Banking and Other Allied

UNIT 7 BANKING AND OTHER ALLIED Regulations

REGULATIONS

Objectives

After studying this unit you should be able to:

Understand the evolution of Banking Regulation
Explain the terms and conditions to be complied with for obtaining a bank
license.
Discuss the interface of Banking Regulation Act with other laws
Describe the role of Central Government in regulating the banking sector in
India
Structure
7.1 Introduction
7.2 Evolution of Banking Regulation
7.3 Regulation in relation to Chartering / Licensing
7.4 Regulation in relation to the Bank Management
7.5 Regulations with respect to ensuring Liquidity and Healthy Lending
Practices
7.6 Reporting Requirements, Inspections, and Audit
7.7 Penal Powers
7.8 Summary
7.9 Self Assessment Questions
7.10 Further Readings

7.1 INTRODUCTION
Regulation of financial sector is extremely important. But within the sector,
banking sector regulation is most important. The reason has to do with the
importance of the role it plays in the economy, the fragile nature of the business
model of the banks and the consequences of bank failures, as has been observed
in most serious recessionary phases in recent history, including Great Recession
of 2008.

Banks not only serve as depository of people’s savings, but also serve as a payment
mechanism. The payment system, which majorly runs on payment orders made
to and cheques drawn by us on our banks, runs on the assumption that the amount
standing to our credit in the account is as good as real money. The agreement
between two parties to do an impossible act itself is void. A contract may also
void because of an event which makes the performance of promise impossible or
unlawful after the completion of the contract. The amount shown in our account
as credit is a mere debt due to us from the bank which is repayable on our demand.
Our confidence that it would be so paid whenever asked for, and the ability of
banks in almost all instances to do so ensures that we treat it as good as money.
But we tend to forget that the bank lends this money, and to cover for its cost of
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Legal and Regulatory operations and the interest paid to us, it has to lend it at a higher interest rate
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which would usually be for a fixed duration. Thus, we come to a situation where
the bank has liabilities which are short term in nature, and assets which are long
term. This mismatch between the time frame of assets and liabilities is what
underlies the fragility of the banking business. The business not only has to
manage the liquidity, but also ensure that the depositors retain confidence in the
bank, so that not only fresh funds keep coming in to match the payment orders
and instructions, but also that the depositors do not lose confidence in the bank
as the loss of confidence would certainly would cause a run on the bank causing
it to fail.

A bank failure has an effect on all segments of the economy. The depositors not
only lose their liquid assets, but may even be the cause of failure of businesses
which used the failed bank for receiving and making payments, for providing
bank guarantees or which had an overdraft facility on the back of the security
given by them. This would now not be released any time soon till the bank
insolvency process is completed. This may even have a systemic effect, if the
entity is large. A bank failure may lead to a panic reaction amongst the general
mass of depositors, leading them to withdraw deposits from other banks, causing
a bank run. Healthy banks would fail if suddenly there is a run on their deposits.
Depositors and businesses dependent upon them fail and soon enough an isolated
instance of bank failure balloons into a system wide series of failures as was
experienced during the Great Depression of 1929 and Great Recession of 2008.
The failures also affect the money supply floating in the economy, as the banking
system multiplies the money. The money in circulation due to the operation of
the banking system is usually a few multiples of the base money (the printed
money or the issued coins).

7.2 EVOLUTION OF BANKING REGULATION

After understanding the importance of banks in the economy and the necessity
of regulating them, more than other players in the economy, the question arises
as to who is best placed to regulate the banks and the legal basis of the regulatory
power.

The first necessity for bank regulation came by the need for cooperation amongst
the banks in executing payment instructions and making collections on the cheques
deposited with them. Instead of chasing each bank individually, it was thought
fit to have a central place where the banks of a local area could meet and instead
of paying each cheque individually to another bank for the other bank’s customers,
only the net balance due to each bank be paid. So, local areas had a clearing
houses. Since cheques honoured in the interim may bounce, either due to
insufficiency of funds or signature of the purported cheque writer not matching,
the collecting bank had to be solvent enough for return of moneys in such cases.
Clearing house membership was an informal regulation of the industry as it was
dependent upon confidence in the solvency of the banks who met. But the role of
industry specific bodies in forming standards for the guidance of its members
has over a period of time has become more formal, and recognized by courts in
determination of industry standards for service.

