understanding banking sector in india

8/9/2019 Understanding Banking Sector in India

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Understanding Indian Banking Sector& Banking Institution’s Regulation

Dr. Prashant S. Desai.,Assistant Professor of Law,National Law School of India University,Bangalore-560 072

Email – p ra sha ntd e sa [email protected] c .in


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Contents

1. Understanding the term ‘banking’

2. Quick overview of Indian banking sector– its evolution and development

3. The ‘regulation’ of banks (with India asfocal point)


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What is ‘bank’ or ‘banking’?

• As the modern bank performs variety of

functions – it is difficult to give anaccurate definition of it

• Therefore there is no one universally

accepted definition

• Economists have offered differentdefinitions of ‘bank’


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However

• By referring to many major definitions we

can say – Banks accept deposits from the public;

– Banks advance loans to the needy person; and

– Also perform those permitted agency functions• Rather than accepting such a

oversimplified summing up – severalpeople write that ‘banks deal in cashand credit as its main purpose’


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Few more references

• Bank as a body corporate or a non-

corporate that has been recognized bythe Bank of England to accept depositsas defined by that Act

– The Banking Act, 1987 (England)


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• Banking Regulation Act, 1949

• “banking” means the accepting, for thepurpose of lending or investment, ofdeposits of money from the public,

repayable on demand or otherwise, andwithdrawable by cheque, draft, order orotherwise.


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What are the functions of a bank?

PART II


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The functions of bank

• Acceptance of Deposits

• Advancing loans

• Investment of funds

• Promote use of cheques• Other agency functions

– Banking related agency functions

– Other utility agency functions


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Acceptance of deposits

• Two types of deposits

– Demand deposits; and

– Time deposits

• However now there are many hybrid

deposits are also available


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Advancing of loans

• Advances can be broadly classified as

– Advances with security

– Advances without security


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Investment of funds

• Besides loans & advances – banker also

invest a part of its surplus funds ingovernment securities

• In India, the banks are mandated to

invest a part of their funds in governmentand other approved securities

• Though the returns are not high – fundsare ‘near liquid’ but also ‘secure’ for riskperspective


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Agency functions – banking related

• Transfer of funds

• Collecting customer’s funds (cheques)• Purchase & sale of shares and securities (for

its customers)

• Collecting dividends on the shares of thecustomers

• Payment of premium

• Acting as trustee and executor

• Income tax consultancy


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Agency functions – utility related

• Safe custody of valuable goods

• Issuing of travelers’ cheque• Giving information about its customers on

various issues

• Collection of statistics• Accepting bills of exchange on behalf of

customers

• Underwriting of company debentures

• Giving advice on financial matters


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Indian banking sector – its evolution &development

PART III


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• British brought the modern concept of

banking to India• But the concept of ‘banking’– was known to

us – Banking was used in synonymous with money lending

– Vedic literature records the details of bankingtransactions

– Manusmrithi speaks about – deposits, pledge, loansand interest rates etc.,

– Sons ‘ pious obligation’ – to discharge the loan of thefather


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The beginning of Indian ‘modern banking’

• Bank of Hindustan in 1770 [when

Alexander & Co., agency house started]• The Bank of Calcutta [ established by East

India Company in 1806]

• The break-through in 1860 – introductionof limited liability to banks


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The interim period of 1906 to 1913

• The influence of ‘sw a d esh i m ovem en t ’ –

the following banks were started – Peoples Bank of India Ltd.,

– The Bank of India Ltd.,

– The Central Bank of India Ltd., – Indian Bank Ltd.,

– The Bank of Baroda Ltd.,

• The period ended with the crash of 1913-17 overtaking these initiatives


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Establishment of Imperial Bank

• Three presidency banks of Calcutta,

Bombay and Madras were merged intoImperial Bank

• Vide the Imperial Bank of India Act, 1920

• The same became State Bank of Indialater


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Establishment of Reserve Bank of India

• It was given the right of note issue

• Was also to act as ‘bankers bank’ – thefunction which it took-over from ImperialBank

