Final Project on Banking

8/3/2019 Final Project on Banking

1/50

PROJECT

ON

BANKING LAW AND

REGULATIONS


2/50

Preface

Banking law is not a discrete area of law like contract or torts. It

conveniently describes, however, the collection of legal principles

which impact on banking transactions and on the banker-

customer relationship. In that sense, the activity of banking is the

location at which a diverse range of legal principles intersect

which we call banking law.

Those legal principles are drawn from a range of sources. In

India, the nationalized banks are governed by the Banking

Companies (Acquisition and Transfer of Undertaking) Acts of1970 and 1980. State Bank of India and its subsidiaries are

governed by their respective statutes. Private sector banks come

under the purview of the Companies Act, 1956 and the Banking

Regulation Act, 1949. Foreign banks which have registered their

documents with the registrar under Section 592 of the

Companies Act are also banking companies under the Banking

Regulation Act.

Certain provisions of the Banking Regulation Act have beenmade applicable to public sector banks. Similarly, some

provisions of the RBI Act too are applicable to nationalized

banks, SBI and its subsidiaries, private sector banks and foreign

banks.


3/50

Acknowledgement

Inspiration and motivation have played a great role in the success of

my project. It would be incomplete to submit this project without

acknowledging the people behind this endeavour and without whose

support I would not have been able to achieve this.

I am extremely grateful to Mr. for giving me anopportunity to work on this project which helped me learn a lot

about banking laws. I express my thanks for his direction and support

. He has taken pain to go through the project and make necessary

corrections as and when needed.


4/50

Table of Content

Preface..........................................................................................................

Acknowledgement....................................................................................

1. History of Banking in India...............................................................

2. Evolution of banking regulations in India....................................

2.1 Institutional evolution

2.2 Legislative evolution

2.3 Policy Framework and regulatory environment

2.3.1 Branch authorisation policy

2.3.2 Operations of foreign banks in India2.3.3 Securitisation Guidelines of RBI

2.3.4 Migration to principle based regulation

3. Laws governing Indian Banks..........................................................

3.1 Banking regulation act

3.2 Negotiable Instrument act

3.3 SARFAESI act

3.4 RBI act

Appendices..................................................................................................

Bibliography...............................................................................................


5/50

HISTORY OF BANKING IN INDIA

Without a sound and effective banking system in India it cannot have a healthyeconomy. The banking system of India should not only be hassle free but it

should be able to meet new challenges posed by the technology and any otherexternal and internal factors. For the past three decades India's banking systemhas several outstanding achievements to its credit. The most striking is itsextensive reach. It is no longer confined to only metropolitans or cosmopolitansin India. In fact, Indian banking system has reached even to the remote cornersof the country. This is one of the main reasons of India's growth process. Thegovernment's regular policy for Indian bank since 1969 has paid rich dividendswith the nationalization of 14 major private banks of India. Not long ago, anaccount holder had to wait for hours at the bank counters for getting a draft orfor withdrawing his own money. Today, he has a choice. Gone are days when

the most efficient bank transferred money from one branch to other in two days.Now it is simple as instant messaging or dial a pizza. Money has become theorder of the day. The first bank in India, though conservative, was established in1786. From 1786 till today, the journey of Indian Banking System can besegregated into three distinct phases.

They are as mentioned below: Early phase from 1786 to 1969 of Indian Banks Nationalization of Indian Banks and up to 1991 prior to Indian banking sectorReforms.

New phase of Indian Banking System with the advent of Indian Financial &Banking Sector Reforms after 1991.To make this write-up more explanatory, I prefix the scenario as Phase I, PhaseII and Phase III.

Phase I

The General Bank of India was set up in the year 1786. Next came Bank ofHindustan and Bengal Bank. The East India Company established Bank ofBengal (1809), Bank of Bombay (1840) and Bank of Madras (1843) as

independent units and called it Presidency Banks. These three banks wereamalgamated in 1920 and Imperial Bank of India was established which startedas private shareholders banks, mostly Europeans shareholders.

