It said no bank and financial institution should acquire more than a 5 per cent stake in another bank's equity. Releasing fresh prudential norms on capital adequacy and cross-holding of capital among banks and financial institutions, the banking industry's regulator said, "Banks and financial institutions should not acquire any fresh stake in a bank's equity shares, if by such acquisition the investing bank's/FI's holding exceeds 5 per cent of the investee bank's equity capital."

It also said banks and institutions, which hold more than the stipulated limit, should apply to it within 45 days, along with a definite road map for reducing their exposure to the prudential limits.

An RBI spokesperson, however, clarified that the new rule would not apply to the State Bank of India, which holds more than 90 per cent of the equity of its seven associate banks.

So far, banks and institutions were allowed to invest up to 10 per cent of their capital funds in other banks' tier-II capital or subordinated debt.

The RBI has tightened this norm and said the 10 per cent limit will now include investment in equity shares, preference shares eligible for capital status, hybrid debt capital instruments and any other instrument approved as "in the nature of capital," besides subordinated debt. In this case also, banks will be required to report to the Reserve Bank with a time-bound plan to cut their exposure.

This essentially will restrict the banks' investment in tier II issues of other banks. Normally, a capital-starved bank floats a tier II issue to prop up its capital adequacy ratio, which enables it to build a bigger asset base. The capital adequacy ratio of a commercial bank has to be 9 per cent. This means that every Rs 100 worth of asset has to be backed by a capital of Rs 9.

"Even though this is a circular on cross-holding and has nothing to do with the draft proposal on private banks' ownership floated last week, it appears that RBI has zeroed in on the 5 per cent stake limit for all banks," said the chairman of a public sector bank.

Another public sector bank chief said the norm of the tier II capital subscription would affect the ability of banks to raise funds to prop up their capital adequacy ratio. He added that some of the banks would have to sell their investments in other banks in the market, which would depress the prices of these instruments.

A banking sector analyst, however, pointed out that the tightening of the tier II investment norms would put an end to the prevailing practice of banks scratching each other's backs.

The investments of banks and the institutions' investments in the equity capital of subsidiaries are at present deducted from their tier I capital for capital adequacy purposes. Investments in other instruments issued by banks like equity and preference shares will attract 100 per cent risk weight for credit risk for capital adequacy purposes, the RBI said.

The central bank had on September 2 last year permitted the aggregate investment of banks in the tier II bonds issued by other banks and financial institutions to be up to 10 per cent of the capital funds (tier I plus tier II capital). It has now reviewed this to restrict their exposure.