The fragility of the banking system meant that whenever there was a run on the
banks, howsoever well run and solvent they might be individually, howsoever
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good their asset quality be, there would always be a chance that they might fail. Banking and Other Allied
Regulations
No other financier would be willing to lend to the bank because it would be
afraid that even if the money lent is not lost, it may not be available to it in times
of crisis. So, a need was felt for a lender of last resort in times of crisis – an entity
willing to lend when no one is willing to do so because they are dependent on
demand deposits to lend. The entity should not depend on retail deposits and
have the power to create the money which is accepted as a valid tender.

In the late nineteenth century, Bank of England emerged as a lender of last resort
to the English banks. In the first decade of the twentieth century, the Federal
Reserve Board was formed to be the lender of last resort in the United States of
America. During the Great Depression a need was felt to have a lender of last
resort. In pursuance of this strongly felt need, the Reserve Bank of India (RBI)
was formed in 1934. Basically, the structure followed was that the banks which
wanted to be eligible to be considered for lending by the RBI, had to maintain a
certain percentage of their deposits with such lender of last resort (central bank)
and had to observe prudent business practices to be considered for lending in
emergency situations. It is like a bank exercising some control and surveillance
over a borrower who has been given an overdraft facility. With banks having
deposits with the RBI, it also has a role in the clearing house operations, thus
giving it a bird’s eye view of the working of the financial system and the solvency
of the individual players.

Regulation by perceptions of solvency and contract were thought to be insufficient.

Regulatory power was not statutory, as though the entities like Bank of England
or RBI may have come into existence either by charter or statute, the shareholders
were private individuals. After the nationalization of Bank of England and the
Reserve Bank of India, regulatory powers were given to the central bank, in the
same way as they could be exercised by the said executive wing of the government.
The powers have been reserved with the executive wing of the government in
some countries. But it was thought appropriate to give it to an entity which has
expertise in the sector, which would anyway perform a regulatory role with regard
to most of the banks because of it being the lender of last resort and thus avoid
duplication of effort. In this way, Banking Regulation Act, 1949, gave the Reserve
Bank of India the statutory regulatory power over most of the banks. The
government retained for itself the role of giving directions where it found
appropriate, and being a forum for appeal for most decisions taken by the RBI.

While RBI has the primary role in regulation of banks, it shares the regulatory
space with certain other bodies. In the case of agricultural cooperative banks and
regional rural banks, National Bank for Agriculture and Rural Development
(NABARD) also has a regulatory role as it is the principle refinancing body for
these banks serving specific needs of a sector of the economy. In the case of
urban cooperative banks, the principle means by which the RBI used to regulate
was by being the lender of the last resort for the banks which were in the second
schedule of the RBI Act. Recently, by amendment to the Banking Regulation
Act, RBI has been given a primary regulatory role over these banks, almost at
par with what it has in the case of commercial banks. However, it ought to be
noted that cooperatives having been organized under the state statutes relating to
cooperatives, the registrar of cooperatives of the state of incorporation will also
have a regulatory role (not so in the case of multi state cooperatives). In the case
of public sector banks, the regulatory role of the RBI is dependent upon how
much of the regulatory powers relating to them is ceded by the Central 151
Legal and Regulatory Government to the RBI under the Banking Regulation Act (BRA). At present,
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Central Government has given the RBI almost all the powers over the public
sector banks which the RBI has over the private commercial banks, with the
exception of the powers over the Board and other Officers of the bank.

We have considered the regulation by industry standards setting bodies,

contractual arrangements for deriving of benefits, either as lender of last resort
or refinancing arrangements or deposit insurance etc., and by statute. Another
source of regulation is the soft law framed by different international associations
for regulators for the guidance of the member regulatory bodies. As far as banking
is concerned two transnational bodies are important. The first is Bank of
International Settlements, Basel, and the Financial Action Task Force.

