By Akshat Khetan

Imagine a corporate MSME, approaching a bank for a loan to meet some obligation. Now, what if the bank rather than provisioning this business with a loan decides to take an equity stake? Legally, traditionally-operating American and Indian banks are refrained from entering into such a relationship. That, although there are development banks, bank-subsidiaries, and special purpose vehicles lending on the basis of equity participation. 

The interest in banks adopting an equity participation model is increasing and driven by a confluence of economic, regulatory, and technological factors. Primarily, there has been an acknowledgment that traditional debt financing has been inefficient in supporting business growth. Secondly, there has been a need to address lending practices in high-growth sectors such as technology or renewable energy where a traditional lending model can be limiting. More importantly, to the traditional banking model the new model could be a crucial diversification strategy. 

One of the most compelling arguments for banks adopting an equity participation model is the alignment of interests between the bank and the borrowing company. In a traditional loan arrangement, the borrower bears the full risk of the business venture, while the bank is primarily concerned with the repayment of the loan and interest. Equity participation, on the other hand, transforms banks into stakeholders, incentivizing them to support the long-term success of the company.

This model also offers the potential for higher returns. Unlike fixed interest income from loans, equity stakes can yield significant dividends and capital gains if the company performs well. This can be particularly advantageous in high-growth sectors such as technology and renewable energy, where traditional lending might be too risky due to the volatility and uncertainty involved.

Risks and benefits for banks

Furthermore, equity participation can provide companies with more flexible financing options. Without the burden of regular interest payments, companies can reinvest cash flows into their operations, fueling further growth and innovation. This can be a critical advantage for startups and companies in capital-intensive industries.

Despite the potential benefits, there are significant risks associated with equity participation by banks. The most obvious risk is market volatility. Equity investments are subject to fluctuations in market value, which can result in substantial losses for banks. This is particularly concerning in a country like India, where economic and market conditions can be highly unpredictable.

Another critical issue is corporate governance. Banks traditionally focus on credit risk management, and transitioning to equity participation requires expertise in managing corporate governance and operational risks. There is a risk that banks may lack the necessary skills and experience to effectively oversee the companies they invest in, potentially leading to poor investment decisions.

Also read: Quasi-equity financing: The non-dilutive option for startups to build scalable business

Regulatory constraints pose a significant hurdle. The Reserve Bank of India (RBI) currently restricts banks from holding equity stakes in non-financial companies, except within specified limits for financial services and insurance businesses. This restriction is in place to mitigate risks associated with conflicts of interest and ensure the stability of the banking sector. According to a 2023 RBI circular, banks are limited to a maximum of 10% equity in financial and insurance companies, aimed at preventing overexposure to market risks and ensuring a focus on core banking activities.

Several papers have deliberated on the pros and cons of such a model. For banks to adopt an equity participation model, several regulations would have to be evaluated. Any legal amendments would require careful consideration of the potential impact on financial stability and the development of stringent guidelines to manage associated risks. Policymakers would also need to balance the potential economic benefits of increased equity financing against the need to maintain a stable and secure banking system. As such, it remains a topic worthy of detailed consideration and debate among policymakers, financial institutions, and corporate stakeholders.

(The author is a corporate and legal advisor and founder of AU Corporate and Legal Advisory Services Limited. Views expressed are the author’s own and do not reflect the official position or policy of FinancialExpress.com. Reproducing this content without permission is prohibited.)