Brokers can be good banks

I have an opinion piece in today's Economic Times titled: Brokers deserve as fair a chance as banks. Here is the article:

"RBI has come out with a set of draft guidelines for licensing new banks in the private sector. A trial balloon that the central bank launched, proposes sound eligibility criteria such as shareholders primarily being residents of India, a diversified shareholding pattern, transparent holding structures, credentials, expertise showing ability to run a bank and qualitative aspects like high standards of governance and ethics across the corporate group and restrictions on related party transactions.

RBI has got most things right. But we can argue about some details such as whether a minimum capital of Rs 500 crore is too high or too low, whether a stipulated dilution to 15% ownership in 12 years is a good time period, whether the voting cap of 10% imposed on non-promoters is right or not, and whether seeking a listing in just two years is too high an expectation.

However, an area where the central bank has made a big error is disallowing stock broking entities from a licence. The paper states: "Banking is essentially based on fiduciary principles as depositors' money is involved. It, therefore, becomes imperative that the fit and proper assessment framework for bank promoters is much more comprehensive in scope as compared to other sectors.

Any such framework also needs to look into the nature of activities the promoter group of the bank is predominantly engaged in. There are certain activities, such as real estate and 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." There are several reasons why the above reasoning is not sound.

First, brokers are familiar with the fiduciary principles of client money. In fact, brokers have far more complex and higher standards of fiduciary duties to their customers than banks. Brokers are obliged not only to separate their own money from their clients', but also to segregate one client's property from another's.

Thus, to assume that banks are somehow unique in understanding fiduciary duties is fallacious. Second, brokers are amongst the most heavily regulated of all entities. Sebi has done an excellent job of regulating brokers and has imposed very strict fit and proper criteria on brokers.

Thus, to bar brokers based on fit and proper criteria is wrong, in fact, since brokers have already gone through this continuing and strict eligibility criteria, that ought to be a ground for making such brokers more easily eligible for a banking licence. Third, the central bank's assertion that broking activity is 'inherently riskier' is not correct.

In fact, brokers mainly do an agency business with no inherent leverage at all. While some brokers do lend to clients, the leverage is minuscule and short term. Many brokers do not do any proprietary trades and are completely leverage free. This is in sharp contrast to banks that are highly leveraged. The draft guideline itself says at the conclusion that "Banking [is] a highly leveraged business".

Fourth, brokers do not represent "a business model and business culture which are quite misaligned with a banking model". Not only are brokers well-versed with the economy, the financial and real sectors, but they represent a very similar business model and culture as banks.

Most big brokers (who would be eligible to apply for a bank licence) would have cultures not at all dissimilar to the one at private bank, professional, meritocratic and ethical corporate institutions rather than some cunning, market-manipulating individual stereotype sitting in his Lexus car, the RBI probably has in mind.

Fifth, the RBI's assertion that internationally too there are attempts to "separate banking from proprietary trading" is a reference to proprietary trading that is a principal business. The reference is to investment banking and proprietary desks that could jeopardise the bank's capital, rather than what brokers do.

Finally, to imply that all brokers are avatars of Harshad Mehta is a bit like saying all banks are avatars of the Bank of Karad. Thus, to say that the "past experience with brokers on the boards of banks has not been satisfactory" is not only an ad hominem attack on a well-regulated profession but is based on an assumption that the broker is a human being who sits on boards of banks and creates pointless pollution there.

The fact is that not only are all the big brokers limited companies, rather than individuals whose 1990s' record the RBI is unhappy with, but that many, if not most, of the big banks of India have broking subsidiaries or affiliates. If broking is such a filthy profession, RBI should bar banks from indulging in it. If not, they should not be barred from banking licence."