Bank for International Settlements (BIS) was originally a small body of central
banks of developed economies, but its membership has recently expanded. The
bank has as its primary remit the stability of the international financial system.
After the Herstatt crisis in the mid 1970s, when the failure of a German bank
created problems for the payment system in New York, BIS has sought to address
the issue of how to ensure that the banks which are participants in the international
payments systems and mechanisms, stay solvent to honour their commitments.
Towards this end, with the sanction of the member central banks it has periodically
made rules for calculation of the capital required by a bank for doing business.
Though the rules are meant only for the banks engaged in cross border payments
and which belong to the member states, requirements of international trade and
international payment system operation almost made it incumbent to most central
banks to frame regulations based on the BIS guidelines. International trade
depends upon letters of credit and banks must have confidence in the letter of
credit opened by its counter party in another country to agree to become the
payer on being presented the documents by the exporter. In a similar manner,
the guidelines of the Financial Action Task Force (FATF), formed for the purpose
of curbing the use of the financial system for money laundering, are adopted by
not just the member countries but all others who want their financial institutions
not to be excluded from the international financial system.

One has to remember that regulatory bodies acquire expertise in certain sectors
of the economy. The legislature may want to use the expertise developed by
these bodies for regulating the allied sectors. Sometimes it is necessary, as carrying
out the responsibilities in one area may require an input from or a corresponding
action in another arena of economic activity. Inactivity in the allied area may
lead to the players exercising what many would call the regulatory arbitrage -
taking advantage of the absence of rules in the allied sector to carry on the same
activity without checks and balances. Banks and non banking finance companies
(NBFCs) are different. The deposits of the latter are not repayable on demand
and they don’t act as the agent of their customers in the payment system and so
don’t form part of the payment system. But a very short term deposit or
commercial paper (as in the case of Lehman Bros which failed in 2008) may
make them also very fragile. If the lenders to these institutions are banks, then
the regulator for banks becomes interested in their solvency, more so if the banks
form these NBFCs to bypass the regulatory barriers. That is why they are
sometimes called shadow banks. As a result of this, the RBI was given the
regulatory remit for the NBFC sector by an amendment to the RBI Act in 1997,
when a regulatory vacuum in the NBFC sector was noticed after the failure of
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many depository NBFCs. Similarly, since the RBI has the remit to maintain the Banking and Other Allied
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monetary stability (stability in the value of the currency), it has the regulatory
powers in the money market (short duration loan and short term debenture market)
under the RBI Act, monetary payment and settlement systems (under Payment
and Settlement Systems Act) and regulates the capital flows in the foreign
exchange market (under Foreign Exchange Management Act).

7.3 REGULATION IN RELATION TO

CHARTERING / LICENSING
Banking is a business of borrowing and lending money, but with special features
which are absent in other borrowing and lending businesses. Not only are deposits
with it repayable on demand, but they are repayable only in the branch with
which the account is kept, and the bank also gives the cheque facility to its
customers and would collect cheques on their behalf. The last requirement means
that the bank has to take a debt/deposit from its customer and whenever the
customer wants it the bank cannot refuse it as in case of ordinary debtors.
Banking Regulation Act prevents any person or entity to give a cheque writing
facility to its customers if the person or entity is not a bank. Further it prevents
the use of the term bank by any entity which is not a banking company registered
under the Banking Regulation Act (though some entities use the terminology
under the special statutes by which they are created or under which they are
incorporated). While banks were in business long before BRA came to be enacted,
a time frame was given for such banks to get the license to operate as a bank
from the RBI. All new banks to operate as a bank needed a license from the RBI.
The grant of a license is the discretion of the RBI, but the BRA lays down certain
conditions for the exercise of its discretion, conditions which it is required to be
satisfied about before grant of a license. The company must not only be in a
position to repay present and future depositors in full as their claims accrue, but
should have adequate capital structure and earning prospects along with the
character of the proposed management and the conduct of its affairs not being
opposed to public interest or interests of depositors . In addition, the RBI will
look into the public interest and availability of banking facilities in the proposed
area of operations. While granting license, the RBI may lay down conditions to
be fulfilled by the licensee when operating as a bank.
Banking Regulation Act (BRA) gives RBI wide amplitude in the granting of a
license. The RBI has in recent times given out a policy papers on how it would
exercise its discretion. The conditions for license for different types of banks are
different as each of them would pose different risks to the financial system. At
present, banking license for commercial banks are in three categories - payment
banks, small finance banks and full-fledged commercial banks. The first do
not give out any commercial loans while the second give loans only up to a
specific amount allowed by the RBI (Rupees twenty five lakhs at present). Since
the first and second categories of banks pose a lower risk, the licensing conditions
are less onerous for them. The third category of banks has more onerous conditions
regarding capital and character of the management. One change by the RBI in
the latest policy statement is that from now on the bank licenses are to be on tap
provided the applicant meets its rigorous conditions for them and it has also laid
out a roadmap for payments banks to progress to small finance banks and then to
full-fledged commercial banks.
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Legal and Regulatory The RBI license is also required for the opening of bank branches, the definition
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of which is very wide in the BRA to take into account all payment offices. At
present, such licenses are not individually given but banking companies have
been given general permission to open branches provided a spatial distribution
in terms of rural and urban branches is maintained. Foreign banks wanting to
open branches in India are required to have a license from the RBI. The license
is granted on the basis of reciprocity (Indian banks can open branches in the
country of incorporation of the foreign bank). The latest guidelines of the RBI
provide that the foreign banks wanting to start a bank in India will have to do so
through a subsidiary incorporated in India, as it wants to insulate the Indian limb
of the business of the foreign bank from the fluctuations in the fortunes of the
foreign bank in other jurisdictions.