In 1865 Allahabad Bank was established and first time exclusively by Indians,Punjab National Bank Ltd. was set up in 1894 with headquarters at Lahore.Between 1906 and 1913, Bank of India, Central Bank of India, Bank of Baroda,


6/50

Canara Bank, Indian Bank, and Bank of Mysore were set up. Reserve Bank ofIndia came in 1935. During the first phase the growth was very slow and banksalso experienced periodic failures between 1913 and 1948. There wereapproximately 1100 banks, mostly small. To streamline the functioning andactivities of commercial banks, the Government of India came up with The

Banking Companies Act, 1949 which was later changed to Banking RegulationAct 1949 as per amending Act of 1965 (Act No. 23 of 1965). Reserve Bank ofIndia was vested with extensive powers for the supervision of banking in Indiaas the Central Banking Authority. During those days public has lesserconfidence in the banks. As an aftermath deposit mobilization was slow.Abreast of it the savings bank facility provided by the Postal department wascomparatively safer. Moreover, funds were largely given to traders.

Phase II

Government took major steps in this Indian Banking Sector Reform after

independence. In 1955, it nationalized Imperial Bank of India with extensivebanking facilities on a large scale especially in rural and semi-urban areas. Itformed State Bank of India to act as the principal agent of RBI and to handlebanking transactions of the Union and State Governments all over the country.

Seven banks forming subsidiary of State Bank of India was nationalized in 1960on 19th July, 1969, major process of nationalization was carried out. It was theeffort of the then Prime Minister of India, Mrs. Indira Gandhi. 14 majorcommercial banks in the country were nationalized.

Second phase of nationalization Indian Banking Sector Reform was carried outin 1980 with seven more banks. This step brought 80% of the banking segmentin India under Government ownership. The following are the steps taken by theGovernment of India to Regulate Banking Institutions in the Country:

1949 : Enactment of Banking Regulation Act. 1955 : Nationalization of State Bank of India. 1959 : Nationalization of SBI subsidiaries. 1961 : Insurance cover extended to deposits.

1969 : Nationalization of 14 major banks. 1971 : Creation of credit guarantee corporation. 1975 : Creation of regional rural banks. 1980 : Nationalization of seven banks with deposits over 200 crore.


7/50

After the nationalization of banks, the branches of the public sector bank Indiarose to approximately 800% in deposits and advances took a huge jump by11,000%. Banking in the sunshine of Government ownership gave the publicimplicit faith and immense confidence about the sustainability of theseinstitutions.

Phase III

This phase has introduced many more products and facilities in the bankingsector in its reforms measure. In 1991, under the chairmanship of MNarasimham, a committee was set up by his name which worked for theliberalization of banking practices.

The country is flooded with foreign banks and their ATM stations. Efforts arebeing put to give a satisfactory service to customers. Phone banking and net

banking is introduced. The entire system became more convenient and swift.Time is given more importance than money. The financial system of India hasshown a great deal of resilience. It is sheltered from any crisis triggered by anyexternal macroeconomics shock as other East Asian Countries suffered. This isall due to a flexible exchange rate regime, the foreign reserves are high, thecapital account is not yet fully convertible, and banks and their customers havelimited foreign exchange exposure.


8/50

The Evolution of Banking Regulation in India

Institutional Evolution of the Indian Banking

The roots of commercial banking in India can be traced back to the early

eighteenth century when the Bank of Calcutta was established in June 1806 which was renamed as Bank of Bengal in January 1809 mainly to fundGeneral Wellesleys wars. This was followed by the establishment of the Bankof Madras in July 1843, as a joint stock company, through the reorganisationand amalgamation of four banks viz., Madras Bank, Carnatic Bank, Bank ofMadras and the Asiatic Bank. This bank brought about major innovations inbanking such as use of joint stock system, conferring of limited liability onshareholders, acceptance of deposits from the general public, etc. The Bank ofBombay, the last bank to be set up under the British Raj pursuant to the Charterof the then British East

India Company, was established in 1868, about a decade after the Indias firstwar of independence. The three Presidency Banks, as these were then known,were amalgamated in January 1921 to form the Imperial Bank of India, whichacquired the three-fold role: of a commercial bank, of a bankers bank and of abanker to the government. It is interesting to note here that merger of banks andconsolidation in the banking system in India, is not as recent a phenomenon asis often thought to be, and dates back to at least 1843 and the process, ofcourse, still continues. With the formation of the Reserve Bank of India in 1935,some of the central banking functions of the Imperial Bank were taken over bythe RBI and subsequently, the State Bank of India, set up in July 1955, assumed

the other functions of the Imperial Bank and became the successor to theImperial Bank of India.

