BW Communities

Small Banks: A Holy Grail For Investors?

Business World Nov 17, 2015

In FY 2014, the microfinance sector in India raised about $192 million through 5 private equity transactions; whereas, Q1 2015 alone accounted for 4 investments worth $535.15 million. According to a report by India Ratings and Research, the MFI sector is expected to grow at 24% annually over FY15-19. The Andhra Pradesh MFI crisis seems like distant turbulence in a sector making its journey towards transformation, stability and growth. In this context, the RBI's Guidelines for Licensing of (privately owned) Small Finance Banks ("Small Bank Guidelines") are an important step towards promoting investment in this sector. It is anticipated that Small Finance Banks, together with successful payments bank licensees, may need to mobilise at least close to Rs 2,000 crore to meet their statutory minimum paid-up capital requirements. This article examines material provisions of the Small Bank Guidelines to the extent they impact structuring, control and exit of private investment from Small Finance Banks. Several issues raised here are equally pertinent for investments in universal banks and payment banks. Overview The Small Bank Guidelines regulate small banks serving niche interests in unbanked and under-banked regions and RBI has already issued in-principle approval to 10 applicants for setting up Small Finance Banks ("SFBs") out of a total of 72 initial applicants. The objective of setting up SFBs is to further financial inclusion through high-technology and low-cost operations by providing "savings" vehicles to "unserved" and "under-served" sections and promoting the supply of credit to small businesses, farmers, industries and other unorganised sectors. Like healthcare and pharma, financial services, as a sector, touches upon a number of India's selling points to global investors: a scalable model due to the demographic dividend, vast unmet demand and the ability to make gains in productivity with even modest use of technology. Corporate Structure The SFBs are mandatorily required to be registered as a public limited company under the Companies Act, 2013 and to use the words "Small Finance Banks" in their corporate names. SFBs are not permitted to incorporate any subsidiaries, making control and management easier for investors, who need not worry about decisions or transactions at subsidiary boards where they do not have direct oversight. Conversion from Financial Institutions to SFBs Several SFB licensees are existing MFIs or NBFCs. Upon conversion into an SFB, the existing businesses of such NBFC or MFI (for instance the lending activities which can be carried on by the SFB), would be carried on by the SFB. Those activities which cannot be carried on by the SFB, but were not prohibited to the existing financial institution, would have to be divested within a period of 18 months from the date of in-principle approval, or as on the date of the commencement of banking business, whichever is earlier. These requirements make it imperative for private investors to anticipate the implications of such restructuring and assess any adverse tax consequences or other leakages that may impact the value of the loan book. Investors must be cautious while migrating to the SFB regime so that potential for leakage in terms of costs, ownership or control is minimised.   Minimum Capital The minimum paid-up equity capital for an SFB is Rs 100 crores. While freshly incorporated SFBs need to adhere to this immediately, the RBI has clarified that in case of existing MFIs/ NBFCs are converting into SFBs in accordance with the provisions of the Small Bank Guidelines, a minimum net worth of Rs 100 crores is mandatory (as opposed to minimum paid-up capital requirement). The promoters are required to furnish a plan for raising paid-up capital (to Rs100 crores) within 18 months of registration as an SFB. For investors and promoters alike, the bankability of these covenants, and the need to adhere to the RBI's timeframe, will be critical. Short term changes in the business cycle could pose challenges to locked-up funding requirements and certainly lead to dilution as investors would like to back-end as much of their commitments as possible. Listing Requirement The Small Bank Guidelines have stipulated that SFBs need to be mandatorily listed within a period of 3 years of reaching a net worth of Rs 500 crore. The minimum public shareholding requirement for a listed company is 25%. Unlike in case of universal banks, the listing requirements for the SFBs is not linked to a specific timeline from the commencement of business, but is instead pegged to the SFBs reaching a specified net worth. However, SFBs with lower net worth are also permitted to voluntarily list. Corporate Governance The Small Bank Guidelines prescribe a number of corporate governance driven requirements for SFBs such as majority independent directors on the board and compliance with the corporate governance guidelines issued by the RBI from time to time, including the 'fit and proper' criteria for directors. RBI has clarified that even though there can be non-executive common directors in the promoter entity and the SFB, any director on the board of the promoter entity will not be consider as an independent director on the board of the SFB. These requirements need to be considered while negotiating the board governance rights of the shareholders of the SFB and it could pose significant challenges at the investment stage if diversified investors (bear in mind 10% investment limit for single investors discussed below) want representation on the board. This issue could be partially mitigated by the appointment of observers on the board of the SFB and by entering into appropriate shareholders' arrangements which envisage a greater role and oversight of the shareholders in the management of the SFB. Foreign Direct Investment The restrictions on foreign investment in SFBs are substantially similar to the restrictions on foreign shareholding in private sector banks in under the FDI policy. Consequently, currently, at least 26% of the paid up capital of an SFB has to be held, at all times, by residents. Foreign investment up to 49% can be undertaken under the automatic approval route and any foreign investment beyond 49%, subject to an overall cap of 74%, require prior approval of the government, granted by the Foreign Investment Promotion Board. Any Foreign Institutional Investors (FIIs) / Foreign Portfolio Investors (FPIs) shareholding is capped at 10% (which is also similar to the cap on any single non-promoter shareholder). The aggregate limit for all FIIs / FPIs / Qualified Foreign Investors is capped at 24% of the total paid-up capital of the SFB, which can be raised by the SFB to 49% by passing a board resolution and a special resolution at it shareholders meeting in this regard. NOFHC Structure Unlike banks in the private sector, SFBs are not required to be mandatorily held through an intermediate holding company structure. However, if an SFB is held through an intermediate holding company, such intermediate company