For any company to be licensed to operate as a bank, one essential aspect which
is required to be looked into is its capital. Capital of the banking company will
have two aspects, initial capital and capital in relation to business. BRA concerned
itself only with the initial capital and the amounts mentioned therein have only a
historical importance, no longer relevant in the present times. RBI gives out the
minimum capital the bank requires to have(depending upon the type of bank
license applied for), but also lays out the capital which a bank needs to have in
accordance with the size of business and the risk profile of its loan assets. This is
in pursuance of the application of the norms agreed upon by the central banks in
the Basel Accords. Basel Accords (at present we have Basel III) take into account
the reality that the shareholder, who controls the management, has a limited
liability. Because the liability of the shareholder is limited, the shareholder body
has an incentive to push the management to take greater risks in lending so as to
increase the shareholder returns. This risk reward conundrum in a limited liability
entity can only be broken by requiring that the shareholder put in additional
capital where the risks are greater. So now the capital requirements of a bank are
based on the size of its loan book and the quality of its loan book. Less shareholder
capital is required when money is lent to the government, more capital is required
when money is lent to an individual backed by the security of mortgage of self
occupied house and most capital is required when an unsecured loan is given for
a business. Basel norms also takes into account of balance sheet exposure of
banks in the form of bank guarantees, etc. The Basel capital requirements refers
to capital which is available to depositors of the bank as a cushion in the event of
bank not performing well. The capital can be in the form of equity shares,
irredeemable preference shares and debt in form of debentures (convertible or
non convertible) or bonds which are subordinate to debt due to the depositors.
The capital requirements can further be divided into tier one and tier two,
depending upon how permanent the capital is. Tier one comprises equity shares,
irredeemable preference shares and some debentures or bonds with the condition
that their redemption is dependent upon the banking company fulfilling certain
conditions and it wanting to redeem it.

7.4 REGULATION IN RELATION TO THE BANK

MANAGEMENT
As was observed earlier, that the law is concerned about the general character of
the proposed management and as to how the affairs of the bank are conducted so
that the public interest and the interests of the depositors are not affected. There
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are two aspects to the above issue. One is who controls the bank that is the Banking and Other Allied
Regulations
shareholding composition and the degree of control a body of shareholders can
exercise, and the second issue comprises the quality of the management and its
conduct.

It is important for the banking company’s depositors as to the distribution of the

shareholding and the extent of the control that the dominant group of
shareholders exercises over the bank. Part of the problem is taken care of by the
BRA, and part of the problem is taken care of by the conditionalities laid out by
the RBI in giving the license and its powers to issue directions to the banks.

First of all the statute denies voting rights to preference shareholders irrespective
of the fact that they have not been paid preferential dividend for two years or
more.

Secondly, even in the case of equity shares, no shareholder can exercise voting
rights in excess of ten percent of the issued equity share capital. This cap on
voting powers can be increased by the RBI up to twenty six percent. Thirdly, no
one on his own or in concert with others can own five percent or more of the
equity share capital or voting rights in a company without the prior permission
of the RBI.

In addition to these statutory restrictions, the RBI at the time of the granting the
license lays down a schedule for the dilution of the promoter of the banking
company. These are to ensure that individual interests do not get equivocated
with the interests of the bank and there is a diversity of shareholding and voting
power so that there is sufficient control over the dominant shareholder without
there being a takeover which may not be in the interests of the depositors.