Evolution of Legislative Regulation of Banking in India

In the very early phase of commercial banking in India, the regulatoryframework was somewhat diffused and the Presidency Banks were regulatedand governed by their Royal Charter, the East India Company and theGovernment of India of that time. Though the Company law was introduced inIndia 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 connectedlending practices, resulting in large-scale bank failures. The recommendationsof the Indian Central Banking Enquiry Committee (1929-31), which looked intothe issue of bank failures, paved the way for a legislation for banking regulationin the country.


9/50

Though the RBI, as part of its monetary management mandate, had, from thevery beginning, been vested with the powers, under the RBI Act, 1934, toregulate the volume and cost of bank credit in the economy through theinstruments of general credit control, it was not until 1949 that a comprehensiveenactment, applicable only to the banking sector, came into existence. Prior to

1949, the banking companies, in common with other companies, were governedby the Indian Companies Act, 1913, which itself was a comprehensive re-enactment of the earlier company law of 1850. This Act, however, contained afew provisions specially applicable to banks. There were also a few ad hocenactments, such as the Banking Companies (Inspection) Ordinance, 1946, andthe Banking Companies (Restriction of Branches) Act, 1946, covering specificregulatory aspects. In this backdrop, in March 1949, a special legislation, calledthe Banking Companies Act, 1949, applicable exclusively to the bankingcompanies, was passed; this Act was renamed as the Banking Regulation Actfrom March 1966. The Act vested in the Reserve Bank the responsibility

relating to licensing of banks, branch expansion, liquidity of their assets,management and methods of working, amalgamation, reconstruction andliquidation. Important changes in several provisions of the Act were made fromtime to time, designed to enlarge or amplify the responsibilities of the RBI or toimpart flexibility to the relative provisions, commensurate with the imperativesof the banking sector developments.

It is interesting to note that till March 1966, the Reserve Bank had practically norole in relation to the functioning of the urban co-operative banks. However, bythe enactment of the Banking Laws (Application to Co-operative Societies) Act,

1965, certain provisions of the Banking Regulation Act, regarding the mattersrelating to banking business, were extended to the urban co-operative banksalso. Thus, for the first time in 1966, the urban co-operative banks too camewithin the regulatory purview of the RBI.

Prudential Policy Framework for Banking Regulation and

Supervision

The basic rationale for exercising fairly close regulation and supervision ofbanking institutions, all over the world, is premised on the fact that the banksare special for several reasons. The banks accept uncollateralised publicdeposits, are part of the payment and settlement system, enjoy the safety net ofdeposit insurance funded by the public money, and are an important channel formonetary policy transmission. Thus, the banks become a keystone in the edificeof financial stability of the system which is a public good that the publicauthorities are committed to provide. Preventing the spread of contagion


10/50

through the banking system, therefore, becomes an obvious corollary ofregulating the banks to pre-empt any systemic crisis, which can entail enormouscosts for the economy as a whole. This is particularly so on account of theinevitable linkages that the banks have by virtue of the nature of their role in thefinancial system. Ensuring safety and soundness of the banking system,

therefore, becomes a predominant objective of the financial regulators. Whilethe modalities of exercising regulation and supervision over banks have evolvedover the decades, in tandem with the market and technological developments,the fundamental objective underlying the exercise has hardly changed. Ofcourse, a well-regulated and efficient banking sector also enhances theallocative efficiency of the financial system, thereby facilitating economicgrowth. In this backdrop, as the functions of the RBI evolved over the years, thefocus of its role as a regulator and supervisor of the banking system has shiftedgradually from micro regulation to macro prudential supervision. A journeythrough the major landmarks in the evolution of the RBIs role vis--vis the

commercial banks provide interesting insights.

