Foreign Direct Investment In Indian Banking Sector

Foreign direct investment (FDI) is defined as “investment made to acquire lasting interest in enterprises operating outside of the economy of the investor.” The FDI relationship consists of a parent enterprise and a foreign affiliate which together form a Multinational corporation (MNC). In order to qualify as FDI the investment must afford the parent enterprise control over its foreign affiliate. The UN defines control in this case as owning 10% or more of the ordinary shares or voting power of an incorporated firm or its equivalent for an unincorporated firm; lower ownership shares are known as portfolio investment.

Indian federal government has opened up the banking sector for foreign investors raising the ceiling of foreign direct investment in the Indian private sector banks to 49 percent. However, the ceiling of FDI in the country’s public sector banks remains unchanged at 20 percent. Foreign banks having branches in India are also entitled to acquire stakes up to 49% through “automatic routes”. It is to be noted that  under “automatic route” fresh shares would not be issued  to  foreign investors who already have  financial or technical collaboration  in banking or allied sector. They would require FIPB approval. However, some statutory approvals of the Reserve Bank of India (RBI), country’s central banking authority, would be required.

Statutory Limits

  • Foreign direct investment (FDI)  up to 49 percent is permitted in Indian private sector banks  under “automatic route” which includes Initial Public Issue (IPO), Private Placements, ADR/GDRs; and Acquisition of shares from existing shareholders.
  • Automatic route is not applicable to transfer of  existing shares in a banking company from residents to non-residents. This category of investors require approval of FIPB, followed by “in principle” approval by Exchange Control Department  (ECD), Reserve Bank of India (RBI).
  • The “fair price” for transfer of existing shares is determined by RBI, broadly on the basis of Securities Exchange Board of India (SEBI) guidelines for listed shares and erstwhile CCI guidelines for unlisted shares. After receipt of “in principle” approval, the resident seller can receive funds and apply to ECD, RBI, for obtaining final permission for transfer of shares.
  • Foreign banks having branch-presence in India are eligible for FDI  in private sector banks subject to the overall cap of 49% with RBI approval.
  • Issue of fresh shares under automatic route is not available to those foreign investors who have a financial or technical collaboration in the same or allied field. Those who fall under this category would require Foreign Investment Promotion Board (FIPB) approval  for FDI in the Indian banking sector.
  • Under the Insurance Act, the maximum foreign investment in an insurance company has been fixed at 26 percent. Application for foreign investment in banks  which have joint venture/subsidiary in insurance sector should be made to RBI. Such applications would be considered by RBI  in consultation with Insurance regulatory and Development Authority (IRDA).
  • FDI and Portfolio Investment in nationalized banks are subject to overall statutory limits of 20 percent.
  • The 20 percent ceiling would apply in respect of such investments in State Bank of India and its associate banks.

Voting Rights of Foreign Investors

Private Sector  Banks:Not more then 10 percent of the total voting rights of all the shareholders
Nationalized Banks:Not more than 1 percent of the total voting rights of all the shareholders  of the nationalized bank.
State Bank of India:Not more than 10 percent of the issued capital. This does not apply to Reserve Bank of India (RBI) as a shareholder. However, government in consultation with RBI, ceiling for foreign investors can be raised.
SBI Associates:Not more than 1 percent. This ceiling will not be applied to State Bank of India. If any person holds more than 200 shares, he/she will not be registered as a shareholder.

RBI Approval

  • Transfer of shares of 5 percent and more of the paid-up capital of a private sector bank requires prior acknowledgement of RBI.
  • For FDI of 5 percent and more of the paid-up capital, the private sector bank has to apply in the prescribed form to RBI.
  • Under the provision of Foreign Exchange Management Act (FEMA), 1999, any fresh issue of shares of a bank, either through the automatic route or with the specific approval of FIPB, does not require further approval of Exchange Control department (ECD) RBI from the exchange control angle.
  • The Indian banking company is only required to undertake two-stage reporting to the ECD of RBI as follows: (1) the Indian company has to submit a report within 30 days of the date of receipt of amount of consideration indicating the name and address of foreign investors, date of receipt of funds and their rupee equivalent, name of bank through whom funds were received and details of govt. approval, if any. (2) Indian banking company is required to file within 30 days from the date of issue of shares, a report in form FC-GPR (Annexure II) together with a certificate from the company secretary of the concerned company certifying that various regulations have been complied with.

Divestment by Foreign Investors

Sale of shares by non-residents on a stock exchange and remittance of the proceeds thereof through an authorized dealer does not require RBI approval.

  • Sale of shares by private arrangement requires RBI’s prior approval.
  • Sale of shares by non-residents on a stock exchange and remittance of the proceeds thereof through an authorized dealer does not require RBI approval.

A foreign bank or its wholly owned subsidiary regulated by a financial sector regulator in the host country can now invest up to 100% in an Indian private sector bank. This option of 100% FDI will be only available to a regulated wholly owned subsidiary of a foreign bank and not any investment companies. Other foreign investors can invest up to 74% in an Indian private sector bank, through direct or portfolio investment.
The Government has also permitted foreign banks to set up wholly owned subsidiaries in India. The government, however, has not taken any decision on raising voting rights beyond the present 10% cap to the extent of shareholding..
All entities making FDI in private sector banks will be mandatory required to have credit rating. The increase in foreign investment limit in the banking sector to 74% includes portfolio investment [i.e., foreign institutional investors (FIIs) and non-resident Indians (NRIs)], IPO’s, private placement, ADRs or GDRs and acquisition of shares from the existing shareholders. This will be the cap for any increase through an investment subsidiary route as in the case of HSBC-UTI deal.

In real terms, the sectoral cap has come down from 98% to 74% as the earlier limit of 49% did not include the 49% stake that FII investors are allowed to hold. That was allowed through the portfolio route as the sector cap for FII investment in the banking sector was 49%.The decision on foreign investment in the banking sector, the most radical since the one in 1991 to allow new private sector banks, is likely to open the doors to a host of mergers and acquisitions. The move is expected to also augment the capital needs of the private banks.