Second limb of ensuring good management is quality of management and its

conduct. BRA covers almost all aspects of potential control over the management
and almost all the aspects of a Board of Directors working which may affect the
bank. The provisions may appear at some times to be repetitive.
First of all, the BRA deals with the potential conflict of interest between the
bank and its Board. A banking company is forbidden to lend to any director or
any person in whom the director may be interested in. Further, a bank may not
remit any debt due from a director or any person in whom the director may be
interested in without the prior permission of the RBI. This blanket ban on power
to remit extends to extension of time for repayment or change in the terms of
repayment. A person to be a director must not be a proprietor of any business
concern or have a substantial interest (defined by BRA) in any company or firm
or be connected with it in any form if it were not a small scale industrial concern.
The Act prevents a director on the board of a banking company to be a director
on the board of any other company, even another banking company. The only
exception granted to this ban is membership of the board of a subsidiary of the
bank or that of a non-profit company. In addition, from a Chairman appointed on
a whole time basis, directors to all employees of a bank, irrespective of whatever
rank or office they hold, all are deemed to be public servants under Prevention of
Corruption Act and can therefore be prosecuted for causing any loss to the bank
by their corrupt actions.
After dealing with the conflict of interest, the BRA deals with the composition
of the Board. Majority of the board needs to have technical expertise specified 155
Legal and Regulatory by the BRA, with a further requirement of special knowledge and practical
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experience in the case of a whole time Chairman or Managing Director (there
can be only one of the two in a bank). What is important is the power of the RBI
to interfere with the appointment process of the appointment of the Board, the
Chairman and the Managing Director. No amendment in the articles of association
or memorandum, no contract or resolution of the shareholders or the Board of
Directors with regard to the appointment, termination or remuneration of a
Chairman, Managing Director, Director or Chief Executive Officer shall be
effective unless approved by the RBI. Other than Directors who are not whole
time Directors, even the appointment, reappointment or termination of
appointment of the aforesaid managerial personnel requires the prior permission
of the RBI. The RBI can ask the banking company to reconstitute its Board if the
composition of the Board is not in accordance with the BRA. Non compliance
by the banking company of the direction would allow the RBI to remove the
Director/s whose appointment is not in compliance of the law and appoint its
own nominees on the Board. In the same vein, in case the RBI comes to the
conclusion that the whole time Chairman or Managing Director of the company
is not a fit and proper person, it may require the company to change the whole
time Chairman or Managing Director and non compliance with the direction
would allow the RBI to appoint its own nominee to the post. This power is in
addition to the power of the RBI to appoint when the said post is vacant for an
inordinately long period.

In public interest, interest of the depositors or for securing proper management

of the banking company, the RBI can remove any managerial personnel
(Chairman, Managing Director, Chief Executive Officer, etc.) or officer or
employee from the office after following due procedure, and appoint its own
nominee to the post. For the same reasons it may also appoint Additional Directors
on the Board of the banking company and also in consultation with the Central
Government supersede the Board of Directors and appoint an Administrator to
manage the affairs of the banking company.

It would be worthwhile to note that many of these provisions with regard to

managerial personnel, with suitable modifications are also applicable to
cooperative banks. In the case of the public sector banks (which are governed by
separate statutes by which they were formed or nationalized), the powers are
exercised by the Central Government.

7.5 REGULATIONS WITH RESPECT TO

ENSURING LIQUIDITY AND HEALTHY
LENDING PRACTICES
As discussed above, the banking business is inherently fragile as it lends for
long term purposes, from on the basis of funds which are borrowed from short
term sources. Other than ensuring that the management should not be such that it
may compromise the interests of the depositors, certain norms have to be in
place so that liquidity is maintained and the bank’s business is run in such a
manner that it remains solvent. These statutory provisions came about in the
background of historical experiences from some famous bank failures, which
the legislature did not want to be repeated. So there are certain no go areas for
the bank which the Parliament has itself prohibited, or allowed a relaxation only
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with the prior permission of the RBI. As to the rest it has allowed the RBI to give Banking and Other Allied
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guidelines or directions taking into account the best practices in the world and
the economic reality of India.

