Realigning Banking Business

The Reserve Bank of India’s (RBI) recent proposal to revamp banking regulations is poised to have far-reaching implications for Indian banks, particularly their subsidiaries and financial services arms. This strategic shift, announced through a draft circular titled ‘Forms of Business and Prudential Regulations for Investments’, calls for a realignment of the core activities of banks, aiming to strengthen governance, reduce overlap, and ensure regulatory compliance across all bank-linked entities. While the central bank has always emphasized transparency and ethical banking practices, these new guidelines have taken a direct aim at the practices of several large financial institutions.

The proposal places considerable emphasis on ensuring that traditional banking activities such as deposit mobilization and lending remain firmly within the banks themselves, while subsidiaries, especially Non-Banking Financial Companies (NBFCs) and financial arms, are directed to avoid duplicating these functions. As these new rules unfold, the strategic and financial impact on banks, their subsidiaries, and overall market dynamics warrants a closer look.

Impact on Valuations and Subsidiary Business Models

At the core of RBI’s guidelines is the call for banks to eliminate the overlap between their own operations and those of their subsidiaries. Overlapping business functions, such as lending or offering similar financial products through both the bank and its NBFC subsidiaries, are of particular concern. According to the RBI, this overlap creates regulatory loopholes that allow banks to bypass certain norms.

Take, for example, HDB Finance, the financial services arm of HDFC Bank, which is planning an IPO. Much of its lending operations—offering products like gold loans and two-wheeler loans—overlap directly with those offered by the parent bank. Kotak Mahindra Bank faces a similar dilemma, with a number of its subsidiaries, such as BSS Microfinance and Sonata Finance, operating in the same lending space as their parent bank. This overlap raises concerns about market cannibalization, as the same services are provided by both entities under different regulatory umbrellas.

The valuation of these subsidiaries, many of which are profitable and crucial components of their parent banks, will likely face significant reassessment once the new guidelines are enforced. For instance, auditors have warned that the valuation of HDB Finance, which is positioned to go public, may be impacted due to its overlap with HDFC Bank's core lending operations. This situation could trigger a realignment of business models, where subsidiaries might remodel themselves as direct selling agents (DSAs) rather than functioning as full-fledged financial service providers.

Home Loan Business

One of the most prominent areas of overlap identified by the RBI is home loans. Major banks like ICICI Bank, Punjab National Bank (PNB), Canara Bank, and Central Bank of India offer home loans directly to consumers. Simultaneously, their subsidiaries—PNB Housing Finance and Can Fin Homes, among others—also offer similar products. While some of these subsidiaries, such as PNB Housing Finance, are publicly listed entities, others, like ICICI Home Finance and Cent Bank Home Finance, operate as private subsidiaries.

Under the proposed RBI guidelines, home loan products will likely need to be consolidated within the banks themselves, eliminating the duplication between the parent bank and its subsidiary. This will not only impact the operations of these subsidiaries but may also lead to a strategic restructuring of how home loans are marketed and provided. Banks will be expected to reclaim full control over the home loan market, reinforcing their role as the primary lender for consumers, while subsidiaries could shift their focus to niche markets or complementary financial services.

The NBFC Challenge

Beyond home loans, the guidelines will have a ripple effect on the broader NBFC sector. Large banks such as HDFC, ICICI, and Kotak Mahindra operate NBFC subsidiaries that offer products ranging from personal loans to vehicle finance. For example, HDB Finance overlaps with HDFC Bank in providing gold loans, two-wheeler loans, and personal loans, while Kotak Mahindra Investments and Kotak Mahindra Prime target segments like real estate finance and vehicle loans, areas already covered by the parent bank.

In light of the RBI’s proposal, these NBFCs may need to rethink their product portfolios and consider alternative roles in the financial ecosystem. A potential outcome is that these subsidiaries could transition into direct selling agents (DSAs) or shift their focus toward non-lending services such as insurance or wealth management. This would not only reduce overlap but also help banks comply with the RBI’s mandate to keep core banking activities such as lending under the umbrella of the parent institution.

Capping Investments

The RBI’s proposal also introduces restrictions on how much banks can invest in certain financial entities. The draft suggests that banks limit their shareholding in Asset Reconstruction Companies (ARCs) to 20 percent, ensuring that banks do not maintain excessive control over multiple financial entities, which could create conflict-of-interest scenarios. Moreover, banks will be allowed to sponsor only one ARC at a time, reducing the risk of cross-contamination in the financial ecosystem.

Similarly, the guidelines also cap a bank’s stake in any company to a maximum of 30 percent, which includes investments in Alternative Investment Funds (AIFs). Banks will no longer be able to make investments in Category III AIFs, and any investment in Category I or II AIFs will be restricted to the regulatory minima prescribed by the Securities and Exchange Board of India (SEBI). This measure is designed to limit the risk exposure of banks to more speculative investments, ensuring greater financial stability and transparency.

Additionally, the proposal directs that Indian banks’ overseas branches align their activities with those permitted for Indian lenders, ensuring uniformity in operations across jurisdictions. This means Indian banks operating abroad cannot engage in activities that would be prohibited for them domestically, thereby creating a consistent regulatory framework that eliminates opportunities for circumvention.

The Big Picture

As the RBI seeks feedback from banks on these draft guidelines, the potential strategic and financial implications are vast. The immediate impact will be on the valuations of bank subsidiaries, particularly those whose operations overlap with their parent banks. Auditors have already raised concerns about the future valuations of entities like HDB Finance, and similar effects are expected for other bank-linked NBFCs that will need to realign their business models.

The guidelines are also likely to spur consolidation within the banking sector. Banks may seek to absorb certain subsidiaries or transform them into DSAs to avoid conflicts with the RBI’s mandate. This could lead to a wave of mergers and acquisitions, as well as restructuring within India’s financial services landscape. NBFCs, in particular, may need to innovate to remain competitive, finding new ways to add value without directly competing with their parent banks.

From a regulatory standpoint, the guidelines reflect the RBI’s determination to strengthen the governance and risk management practices of Indian banks. By restricting overlap between banks and their subsidiaries, capping investments in speculative financial entities, and ensuring compliance across domestic and overseas operations, the central bank aims to enhance transparency and reduce systemic risks in the Indian financial system.

For India’s banking sector, these guidelines represent both a challenge and an opportunity. Banks will need to adapt quickly, reevaluating their subsidiaries’ roles and ensuring that their business models align with the new regulatory framework. At the same time, this presents an opportunity for banks to streamline their operations, focusing on core activities and ensuring that their subsidiaries complement rather than duplicate their efforts.

Conclusion

The RBI’s draft guidelines mark a transformative moment for India’s banking sector, one that will require a comprehensive realignment of business models and strategies. As banks and their subsidiaries navigate these changes, the focus must remain on strengthening governance, reducing systemic risks, and ensuring that core banking activities remain within the ambit of the parent institution. The changes are set to create a more transparent, resilient, and efficient financial system, but the path to compliance will require significant effort and adaptation from all stakeholders involved.