"A broker is a broker is a broker," warned a friend when I had put in my papers at Hindustan Unilever some 17 years ago. "A stint with a broker will be an indelible blot on your CV, rather, end of the road for your professional career," he concluded.
I still went ahead as I was convinced of a bright future for capital markets and equities, post-reforms. Over the last two decades, broking industry has metamorphosed into an industry that attracts the best talent, uses cutting-edge technology and is customer-centric. So, it will be a pity if our policymaking were still to be guided - rather misguided - by misconceived perceptions about brokers.
RBI's recently-announced draft banking guidelines suggest that entities with exposure to broking assets or income of more than 10% will not be eligible to apply for a banking licence because capital market activities, in particular broking activities which, apart from being inherently riskier, represent a business model and business culture which are quite misaligned with a banking model.
Post-crisis, there are concerted moves even internationally to separate banking from proprietary trading. More importantly, in India, past experience with brokers on the boards of banks has not been satisfactory. Let us examine RBI's argument more closely.
Capital market participants understand risk: Capital market is the fulcrum of any monetary system (see Circular Flow of Money). It provides lifeblood to budding and growing enterprises. Capital formation is the key to sustain growth and generate employment in India. Banks also provide debt capital, but only when the enterprise has adequate equity or owners' capital.
Typically, equity investors own but do not manage. Therefore, easy liquidity and exit is pre-requisite for their money. It is provided by stock exchanges where brokers get buyer and sellers together, help price discovery, execute and settle trades. Capital market participants understand risk better, which is so essential to run the banking business. India's success in producing a vibrant IT industry and successful global corporates such as Bharti and Tata Motors is due to its efficient capital markets.
The broking business risk stands mitigated: Paradoxically, today, there are very few businesses as transparent and risk-free as broking, thanks to screen-based trading, removal of counterparty risk, dematerialised securities and Sebi's robust regulatory framework. Over the last two decades, there have been almost no significant failures in the stock exchanges or broking industry, despite most tumultuous upheavals in financial markets.
Is RBI concerned about risk in future that may not have happened in the past? Then why should it allow existing banks to engage in broking through subsidiaries? Limits on such investments by Section 19(2) of the Banking Regulation Act cannot protect against the reputation risk. If any bank's one arm were to go bust, there would invariably be a run on it. Except with the central bank's support, no bank in the world can survive a run on it.
Banking and broking cultures already aligned: RBI draft guidelines point out that broking business model/culture is not aligned to that of a bank. At present, several banks' broking subsidiaries act like SBUs with completely-aligned cultures and complementary business models. Most banks have an active investment banking division too.
It is anachronistic to say banking and broking cultures cannot align to each other, as they are already working in alignment at so many banks. Also, the guidelines' reference to 'not satisfactory' experience with a broker being bank director appears to be with respect to 1990s, around the Harshad Mehta scam time. After that era, an entity with more exposure to broking than the current norm was given banking licence. It has built a healthy bank.
There can be black sheep in all fraternities. In banking business as well, RBI has had bad experience with corporate-controlled banks, prior to nationalisation or deposit-taking NBFCs in 1990s.
International regulations on proprietary trading: The draft guidelines allude as if proprietary trading is synonymous with broking. International regulation, notably the Dodd Frank Act, which incorporates the Volcker Rule, proposes prohibition and restriction on proprietary trading, investment or sponsorship in hedge funds and private equity groups by banks.
This came after banks indulged in reckless proprietary trading, risking deposit-holders' money. Its application to restriction on broking entities for new banking licences is a case of prescribing the right remedy for a wrong malady. In India, while banks have active proprietary trading desk in g-secs, etc, only a few brokers, corporates and NBFCs have proprietary trading desks.
Financial inclusion and efficiency: Today, most large brokers have a good understanding of financial services industry, a wide distribution network, cost-efficient operations and a well-capitalised balance sheet. Technology for securities transactions has reached masses much better than technology for funds transactions. In a country where equal opportunities are guaranteed by the Constitution, there is no justification to block the road to banking for brokers. RBI has the right to evaluate each individual case on merit and allow all those that are 'fit and proper' and willing to abide by all the regulations to run a bank.
To drive the agenda of financial inclusion and higher efficiency where deposit-holders get higher rates, borrowers pay less, yet banks make healthy profits; our policymakers will have to remove protection and foster competition from new, dynamic and innovative players. This is what the finance minister may have had in mind when he ushered the country towards a new orbit of inclusive growth by announcing new banking licences. It would be a huge opportunity lost if perception and not reality were to govern direction of the policy.
(The author is chairman of the IIFL Group) The above article appeared in The Economic Times on Nov 5, 2011