• However, Imperial Bank was allowed tooperate as the agent of RBI, especially inthose places where RBI had no branches

• Initially RBI was a shareholder’s bank – butwas nationalized in 1948


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Establishment of State Bank of India

• Vide State Bank of India Act, 1955 [which

overtook Imperial Bank] – The bank which commands approximately 25% of

total banking sector business

– With highest bank network in India


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SBI Subsidiaries

• SBI (Subsidiary Banks) Act, 1959

– The Bank of Bikaner

– The Bank of Indore

– The Bank of Jaipur

– The Bank of Mysore

– The Bank of Patiala

– The Bank of Travancore

– The Bank of Hyderabad


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The banking scenario @ 60s

• Overall mismanagement of banks

• Major chunk of advances to – Large;

– Medium; and

– Big industrial houses only• Uncovered priority sectors like

– Small scale industries;

– Agriculture; – Exports etc.,


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The banking scenario @ 60s

• Composition of bank management

– Industrialist directors

– Conflicting interests with their ventures

– Indiscriminate lending to their ‘own’ industrial

establishments


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The immediate response

• Introduction of ‘social control’

• Approach – Establishment of National Credit Council (NCC)

– Legislative Control through amendment to the

Banking Regulation Act, 1949


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Professional banking board

• Sec. 10A

• At least 51% of directors shall be possessing‘special knowledge, practical experience’ in – Accountancy;

– Agriculture & rural economy;

– Banking;

– Cooperation; – Economics;

– Finance;

– Law;

– Small Scale Industry – Any other matter (in the opinion of RBI useful)


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Further

“provided that, out of aforesaid number of

directors, not less than two shall be personshaving special knowledge or practicalexperience in respect of agriculture and

rural economy, cooperation or small-scaleindustry”


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Other mandates

• Directors shall not have substantial interest

– In any other company, except S.25 company – Any firm (carrying trade, commerce or industry, except

small scale industry)

• Restriction on tenure – For continues period of eight years (not applicable toChairman)

– Not to be re-elected for four years – if he is removed

from his office as ‘chairman’ or ‘whole-time director’


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Mandate of ‘whole time chairman’

• S.10B – the objective was to curbindustrialist’s encroachment over bankmanagement

• There shall be ‘whole-time’ chairman or‘managing director’ to manage the bank

• He shall have special knowledge & practicalexperience in any of the following – Working of the bank

– Finance

– Economics – Business administration


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Restriction on loans

• S.20 – no loans or advances on the security

of banks own shares• No loan or advance, to

– Any of its directors;

– Any firm; or

– Any company (except its own subsidiary or S.25company); or

– Any individual

– Provided the director is interested in such entity aspartner, manager, employee or guarantor etc.,


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Miscellaneous

• Additional powers were conferred on RBI

– to supervise and enforce ‘socialcontrol’ initiative

• Punishment provided for

– Obstructing any person from entering or leaving abank;

– Holding demonstrations within the bank; and

– Acting to undermine the depositors’ confidence ina bank


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Era of nationalization starts

• J uly 19, 1969 – 14 major banks

nationalized• 1980 – 6 more banks were nationalized

• Nationalization was perceived as a major

step in achieving the socialistic pattern ofsociety


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Modalities of nationalization

• The official point

– “public ownership of major banks will help mosteffectively the mobilization and development of

national resources and its utilization for productive

purposes in accordance with the plans and priorities”

• The preamble [of the first ordinance, 1969] – “in order to serve better the needs of development of

the economy in conformity with the national policy and

objectives”


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Criticism levied against nationalization

• 168 days [from 1.2.69 to 19.7.69] are too

short period to declare ‘social control’did not work – From June 1968 to March 1968 credit to

• Agriculture increased from Rs.30 crores to Rs.97 crores;

• Small scale industries from Rs.167 crores to Rs.222crores

• The step was determined by political

tussles and was result of inter-partystruggle


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Criticism levied against nationalization

• The banking industry is not nationalized in

some of socialistic countries (ex. Norway,Sweden, Finland and Denmark etc.,)

