Mumbai, Dec 15 (PTI) Evident risks like a conflict of interest and possible systemic issues led the RBI to not accept an internal panel's recommendation to allow large corporate houses to set up banks, but there are virtues in doing so as well, Deputy Governor Rajeshwar Rao said on Wednesday.

In what can be dubbed as the first comments from RBI brass since the new guidelines on ownership of private sector banks were made public late last month, Rao said a closer examination of all the issues is needed and "the jury is still out" on whether to allow large industrial houses or non-banking financial companies (NBFCs) floated by them to set up banks.

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Speaking at the Mint Annual Conclave in the financial capital, Rao said banking is a highly leveraged business, dealing with public money and hence, "it makes sense" to keep industry/business and banking separate.

"This separation is expected to avoid spillover risks - where trouble anywhere in the group entity may result in transferring risks on to the depositors, leading in turn to claims on deposit insurance with subsequent ripple effects, cascading across the largely interconnected financial systems, creating concerns around financial stability," he explained.

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Rao said, so far, there have been eight sets of guidelines on bank ownership, and listed out how they dealt with allowing corporates in different ways and listed out that such entities can be an important source of capital, and provide management expertise and strategic direction to the bank.

It can be noted that an internal working group of the RBI had caused a flutter by recommending that industrial houses be allowed into the banking fold, leading to many like former RBI Governor Raghuram Rajan to call it a "bombshell", which will intensify the concentration of political and economic power in a few business houses. The final guidelines, which came out on November 26, however, did not accept this suggestion of the IWG.

In the past, various industrial houses have either applied for bank licenses or have been widely speculated to be interested in doing so.

Delivering the speech on Wednesday, Rao said conflicts of interest, wherein self-dealing, favouring associates, constricting credit to competitors and connected lending within the group, given the complex structures of companies within the group, are the biggest concerns.

"Another oft-quoted argument also points to the principles of separation of banking and industry/business. While it is an accepted fact that the relationship between the financial economy and real economy is symbiotic, de facto merger of the segments may actually aggravate the systemic risks," he pointed out.

He said the IWG has also flagged many of the issues, and hence, it is necessary to closely examine the related matters before thinking of permitting large industrial houses or NBFCs owned by such houses to set up any new bank.

"To conclude, let me just say that the jury is still out on the issue," he said.

The RBI accepted the IWG's suggestion in raising the promoter holding cap to 26 per cent from the present 15 per cent over a period of time because, in a scenario where diversified ownership leads to the management being concerned with their own interests rather than keeping the wishes of shareholders in mind, the risks would be very high.

Diversified ownership of banks alone is not a "panacea", and the RBI can anyways exercise its judgement on matters using the broader "fit and proper" requirements, he underlined.

Rao also said that the "last thing" the central bank wants to be doing is to decide the remuneration of bank executives, which is to be decided by the board.

"But, there are at times situations where the internal and external equity of such compensation is not adequately justified in the proposal.

“We need to remember that perverse incentives may lead to reckless behaviour or higher risk-taking, which may manifest itself over a period," Rao said, reminding everybody of the 2008 global financial crisis where faulty compensation practices played a part.

He said there is also a need for the independent directors to be "truly independent in form and substance" for better governance at lenders.

(The above story is verified and authored by Press Trust of India (PTI) staff. PTI, India’s premier news agency, employs more than 400 journalists and 500 stringers to cover almost every district and small town in India.. The views appearing in the above post do not reflect the opinions of LatestLY)