As regard the prudential regulatory framework for the banking system, we havecome a long way from the administered interest rate regime to deregulatedinterest rates, from the system of Health Codes for an eight-fold judgmentalloan classification to the prudential asset classification based on objectivecriteria, from the concept of simple statutory minimum capital and capital-deposit ratio to the risk-sensitive capital adequacy norms initially under BaselI framework and now under the Basel II regime. There is much greater focusnow on improving the corporate governance set up through fit and proper

criteria, on encouraging integrated risk management systems in the banks andon promoting market discipline through more transparent disclosure standards.The policy endeavor has all along been to benchmark our regulatory norms withthe international best practices, of course, keeping in view the domesticimperative and the country context. The consultative approach of the RBI informulating the prudential regulations has been the hallmark of the currentregulatory regime which enables taking account of a wide diversity of views onthe issues at hand.

On the supervisory side, we have traversed vast territory in progressively

refining our supervisory focus to ensure a safe and sound banking system,comparable with the best in the world. Thus, we have continually graduatedfrom the system of on-site Annual Appraisal of the banks by the RBI followedin the 1970s to the system of Annual Financial Review during the 1980s, thenon to the Annual Financial Inspection of stand-alone banks during the 1990sand further on to the consolidated supervision of financial conglomerates so asto address the supervisory concerns on a group-wide basis. The off-sitemonitoring of the banking system was also introduced in 1995 as a part of the


11/50

supervisory strategy of ongoing supervision of the banks, so as to supplementthe periodical full-scope on-site bank examinations. The supervisory ratingsmodels (CAMELS and CACS), based on crucial prudential parameters, werealso developed by the RBI to provide a summary view of the overall health ofthe banks. The Prompt Corrective Action (PCA) Framework was put in place to

enable timely intervention in case of any incipient stress in a bank. The latestsupervisory initiative has been the introduction of risk-based supervision of thebanks so as to move away from transaction audit and to enable the modulationof the supervisory efforts in tune with the risk profile of the banks and toachieve optimal deployment of the scarce supervisory resources. Last but notthe least, the Board for Financial Supervision, constituted in 1994 under theChairmanship of the Governor, RBI has been the guiding force in securing thetransformation in the regulatory and supervisory apparatus of the bankingsystem.

While the multi-dimensional regulatory and supervisory measures are justifiablyreflected in the significantly improved prudential parameters of the Indianbanking system, be it the level of NPAs or the capital adequacy ratios, there ishardly any room for complacence. In the era of ever-increasing financialglobalisation and in the face of rapid financial innovations, all of us willcontinually need to remain on a steep learning curve and upgrade our skills andknowledge to be able to meet the emerging challenges in the financial world.


12/50

Some Elucidation Regarding the Regulatory

Environment

Branch Authorisation Policy

The RBI announced a new Branch Authorisation Policy in September 2005under which certain changes were brought about in the authorisation processadopted by the RBI for the bank branches in the country. As against the earliersystem, where the banks approached the RBI, piece meal, through out the yearfor branch authorisation, the revised system provides for a holistic andstreamlined approach for the purpose, by granting a bank-wise, annual

aggregated authorisation, in consultation and interaction with each applicantbank. The objective is to ensure that the banks take an integrated view of theirbranch- network needs, including branch relocations, mergers, conversions and

closures as well as setting up of the ATMs, over a one-year time horizon, intune with their own business strategy, and then approach the RBI forconsolidated annual authorisations accordingly.

There seems to be some misunderstanding in some quarters that, under the newpolicy, the banks have to wait for the annual authorisation exercise and areconstrained in approaching the RBI for any emergent authorisation in between.Since the branch expansion planning of the banks is expected to be a wellthought out, Board-approved annual process, normally, there should be no needfor any emergent or urgent authorisation being required by the banks, in the

interim. However, I would like to emphasise that the new policy does notpreclude the possibility of any urgent proposals for opening bank branchesbeing considered by the RBI even outside the annual plan, specially in the rural/ under-banked areas, anytime during the year. This flexibility has been clearlyarticulated in our policy guidelines as contained in the Master Circular of July2007 but somehow, it seems to have got overlooked.

