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December 24, 2009

FDI in banking


The UPA Government had chosen to carry forward the policy of banking deregulation, following the footsteps of the NDA Government. On 28th February, 2005, the same day that the Union Budget 2005-6 was presented before the Parliament, the Reserve Bank at the instance of the Finance Minister, released a roadmap for the presence of foreign banks in India. The RBI notification formally adopted the guidelines issued by the Ministry of Commerce and Industry under the previous government on March 5, 2004 which had raised the FDI limit in Private Sector Banks to 74 per cent under the automatic route, and went on to spell out the steps that would operationalise these guidelines.


The RBI roadmap demarcates two phases for foreign bank presence. During the first phase, between March 2005 and March 2009, permission for acquisition of share holding in Indian private sector banks by eligible foreign banks will be limited to banks identified by RBI for restructuring. RBI may, if it is satisfied that such investment by the foreign bank concerned will be in the long term interest of all the stakeholders in the investee bank, permit such acquisition subject to the overall investment limit of 74 percent of the paid up capital of the private bank. Appropriate amending legislation will also be proposed to the Banking Regulation Act, 1949, in order to provide that the economic ownership of investors is reflected in the voting rights. Further, the notification announces that foreign banks will be permitted to establish presence by way of setting up a wholly owned banking subsidiary (WOS) or conversion of the existing branches into WOS. A clause on one-mode-presence, i.e. one form of banking presence, as branches or as WOS or as a subsidiary with a foreign investment in a private bank, has been added as the only safeguard against concentration. There are no caps specified for individual ownership (except the 74 per cent overall limit), which in the first phase would be left to RBI’s discretion.6

The second phase will commence on April 2009 after a review of the experience of the first phase. This phase would allow much greater freedom to foreign banks. It would extend national treatment to WOS, permit dilution of stake of WOS and allow mergers/acquisitions of any private sector banks in India by a foreign bank subject to the overall investment limit of 74 percent.

Regulation of Foreign Investment in India

General Rules Limiting Foreign Investment in Indian Companies

A traditional argument against foreign equity participation in domestic companies is that these

businesses involve strategic national interests and therefore, operational and strategic control must be

retained domestically (Lam, 1997). This view held sway in India until the early 1990’s and foreign

3 investment in all domestic companies was restricted and could be undertaken only with the prior approval of the Government of India.The New Industrial Policy of 1991 was the first step toward liberalization. It introduced foreign direct investment (FDI) via the “automatic route”, allowing companies in selected industries to raise new equity capital (in some industries, up to fifty-one per cent ownership) by issuing new shares in foreign markets without prior approval from the Ministry of Commerce and Industry (MCI). Banking was not one of the thirty-five industries where foreign direct investment via the automatic route was allowed.The next significant step occurred in late 1992 when foreign institutional investors were first allowed to invest in outstanding domestic securities. Such investments are referred to as foreign institutional investment (FII). Initially, the holding of any single foreign institutional investor was limited to five percent of the company’s total shares with an aggregate cap of twenty-four percent of the issued and paid-up capital for all foreign institutional ownership. These FII limits were intentionally designed to prevent a controlling interest by any foreign investor or group of investors. On April 4, 1997, the upper limit for FII was allowed to be increased up to thirty percent by the company concerned if its Board of Directors passed a resolution to that effect that was also ratified by its shareholders. Over time, the upper limit on FII was gradually increased – first to forty percent (March 1, 2000) and ultimately to the industry’s sectoral cap. In every instance, the new upper limit was subject to the same conditions (called the “special procedure”) as the thirty percent limit. Table 1 provides additional detail on the sequence of

changes in FII limits. While FDI and FII both enable foreign institutions to invest in Indian firms, FDI and FII are quite different and are subject to very different regulatory treatment. FDI via the automatic route was viewed by the government as a source of new capital and was expected to create large block investors who would have a long term relationship with the firm and its management. On the other hand, FII did not directly generate new capital for the firm since investment was via secondary trading in existing securities and investment by any single institution was limited with the explicit objective of preventing significant influence by any foreign investor or group of investors. As a result of these different purposes and views 4 by the government, FDI and FII were regulated by different governmental bodies and were subject to separate legal limitations and regulatory procedures. The regulations were complex and allowed for different combinations of caps on FII and FDI. Depending on the industry, the caps could be independent or cumulative. Cumulative caps limited the sum of FII and FDI and the cumulative cap could be less than the sum of the two individual caps. For example, FII and FDI could each be allowed up to forty percent individually, but the sum could also be limited to a maximum of forty percent.2 A further complication is that the FDI regulation could include sub-limits based on the purchaser of the newly issued shares. For example, regulation that specified a forty percent limit on FDI could have a sub-limit of twenty percent on capital raised from foreign institutions but allow non-resident Indians (NRIs, or entities they controlled) to invest up to the full forty percent limit.

