India has upped the pressure on foreign banks to put down roots in the country by converting their branches into subsidiaries. But will a package of incentives be enough to allay their fears over tax and onerous lending rules?

The havoc wrought by the global financial crisis on the worldwide banking industry had a chilling effect on India’s regulators. What, they wondered, would have happened if the Indian branches of international banks had been forced by their head offices to disinvest from India to shore up failing subsidiaries elsewhere?

Such fears did not come to pass, but the concern helped revive a Reserve Bank of India (RBI) proposal to have what are currently branches of international banks operating in India convert themselves into locally incorporated but wholly owned subsidiaries. This would ensure that they could be more closely regulated and monitored by Indian authorities.

Analyzing options

Amid the crisis, the RBI stopped issuing new licences to foreign banks. Then, in early 2009, the Indian government commissioned a study of the health of the Indian banking system. It was conducted by the RBI and a specially convened committee on financial sector assessment.

The resulting report backed the formation of subsidiaries by foreign banks so as to help manage any future crisis. “In fair weather it may not be of much relevance, but in times of crisis, the distinction between the branch and the rest of the bank and the legal location of assets and liabilities becomes very important,” says Akil Hirani, the managing partner of Majmudar & Co in Mumbai.

In January, the RBI released a discussion paper detailing its preliminary plans on how to implement the change (see Topics for discussion, page 23).

No thank you

This is not the first time the RBI has flirted with the idea of converting foreign bank branches into wholly owned subsidiaries. A discussion paper in February 2005 outlined similar plans. However, these proposals met with a lukewarm response from international bankers, many of whom expressed concerns over restrictions on equity participation and the lack of a level playing field with domestic banks in terms of branch locations.

As Shishir Mehta, a partner at Khaitan & Co in Mumbai, recalls, “no foreign bank approached the RBI to set up a subsidiary under the 2005 road map”. He points out that this was “primarily due to the lack of incentives”.

Shishir Mehta Partner Khaitan & Co

A sticking point was the fact that India was not offering to treat the wholly owned subsidiaries of foreign banks on par with the country’s domestic banks. Mehta believes that the RBI has subsequently “realized that near-national treatment and other benefits would be required to create an incentive for foreign banks to convert their branches into wholly owned subsidiaries”.

Advantages of the subsidiary model

The new discussion paper, which has been broadly approved by the Finance Ministry, largely reiterates the goals of the 2005 proposals. And while experience shows that its implementation is likely to be problematic, the RBI is confident that the subsidiary model will have a number of advantages over the current system. Principal among them are that:

  • A subsidiary, which would be a separate legal entity from its foreign parent, would have its own capital base and directors. This would discourage the bank from carrying on business in a risky manner.
  • There would be clear delineation between the assets and liabilities of the subsidiary and its foreign parent. The provisions of the Banking Regulation Act, 1994, and the Indian Companies Act, 1956, would ensure that certain assets are ring-fenced for domestic depositors and creditors.
  • Local incorporation would provide more regulatory control in the case of a banking crisis.
  • Insolvency procedures would be uniformly applied with greater certainty.

Ring-fencing capital

“The failure of big banks and financial institutions across the globe during the financial crisis prompted the RBI to come up with a ring-fenced structure for foreign banks in India,” says Cyril Shroff, the managing partner of Amarchand Mangaldas in Mumbai.

Such an approach is recognized by the Cross Border Bank Resolution Group of the Basel Committee on Banking Supervision, which was formed under the aegis of the Bank for International Settlement.

“It entails certain changes to national laws and resolution frameworks,” says Sajai Singh, a partner at J Sagar Associates in Bangalore. “Though some jurisdictions, including India, stipulate locally assigned capital for the branch mode of presence, which serves the purpose of ring-fencing, setting up subsidiaries clearly provides for ring-fenced capital in the country.”