• Public control would leave the door open

for corruption and favoritism• Because of lack of competition the

‘quality of banking’ service will diminish

gradually


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Legal mode

• Saturday, J uly 19, 1969 – Banking

Companies (Acquisition and Transfer ofUndertaking) Ordinance, 1969 waspassed

– 14 major banks (with deposit of Rs.50 crores ormore) were purported to be transferred to 14 new

body corporate viz. ‘corresponding new banks’

– The machinery of management

– Compensation package for shareholders


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Legal mode

• Monday, J uly 21, 1969 – Ordinance was

challenged before SC• Before it was heard (on August 9, 1969) –

Banking Companies (Acquisition and Transfer of Undertakings) Act, 1969 waspassed (which repealed the ordinance)

• The act was also challenged in the SC –interim injunction was granted against

the operation of the Act


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Legal mode

• Decision on February 10, 1970

– 10:1 decision by majority• The act is within the legislative competence;

but void due to the following reasons – Only restricted 14 banks were selected – this a ‘hostile

discrimination’; – Although these 14 were allowed to do other business –

sans assets, staff, premises and even names that wasnot possible hence – unreasonable restriction

– The principle of determination of compensation wasillusory and irrelevant


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Post SC decision

• February 14, 1970 – Another Ordinancepromulgated

• This was followed by the Banking Companies(Acquisition and Transfer of Undertakings)Act, 1970

• March 31, 1970 – The Act receives President’sassent• Most of provisions were deemed to have

come into force from J uly 19, 1969

• The enactment stood the test ofconstitutionality


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“the branch network which was 8262 in

J une 1969 expanded to 60000 by 1992 witmajor expansion (80%) in rural areas. Theaverage number of people served by abranch came down from 60000 to 11000.

the development of credit is more widelyspread all over the country as against onlyin advanced states. In 1969 deposits

amounted to 30% and advances to 25% ofthe GDP…”


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“…deposits grew from a figure of Rs.4669

crores in J une 1969 to Rs.2,75,000 crores on31.3.1993. More than 45% of the total creditwas directed to the priority sector. More

than 45% of the total deposits were used bythe government to fund its five yearplans…”


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Era of nationalization ends

• With the recommendations of

Narasimaham Committee beingaccepted by the Government

• Which also started the entry of foreign

banks on Indian soil


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What were the recommendations?

• Overall emphasis upon ‘de-regulation’

• No further nationalization to be adhered to• No distinction between ‘public’ and

‘private’ sector banks

• Control of banking sector to be centralized(not to be divided between RBI andDepartment of Banking)

• SLR and CRR should be reduced to prudentlevels


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What were the recommendations?

• Concessional lending to be phased out

• The capital base of banks should meetinternational standards

• The appointment of the Chief Executive

of the banks to be de-politized


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Bank regulation


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Why regulate bank?

“the business of banking is fraught withdangers, arising principally from the instabilityin the world economy and from human error ormisjudgment. Like any other enterprise, a bankmay be overtaken by events or may begoverned unwisely. Bank failures are, therefore

no novelty. It is interesting that Bank ofEngland itself faced serious financial problemswithin two years of its foundation in 1964”

- Sir Jo hn C la p ha m , The Ba nk o f Eng la nd –A

Histo ry, CUP, 1994


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‘standing’ & ‘stability’

“two matters have to be consistently watched inorder to avoid disruption to the system. The first

may be loosely described as the general standingof institutions carrying on banking business. Oneway of achieving this object is to enact laws thatregulate banking transactions. The other is to

impose restrictions on the free entry of firms into themail line of banking business. The second matterthat needs to be regulated is the stability ofindividual banks. This involves the introduction ofmeasures to ensure that banks are able to meet

their liabilities” – Elinger’sModern Banking, 4th Edn.


