Connected and circular lending

Connected and circular lending

Subject: Economy

Context:

The Reserve Bank of India (RBI) has kept in limbo the proposal of its Internal Working Group (IWG) for granting banking licence to big corporate houses amid fears over connected lending and self-dealing if they are allowed in the banking space.

Concept:

Connected lending:

• Connected lending involves the controlling owner of a bank giving loans to himself or hisrelated parties and group companies at favourable terms and conditions.
• Business groups need financing, and they can get it easily with no questions asked if they have an in-house bank.
• In short, companies can use the bank as a “private pool of readily available funds”. Big business groups already account for a major chunk of non-performing assets (NPAs) in the banking system even without becoming promoters of a bank.
• While the main argument in favour of allowing corporate presence in banking is that they can bring in capital, business experience and managerial competence, there are apprehensions that it was not easy for supervisors to prevent or detect self-dealing or connected lending as banks could hide connected party or related party lending behind complex company structures and subsidiaries or through lending to suppliers of promoters and their group companies.
• These loans can subsequently become bad assets of the bank. Moreover, highly indebted and politically connected business houses will have the greatest incentive and ability to push for licenses.

Circular lending:

• Another risk associated with banks owned by industry groups is circular lending, with corporate bank X funding projects of an industry group, which owns corporate bank Y, and corporate bank Y funding projects of an industry group owning bank Z, and finally, corporate bank Z funding projects of industry group owning bank X, which is hard to track on a real-time basis.