There also seems to be a feeling among some banks that under the newauthorisation policy, the process adopted is more cumbersome and, as a result,there have been delays in issuing authorisations. Since the banks are required to

approach the RBI only after obtaining the approval of their respective Boardsfor their annual branch expansion plan, it is possible that the preparatory timerequired for filing their annual plan with the RBI might be a little longer. Theprocessing time at the end of the RBI, however, has been generally in the rangeof one to two months which I consider to be reasonable, given the element ofconsultation with the banks built into the process. However, the actual numberof authorisations issued by the RBI under the new policy has been much higherthan before. For instance, as against the a total of 881, 1125 and 1259


13/50

authorisations given by the RBI under the old policy regime during 2003-04,2004-05 and 2005-06, respectively, the number of authorisations issued underthe new policy during 2006-07 was 2028. Thus, as against the generalperception that the new policy has been more restrictive in grantingauthorisations, the fact is that there has been a sharp increase of about 61 per

cent in the total number of authorisations granted last year.

Operations of Foreign Banks in India

At present, there are 29 foreign banks operating in India with a network of 273branches and 871 offsite ATMs. Among some circles, a doubt is sometimesexpressed as to whether the regulatory environment in India is liberal in regardto the functioning of the foreign banks and whether the regulatory approachtowards foreign participation in the Indian banking system is consistent withliberalized environment. Undoubtedly, the facts indicate that regulatory regimefollowed by the Reserve Bank in respect of foreign banks is non-discriminatory,and is, in fact, very liberal by global standards. Here are a few facts which bearout the contention;

y India issues a single class of banking licence to foreign banks and doesnot require them to graduate from a lower to a higher category of bankinglicence over a number of years, as is the practice followed in certain otherjurisdictions.

y This single class of licence places them virtually on the same footing asan Indian bank and does not place any restrictions on the scope of theiroperations. Thus, a foreign bank can undertake, from the very first day ofits operations, any or all of the activities permitted to an Indian bank andall foreign banks can carry on both retail as well as wholesale bankingbusiness. This is in contrast with practices in many other countries.

y No restrictions have been placed on establishment of non-bankingfinancial subsidiaries in India by the foreign banks or of their groupcompanies.

y Deposit insurance cover is uniformly available to all foreign banks at anon-discriminatory rate of premium. In many other countries there is adiscriminatory regime.

yThe prudential norms applicable to the foreign banks for capitaladequacy, income recognition and asset classification, etc., are, by andlarge, the same as for the Indian banks. Other prudential norms such asthose for the exposure limits, investment valuation, etc., are the same asthose applicable to the Indian banks.

y Unlike some of the countries where overall exposure limits have beenplaced on the foreign-country related business, India has not placed anyrestriction on the kind of business that can be routed through the branches


14/50

of foreign banks. This has been advantageous to the foreign bankbranches as the entire home-country business is generally routed throughthese branches. Substantial FII business is also handled exclusively by theforeign banks.

y In fact, some Indian banks contend that certain amount of positivediscrimination exists in favour of foreign banks by way of lower PrioritySector lending requirement at 32 per cent of the adjusted net bank creditas against a level of 40 per cent required for the Indian banks. Unlike inthe case of Indian banks, the sub-ceiling in respect of agriculturaladvances is also not applicable to foreign banks whereas export creditgranted by the foreign banks can be reckoned towards priority sectorlending obligation, which is not permitted for the Indian banks.

y Notably, in terms of our WTO commitment, licences for new foreignbanks may be denied when the share of foreign banks assets in India,including both on- as well as off-balance-sheet items, in the total assets

(including both on- and off-balance-sheet items) of the banking systemexceeds 15 per cent. However, we have autonomously not invoked thislimitation so far to deny licences to the new foreign banks even thoughthe actual share of foreign banks in the total assets of the banking system,including both on- and off-balance-sheet items (on Notional Principalbasis), has been far above the limit. This share of foreign banks stood at49 per cent, as at end-January 2007, as mentioned in the Indias TradePolicy Review, 2007.