has to be a Non-Operating Financial Holding Company ("NOFHC") in compliance with the Guidelines for Licensing of New Banks in the Private Sector dated 22 February 2013. In particular, 100% of the entire share capital of the NOFHC must be directly held by the stated promoter group. It should be noted that an NOFHC cannot have any non-promoter shareholding. Further, RBI has clarified that any change in the shareholding of the NOFHC by 5% or more would also require a prior approval of the RBI. Promoters The Small Bank Guidelines and related clarifications state that the following entities are restricted from promoting an SFB: "    joint ventures between different promoter groups; "    Indian Charitable trusts / private or public trusts; and "    large public sector entities and industrial houses (including NBFCs promoted by them). The RBI has clarified that groups with assets of Rs 1,000 crore and with the non-financial business of the group accounting for 40% of more in terms of total assets or total revenue will be treated as a large industrial / business group. Joint ventures between two (or more) promoter groups are not permitted to promote an SFB. RBI has clarified that even a special purpose vehicle incorporated by two entities within the same promoter group, for the purpose of promoting an SFB, would also comprise of a joint venture and hence be debarred. Non-promoter investment, up to 10% of the share capital of an SFB, is permissible by a single investor. Consequently, foreign investors (including private equity investors) can participate in the shareholding of an SFB. However, such investors must be classified as a non-promoter and each such investor's holding must be capped at 10% of the paid-up equity share capital of the SFB. In case if the promoters are involved in other financial and non-financial services activities, such activities have to be kept distinctly ring fenced, whereby any arrangements for sharing of infrastructure of the parent entities are entered into at an arm's length basis, with suitable firewalls built in, customer confidentiality maintained and instituting risk mitigation measures. Resident individuals promoting an SFB are required to have at least 10 years of experience in banking and finance. Where an SFB is promoted by an entity, or if the existing MFI / NBFC converts into an SFB, a successful track record for a period of at least 5 years is required. <img alt="" src="http://bw-image.s3.amazonaws.com/Small-Banks-lrg.jpg" style="width: 649px; height: 344px;"> Promoters' Lock-in As mentioned above, at least 40% of the initial paid-up equity capital must be held by the promoters. Of the initial promoters' contribution, at least 40% of the paid-up share capital is subject to a statutory lock-in for a period of 5 years from the date of commencement of business of the SFB. Promoters' Divesture In case the initial promoter shareholding is in excess of 40%, the promoters are required to reduce it to 40% within a period of 5 years. Further, the promoters are mandatorily required to reduce their shareholding to 30%, and thereafter to 26% period, within a period of 10 years and 12 years, respectively, from the date of commencement of business by the SFB. Divesture of promoter shareholding may be challenging going forward since any acquisition of more than 5% of the paid-up share capital in an SFB would require a prior approval of the RBI. These promoter dilution and approval requirements may prove to be a major negotiation point in respect of third party investment in the SFB as it may conflict with the exit options sought by the investors and would lead to broad-basing of the shareholding in SFB. So, for example, exercise of rights such as a tag along or a drag along or a share swap may be more challenging for investors. IPOs could be a realistic exit route if the markets have an appetite for such companies. Voting Rights Any single shareholder's voting rights in a private sector bank is statutorily capped at 10%. The Small Bank Guidelines provide that this restriction would also apply to SFBs. The Small Bank Guidelines also state that this limit can be raised to 26% by the RBI in a phased manner. However, RBI has clarified that this is to be construed only as an enabling provision for the future. Promoters' Exit The Small Bank Guidelines are silent on an exit of promoters from the SFBs after the completion of the promoters' lock-in detailed above. However, in the clarifications issued by the RBI on the Small Bank Guidelines, RBI has stated that an exit by promoters from SFBs would "depend on the RBI's regulatory and supervisory comfort / discomfort and SEBI regulations in this regard at that time". Consequently, though it is theoretically possible for the promoters to exit SFBs after the completion of the statutory lock-in, exercise of such an option would hinge on the regulatory atmosphere prevailing at the time of the proposed exit. Realistically, a complete exit by the promoters will be challenging and its difficult to predict the contours of such a transaction. Branch Expansion Plans The SFBs are also required to obtain a prior approval of the RBI for their annual branch expansion plans for the initial five year period. Such plans have to comply with the requirement of operating at least 25% of its branches in unbanked rural centres, which have a population upto 9,999 as per the last census. The Small Bank Guidelines further state that after the initial period of 5 years, the RBI may consider liberalizing the requirement of a prior approval for the annual branch expansion plans and the scope of activities to be undertaken by the SFBs. Application Process At the time of application, the promoters have to submit to the RBI a plan and a methodology for compliance with the Small Bank Guidelines. The applicant, among other things has to submit information concerning its plans for raising its minimum paid - up equity capital (i.e. Rs 100 crore) for the proposed entity, information concerning persons / entities who would subscribe to 5% or more of the equity capital and any foreign equity participation. The promoters would also have to submit its plan for the dilution of the promoter shareholding. Conversion to Bank An SFB may apply to RBI for conversion into a universal bank. In order to convert into a universal bank an SFB must meet the minimum paid-up capital/ net worth requirements, satisfy the performance track record for a period of 5 years and adhere to the RBI's due diligence norms. Upon becoming a universal bank, the SFB will be subject to the regulations governing universal banks (including those relating to NOFHC structure). Since the Small Bank Guidelines do not require the SFBs to be promoted under an NOFHC structure, in case of conversion into a universal bank, the holding structure of the SFB will need to be converted to an NOFHC structure in accordance with the Guidelines for Licensing of New Banks in the Private Sector dated 22 February 2013. The author, Bharat Anand, is partner, Khaitan & Co. Note: The views of the authors are personal, and should not be considered as those of the firm