First of all, a bank, in addition to banking business, can only do a business that is
permitted by section 6(1) of the BRA, though the last sub-clause of section 6(1)
allows the government to notify any other business or activity which a bank
could engage in. What it cannot do directly, it cannot do indirectly, as well. So,
no bank could have shares in excess of thirty percent of the shares in any entity
not engaged in a business mentioned in section 6(1) of the BRA. This restraint
on shareholding is with reference to holding in any form whatsoever i.e., as an
absolute owner, mortgagee or pledgee. Pursuant to historical experience, a bank
is forbidden to trade in goods and hold immovable property (which is not required
for banking business) for a period of more than seven years. In addition, as the
ambit of a bank’s permissible activities are also circumscribed like any company
by the object clause of its Memorandum of Association, and any change in the
Memorandum of Association of the bank requires the prior approval of the RBI.
RBI can also caution or prohibit a bank or banks from entering into a transaction
or class of transactions based upon its apprehensions. The reason for this
comprehensive set of limitations is that the bank which has an opportunity to use
the money parked by its depositors, should limit itself to the business related to
money lending and allied activities. Banks should not venture into a full-fledged
business entity by itself, as then the chances are that the easy liquidity made
available to it by the unsuspecting depositors may incentivize the management
to take risky bets and suppress losses and thus turning the bank in effect into a
ponzi scheme, satisfying old depositors by new deposits of the unsuspecting
customers. Moreover, the drafters of the BRA were concerned that the interests
of the depositors should not be made subservient to the interests of other creditors
of the bank. In pursuance of this objective, there is a prohibition on banks in
giving a floating charge on its assets to any creditor without the prior approval of
the RBI.

In addition to the restraints imposed expressly by it, the BRA gives rule making
powers to the RBI. Though BRA uses the term guidelines and directions for such
rules made by the RBI, they are binding on the bank, though a lending decision
in contravention of them may still be enforceable in a court of law. BRA recognizes
that such guidelines may be specific to a bank or may be general, applicable to
all or a class of banks or a bank. The RBI, when granting a license, may grant it
subject to conditions including conditions relating to loans which a bank can
give, as it does in the case of small finance banks and payment banks. Then
section 21 of the BRA allows the RBI to lay down the policy for bank advances,
generally for all or specific to a bank, including laying down the purpose, margins
for a security, considerations for determining maximum exposures which a
banking company can have to an individual, company or group as well as rates
of interests and conditions for financial accommodation of a borrower. It is in
pursuance of these powers that the RBI lays out the policies for social sector
lending, syndicate lending for large ticket loans, prompt corrective action for
weak banks, margin requirements for different types of securities including market
securities, purposes for which no money could be lent, minimum interest
chargeable and calculation of interest rate in the case of floating rate loans, etc.

Even otherwise, the RBI in public interest or in the interests of the banking
policy or interest of depositors or for proper management of the banking company 157
Legal and Regulatory may give general or specific directions to banks. It is in pursuance of this power
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the RBI has implemented the Basel Accord norms in India and given banks
guidelines as to income recognition (a frequent cause of bank failure by
suppressing its weaknesses), NPA recognition and classification, debt restructuring
of sick enterprises and hauling the insolvent enterprises to the NCLT for
insolvency proceedings. As per one of its directions, every bank should have a
risk management committee to monitor the lending practices of the bank so as to
ensure its stability.

To handle potential liquidity crisis in a bank, even if it is well run, the law follows
a two pronged approach. The first is to prevent a sudden abnormal surge in the
need for liquidity due to panic amongst bank customers and the second approach
is to ensure that the bank has enough investment in assets which can be considered
liquid so that cash could be rustled up whenever the need for it arises. To prevent
panic, BRA makes it a punishable offence any act which is designed to undermine
the confidence of depositors in a banking company. Further, the depositors are
automatically given a deposit insurance to the extent of Rupees five lakhs. To
ensure liquidity in case of sudden demand, in addition to the lender of last resort
role of the RBI under section 19 of the RBI Act to the scheduled banks (a lending
done at the Bank Rate fixed by the RBI), every scheduled bank has to maintain
a deposit with RBI a certain percentage (fixed by the RBI, but at a minimum
three percent) of its time and demand liabilities. This cash reserve ratio helps in
the settlement in interbank transactions via the RBI and also is an emergency
liquid reserve available in an emergency. In addition to cash reserve ratio, the
banks have also to invest a certain fixed percentage of deposits in assets which
can be liquidated easily to raise cash. Called statutory liquidity ratio, these assets
are generally government bonds or bonds guaranteed by the government, though
few other assets have also been qualified to be part of the statutory liquidity
ratio. Subject to the floor and ceiling rates prescribed by the BRA, the cash
reserve ratio and the statutory liquidity ratio is fixed by the RBI. In addition to
these three means to ensure liquidity, the RBI has also provided a repo window
to the banks. Essentially, a repo transaction is a short term lending disguised as a
sale and repurchase transaction between the parties. Securities are sold by the
bank to the RBI with an understanding that they will be bought back by the bank
after a specified period (usually a few weeks), at a fixed rate which represents
the price of original sale and a specified interest rate called the repo rate (fixed
by the Monetary Policy Committee).