It is thus very obvious that the Indian regulatory regime is essentially

non-discriminatory as between branches of foreign banks and domesticbanks, in regard to their authorisation or the scope of their operations,though some hold that there is some positive discrimination in favour ofthe foreign banks. As explained, Indian regulatory regime is in fact muchmore equitable and provides a far more level playing field to the foreignbanks, than in many other jurisdictions both developed and emergingeconomies


15/50

Securitisation Guidelines of the RBI

The RBI had first issued the draft guidelines for securitisation of standard

assets in April 2005, for public comments and after an extensive consultativeprocess, the final guidelines were issued in February 2006, in order to facilitatean orderly development of this market. In certain quarters, however, a view hasbeen expressed that these guidelines, tend to negate the benefits envisaged inthe very concept of securitisation, and thus, are hindering the growth ofsecuritisation market in the country. Let me attempt to briefly present today theinternational perspective vis--vis RBI guidelines and the thinking and rationaleunderlying our formulation.

RBIs guidelines are broadly in tune with the stipulations of several regulatorsin other jurisdictions. For instance, concept of true sale and the independenceof the Special Purpose Vehicle (SPV) from the originator of the assets,prescribed in our guidelines is also embedded, in one form or the other, in theregulatory guidelines obtaining in Australia, Malaysia, Singapore, the UK andthe USA. Similarly, the prudential treatment of the credit enhancement providedto the SPVs and the requirement of capital charge there against, as prescribed inour guidelines, is also echoed in the regulatory framework in Australia, theUnited Kingdom and Singapore. Likewise, the provisions relating to the Cleanup Calls, or repurchase of the residual performing assets from the SPV by theoriginator, also figure in the regulations in Australia, the United Kingdom andSingapore. The restrictions placed by us on purchase of securities issued by theSPV by the originator are also found in other jurisdictions such as Australia,Singapore and the UK. Similarly, the restrictions in regard to the provision ofliquidity facility to the SPV, underwriting of the securities issued by 10 the SPVand the servicing of the securitised assets are also found in several otherjurisdictions, with variations in details and in the degree of stringency. I amciting all this at some length to point out that RBIs guidelines on securitisationare broadly in line with the practices obtaining in several other jurisdictions,though they have some unique features.

The accounting treatment prescribed in our guidelines provides for upfront

recognition of any loss incurred on sale of assets to the SPV but the profitarising from such sale is required to be amortised over the life of the securities

issued / to be issued by the SPV. Thus, we have not permitted the banks torecognise the profit upfront, on sale of assets to the SPVs. As you are aware, themain considerations for the originator in undertaking a securitisation transactionare obtaining the regulatory-capital relief and generating liquidity from anotherwise illiquid loan book, and not the profit, per se. In this background,


16/50

RBIs guidelines have justifiably adopted such an approach in order to ensurethat profit-booking does not become the primary motive for undertakingsecuritisation transactions which could perhaps lead to profit smoothening,possibly through inappropriate valuations, and the consequent window dressingof the financial statements none of which is prudentially desirable. In brief,

the restrictions in our guidelines on upfront recognition of profit on sale ofassets by the banks seek to create the right incentive framework for the banks sothat the basic objective underlying the concept of securitisation does not getnegated.

In the aftermath of the recent sub-prime episode in some of the developedcountries, caused also by wide dispersal of credit risk throughout the systemthrough complex structured transactions, I am sure, you would appreciate themerit of adopting an appropriate incentive-compatible prudential approachtowards securitisation. We need to squarely recognise that securitisation, after

all, is also a credit-risktransfer instrument and has the potential of dispersing therisks from the originating banks to those parts of the system which might notnecessarily be best equipped to manage that risk. Hence, RBIs stand in creatingthe right incentive framework through prudential restrictions would seem to bean approach which has much to commend itself.

Migration to Principles-Based Regulation (PBR)

A view has been expressed in certain quarters that the Indian regulatoryframework should migrate to principles-based regulation from the current rules-based approach. The merits of a principles-based approach are that in a dynamicmarket context, where the product innovation is the order of the day, theprinciples-based approach to regulation provides a more enduring regulatoryoption since the underlying principles would not need to change with every newproduct whereas the detailed rules may have to be constantly modified toaddress the unique features of market and product developments. However,despite the stated superiority of the principles-based approach, so far very fewcountries have adopted this model in a big-bang or comprehensive manner. TheFSA of the UK which is one of the forerunners in adoption of principles-basedregulation has a rule book which has over 8000 pages. So, the PBR is not as

simple to operationalise as it is to advocate.