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Recent past

• Crash of world economy of 1929-33

(interim periods of world war)• Banking crises of UK during 1973-76

– ‘life boat operation’

– Similar crises in Germany

• Recent ‘melt-down’


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Few other points

• Systemic risk

• Prevention of fraud• Money laundering & terrorism

• Consumer protection

• Competitive (or antitrust) policy


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Banking regulation in India


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Banking

• ‘Banking’ means the accepting, for the

purpose of lending or investment, ofdeposits of money from the public,repayable on demand or otherwise, and

withdrawal by cheque, draft, order orotherwise – S. 5(b)


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Essential functions

• Acceptance of public deposits

• Lending or investment of such deposits;and

• Agency functions


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Permissible banking business

• Sec. 6(1)

• About 15 elements – Borrowing, raising or taking up money; – Lending – with or without security;

– Issuance of letters of credit, travelers cheques

– Dealing in bullion and specie – Dealing in stocks and shares

– Underwriting

– Providing of safe deposit vaults

– Collecting and transmitting of money and securities


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– Acting as agents of the government

– Transact any kinds of guarantee and indemnity

business – Undertake and execute trusts

– Acquire, construct and maintain any building for itsown purpose

– Do all such things which are incidental or conducive tothe promotion or advancement of the business of thecompany

– Do any other business specified by the CentralGovernment as the lawful business of banking

company


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• Further – Sec. 8 – prohibits specifically a

banking company from engagingdirectly or indirectly in trading activitiesand undertaking trading risks


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Organization

• Dual control

– For entry – For expansion


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Entry license

• Sec. 22• Criteria

– The capacity of the company to pay its present andfuture depositors

– Whether there is anything to indicate – the permitwould affect the interests of the depositors

detrimentally – Impact upon the public interest

– Company’s capital structure and its adequacy

– Other ‘banking facilities’ available in the proposed area

– Such other condition which RBI considers relevant


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• Additional conditions for foreign banks

– Whether carrying of business by the company inIndia will be in pubic interest

– Whether the government or the law of the countryin which the company is incorporated

discriminates in any way against bankingcompanies registered in India; and

– Whether the company complies with theprovisions of the BR Act as applicable to foreign

companies


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• The grant of license is a discretionary

administrative function – Sh iva b ha i v RBI,A IR 1986 G uj. 19

• Licence granted may be cancelled –

Sec. 22(4)


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Expansion

• To open new branches – RBI sanction is

mandatory• Sec. 23

• While grant of such licencesRBI may

impose appropriate conditions• There are exceptions


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Capital & reserves

• Sec. 12(1)

– Subscribed capital of a banking company shall notbe less than half of its authorized capital;

– Paid up capital shall not be less than half of its

subscribed capital

– If the capital structure is changed then these

proportions shall also be changed, with in two

years


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Capital composition

• Narasimham Committee has

recommended for public issue• Hence, the Banking Companies(Acquisition and Transfer of Undertakings)Act, 1970/1980 were amended – To enable public to subscribe to the capital of the

nationalized banks up to 49% of their total capital

• The State Bank of India Act, 1955 was also

suitably amended to raise public funds


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Reserve funds

• Sec. 17

• Creation of reserve fund (not applicableto foreign banks) – To be created out of profit

– Not less than 20% of the profits have to betransferred to the reserve fund (before anydividend to be declared)

– However, the Central Government (on the

recommendation of RBI) may exempt the bank forcertain period of time


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• For foreign banks – there is no mandate

• But the foreign banks – Shall deposit with RBI – 20% of their profits each

year

– The amount may be in cash or unencumberedapproved securities


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Cash reserves

• Sec. 42 (RBI Act) – cash reserve to be

maintained by the Scheduled Bank (as tobe determined by RBI from time to time)

• Sec. 18 – (for non scheduled banks) at

least 3% of its demand and time depositsin India


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Maintenance of liquid assets

• Sec. 24 – mandatory maintenance of

liquid assets• Not exceeding 40% of its total demand

and time liabilities in cash, gold or

unencumbered approved securities• RBI will prescribe details


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Annual accounts & audit

• Sec. 29

• Mandate to prepare final accounts (atthe end of each financial year)

