Reserve Bank of India ordered Banks to set aside more Capital for Investments in Financial Entities

The Reserve Bank of India (RBI) ordered banks to set aside more capital for their investments in financial entities such as insurance with an objective to strengthens the ring fence around banks. However the move can strain capital resources which are increasingly getting scarce. The RBI proposed the raise in risk weight to prevent banks from getting affected because of their holdings in other finance entities.

The banks are to set aside 25% more capital following  the central bank raise of the risk weight for buying or holding of equity in financial entities. Banks’ investments in paid-up equity of financial entities, even if they are exempted from the capital market exposure norms, will thus be assigned a 125 percent risk weight. The proposal is expected to  lead banks, which at present set aside Rs  9 for every Rs 100 of investment in financial entities, to keep aside about Rs 11.

As per the apex bank, inter-linkages between insurance and banking sector are a matter of concern, as many insurance companies being part of financial conglomerates. Any financial stability issue regarding the bank in the conglomerate therefore may have an amplifying effect on the insurer. The contagion between the banking and insurance sector will also depend on the insurance companies’ overall exposure to banks.

RBI opined that consolidation in the banking sector would pave the way for stronger financial institutions with the capacity to meet corporate and infrastructure funding needs, and to rescue distressed lenders. However, it prescribed a non-operative bank holding company structure to avoid creation of complex institutions.

Voluntary mergers and transfers help consolidation in the financial sector and pave the way for stronger financial institutions to rescue the weaker ones. These voluntary measures provide business opportunity to the stronger ones to spread their presence in different geographies. The Competition Act, 2002 (as amended by the Competition (Amendment) Act, 2007) could however come in the way of consolidation. One of the provisions of the Act requirean enterprise proposing to enter into a combination via a merger or an amalgamation to notify the Competition Commission.