Thus, in any regulatory regime, complete reliance on a principles-basedapproach would rarely be a feasible option since the high-level principles wouldneed to be underpinned by the detailed rules at the operational level, to achievethe regulatory objectives. To illustrate, it might be easy to enunciate theprinciple that Treat your customer fairly but ensuring it at the ground level


17/50

would invariably require specific rules and prescriptions to achieve theobjective underlying the principle. Besides, a PBR approach also pre-supposesgreater reliance on the discretion and judgment of the supervisors and regulatorsin interpreting the broad principles an aspect with which the market playersmight not be very comfortable. On the other hand, the regulated entities too, in

the absence of detailed regulatory prescriptions, would need to develop a certainlevel of maturity of outlook to correctly understand the spirit of the principleswhile implementing them at the operational level. This approach would,therefore, also require a good deal of skill up gradation on the part of theregulator as well as the regulated entities.

Moreover, in any jurisdiction, there could be certain areas of regulation whichwould be more amenable to a PBR approach while certain other areas mightinevitably require detailed prescriptive rules. Thus, the rules-based andprinciples-based approaches to regulation are not mutually exclusive options but

could very well co-exist and complement each other. To illustrate, the Pillar 1of the Basel II framework is essentially rule-based prescription while the Pillar2 is more oriented towards principles-based regime. Within the RBI, we too arein the process of exploring the feasibility of adopting a principles-basedapproach to banking regulation but it may be quite some time before we couldbe ready for adoption of the PBR approach on a significant scale in the Indiancontext.


18/50

Laws Governing Indian Banks

Various laws have been made from time to time to govern thebanking activities and to see the bank customer relationship aswell.

Some of these are as follows:

The Banking Regulation ActThe Reserve Bank Of India ActThe Negotiable Instrument ActSARFAESI actThe State Bank Of India Act


19/50

BANKING REGULATION ACT, 1949

I. Introduction

Financial sector reforms have been introduced in a calibrated and well-

sequenced manner since the early 1990s and have resulted in a competitive,healthy and resilient financial system. There has been financial deepening: thedeposits/ GDP ratio rose from 16.4 per cent in 1971-75 to 36.1 per cent in 1989-90 and further to 60 per cent in 2004-05. Bank credit to commercial sectorincreased from 15.6 per cent to 30.3 per cent of GDP in 1989-90 and 48 per centin 2005-06.

The Annual Policy Statement for the year 2007-08 by Governor, Reserve Bankof India at para 185 states that ' with a view to directing the resources of banksto their niche areas and to sustain efficiency in the banking system, a graded

approach of licensing may be appropriate which can be equally applicable toboth domestic and foreign banks. A technical paper on this subject will beplaced on website inviting comments/suggestions from the public'

Accordingly, an internal study in RBI covered the background on bankingregulation, licensing of banks under Banking Regulation Act, 1949, extantpolicy relating to bank licensing, both Indian and foreign banks internationalexperience and practice on limited bank licensing.

II. Statutory background- Banking Regulation Act, 1949

2.1 Background

Prior to the enactment of Banking Regulation Act, 1949 which aims toconsolidate the law relating to banking and to provide for the nature oftransactions which can be carried on by banks in India, the provisions of lawrelating to banking companies formed a part of the general law applicable tocompanies and were contained in Part XA of the Indian Companies Act, 1913.

These provisions were first introduced in 1936, and underwent two subsequentmodifications, which proved inadequate and difficult to administer. Moreover, itwas recognised that while the primary objective of company law is to safeguardthe interests of the share holder, that of banking legislation should be theprotection of the interests of the depositor. It was therefore felt that a separatelegislation was necessary for regulation of banking in India. With this objectivein view, a Bill to amend the law relating to Banking Companies was introducedin the Legislative Assembly in November, 1944 and was passed on 10th March,1949 as the Banking Companies Act, 1949. By Section 11 of the Banking Laws


20/50

(Application to Cooperative Societies) Act, 1965, the nomenclature waschanged to the Banking Regulation Act, 1949.

