Regulating ‘banks’

Course No. II (MBL)

1. Structure and Functions of Commercial Bankers &

Financial Institutions (Module I)

2. Reserve Bank of India – Structure and Functions

(Module II)

3. Law of Banking Regulations (Module III)

4. Negotiable Instruments – Law and Procedure

(Module IV & V)

5. Banker and Customer relation (Module VI)

6. Advances, Loans and Securities (Module VII & VIII)

7. Procedural Aspects of Banking Law (Module IX)

Why regulate bank – in the first place?

“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 1694”

- Sir John Clapham, The Bank of England – A History, Cambridge, 1944

Recent history

• Crash (of world economy) of 1929-33 (interim

period of world wars)

• Banking crises of UK during 1973-76

– ‘life boat operations’– by Bank of England to rescue smaller banking institutions

• Similar crises during the same periods in

Germany

‘standing’ & ‘stability’ of banks

“two matters have to be constantly 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 main 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”

-Eligner’s Modern Banking, Fourth Edn. p.27

Indian banking regulatory environment

Certain important milestones

• 1968 – ‘Social Control’ on banking companies

imposed vide – Act, 58 of 1968 (came into

effect 01.02.1969)

• 1969 – first installment of Nationalization vide

Banking Companies (Acquisition and Transfer

of Undertakings) Act, 1970

• 1980 – second installment of Nationalization

vide Banking Companies (Acquisition and

Transfer of Undertakings) Act, 1980

• 1991– Narasimham Committee report

Scenario of 60’s

• Mismanagement of banks

• Major chunk of advances to (i) large; (ii)

medium; and (iii) big industrial houses only

• Uncovered priority sectors – (i) small scale

industries; (ii) agriculture; and (iii) exports

• Composition of banking management

– Industrialist directors

– Conflicting interests with their other ventures

– Indiscriminate lending to their ‘own’ industrial establishments

The response of the government

• No ‘real’ intentions to ‘nationalize’ initially

• Policy response to induce – ‘social control’

• Steps taken

– Establishment of National Credit Council (NCC)

– Legislative control – through amendment to the Banking Regulation Act, 1949

• The NCC got dissolved after bank

nationalization – hence, needs no further

discussion

Legislative intervention for ‘social control’

“An act further to amend the Banking Regulation

Act, 1949, so as to provide for the extension of

social control over banks and for matters

connected therewith or incidental thereto”

Induction of professionalism in the banking board – S. 10A

• At least 51% of directors shall be possessing

‘special knowledge, practical experience’ in

– Accountancy;

– Agriculture & rural economy;

– Banking;

– Co-operation;

– Economics;

– finance;

– law;

– Small scale industry;

– Any other matter (in opining of RBI useful)

Rider to ‘special knowledge’ clause

“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, co-operation or small-scale

industry”

Other mandates

• That the 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’

Power of the RBI for reconstitution

• The new sub-section – provides for sweeping

powers to the RBI to reconstitute the board

Mandate of ‘whole time chairman’ – 10B

• The basic objective – to curb the ‘industrialist’s’ encroachment over bank management

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

• He shall have special knowledge & practical experience in – Working of the bank;

– Finance;

– Economics; or

– Business administration.

Power of the RBI

• If found that – person so appointed as

‘chairman or managing director’ is not fit to

hold the position

– Two month’s notice to the person and bank to make alternative arrangement;

– If not rectified within two months – the RBI can appoint a suitable person to manage the affairs;

– Person so appointed can continue for the residuary period of the earlier appointed person

– The aggrieved person might appeal to central government within 30 days

Restriction on loans and advances – 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.

Such grant before 1.2.1969

• Such grant must be recovered

– Within such period for which the grant is made;

– If not period is specified – within one year

– RBI had discretion to extend such time

• Not such grant shall be remitted without the

previous approval of the RBI

• If not recovered within due date – then on such

date the director is deemed to have vacated his

office on such date

Others

• Additional powers were conferred on the RBI

to enforce and supervise the social control

• Punishment for the following was provided

– Obstructing any person from entering or leaving a bank;

– Holding demonstrations within the bank; and

– Acting to undermine the depositors’ confidence in a bank.

• Special powers of the Central Government to

acquire undertakings – upon such report by the

RBI (that banking company has defaulted)

Bank nationalization

The second stage of development

Introduction

“The nationalization of the commercial banks

was ‘a revolution’ in the Indian banking

system. This ‘revolution’ did not merely

signify a change of the ownership of these

banks but it was the beginning of a coordinated

endeavour to use an important part of the

financial mechanism for the country’s

economic development”

- M L Tannan, Banking Law and Practice

Process of nationalization

• 1955 – Imperial Bank of India was taken over

by the State Bank of India

• 19.7.1969 – first installment

– The Central Bank of India Ltd.

