The Risky Truth about Investments by Banks: The RBI’s Amendment To Financial Services Directions

[Utsav Gandhi is a corporate lawyer based in Bangalore]

Introduction

The Reserve Bank of India (“RBI”) last month amended the Master Direction – Reserve Bank of India (Financial Services provided by Banks) Directions, 2016 (“Directions”). This allows banks to invest in a multitude of entities such as Real Estate Investment Trusts (“REITs”), Infrastructure Investment Trusts (“InvITs”), Category II Alternative Investment Funds (“AIFs”) and Companies engaged in Non-Financial Services (“NFS Company”). The amendment also strengthens certain risk-management tools with respect to banks. The RBI has now allowed banks to become a Professional Clearing Member (“PCM”) of and offer broking services for the Commodity Derivatives Segment (“CDS”).

Consequently, this post seeks to analyse the rationale behind introduction of these amendments.

Investment in REITs and InvITs

Pursuant to the amendment, even though banks can now invest in REITs and InvITs, such an investment has been capped at 10% of the unit capital of a REIT/InvIT and is subject to an overall ceiling of 20% of its net worth. This is yet another step to liberalise the norms relating to investment in REITs and InvIT. Last year, the RBI allowed foreign investors to participate in REITs and InvITs, and the Government also introduced a slew of tax exemptions for these entities. Thus, this amendment has been made with a view to provide another funding boost to these fledgling entities in a cash-strapped real estate sector.

Investment in AIFs

As aforementioned, the RBI has now allowed banks to invest in Category II AIFs, which include real estate funds, private equity funds, etc. However, investment in a Category III AIF (funds which employ varied complex trading strategies and includes hedge funds, etc) is prohibited unless it is by a bank’s subsidiary and such investment is subject to the minimum criteria prescribed by SEBI.

Although, investment in venture capital funds and Category I AIFs by banks was previously allowed, a comparison of the recent trends in investment amongst all three categories of AIFs shows that, by the end of June 2017, the investments made by Category II AIFs were more than double of those made by Category I and Category III AIFs, respectively. Thus, providing an additional source of funding to Category II AIFs is a logical step since the rapid growth of these funds may provide investing banks with greater returns by participating in such funds.

However, investments made in these funds are subject to certain embargoes. The RBI has capped the investments in Category I and II AIFs at 10% of the paid-up capital / unit capital of the respective AIF. Further, prior approval of the RBI shall be required in the event a bank’s subsidiary is making a portfolio investment in another company and acquiring a controlling interest therein. However, this will not be applicable to investments made by Category I and II AIFs set up by a subsidiary.

Investment in a NFS Company

Non-financial services are defined under the Directions that include carrying on the business of borrowing, lending, issuing loans, participating/carrying out of issues, credit information or as an intermediary, etc.

A bank, along with (a) its subsidiaries/associates/joint ventures; (b) entities controlled by the bank, directly or indirectly; or (c) bank-controlled asset management companies managing mutual funds, are not allowed to hold more than 20% of paid up capital of an NFS Company. However, banks can invest in companies which are engaged in non-financial activities, statutorily permitted for banks in terms of Section 6(1) of the Banking Regulation Act, 1949 and if such additional acquisition is through restructuring of a debt or to protect bank’s interests on loans/investments made to a company.

Focus on Risk Management

The amendment imposes certain checks on banks to ensure that proper risk control measures are in place. The bank needs to have a minimum prescribed capital which includes Capital Conservation Buffer (“CCB”) if the bank seeks to:

– Invest in a subsidiary and a financial services company, which is not a subsidiary, without taking prior approval from the RBI;

– Undertake the business of insurance and pension fund management; or

– Become a trading or clearing member of the currency derivatives segment of stock exchanges.

It is crucial to note that earlier the Directions only provided that the capital adequacy ratio shall not be less than 10%. By way of this amendment requiring banks to maintain a CCB whereby the capital will not be allowed to fall below the buffer level, the regulatory authority intends to ensure that the minimum capital requirement is not breached.

The RBI has also mandated that in the event of any equity investments in AIFs, ascertainment of risks by banks shall be within the Internal Capital Adequacy Assessment Process (“ICAAP”) framework and that the determination of the additional capital required will be subject to supervisory examination as part of Supervisory Review and Evaluation Process.

Thus, the amendment also makes provisions for the banks to make their own risk assessments, through a well-defined internal process, including maintaining an adequate capital cushion for such risks.

CDS market gets a boost!

  1. Professional Clearing Member

A bank shall be allowed to become a PCM subject to fulfilment of the prudential criteria prescribed under the Directions. Apart from satisfying the statutory norms, the bank’s board has the responsibility to prepare risk control measures and prudential norms on risk exposure with respect to each of its trading members. The banks are prohibited from undertaking trading in the derivative segment and are restricted only to clear and settle transactions undertaken by their clients.

  1. Broking Services

Banks have also been allowed to offer broking services for CDS, albeit through a separate subsidiary set up for this purpose. Here too, the subsidiaries and their boards have to put in place effective risk control measures and comply with the statutory norms governing margin requirements. The subsidiaries are also forbidden from undertaking proprietary positions in the CDS.

By allowing banks to act as brokers, a highly volatile commodities derivatives market shall get a shot in the arm, as banks acting as intermediaries may help farmers and small traders to better understand and manage their risk exposure since the banks will have the technical expertise to understand and tackle the risks pervading the CDS. Further, a bank’s net worth and credibility will also go a long way in assuaging the market participants regarding hedging of their risks.

Conclusion

In all, the amendments to the Directions provide a huge boost to the nascent entities in the real estate sectors as well as certain investment funds. However, a deeper study of the rationale underlying the need for certain compliances by the banks strongly suggests that the inherent idiosyncrasies in such sectors have prompted the regulator to counterbalance this activism by mandating a risk-control environment for the banks. Further, allowing banks to participate in the commodities derivatives market will ensure that the risk management tools with banks will counteract against the volatility of this market. At this stage, one can only speculate the speed at which the entities would stand to gain from the changes introduced by the amendment, since it would primarily depend on, among other variables, strong abidance and focused execution of policy reforms.

– Utsav Gandhi

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