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prof. O.V. Nandimath
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Indian banking sector – its evolution & development
PART III
• 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 banking
transactions– Manusmrithi speaks about – deposits, pledge, loans
and interest rates etc.,– Sons ‘pious obligation’ – to discharge the loan of
the father
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 – introduction of limited liability to banks
The interim period of 1906 to 1913
• The influence of ‘swadeshi movement’ – 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
Establishment of Imperial Bank
• Three presidency banks of Calcutta, Bombay and Madras were merged into Imperial Bank
• Vide the Imperial Bank of India Act, 1920
• The same became State Bank of India later
Establishment of Reserve Bank of India
• It was given the right of note issue• Was also to act as ‘bankers bank’ – the
function which it took-over from Imperial Bank
• However, Imperial Bank was allowed to operate as the agent of RBI, especially in those places where RBI had no branches
• Initially RBI was a shareholder’s bank – but was nationalized in 1948
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
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
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.,
The banking scenario @ 60s
• Composition of bank management – Industrialist directors– Conflicting interests with their ventures– Indiscriminate lending to their ‘own’
industrial establishments
The immediate response
• Introduction of ‘social control’• Approach – Establishment of National Credit Council
(NCC)– Legislative Control through amendment to
the Banking Regulation Act, 1949
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)
Further
“provided that, out of aforesaid number of directors, not less than two shall be persons having special knowledge or practical experience in respect of agriculture and rural economy, cooperation or small-scale industry”
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 to Chairman)– Not to be re-elected for four years – if he is
removed from his office as ‘chairman’ or ‘whole-time director’
Mandate of ‘whole time chairman’
• S.10B – the objective was to curb industrialist’s encroachment over bank management
• There shall be ‘whole-time’ chairman or ‘managing director’ to manage the bank
• He shall have special knowledge & practical experience in any of the following– Working of the bank– Finance– Economics – Business administration
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.25
company); or – Any individual – Provided the director is interested in such entity
as partner, manager, employee or guarantor etc.,
Miscellaneous
• Additional powers were conferred on RBI – to supervise and enforce ‘social control’ initiative
• Punishment provided for – Obstructing any person from entering or
leaving a bank;– Holding demonstrations within the bank;
and – Acting to undermine the depositors’
confidence in a bank
Era of nationalization starts
• July 19, 1969 – 14 major banks nationalized
• 1980 – 6 more banks were nationalized • Nationalization was perceived as a
major step in achieving the socialistic pattern of society
Modalities of nationalization
• The official point– “public ownership of major banks will help most
effectively 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”
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.222 crores
• The step was determined by political tussles and was result of inter-party struggle
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
Legal mode
• Saturday, July 19, 1969 – Banking Companies (Acquisition and Transfer of Undertaking) Ordinance, 1969 was passed– 14 major banks (with deposit of Rs.50 crores
or more) were purported to be transferred to 14 new body corporate viz. ‘corresponding new banks’
– The machinery of management – Compensation package for shareholders
Legal mode
• Monday, July 21, 1969 – Ordinance was challenged before SC
• Before it was heard (on August 9, 1969) – Banking Companies (Acquisition and Transfer of Undertakings) Act, 1969 was passed (which repealed the ordinance)
• The act was also challenged in the SC – interim injunction was granted against the operation of the Act
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 was not possible hence – unreasonable restriction
– The principle of determination of compensation was illusory and irrelevant
Post SC decision
• February 14, 1970 – Another Ordinance promulgated
• This was followed by the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970
• March 31, 1970 – The Act receives President’s assent
• Most of provisions were deemed to have come into force from July 19, 1969
• The enactment stood the test of constitutionality
“the branch network which was 8262 in June 1969 expanded to 60000 by 1992 with major expansion (80%) in rural areas. The average number of people served by a branch came down from 60000 to 11000. the development of credit is more widely spread all over the country as against only in advanced states. In 1969 deposits amounted to 30% and advances to 25% of the GDP…”
“…deposits grew from a figure of Rs.4669 crores in June 1969 to Rs.2,75,000 crores on 31.3.1993. More than 45% of the total credit was directed to the priority sector. More than 45% of the total deposits were used by the government to fund its five year plans…”
Era of nationalization ends
• With the recommendations of Narasimaham Committee being accepted by the Government
• Which also started the entry of foreign banks on Indian soil
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 and Department of Banking)
• SLR and CRR should be reduced to prudent levels
What were the recommendations?
• Concessional lending to be phased out• The capital base of banks should meet
international standards• The appointment of the Chief Executive
of the banks to be de-politized
Bank regulation
Why regulate bank?
“the business of banking is fraught with dangers, arising principally from the instability in the world economy and from human error or misjudgment. Like any other enterprise, a bank may be overtaken by events or may be governed unwisely. Bank failures are, therefore no novelty. It is interesting that Bank of England itself faced serious financial problems within two years of its foundation in 1964”
- Sir John Clapham, The Bank of England – A History, CUP, 1994
‘standing’ & ‘stability’
“two matters have to be consistently watched in order to avoid disruption to the system. The first may be loosely described as the general standing of institutions carrying on banking business. One way of achieving this object is to enact laws that regulate banking transactions. The other is to impose restrictions on the free entry of firms into the mail line of banking business. The second matter that needs to be regulated is the stability of individual banks. This involves the introduction of measures to ensure that banks are able to meet their liabilities” – Elinger’s Modern Banking, 4th Edn.