Impact of FDI on banking

India’s financial system has very little exposure to foreign assets and their derivative products and it is this feature that is likely to prove an antidote to the financial sector ills that have plagued many other emerging economies.

The global banking industry weathered turbulent times in 2007 and 2008. The impact of the economic slowdown on the banking sector in India has so far been moderate. Owing to at least a decade of reforms, the banking sector in India has seen remarkable improvement in financial health and in providing jobs. Even in the wake of a severe economic downturn, the banking sector continues to be a very dominant sector of the financial system. The aggregate foreign investment in a private bank from all sources is allowed to reach as much as 74% under Indian regulations.

The third quarter of 2008 saw the beginning of negative net capital inflows into the country. Notwithstanding this bleak scenario, the investment pattern with regard to foreign direct investment (FDI) and inflows from non-resident Indians remains resilient and FDI inflows into the country grew by an impressive 145% between fiscal 2006 and 2007 and by a respectable 46.6% between fiscal 2007 and 2008. However, owing to the economic downturn, the growth in FDI inflows in fiscal 2009 slowed to 18.6% from the previous fiscal.

Despite the surge in investments, the stringent regulatory framework governing FDI has proved to be a significant hindrance. However, FDI norms have been relaxed to a considerable extent with respect to certain sectors. Private banks, for instance.

Foreign investment, in addition to technological innovation and expertise, brings with it a plethora of risks. An unwarranted increase in the size of foreign holding in the banking sector will inevitably expose the country to risks not commensurate with those that an emerging market economy such as ours is equipped to grapple with.

At the same time, it is important to recognize that FDI in banking can address several issues pertaining to the sector such as encouraging development of innovative financial products, improving the efficiency of the banking sector, better capitalization of banks and better ability to adapt to changing financial market conditions.

Limits for FDI

FDI in the banking sector has been liberalized by raising FDI limit in private sector banks to 74 per cent under automatic root including investment by foreign investment in India. The aggregate foreign investment in a private bank from all sources will be 74 per cent of paid-up capital of the bank.

FDI and Portfolio investment in nationalized banks are subject to overall statutory limit of 20 per cent. The same ceiling also applies in respect of such investment in State Bank of India and its associate banks.

The Present Banking Scenario

In recent times economy is been pushing to increase the role of multi-national banks in the banking sector.

But it is opposed on the front that it will lead to state run insurers loosing business and workers their job. There are several reasons why giving foreign investors greater voting rights is fraught with dangers. When domestic or foreign investors acquire a large share holding in any bank and exercise proportionate voting rights, it creates potential problems not only of excursive concentration in the banking sector but also can expose the economy to more intensive financial crises at the slightest hint of panic.

Opposition is not considering the need of present situation. FDI in banking sector can solve various problems of the overall banking sector. Such as –

i) Innovative Financial Products
ii) Technical Developments in the Foreign Markets
iii) Problem of Inefficient Management

iv) Non-performing Assets
v) Financial Instability
vi) Poor Capitalization
vii) Changing Financial Market Conditions

If we consider the root cause of these problems, the reason is low-capital base and all the problems is the outcome of the transactions carried over in a bank without a substantial capital base. In a nutshell, we can say that, as the FDI is a non-debt inflow, which will directly solve the problem of capital base. Along with that it entails the following benefits such as –

Technology Transfer
As due to the globalization local banks are competing in the global market, where innovative financial products of multinational banks is the key limiting factor in the development of local bank. They are trying to keep pace with the technological development in the banks. Now a days banks have been prominent and prudent in the rapid expansion of consumer lending in domestic as well as in foreign markets. It needs appropriate tools to assess (how such credit is managed) credit management of the banks and authorities in charge of financial stability. It may need additional information and techniques to monitor for financial vulnerabilities. FDI's tech transfers, information sharing, training programs and other forms of technical assistance may help meet this need.