7.6 REPORTING REQUIREMENTS, INSPECTIONS

AND AUDIT
It is important for the regulator to be aware of the health of the regulated entities.
This is not just to see whether compliance is in accordance with the letter and
spirit of the regulations, but also to allow a preemptive action to be taken to
ensure that the regulated entity does not fail or its failure, if inevitable, does not
pose a systemic risk. The three pillars of this regulatory awareness are regular
reporting, statutory audits by trusted auditors and inspections. In the case of
banks, these three serve as an additional avenue of information in addition to
what is gleaned by the RBI from the working of the payment system.

The banks have to maintain the cash reserve ratio, statutory liquidity ration and
158 a minimum of seventy five percent of assets in India equal to its demand and
time liabilities in India. These three ratios have to be regularly calculated at Banking and Other Allied
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given intervals, so the RBI also needs to be informed about their compliance.
Therefore, on the last Friday of every month, every bank has to submit in the
given format data with regard to the liabilities and assets of the bank along with
any other information which the RBI may ask for. Further, under the RBI Act,
the banks have to share with the RBI credit information (which is much more
than advances made by the banks and includes information about guarantees,
securities and other potential liabilities), which the RBI can share with other
banks (express provision for sharing of such information was necessary because
of the customary law that banks should maintain confidentiality about their
customers financial affairs). This was thought of as a way to reduce systemic
risk. BRA now allows the RBI to publish any information received by it from the
banks as well as any credit information disclosed under Credit Information
Companies (Regulation) Act. This power should be read in consonance with the
power given in the RBI Act by which the information shared with the public
should not name the borrower and the lender.
The second limb of maintaining financial health through awareness is audit. While
the company law provisions with regard to audit are also applicable in so far as
they are not in conflict with the BRA, in the audit process of a company the RBI
has a certain control as it is, on behalf of the depositors, also interested in the
audit process. The auditor in addition to being deemed to be a public servant
under Prevention of Corruption Act, has to be approved by the RBI before his/
her appointment, reappointment or removal in addition to following the
Companies Act in such matters (RBI has a list of approved auditors). The RBI
can also order a special audit of the banking company, to be conducted either by
the banking company’s auditor or any other auditor appointed by the RBI. The
auditors are also supposed to report on matters directed by RBI to be looked into
and the report of the auditors, normal as well as the special shall be shared with
RBI.
The third important pillar of this process to find the truth is the inspection powers
of RBI, which it may do so on its own or shall do so on the directions of the
Central Government. During inspections not only the records of the bank will be
scrutinized, but the officers and employees may also be examined under oath.

7.7 PENAL POWERS

Any regulator’s powers have three components i.e., legislative (rule making),
executive and judicial (power to impose penal sanctions). The third component
is as important as the first two components because it is the third component
along with its expertise in the subject matter which puts the fear of the regulator
in the hearts of the regulated. What can be the penal consequences for non
observance of the regulatory guidelines and directions other than that of the
change of key personnel, supersession of Board, nomination of additional
members on the Board etc., which the RBI can exercise or threaten to exercise to
ensure compliance?

