, they want it all done now! India is currently the hot new thing on the global investment block and everybody desperately wants in. Even foreign banks that once found business in India only marginally engaging now suddenly want to hitch their wagons to this emerging economic powerhouse. For example, certain European banks, which, in an exemplary display of foresight, had deliberately shrunk their Indian businesses in the ’90s, are today jostling to catch a piece of the action. And, this requires branch expansion of an unprecedented scale. 

But then the RBI thinks otherwise. The central bank has been deliberately going slow in granting new branch licences, driven by larger apprehensions of systemic risk. As an alternative, some foreign banks have been expanding their presence through finance companies, or NBFCs. These NBFCs don’t need to approach the RBI for opening branches. Most of them don’t even accept deposits in order to escape the RBI’s gimlet gaze. As a result, foreign banks have been opening NBFC branches furiously. These branches are, for all practical purposes, like bank branches with only one crucial difference — these can grant loans for buying houses, cars or two-wheelers, but cannot issue cheque books. According to a report of an RBI internal group on ‘Level playing field, regulatory convergence and regulatory arbitrage in the financial sector’, banks are likely to set up NBFCs to benefit from regulatory arbitrage: “A bank’s NBFC subsidiary which grants retail loans such as consumer loans, vehicle loans, housing loans, etc., coupled with a bank ATM can circumvent the branch authorisation restrictions imposed on the bank by extending its outreach substantially. The customer can deposit or withdraw cash at the bank ATM, obtain a loan from the NBFC and make repayments into the loan account by using the bank ATM. Thus, the bank together with its NBFC subsidiary can perform more or less all the functions which a bank branch undertakes.”

The trend has now taken a curious twist. The RBI has now stopped a few banks from opening or operating NBFCs, without doing anything about the existing ones. Barclays, Deutsche Bank and HSBC find their applications for NBFCs lost in a black hole. Interestingly, NBFCs launched by non-banks have sailed through — in addition to GE Money, US insurance giant AIG recently got the nod to launch and operate an NBFC. So did Singapore’s Temasek, which bought over an existing NBFC (something reportedly done by Goldman Sachs). In the midyear review of its 2006-07 credit and monetary policy, the RBI has even allowed these NBFCs to issue co-branded credit cards and sell MF products. This puts them somewhat on par with banks.

The RBI’s concern with bank-run NBFCs is not totally out of place. Many of these NBFCs extend risky loans, including loans to speculate in the capital markets. This is risky on two counts — first, any default can lead to an impairment of the parent bank’s capital. But the riskier proposition is the contagion effect it may have on the system as a whole. Most of these NBFCs are heavily leveraged, which means they borrow in multiples of their capital (can be 10-15 times) from the market to finance their lending operations. So, any slight slippage might affect even the lenders, who in turn might knock over another chain of financial agents in the system. 

In all likelihood, the RBI might opt for stricter regulation of the banks that have promoted NBFCs. For instance, it might choose to treat a bank and its family of NBFCs as a conglomerate, inviting consolidated supervision, including imposition of ceilings on the conglomerate’s lending to industrial groups. There might even be stricter norms introduced for bank financing of NBFCs against shares, debentures and PSU bonds, in addition to finding ways that staunch the flow of bank funds to the capital market through NBFCs. Another alternative would be closer coordination with Sebi for regulating finance companies that are engaged exclusively in the stock markets. The overall purport of the new NBFC policy will be to make a distinction between bank-sponsored NBFCs and independent ones, against the current difference of deposit-accepting and nondeposit accepting NBFCs.

All that’s fair enough. But there’s another problem here: if the RBI shuts the door now, it presents a new kind of hazard. It provides the existing foreign banks with an unfair advantage over the others, which might then induce the excluded lot to indulge in an extreme form of regulatory arbitrage. The top five foreign banks already account for 82% of the total profit reported by all the 30 MNC banks in the country. Any form of prospective selection through regulatory fiat might only enhance this discrimination. The Institute of Chartered Accountants of India shut the door on foreign accounting firms some years ago, but only after it had allowed in a couple of the foreign firms. However, the ones left standing outside the gates still managed to sneak in through cracks in the wall. MNC banks, deprived of either branches or NBFCs, might be also tempted to attempt something extreme, thereby putting the entire system to even a greater risk. The RBI’s reputation as a regulator is rock-solid in the global financial system; it now has to ensure that its regulation on NBFCs has the life span of a turtle.