Sajai Singh Partner J Sagar Associates

Another way of doing the same thing – the universal approach – puts all creditors on the same footing. But Mehta says the RBI realized that it was unworkable as an agreement on a mechanism to resolve cross-border disputes between internationally active banks was not likely to be achieved in the near future. “As such, allowing subsidiaries of foreign banks would make the resolution process easier and would help the host jurisdiction to achieve a higher degree of regulatory control,” he says.

“The RBI weighed the pros and cons of both options and has observed that the advantages in a subsidiary form outweigh the downside risks,” concurs Rajiv Luthra, the founding partner of Luthra & Luthra in New Delhi.

Testing the waters

The RBI invited comments on its new discussion paper, and of those that have been made public, some have been scathing. “There is no right business model for a bank, whether foreign-owned or domestic,” thundered the British Bankers’ Association. The association asked the RBI to maintain “an agnostic view on the best corporate structure for each foreign-owned bank operating in India”.

Other observers have even questioned the legality of the proposals. Nandan Nelivigi, a New York-based partner at White & Case, wrote in a recent note to clients: “Unless the elimination of the branch mode as an option for new entrants in India and other changes can be justified as necessary for prudential reasons, these proposals may be open to challenge as being inconsistent with India’s commitments to the World Trade Organization.”

The banks themselves are sending mixed signals. Standard Chartered’s Asia CEO, Jaspal Bindra, told the media at the World Economic Forum in Davos in January that “the subsidiary route for us is more or less certain, barring unforeseen circumstances.”

Others like Sipko Schat, a member of the executive board at Rabobank, are waiting for the proposals to be finalized before passing comment. “As the final contours of the policy are under discussion it is difficult to make definitive comments on the net impact of the final changes.”

But most would agree with Gunit Chadha, the CEO of Deutsche Bank India who says, “the option to stay wholly owned is critical from a foreign bank’s viewpoint”.

Gunit Chadha CEO Deutsche Bank India

India’s attraction for foreign banks

Rabobank became the 35th foreign bank allowed to operate in India after it was awarded a licence to open a branch in Mumbai at the end of March. “India is a key country for us,” says Schat, who is overseeing the establishment of the new branch from the bank’s headquarters in Utrecht in the Netherlands.

According to RBI data, the 34 foreign banks already licensed have 315 Indian branches. At the end of March 2010, their assets represented 10.52% of the country’s total banking assets. Citibank has the largest share, with 1.6%, followed by HSBC (1.52%) and Standard Chartered (1.50%).

Banking on good returnsWhile some international banks, like Bank Internasional Indonesia, have only one branch, others are clamouring to be let in despite the drawn-out application procedure. For example, the government is still considering whether to allow Beijing-based Industrial and Commercial Bank of China, which applied for a licence in 2006, to open a branch in Mumbai. And Istanbul-based Bank Asya, which launched its application in 2010, wants to become the first international Islamic financial institution to set up in India.

The lure, say analysts, is the consistently high return on equity in the Indian banking industry without the volatility of other high-growth markets (see Banking on good returns, page XX). “India has emerged as one of the hottest destinations for foreign banks,” says Monish Shah, a director with the management consultancy Deloitte Touche Tohmatsu India in Mumbai.

It isn’t yet clear how the RBI’s new proposals might affect international banks that have applied to operate in India, or those that have yet to apply. “New banks looking to enter into India … may have to follow these rules mandatorily,” says Hirani at Majmudar & Co.

Topics for discussion

Key points in the Reserve Bank of India’s discussion paper on the conversion of foreign bank branches into wholly owned subsidiaries

Obligation to establish a subsidiary

  • The following banks will be compelled to operate through wholly owned subsidiaries in India: (i) banks that are incorporated in a jurisdiction where, a) the law gives deposits in that jurisdiction a preferential claim in a winding up, b) where disclosure is inadequate, or c) where the RBI feels supervisory arrangements and market discipline are inadequate; and (ii) banks with complex structures, or those that are not widely held.
  • Other banks may convert on a voluntary basis, but conversion will become mandatory if their assets in India are equal to 0.25% or more of the total assets of all scheduled commercial banks in the country.