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’
Few other points
• Systemic risk• Prevention of fraud• Money laundering & terrorism• Consumer protection• Competitive (or antitrust) policy
Banking regulation in India
Banking
• ‘Banking’ means the accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise, and withdrawal by cheque, draft, order or otherwise – S. 2(b)
Essential functions
• Acceptance of public deposits• Lending or investment or such deposits;
and• Agency functions
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
– 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 its
own purpose– Do all such things which are incidental or conducive
to the promotion or advancement of the business of the company
– Do any other business specified by the Central Government as the lawful business of banking company
• Further – Sec. 8 – prohibits specifically a banking company from engaging directly or indirectly in trading activities and undertaking trading risks
Organization
• Dual control – For entry– For expansion
Entry license
• Sec. 22• Criteria
– The capacity of the company to pay its present and future depositors
– Whether there is anything to indicate – the permit would 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
• Additional conditions for foreign banks– Whether carrying of business by the
company in India will be in pubic interest– Whether the government or the law of the
country in which the company is incorporated discriminates in any way against banking companies registered in India; and
– Whether the company complies with the provisions of the BR Act as applicable to foreign companies
• The grant of license is a discretionary administrative function – Shivabhai v RBI, AIR 1986 Guj. 19
• Licence granted may be cancelled – Sec. 22(4)
Expansion
• To open new branches – RBI sanction is mandatory
• Sec. 23• While grant of such licences RBI may
impose appropriate conditions• There are exceptions
Capital & reserves
• Sec. 12(1)– Subscribed capital of a banking company
shall not be 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
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
Restriction on voting rights
• No shareholder (of the nationalized bank) other than the Central Government shall be entitled to exercise voting rights in respect of any shares held by him in excess of one percent of the total voting rights of all the shareholders of the corresponding new bank (s. 12(2))
• The limit was raised from 1% to 10% with effect from 31.3.1994
• S. 13• A banking co. shall not pay out directly
or indirectly by way of commission, brokerage, discount or remuneration in any form in respect of shares issued by it.
• It restricts the amount that may be paid by a banking company as commission etc. on the issue of shares.
• S. 15• Prohibits payment of dividend by any
banking co. until all of its capitalized expenses have been completely written off.
• It is inappropriate when capitalized expenses are outstanding
Exceptions
• The depreciation in the value of its investments in approved securities, where such depreciation has not been capitalized
• The depreciation in the value of its investments in share etc., where adequate provision for depreciation has been made to the satisfaction of the auditor
• The bad debts, where adequate provision has been made to the satisfaction of the auditor
Reserve funds
• Sec. 17 • Creation of reserve fund (not applicable
to foreign banks)– To be created out of profit– Not less than 20% of the profits have to be
transferred to the reserve fund (before any dividend to be declared)
– However, the Central Government (on the recommendation of RBI) may exempt the bank for certain period of time
• 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
unencumbered approved securities
Cash reserves
• Sec. 42 (RBI Act) – cash reserve to be maintained by the Scheduled Bank (as to be determined by RBI from time to time)
• Sec. 18 – (for non scheduled banks) at least 3% of its demand and time deposits in India
• Non scheduled banks are required to submit a monthly statement to the RBI
Maintenance of liquid assets
• Sec. 24 – mandatory maintenance of liquid assets not less than 25% of the net demand and time liabilities.
• Not exceeding 40% of its total demand and time liabilities in cash, gold or unencumbered approved securities
• RBI will prescribe details (Statutory liquidity ratio)
Annual accounts & audit
• Sec. 29• Mandate to prepare final accounts (at
the end of each financial year)• The Balance Sheet and Profit & Loss
Account have to be prepared in accordance with the formats prescribed in III Schedule
Audit & auditors
• Sec. 30• The Balance Sheet and Profit & Loss
Accounts have to be audited– Audit by a person duly qualified to audit– The appointment, reappointment or
removal of an auditor – to be done with the prior approval of the RBI
The audit report
• Sec. 227 of Companies Act – (regarding the powers, 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 of the company
Publication of final accounts
• Sec. 31 r/w Rule 15 [of Banking Regulation (Companies) Rules, 1949
• Final accounts are to be published in a news paper, within a period of six months
• Three copies of final accounts are to be submitted to RBI (within 3 months)
• Sec. 220 of Companies Act – Final accounts and auditors report to the Registrar of Companies
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 RBI by furnishing the copy to the bank)
• S.35 RBI’s Powers of Inspection• S.35A RBI’s Powers to issue directions
a. in the public interest / banking policyb. to prevent the affairs conducted in a manner detrimental to the interest of the depositors / prejudicial to the interests of the banking co.c. to secure proper management
Amalgamation
• Voluntary amalgamation – U/sec. 44A
• 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
Compulsory amalgamation
• Induced or forced by RBI – U/Sec. 45
• RBI recommends to the Central Government
Merger of bank and NBFC
• Amalgamations are governed by Ss. 391 to 394 of the Companies Act, 1956
• The scheme of amalgamation has to be approved by the High Court
• June 2004 – Banks were advised to obtain the approval of RBI after the scheme of amalgamation is approved by its board before it is submitted to the HC for approval
Amalgamation by government
• Central Government may order for amalgamation of two banks – after due consultation with the RBI– u/sec. 396 of Companies Act, 1956
Winding up
• Suspension of business and winding up– Sec. 37
• Winding up by the High Court – Sec. 38
• Voluntary Winding up– Sec. 44
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 all
proceedings to stay for fixed term not exceeding six months
– On passing of the moratorium order, the court may appoint a special officer to take custody and control of the assets, books etc., of the bank
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 the
banking business – by rejection or cancellation of license
– Failure to comply with the requirements of the BR Act other than Sec. 11 and continuance of such failure beyond the period specified by RBI in this behalf
• 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 prejudicial to the interest of the depositors
• Once applied by RBI – the court is bound to allow the application [Palai Central Bank Case, AIR 1962 SC 1371]
Voluntary winding up
• Not possible unless RBI certifies • The HC during this stage intervene (i)
by itself; 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