• The Balance Sheet and Profit & Loss

Account have to be prepared inaccordance with the formats prescribedin III Schedule


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Audit & auditors

• Sec. 30

• The Balance Sheet and Profit & LossAccounts have to be audited

– Audit by a person duly qualified to audit

– The appointment, reappointment or removal of anauditor – to be done with the prior approval of the

RBI


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The audit report

• Sec. 227 of Companies Act – (regarding thepowers, functions and duties) are all

applicable to Banking Companies as well• Some additional information to be provided

– Whether or not transactions of the company as noticed

by him were within the powers of the company – Whether or not returns from branches were adequate

for the audit

– Any other matter which the auditor considers

necessary to bring to the notice of the shareholders ofthe company


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Publication of final accounts

• Sec. 31 r/w Rule 15 [of Banking Regulation(Companies) Rules, 1949

• Final accounts are to be published in anews paper, within a period of six months

• Three copies of final accounts are to besubmitted to RBI (within 3 months)

• Sec. 220 of Companies Act – Finalaccounts and auditors report to the

Registrar of Companies


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Special audit

• Sec. 30(1B)

• The RBI may order for special audit – Such order may relate to any transaction or class of

transactions; or

– Such period or periods as RBI may specify in the order

– The RBI appoints such auditor (or can ask the regular

auditor)

– The directors are binding upon the auditor of the

banking company – and to make report directly to RBIby furnishing the copy to the bank)


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Amalgamation

• Voluntary amalgamation

– U/sec. 44A


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• Procedure

– Scheme has to be prepared & the same to be placed

before the shareholders (notice to all shareholders is

must)

– Seeking sanction from the shareholders with 2/3rd

majority – Dissenting share holders may take out their share

value

– Then the scheme has to be presented to RBI

– On sanction of RBI the amalgamation may happen


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Compulsory amalgamation

• Induced or forced by RBI

– U/Sec. 45• RBI recommends to the Central

Government


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Merger of bank and NBFC

• Amalgamations are governed by Ss. 391to 394 of the Companies Act, 1956

• The scheme of amalgamation has to beapproved by the High Court

• J une 2004 – Banks were advised to obtainthe approval of RBI after the scheme ofamalgamation is approved by its boardbefore it is submitted to the HC for

approval


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Amalgamation by government

• Central Government may order for

amalgamation of two banks – after dueconsultation with the RBI

– u/sec. 396 of Companies Act, 1956


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Winding up

• Suspension of business and winding up

– Sec. 37• Winding up by the High Court

– Sec. 38

• Voluntary Winding up – Sec. 44


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Suspension of business• When the bank is temporarily unable to

meet its obligations

• Procedure – The bank to apply to HC u/s 37

– The report of the RBI be enclosed

– If not the court can take action, by calling the report

– If satisfied the court can (with conditions) for allproceedings to stay for fixed term not exceeding sixmonths

– On passing of the moratorium order, the court may

appoint a special officer to take custody and control ofthe assets, books etc., of the bank


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Winding up by the HC• To be initiated by RBI – by applying for

winding up

– Inability to pay debts – If RBI is asked by the Central Government to make an

application

– Failure to comply with requirements of Sec. 11

– If the bank becomes incapable of carrying out thebanking business – by rejection or cancellation oflicense

– Failure to comply with the requirements of the BR Actother than Sec. 11 and continuance of such failure

beyond the period specified by RBI in this behalf


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• Additional grounds for RBI

– A compromise or arrangement sanctioned – can’t be

worked satisfactorily with or without modification; or

– The returns, statements and information given by the

bank under the Act show that it can’t pay its debts; or

– The continuance of the banking company is prejudicialto the interest of the depositors

• Once applied by RBI – the court is bound toallow the application [Palai Central BankCase, AIR 1962 SC 1371]


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Voluntary winding up

• Not possible unless RBI certifies

• The HC during this stage intervene (i) byitself; or (ii) by the application of RBI

– And may order for continuation of the business for

some time – It may even supervise the winding up proceedings

understanding banking sector in india

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