Capital requirements

  • Minimum capital requirements for subsidiaries may be in line with those prescribed for new private-sector banks (10% of the risk-weighted assets).

Corporate governance

  • Not less than 50% of directors of subsidiaries should be Indian nationals who are resident in India.
  • Not less than 50% of directors should be non-executive directors.
  • At least one-third of the directors should be totally independent of the management of the subsidiary in India and its parent or associates.
  • Directors must conform to the RBI’s “fit and proper” criteria.

Prudential norms and governing laws

  • Subsidiaries will be subject to licensing requirements and conditions broadly consistent with those for new private sector banks.
  • They will be governed by the Companies Act, 1956, the Banking Regulation Act, 1949, the Reserve Bank of India Act, 1934, and other relevant statutes and directives.

Raising of non-equity capital in India

  • Subsidiaries may be granted access to rupee-denominated resources through the issue of non-equity capital instruments in the form of innovative perpetual debt instruments (IPDI), tier-one and tier-two preference shares and subordinate debt, as allowed to domestic private sector banks.

Branch expansion

  • Subsidiaries may enjoy a less restrictive branch expansion policy as compared to that for branches of foreign banks. However, they will not be on par with domestic banks.
  • Expansion of branch network of banks that are in branch mode will be according to WTO commitments, i.e. 12 branches per year.

Priority-sector lending rules

  • Subsidiaries can expect more onerous priority-sector obligations than at present for branches of foreign banks. But their obligations would be less than that of domestic banks.
  • Subsidiaries may be allowed to classify export finance as a part of their priority-sector lending.

Containing the dominance of foreign banks

  • When capital and reserves of both branches and subsidiaries of foreign banks in India exceed 25% of the capital of the banking system, restrictions would be placed on: (i) the entry of new foreign banks, (ii) branch expansion in tier-one and tier-two cities, and (iii) capital infusion into subsidiaries.

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Priority-sector lending obligations

Stephanie Woo, an analyst in Hong Kong with the hedge fund Marshall Wace, points out that banks might also have to take on so-called priority-sector loan obligations. This would mean reserving part of their loan portfolio for borrowers in agriculture, small and medium-sized enterprises, exports and home loans. “They would be subject – just like Indian banks – to giving 40% of their loans to priority sectors,” she says.

While the government might be hoping to lessen the burden on local banks by forcing foreign banks to take on such obligations, some international bankers have already balked at such a role. Piyush Gupta, the CEO of DBS Bank India, told the Indian media that he could not see his bank – a business-oriented lender based in Singapore – being able to “reach out to farmers”.

Experts say that definite plans for priority-sector lending have yet to be set, although from what is known so far, it appears that the obligations would be phased in gradually. “Wholly owned subsidiaries set up by the conversion of existing branches would be given a transition period of five years to meet priority-sector lending norms,” says Mehta at Khaitan & Co.

Quid pro quo

One thing is for sure: if bankers are forced to follow new guidelines relating to their corporate structures and priority-sector lending, they will expect something in return.

“There are increased requirements on priority-sector lending, which are expected to be compensated by a more liberalized branching regime,” says Schat at Rabobank.

One possibility is that the RBI will use a fast-track approvals process as a carrot to dangle in front of banks using the subsidiary model. “There appears to be a better possibility of receiving an approval if a foreign bank opts to enter India through the subsidiary route,” says Shroff at Amarchand Mangaldas. “Additionally, foreign banks present as a subsidiary in India will have potential capital raising benefits and access to local funds.” For example, they may be permitted to raise rupee-denominated resources by issuing non-equity capital resources in the form of innovative perpetual debt instruments, tier-one or tier-two preference shares or subordinate debt.

Cyril Shroff Managing Partner Amarchand Mangaldas

Domestic private sector banks are already permitted to do this.

