Youth for P olicy & D ialogue India’s first Think Tank of young people www.youthpolicy.in Youth for P olicy & Dialogue www.youthpolicy.in T +91 98 9969 2695|E[email protected]| #26, Sector- 49, Noida, U.P. Economics and Finance Initiative Poli cy Brief EF202 –BANKING REGULATION STRUCTURE IN INDIAABSTRACTBanking regulation is rising as an issue of prime importance since the global financial crisis of 2007-08. The analysis of impact impressed upon the governing bodies worldwide, that the financial systems require stringent regulatory oversight. Banking sector in India has been quite robust in terms ofasset quality and health of balance sheets. This paper present a detailed analysis ofthe structure of banking regulations in India and their critical importance in the architecture of sustainable growth model of our economy. This articles hopes to serves as an informative piece for policy enthusiasts and deepen their understanding about our banking system and the regulatory regime. The Finance & Economic Initiative at Youth for Policy & Dialogue aims at gathering decision- makers and young researchers to develop non- partisan and thorough research on Finance & Economic issues. The Initiative’s current events are:• Study Banking Regulations &issues on Climate Finance •Monthly Dialogue/Lecture series on issues ofEconomy & Finance •Advocacy & Representation of young people in different economic forums, government institutions & policy making. Initiative Head: Abhishek Bhardwaj Prepared By:Abhishek Bharwda jabhishek.bhardwaj@youthpolicy.i nFor Economics & Finance Initiative at Youth for Policy & Dialogue [email protected]June 15, 2011
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Though the Company law was introduced in India way back in 1850, it did not apply to the banking
companies. The banking crisis of 1913, however, had revealed several weaknesses in the Indian bankingsystem, such as the low proportion of liquid assets of the banks and connected lending practices,
resulting in large-scale bank failures. The recommendations of the Indian Central Banking Enquiry
Committee (1929-31), which looked into the issue of bank failures, paved the way for legislation for
banking regulation in the country.
Though the RBI, as part of its monetary management mandate, had, from the very beginning, been
vested with the powers, under the RBI Act, 1934, to regulate the volume and cost of bank credit in the
economy through the instruments of general credit control, it was not until 1949 that a comprehensive
enactment, applicable only to the banking sector, came into existence. Prior to 1949, the banking
companies, in common with other companies, were governed by the Indian Companies Act, 1913, which
itself was a comprehensive re-enactment of the earlier company law of 1850. This Act, however,
contained a few provisions especially applicable to banks. There were also a few ad hoc enactments,
such as the Banking Companies (Inspection) Ordinance, 1946, and the Banking Companies (Restriction of
Branches) Act, 1946, covering specific regulatory aspects. In this backdrop, in March 1949, a special
legislation, called the Banking Companies Act, 1949, applicable exclusively to the banking companies,
was passed; this Act was renamed as the Banking Regulation Act from March 1966. The Act vested in the
Reserve Bank the responsibility relating to licensing of banks, branch expansion, and liquidity of their
assets, management and methods of working, amalgamation, reconstruction and liquidation. Important
changes in several provisions of the Act were made from time to time, designed to enlarge or amplify
the responsibilities of the RBI or to impart flexibility to the relative provisions, commensurate with the
imperatives of the banking sector developments.
It is interesting to note that till March 1966, the Reserve Bank had practically no role in relation to the
functioning of the urban co-operative banks. However, by the enactment of the Banking Laws
(Application to Co-operative Societies) Acts, 1965, certain provisions of the Banking Regulation Act,
regarding the matters relating to banking business, were extended to the urban co-operative banks also.
Thus, for the first time in 1966, the urban co-operative banks too came within the regulatory purview of
the RBI.
The Indian banking sector has witnessed wide ranging changes under the influence of the financial
sector reforms initiated during the early 1990s. The approach to such reforms in India has been one of
gradual and non-disruptive progress through a consultative process. The emphasis has been on
deregulation and opening up the banking sector to market forces. The Reserve Bank has been
banking development needs to be taken forward to serve the larger need of financial inclusion through
expansion of banking services, given their low penetration as compared to other markets.