At the first level the RBI can deny the permissions which can be expected from
it, or deny the enjoyment by the regulated entity (banking company) of the general
permissions granted to the sector. So as a disciplinary step it may not sanction
the renewal of a Chairman or Managing Director’s appointment, or tell a bank
not to open new branches under a general permission given to all banks.
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Legal and Regulatory The second method of penalizing a bank is to forbid it from doing what constitutes
Framework for Financing and
Investments of Business
the core of the banking business, a denial of which might mean a slow death of
the bank. So, using its powers to prohibit a certain transaction or class of
transactions generally or specifically, it can impose restrictions on a bank on
making advances or certain types of advances. The Central Government, if it is
convinced on the basis of an inspection report by the RBI that the banking
company’s affairs are being run in a manner which is detrimental to the interests
of the depositors, then it may prohibit the bank from taking fresh deposits. Failure
to comply with cash reserve ratio may also result in the RBI prohibiting the bank
from accepting fresh deposits.

The third way of penalizing is imposing a fine on the bank and/or its officers. So
non observance of the mandated cash reserve ratio and statutory liquidity ratio
would result in the imposition of penal interest on the bank to the extent it is
short of the required ratio and in addition the officers of the bank may be liable
for fine calculated on the basis of per day the bank was in default. Penalty is also
prescribed to those responsible for furnishing misleading information, not
furnishing the asked for information, accepting fresh deposits in contravention
of the prohibition or contravening the provisions of the BRA. However, a court
can take cognizance of the offence only if the RBI approaches it. The RBI also
has the powers to impose fines on its own.

The fourth way the penal consequence visits the non compliant bank is the
cancellation of license of the bank itself or of its branch. There are certain
conditions which BRA requires for grant of license (discussed above) and in
addition there can be certain conditions which the RBI may impose in granting a
license. If these conditions are not being fulfilled then the RBI may cancel the
license issued by it.

The fifth way in which the RBI may discipline the bank is by initiating the
winding up of the banking company. The RBI may make an application before
the Tribunal for winding up a banking company if it is convinced that the affairs
of the banking company are being conducted in a manner detrimental to the
interests of the depositors. Non adherence to the capital requirements of a bank,
non compliance with the conditions of the license, prohibition from acceptance
of fresh deposits and non compliance with the provisions of the BRA are also
grounds for initiating such action in addition to the insolvency of the bank.

The sixth tool to discipline a bank is by penalizing the shareholders without

winding up the bank. The Central Government can acquire a banking company
(on the basis of a report by the RBI) if it is in repeated violation of the RBI
directions or the affairs of the banking company are being conducted in a manner
detrimental to the interests of the shareholders. There is provision for shareholder
compensation for the expropriation, but no control premium is paid. In a similar
vein the RBI can reconstruct a banking company or amalgamate it with another
after imposing a moratorium on the bank. Here, in addition to the shareholders,
the depositors too may lose a part of their deposits (a ‘haircut’).

7.8 SUMMARY
Regulation of financial institutions is extremely important because of the unique
nature of a financial asset. It is an asset which derives its value by description
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and its own existence is dependent upon the solvency/existence of the parties. Banking and Other Allied
Regulations
Amongst all the players in a financial system, the banks are the most unstable of
the lot because of their business model. Regulation seeks to reduce the risks of
operation to the bank itself, to the banking system and to the overall financial
system and the economy. Since banking as an industry keeps in evolving and
new risks keep on getting identified and the relative importance of some of the
old identified risks may get reduced, regulatory legal structure needs to be flexible
enough to take into account the new challenges with alacrity. Indian regulatory
structure for the banking industry tries to merge flexibility, so as to take into
account the global best practices and Indian reality, with some certainties as to
the considerations which will go into the rule making. Some provisions also
seek to ease the hurdles in the smooth conduct of the banking business. Therefore,
provisions for evidence by banks in Bankers Book of Evidence Act, nomination
in the BRA and sharing of credit information under the RBI Act and Credit
Information Companies (Regulation) Act seek to remove the landmines which
are there in law in the conduct of banking business.

7.9 SELF ASSESSMENT QUESTIONS

1) “RBI is the banker of the last resort”. Do you agree with the statement?
2) Stringent terms and conditions are required to be complied with for obtaining
a bank license. Please explain such terms and conditions.
3) Discuss the interface of Banking Regulation Act with other laws.
4) Discuss the socio-economic impact of the banking system in any country.
5) Discuss the role of shareholders in banking companies.
6) Discuss the role of Central Government in controlling and regulating the
banking sector in India.

7.10 FURTHER READINGS

1) Gupta, S.N., 2017, The Banking Law In Theory And Practice, Universal
Law Publishing
2) M.L. Tannan, M.L., 2014, Banking Law And Practice In India, Lexis Nexis

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