Published as an Op-Ed in The Economic Times (November 1, 2006)

The Business Of Politics

For lasting success, political families should imbibe some of the best practices that business families have implemented to survive and grow

DYNASTY ought to become a four-letter word for politicians, as most family-run businesses have realised to their peril. There’s further evidence of that now from far away lands. In a recent survey of over 700 mid-size manufacturers spread across France, Germany, the UK and US — conducted jointly by McKinsey and London School of Economics — it was found that, on average, family-owned companies with outsiders as the chief executive seemed to be better run than those managed by family members. But, even if the number of successful family-run businesses constitutes a small percentage of the total sample, they seem to hold a message for the political families — for lasting success, they should imbibe some of the best practices that business families have implemented to survive and grow. 

Pioneering US businessman Andrew Carnegie had conveniently provided today’s business families and politicians with a peg to hang their learnings: “From shirtsleeves to shirtsleeves in three generations”. Translated, that means the first generation works hard to accumulate wealth (and so is dressed in shirtsleeves), the second generation consolidates the wealth and the third generation blows it all up, ending up in shirtsleeves as well. Plus, there is the inherent conflict — family, as the only natural and oldest sociological grouping, is intrinsically socialist in nature while managing a business is essentially capitalist. As evidence, the courtyard of post-Independence, postindustrial India is littered with the ruins of many family-run businesses, which have perished in the dynastic death-trap.

At the same time, there are numerous other family-run businesses that have managed to sidestep the grim reaper of bankruptcy. They have managed to do so after a lot of hard work, outside consultation, internal discussions and a clear vision. Businesses run by families have long been the subject of intense study by management experts. B-schools hold special courses for scions of business families, which teach them the nuances of managing and growing their businesses. Many families have even engaged external consultants from famous B-schools to tutor them in the art of resolving family-based conflicts to grow their businesses.

A large number of successful businesses worldwide — such as, Wal-Mart, Ford, Motorola, Cargill, and Hewlett-Packard — are family-owned and many of them are managed by hired professionals. In these cases, the family prefers to oversee and safeguard their investments from the vantage point of a board position. They even lay down a set of values — unique for that family or bequeathed by the founder and followed by subsequent generations — for executives to follow. Even where a family member is part of the management team, he needs to have a separate set of guidelines to steer him through the minefield of familial squabbles and differing expectations. A large number of Indian family-run groups have managed to defuse the in-built, shirtsleeves-time-bomb in their businesses by following a set of structured processes. As a result, they have also reaped the benefits — higher m-cap rewarded by the market, zero day appearance on B-school campuses, easier and cheaper financing options, ability to hire top-of-the-line professionals and respect from JV partners.

So, what kind of lessons do these companies hold for politicians whose kids are also keen on joining politics and nurturing their dad’s constituencies? The first trick is to separate issues of ownership and business control, roles that are essentially conflicting in nature but often end up overlapping with each other. In the politician’s case, ownership is the dedicated vote bank and party workers that dad hands over to the son. But business control is what junior chooses to do with the constituency — by improving governance, infrastructure and the general well-being of the voters. This provides a lasting business model for the son and has beneficial impact on ownership issues as well by earning him higher recognition in the party. According to a 2003 article in the McKinsey Quarterly (Keeping The Family In Business: Heinz-Peter Elstrodt), “at the core of a durable family enterprise is the philosophy that ownership implies, not necessarily the right to sell, but rather the responsibility of handing a stronger company over to the next generation.” TV show host Jay Leno is believed to have remarked: “If God wanted us to vote, he would have given us candidates!” Politics 101: over time, the son should aim to become a candidate, and not something foisted on an unsuspecting public.

There’s another important learning: how to resolve conflicts. Indian politics has seen many sons estranged from their mothers, sons from their fathers, sons-in-law from their fathers-in law, and so on. This brings about a break in succession planning and often ruins the politico-business model. Business families with many members typically spend a lot of time in conflict resolution, before arriving at a consensus. Once that’s done, everybody falls in line. Splits in family-owned groups often happen because of conflicting ambitions among family members and the desire by multiple members to have a say in the working of the business. It is often argued that the rate of survival for a consolidated business is much higher than allowing the business to split into numerous parts with separate investments.

The final bit of knowledge lies in the history of the Rothschild family. In the mid-18th century, Mayer Amschel Rothschild entrusted his five sons with expanding the family’s banking business in the five major European financial capitals of that time — Frankfurt, Vienna, Paris, London and Naples. Each of them was lent money under the stipulation that once the original loan was repaid, they could retain the profits in the individual centres. Over time, only the London and Paris branches survived the ravages of time and modern history. But, the story has a moral: Rothschild Sr could insulate the original business from the shirtsleeves syndrome by diversifying through his sons. Political families with more than one heir should use the Rothschild example to resolve the aspiration issue — one son gets into politics while the others join a completely different profession.

Published as an Op-Ed in The Economic Times (October 12, 2006)