– The Bank of India Ltd.

– The Punjab National Bank Ltd.

– The Bank of Baroda Ltd.

– The United Commercial Bank Ltd.

– The Canara Bank Ltd.

– The United Bank of India Ltd.

– The Dena Bank Ltd.

– The Syndicate Bank Ltd.

– The Union Bank of India Ltd.

– The Allahabad Bank Ltd.

– The Indian Bank Ltd.

– The Bank of Maharashtra Ltd.

– The Indian Overseas Bank Ltd.

• 15.4.1980 – Second installment (of six more

banks)

– The Andhra Bank Ltd.

– Corporation Bank Ltd.

– The New Bank of India Ltd.

– The Oriental Bank of Commerce Ltd.

– The Punjab and Sind Bank Ltd.

– Vijaya Bank Ltd.

Points for nationalization

• Why ‘social control’ was not tried sufficiently?

– “…the weakness of social control was that in many banks people who had been controlling their policies in the past continued to exercise their influence over them in one way or another, some times by the continued presence of the old Chairman or Vice-Chairman of the Boards. The Banks might, as some did, obey the instructions and directions given to them. But there is all the difference in the world between people who carry out a policy wholeheartedly and with enthusiasm and those who do so only because of certain instructions” - PM on Nationalization

• The official point

– “public ownership of the 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”

• The final point

– The private banks were operating with ‘public money’ substantially

– December 1968 – for instance the total deposits of all the banks were Rs.2,750 crores; whereas the paid-up capital was only Rs.28.5 crores (i.e. hardly over 1%)

Criticism leveled against nationalization

• 168 days [from 1.2.1969 to 19.7.1969] are too

short period to declare ‘social control’ didn't

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 the result of inter-party struggle

• The banking industry is not nationalized in

some of the socialistic countries (ex: Norway,

Sweden, Finland and Denmark)

• Public control would leave the door open for

corruption and favoritism

• Because of lack of competition the ‘quality of

banking’ service will diminish gradually

The legal mode for nationalization

• Saturday the 19th July 1969 – Banking

Companies (Acquisition and Transfer of

Undertakings) 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

• Monday 21st July 1969 – Ordinance was

challenged (for constitutionality) before SC

• But before it was heard – 9th August 1969 –

Banking Companies (Acquisition and Transfer

of Undertakings) Act, 1969 was passed (the act

repealed the earlier Ordinance)

• The act was also challenged in the SC – and

interim injunction was granted against the

operation of the Act

The verdict of Supreme Court

• Decision of 10th February 1970– 10:1 decision by majority

– The act is within the legislative competence; but void due to the following reasons

1. Only restricted 14 banks; whereas others were allowed to function – this is ‘hostile discrimination’;

2. Although these 14 were allowed to do other business – sans assets, staff, premises and even names that was not possible hence –unreasonable restriction

3. The principle for determination of compensation – was illusory and irrelevant

Post SC decision

• 14th February 1970 – Ordinance promulgated

– followed by – The Banking Companies

(Acquisition and Transfer of Undertakings)

Act, 1970 [No.5 of 1970]

• 31st March 1970 – the act received President’s

assent

• Most of the provisions were deemed to have

come into force on 19th July 1969

• The enactment stood the test of

constitutionality

Salient features of the Act

1. The mode and mechanics of transfer of the

undertakings;

2. Payment of compensation to the banking

companies; and

3. Management of the 14 new nationalized

banks

Capital composition of nationalized banks

• 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

Voting rights of shareholders

• No shareholder (of the nationalized banks),

other than the Central Government shall be

entitled to exercise voting rights in respect of

any shares held by him in excess of one per

cent of the total voting rights of all the

shareholders of the corresponding new bank

Management of nationalized bank

Accounts and audit

Limited application of Banking Regulation Act

• The BRA, 1949 – as such does not apply to the

nationalized banks

• Only certain provisions of that Act are made

applicable to the new banks especially by

virtue of certain sections of the Banking

Companies (Acquisition and Transfer of

Undertakings) Act, 1970/1980

Banks – categorization in India

1. Body corporate constituted under a special

statute

– The State Bank of India Act, 1955 (SBI)

– State Bank (Subsidiary Banks) Act, 1959 (six subsidiaries of SBI)

– Regional Rural Banks Act, 1976 (RRBs)

– Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970

– Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980

2. Banking Companies Registered under the

companies Act, 1956 or a foreign company

3. Cooperative Banks [registered under co-

operative society law concerned]