Better Risk Management

As the banks are expanding their area of operation, there is a need to change their strategies exert competitive pressures and demonstration effect on local institutions, often including them to reassess business practices, including local lending practices as the whole banking sector is crying for a strategic policy for risk management.

Through FDI, the host countries will know efficient management technique. The best example is Basel II. Most of the banks are opting Basel II for making their financial system more safer.

Financial Stability and Better Capitalization

Host countries may benefit immediately. From foreign entry, if the foreign bank re-capitalize a struggling local institution. In the process also provides needed balance of payment finance. In general; more efficient allocation of credit in the financial sector, better capitalization and wider diversification of foreign banks along with the access of local operations to parent funding, may reduce the sensitivity of the host country banking system and lead towards financial stability.


So due to the aforesaid benefits economy has consistent flow of FDI over the past few years. In addition to that, the govt. has also taken step to enhance the FDI (eg. Telecom, civil aviation) FDI up to 100% through the Reserve Bank's automatic route was permitted for a no. of new sectors in 2005-06 such as Greenfield airport projects, export trading. All these measures have been contributing towards increasing direct investment.

This overall FDI is evident from the above graph.

'FDI & FII have risen sharply during the 1990s reflecting the policies to attract non-debt creating flows.

Cumulative foreign investment flows have amounted to US & 106 billion since 1990-91 and almost evenly balanced between direct invest flows (US & 49 bn) and portfolio flows (US & 57 bn). Since 1993-94, FDI flows have exceeded portfolio flows in the 5 years while portfolio flows have exceeded FDI in the remaining 8 years. As a proportion to FDI flows to emerging market and developing countries, FDI flows to India have shown a consistent rise from 1.6% in 1998 to 3.7% in 2005'1.

India's FDI growth of above 30% during past 2 years is encouraging. Although the FDI inflows into India are small as compared to other emerging markets, their size is growing on the back of growing interest by many of the world's leading multinationals. India has improved its rank from fifteenth (in 2002) to become the second most likely FDI destination after China in 2005'1.


The IMF's study is in supportive to the above-discussed features of FDI. This study talks about the optimism over India emanates from a contribution of following factors.

* India contributed nearly one fifth of Asian domestic demand growth over 2000-05. Looking forward, India slated to be the second largest demand driver in the region, after China.

* India accounts for almost one quarter of the global portfolio flows to emerging market economies, nearly $ 12 bn in 2005.

* India is the world's leading recipient of remittances, accounting for about 20% of the global flows.

Even though above discussed factors are fair enough for the development of economy. But it is a noted fact that, economy drivers are reluctant towards more liberalization for FDI in the banking sector. As the ceiling rates are not increased, FDI in Financial Sector is not getting a wholesome environment. But the foreign investment is finding its own way to come in the economy. May be the way of FII. It is evident from the diagram.

Now a days, foreign commercial and investment banks have quietly begun picking up public sector bank's bond issues. Bankers said that the funds were coming into these bonds; some of the foreign banks were also using the banks' bonds as an arbitrage opportunity in view of the increasing liquidity.

So, therefore from last 2 years FIIs have exceeded the FDI and in portfolio investment into India since 2003-04 reflects both domestic and global factors. Compared with FII always FDI has a greater and long-term effect on the Indian market due to the whimsical nature of FII. (As it is considered as hot money)

The present scenario looks more closely at the paradigm of exponential growth and laments that India's role as an engine for global growth has been limited by the still relatively closed nature of its economy.

Growth Prospect


Advantage India – FDI


The Reserve Bank of India (RBI), has allowed foreign players to set up branches in rural India and take over weak banks with an investment of up to 74 per cent, and further relaxations are on the anvil by 2010, with the second phase of opening expected to com-mence in April 2009.

Some of the biggest names in global financial services and banks like Credit Suisse, Rabo Group and ANZ are seeking a banking license in India. The RBI has, in recent months, given fresh banking licenses to UBS - Switzerland's largest bank, Dresdner Bank and United Overseas Bank.

ANZ and Rabobank Group, the Dutch Group, is now in the process acquiring a banking license. The Rabobank Group already holds 18.2 per cent stake in another local private bank YES Bank. Some of the existing players such as StanChart, Citi and HSBC, hold India as one of their top markets.

Due to current Global crisis, we expect the deadline for second phase i.e. April 2009 to be extended further. However, banking authorities has not announced about the extension of the phase.

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