The promise of faster growth

One more benefit that could be offered to foreign banks is the opportunity to roll out new branches faster. “Foreign banks will need a level playing field when it comes to branch licensing,” says Chadha at Deutsche Bank India.

India’s current branch expansion policy for foreign banks permits them to open only 12 branches each year. However, the RBI proposes allow the wholly owned subsidiaries of foreign banks to exceed this limit. “This means that they will be able to open branches in tier-three to tier-six centres, except at a few locations considered sensitive due to security considerations,” says Hirani at Majmudar & Co.

Applications for setting up branches in tier-one cities – Delhi, Mumbai, Kolkata, Chennai, Bangalore, Hyderabad, Ahmedabad and Pune – and tier-two cities will also be dealt with in a less restrictive way. “This, in turn, will enable foreign banks to run their Indian operations under a single mode of presence, as opposed to acquiring non-banking financial company licences or seeking differential licenses for carrying out activities that cannot be conducted through a branch presence,” says Hirani.

The RBI’s proposals provide for restrictions that will come into force if the capital and reserves of foreign banks reach more than 25% of the total value of the country’s banking system. The restrictions are likely to include pauses on new foreign bank admissions, temporary prohibitions on new branch openings and freezes on capital infusions.

Tax uncertainties

Observers are divided as to how converting to the subsidiary model will affect a bank’s tax obligations. Woo at Marshall Wace says, “foreign banks would enjoy a lower tax liability”.

However, H Jayesh, the founder partner of Juris Corp in Mumbai, believes that “tax will be a major concern”. He warns that moving to a wholly owned subsidiary could trigger other taxes under certain conditions.

“One concern is whether the transfer of assets from the branch into the wholly owned subsidiary will be treated as a capital gain and therefore subject to a high incidence of tax,” says Jayesh, who recommends that the RBI should allow a tax exemption for such conversions.

H Jayesh Founder Partner Juris Corp

Moreover, foreign lenders aiming to transform themselves into wholly owned subsidiaries might not be able to dilute their equity – as they do when they issue Indian depositary receipts – as this may trigger capital gains tax.

“Full clarity on the tax angle is imperative for foreign banks before they decide to take the plunge,” warns Jay Parikh, a partner with Bharucha & Partners in Mumbai.

Jay Parikh Partner Bharucha & Partners

Ambiguities loom large

Lawyers are also concerned about ambiguities in other parts of the proposals. Singh at J Sagar Associates warns of possible difficulties covering foreign exchange. “The Foreign Exchange Management Act, 1999, and rules and regulations passed thereunder are sometimes vague and badly drafted, leaving room for confusion, interpretation and contradiction with other legislations in India,” he says. “Therefore, if the foreign exchange laws are not clear, it would be prudent to have a conservative approach.”

Meanwhile, Jayesh at Juris Corp is concerned that the RBI may not take a favourable view on “the setting up of subsidiaries or significant investment in associates for activities that can be undertaken within the bank”. He believes this could pose serious operational and compliance problems for foreign banks that also have affiliates that are non-banking entities.

Busy days ahead

Lawyers expect to have their hands full as soon as the RBI guidelines become clear. “Once the RBI notifies the exact procedure for shifting to the subsidiary model, lawyers will need to advise on the process that will need to be rolled out to effect this transfer,” says Shroff at Amarchand Mangaldas, citing taxation and stamp duty-related implications as well as advising on the impact on the business activities of the bank.

Setting up a wholly owned subsidiary would mean meeting the requirements of the Indian Companies Act, 1956, which is not the most user-friendly piece of legislation. But some lawyers point to shortcuts that might simplify the process. “The time taken setting up a company in India may be reduced if the process of incorporation is structured in such a manner that the requirements for notarization and apostil outside India are reduced,” says Singh.

Most bankers, however, are sanguine about the proposals. “I think we are moving in the right direction, with the RBI having put out a paper and the banks responding to it,” says Chadha at Deutsche Bank. “It is still a work in progress.”