According to the Statement on Developmental and Regulatory Policies announced along with its Monetary Policy Statement on December 8, 2023, the RBI plans to bring in a unified regulatory framework on ‘Connected Lending’ (CL) for the regulated entities.

The term ‘Connected Lending’, not commonly prevalent in the Indian banking context, led some to confuse it with ‘interconnectedness.’ It also led some to speculate whether RBI has already smelled smoke, and therefore, it is readying the fire brigade, proactively.

The Definition

A World Bank Working Paper defines connected lending as:

“Connected lending is the extension of credit to individuals or firms connected through ownership or the ability to exert control, whether direct or indirect. Examples of connected parties include a firm’s parent, major shareholders, subsidiaries, affiliated companies, directors, and executive officers. Firms are also connected where they are controlled by the same family or group.”

In short, CL means loans extended by a bank to its owners or managers and to their related businesses on terms softer than the market-determined terms.

Contrasting Views

Since 1960s there has been a growing literature on CL, globally.

There are two contrasting views on CL. The favourable view, known as “information view”, finds “close ties” between banks and borrowers as “valuable” to both, as it improves “credit efficiency” by facilitating smooth two-way information flow leading to improvement in “ex ante risk characteristics of investment projects” and consequent decisions, thus mitigating the twin problems of moral hazard and asymmetric information.

Further, when there is inter se equity holding, neither banks nor firms can act against each other, without jeopardising their mutual interests.

The proponents of the contrasting view, known as “looting view”, argue that “close ties between banks and borrowers allow insiders to divert resources from depositors or minority shareholders to themselves.” Close ties disincentivise banks to treat borrowers at arm’s-length, and since borrowers are assured of liquidity, information flow suffers.

Moreover, the bank would not be incentivised to appoint observers in the company to identify and rectify the problems, or make provisions for non-performing loans. Thus, both information asymmetry and moral hazard issues would exist. Basically, this implies that CL benefits the borrower, but may impair the bank’s finances.

Some Country Evidence

In Mexico, CLs were offered on easier terms and constituted “a large fraction of the banking business” in 1995, and subsequently when recession set in, the proportion doubled for the banks which later went bankrupt; CLs reported high default; and the defaulters were closest to the banks’ controllers. In Spain, the Rumasa Group was a holding company which owned 20 banks and over 700 other companies. CL to the Group led to the Spanish banking crisis of the 1980s.

Many Russian firms are shareholders (some even major shareholders) in banks that finance them. Firms related to banks get preferential loan limits.

CL led to banking problems in Argentina, Bangladesh, Brazil, Chile, Indonesia, Japan (bank lending inside the keiretsu groups), Malaysia and Thailand.A detailed research (1996) of 29 systemic banking crises revealed that CLs (along with government interference) played significant role in at least one-third of the crises. Political connections exacerbate CL. In the US, it was observed that during 2003-08 the cost of bank loans was significantly lower for those S&P 500 companies which had politically connected board members.

The Indian Scene

Section 20 of the Banking Regulation Act, 1949 prohibits loans and advances (other than for personal use) to directors or to any firm or company in which directors are interested or individuals in respect of whom any of its directors is a partner or guarantor.

In respect of non-fund based facilities, which are not regarded as loans and advances within the meaning of Section 20, any devolvement on the bank resulting in creditor-debtor relationship between the bank and the director, etc., attracts Section 20.

The Report on Banking Sector Reforms (1998) (Chairman: M Narasimham) on CL opined that although India has legislations “effectively prohibiting” such loans, yet, with accelerating liberalisation and privatisation of banks, “there is a possibility that the phenomenon of connected lending might reappear even while adhering to the letter of the law.” To curb this, it urged RBI to prescribe prudential norms for exposures, concentration ratios, etc.

Principle X of the RBI’s Core Principles of Effective Banking Supervision (October 1999) deals with CL. In order to leash unethical practices of granting loans and advances to relatives of directors of the bank, other banks and/or their relatives, RBI has issued strict guidelines.

RBI has sought a legislative amendment to empower it to take appropriate steps against siphoning of banks’ funds through CL and to initiate criminal prosecution in such cases.

The issue of CL was debated in the domestic media when the RBI’s Internal Working Group to Review Extant Ownership Guidelines and Corporate Structure for Indian Private Sector Banks (October 2020) recommended allowing large corporate/industrial houses as promoters of banks, “only after necessary amendments to the Banking Regulations Act, 1949 to deal with connected lending…”

The RBI’s proposal to unify the hitherto scattered regulations on CL is welcome as it will help ameliorate misallocation of credit and the ensuing financial and non-financial ills. However, banks should disclose their CL positions in their balance sheets (‘Notes to the Accounts’). This will enhance transparency in bank financials on one hand and promote depositors’ and shareholders’ discipline on banks.

The writer is a former senior economist, SBI.

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