Regulatory Framework
The Reserve Bank has been taking timely initiatives to ensure that the regulatory framework for
the banking industry is regularly updated in keeping with the evolution of the financial
system, reduce chances of regulatory/ supervisory arbitrage and excessive risk taking. Besides
higher capital adequacy ratio and requirement of statutory liquidity buffers in the form of Cash
Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR), banks are subject to regulatory
norms pertaining to concentration risks, capital market exposure, inter-bank exposures, and
external debt intermediation. Banks’ exposure to derivatives have also been brought under
the ambit of capital adequacy regime with prescriptions on use of credit conversion factors
linked to the maturities of interest rate and exchange rate contracts. The Reserve Bank hasalready put in place a monitoring mechanism to capture the ‘contagion risk’ within financial
conglomerates as also its cumulative exposure to specific outside entities, sectors and market
segments from the point of view of various concentration risks facing the conglomerates.
Institutional Developments
In order to promote financial inclusion through larger number of banks, competition and good
governance with diversified ownership, the Reserve Bank released a discussion paper on
licensing of new private banks on 11 August, 2010. The discussion paper seeks to obtain
feedback on the following aspects:1. Minimum capital requirements for new banks and promoters contribution
2. Minimum and maximum limits on promoter shareholding and other shareholders
3. Foreign shareholding in the new banks
4. Whether industrial and business houses could be allowed to promote banks
5. Should Non-Banking Financial Companies be allowed conversion into banks or to
promote a bank
6. Business model for the new banks.
Core investment companies primarily holding financial instruments are prone to market risk
and hence need to be properly regulated to prevent systemic implications of their failure on the
financial system. Accordingly, in August 2010 the Reserve Bank unveiled regulatory norms for
core investment companies holding not less than 90 per cent of assets in the form of equity
shares, preference shares, debt or loans in group companies. These holding companies and
investment firms of large business houses with assets above ` 100 cores will be required to
register with the Reserve Bank, maintain a minimum level capital and remain subject to
Further, changes relating to the counterparty credit risk framework are likely to have capital
adequacy implications for some Indian banks having large OTC bilateral derivatives positions.
Meanwhile, since the BCBS has taken in-principle position that no assets, including cash should
be exempted for the measurement of leverage ratio, the SLR would not be excluded for
the calculation of leverage. However, the proposed regulation would not constrain banks due
to the existing lower leverage ratio and adequate Tier I capital and limited derivatives
positions. On the other hand, few banks may be called upon to maintain additional capital
and liquidity charges to cover systemic risk capital and liquidity. With national discretion
provided on proposals relating to forward looking countercyclical buffers, the impact of this
regulation may have to be considered from the standpoint of its effect on overall credit
growth, although building such buffers would not be too difficult for banks in a cyclical upturn.
In the Indian context it would be preferable to follow sectorial approaches to countercyclical
policies which have served well so far. Meanwhile the risk management framework for the
banking system as prescribed by the Reserve Bank continues to be strengthened with
guidance received from standard setting bodies.
Long Term Financing
The constraints on the maturity of liabilities of the banking system largely consisting of
retail deposits – biased towards the shorter end could inhibit banks to fulfill long term
financing needs of sectors such as infrastructure as recent trends show that the bank lending
to infrastructure sector is growing appreciably. The changing composition of bank credit in favor
of long term financing can potentially aggravate asset liability mismatches in the bankingsystem. It may not be prudent to further increase individual and group exposure norms for
infrastructure financing, which already stand relaxed. Going forward, added impetus on take-
out financing or other innovative credit enhancements mechanisms may have to be encouraged
for bridging the gap between the demand and supply of long term funds.
Banks in India have also shown interest in sponsoring and managing private pools of capital such
as venture capital funds and infrastructure funds. A discussion paper on prudential issues in
banks’ floating and managing such off balance sheet activities was issued by the Reserve Bank in
January 2010 for comments. To promote infrastructure investment, in July 2010, the Reserve
Bank permitted take - out financing arrangement through External Commercial Borrowings(ECB), under the approval route and subject to specified conditions, for the purpose of
refinancing of Rupee currency loans availed of from the domestic banks by the sea port and
airport, roads including bridges and power sectors for the development of new projects.
In August 2010, the Reserve Bank issued draft guidelines for CDS to seek feedback from
stakeholders. The introduction of CDS would help banks to manage exposures while increasing
flexibility and strengthen both the interest rate and credit channels of monetary transmission.
Interest rates on deposits have been rising since December 2009 taking cues from the rise in
policy rates by the Reserve Bank. Going forward, it is important that banks focus on deposit
mobilization with commensurate interest rates that could boost retail deposits.
