The RBI working group's proposal to allow corporate houses to set up banks is a "bombshell" and at this juncture, it is more important to stick to the tried and tested limits on the involvement of business houses in the banking sector, according to an article jointly written by former RBI Governor Raghuram Rajan and ex-Deputy Governor Viral Acharya.

They also said that the proposal is "best left on the shelf".

"The history of connected lending is invariably disastrous. How can the bank make good loans when it is owned by the borrower? Even an independent committed regulator, with all the information in the world, finds it difficult to be in every nook and corner of the financial system to stop poor lending," the article said.

Last week, an Internal Working Group (IWG) set up by the Reserve Bank of India (RBI) made various recommendations, including that a large corporation may be permitted to promote banks only after necessary amendments to the Banking Regulations Act.

The IWG was set up to review extant ownership guidelines and corporate structure for Indian private sector banks.

Referring to the group's proposal to allow Indian corporate houses into banking, the article said, "its most important recommendation, couched amidst a number of largely technical regulatory rationalisations, is a bombshell".

"... it proposes to allow Indian corporate houses into banking. While the proposal is tempered with many caveats, it raises an important question: Why now?," the article said.

The article -- posted on Rajan's LinkedIn profile on Monday -- noted that the IWG has suggested significant amendments to the Banking Regulation Act of 1949, aimed at increasing the RBI's powers, before allowing corporates houses into banking.

"Yet if sound regulation and supervision were only a matter of legislation, India would not have an NPA problem. It is hard not to see these proposed amendments as a subtle way for the IWG to undercut a recommendation it may have had little power over.

"In sum, many of the technical rationalisations proposed by the IWG are worth adopting, while its main recommendation -- to allow Indian corporate houses into banking -- is best left on the shelf," they opined.

"Have we learnt something that allows us to override all the prior cautions on allowing industrial houses into banking? We would argue no. Indeed, to the contrary, it is even more important today to stick to the tried and tested limits on corporate involvement in banking," the article said.

Further, Rajan and Acharya said that as in many parts of the world, banks in India are rarely allowed to fail - the recent rescue of Yes Bank and of Lakshmi Vilas Bank are examples. For this reason, depositors in scheduled banks know their money is safe, which then makes it easy for banks to access a large volume of depositor funds.

They noted that the rationales for not allowing industrial houses into banking are then primarily two. First, industrial houses need financing, and they can get it easily, with no questions asked, if they have an in-house bank.

According to Rajan and Acharya, the second reason to prohibit corporate entry into banking is that it will further exacerbate the concentration of economic (and political) power in certain business houses.

"Even if banking licenses are allotted fairly, it will give undue advantage to large business houses that already have the initial capital that has to be put up. Moreover, highly indebted and politically connected business houses will have the greatest incentive and ability to push for licenses," they said.

The approach of the RBI regarding ownership of banks by large corporate/ industrial houses has, by and large, been a cautious one in view of serious risks, governance concerns and conflicts of interest that could arise when banks are owned and controlled by large corporate and industrial houses.

For the first time in 2013, the RBI, in its Guidelines for Licensing of New Banks in the Private Sector, had prescribed several structural requirements of promoting a bank under a Non-Operative Financial Holding Company (NOFHC).