Securitization
The RBI had issued guidelines on securitization of standard assets in February
2006. These guidelines prohibit originators from booking g profits upfront at the time of
securitization. Two other features relate to maintenance of capital at the required minimum
of 9 per cent on any credit enhancements provided, and disallowing the release of credit
enhancement during the life of the credit- enhanced transaction. Thus, banks in India do not
have incentive to resort to unbridled securitization as observed in “originate -to - distribute”
and “acquire and arbitrage” models of securitization in many other countries. In the light of
the international experience of the financial crisis, particularly, the inability of regulation to
prevent the excessive building up of risks through securitization and off balance sheet
leveraging, the Reserve Bank has issued draft guidelines on securitization for banks and non-
banking financial institutions in April 2010 and in June 2010, respectively, seeking comments on
the same. Two important features included in the draft guidelines pertain to defining a
minimum holding period before selling an asset to the Special Purpose Vehicle (SPV) and
retention of a minimum portion of the loan prior to securitization.
Accounting Standards
Well-designed accounting covenants are necessary for maintaining financial stability.Accordingly, the G -20 Group on Enhancing Sound Regulation and Strengthening Transparency
has recommended that the accounting standards setters and prudential supervisors should
together identify solutions that are consistent with the complementary objectives of
promoting financial stability and transparency. The Annual Policy Statement of
2010-11 announced that as part of the effort to ensure convergence of the Indian
Accounting Standards (IAS) with the International Financial Reporting Standards (IFRS), all SCBs
would be required to convert their opening balance sheet as at April 1, 2013 in compliance with
the IFRS converged IAS. The presentation of financial statements in line with IFRS will be
challenging for banks. The changeover from currently followed accounting principles viz.,
those prescribed by RBI to IFRS may have material impact on financial statements of bankparticularly in areas such as provision of loan losses and impairment of investments which
would require high level of judgment and extensive use of unobservable inputs and
assumptions. This is turn would entail significant changes in financial reporting process.
Specifically y, unlike under the current RBI accounting rules where loans losses are provided
based on provisioning rates in a mechanical fashion, the IFRS would require prior and fair
assessment of expected impairment and upfront provisioning of loan losses.
However r, with regard to Urban Co - operative Banks (UCBs) and Non-Bank Finance
Companies (NBFCs), a staggered implementation schedule was considered appropriate
depending on the size of net worth. Considering the amount of work involved in the
convergence process, it is expected that banks and other entities initiate appropriate measures
to upgrade their skills, management information system and information technology capabilities
to manage the complexities and
Challenges of IFRS.
Financial Inclusion
Financial inclusion is being accorded top most priority by the Government and the Reserve
Bank and is a central part of the policy agenda which needs to be carried forwarded in cost
effective means particularly through use of effective technological solutions. Financial
inclusion is important for the poor as it provides them opportunities to build savings, avail
credit, make investments and equips them to meet emergencies. A combination of regulatory
mandates, cost effective technology solutions and implicit and explicit incentives and moral
suasion has been used to increase financial penetration of affordable banking services
particularly in the rural and unorganized sectors.
Out of the 600,000 habitations in the country, only about 5 per cent have a commercial bank
branch. Just about 40 per cent of the populations across the country have bank accounts,
and this ratio is much lower in the north-east region of the country. People with debit cards
comprise 13 per cent and those with credit cards comprise only 2 per cent. As discussed in
Chapter IV, India ranks low when compared with the OECD countries and select Asian peergroup in respect of financial penetration. The untapped potential with regard to financial
inclusion needs to be harnessed using cost effective technology solutions and appropriate
business models that make small value transactions viable.
During 2009-10, the Platinum Jubilee year of the Reserve Bank, the flagship project was the
outreach programme aimed at financial inclusion and financial literacy. The Reserve Bank chose
160 remote unbanked villages to convert them into villages having
100 per cent financial inclusion with each household having at least one credit facility along
with effective grievance redressed mechanism and awareness.
Financial Stability
Maintaining financial stability is one of the core goals of monetary policy in India. The
Reserve Bank brought out its first Financial Stability Report in March 2010 which concluded
that India was relatively less impacted by the global financial meltdown as robust regulatory
and supervisory policies ensured the resilience of the financial sector r. A financial stress