2.2 Indian banking system

The Indian financial system currently consists of commercial banks, co-operative banks, financial institutions and non-banking financial companies (NBFCs). The commercial banks can be divided into categories depending onthe ownership pattern, viz. public sector banks, private sector banks, foreignbanks. While the State bank of India and its associates, nationalised banks andRegional Rural Banks are constituted under respective enactments of theParliament, the private sector banks are banking companies as defined in theBanking Regulation Act. The cooperative credit institutions are broadlyclassified into urban credit cooperatives and rural credit cooperatives.

2.3 Powers and responsibilities of RBI in respect of regulation ofbanks

The Reserve Bank of India has been entrusted with the responsibility under theBanking Regulation Act, 1949 to regulate and supervise banks' activities inIndia and their branches abroad. While the regulatory provisions of this Actprescribe the policy framework to be followed by banks, the supervisoryframework provides the mechanism to ensure banks' compliance with the policyprescription.

2.4General Framework of RegulationThe existing regulatory framework under the Banking Regulations Act 1949 canbe categorised as follows :

a) Business of Banking Companiesb) Licensing of banking companiesc) Control over Managementd) Acquisition of the Undertakings of banking companies in certain casese) Restructuring and Resolution including winding up operationf) Penal Provisions

2.5 Licensing of banks

In terms of Sec 22 of the B.R.Act, no company shall carry on banking businessin India, unless it holds a licence issued in that behalf by Reserve Bank and anysuch licence may be issued subject to such conditions as the Reserve Bank maythink fit to impose.


21/50

Before granting any licence, RBI may require to be satisfied that the followingconditions are fulfilled:

i) that the company is or will be in a position to pay its present or futuredepositors in full as their claims accrue;

ii) that the affairs of the company are not being , or are not likely to be,conducted in a manner detrimental to the interests of its present or futuredepositors;iii) that the general character of the proposed management of the proposed bankwill not be prejudicial to the public interest or the interest of its depositors;iv) that the company has adequate capital structure and earning prospects;v) that having regard to the banking facilities available in the proposed principalarea of operations of the company, the potential scope for expansion of banksalready in existence in the area and other relevant factors the grant of the licencewould not be prejudicial to the operation and consolidation of the banking

system consistent with monetary stability and economic growth;

2.6 Business of banking

As per Section 5 (b) of Banking Regulation Act, 1949 ' banking ' means theaccepting , for the purpose of lending or investment, of deposits of money fromthe public, repayable on demand or otherwise and withdrawable by cheque,draft, order or otherwise.

2.7 Permissible Activities of a Banking Company

Section 6 of B.R. Act, 1949 gives the details of forms of business in which abanking company may engage. However, it is a long list and banks may carryout one or more activities permitted in the section.

III. Policy of issuing licence to banks in India

The policy framework for issuing licences to private sector and foreign banksare discussed below:

3.1 Private sector banks

y The guidelines for licensing of new banks in the private sector wereissued by the Reserve Bank of India (RBI) on January 22, 1993. Therevised guidelines for entry of new banks in private sector were issued onJanuary 3, 2001. The foreign investment limit from all the sources inprivate banks was raised from a maximum of 49 per cent to 74 per cent inMarch 2004. In consultation with the Government of India, the ReserveBank released a roadmap on February 28, 2005, detailing the norms for


22/50

the presence of foreign banks in India. The Reserve Bank also issuedcomprehensive guidelines on Ownership and Governance in privatesector banks. The broad principles underlying the policy framework wereto ensure that the ultimate ownership and control of private sector banksis well diversified. Further, the fit and proper criteria have to be the over-

riding consideration in the path of ensuring adequate investments,appropriate restructuring and consolidation in the banking sector. Nosingle entity or group of related entities would have shareholding orcontrol, directly or indirectly, in any bank in excess of 10 per cent of thepaid up capital of the private sector bank. Any higher level of acquisitionwill be with the prior approval of RBI and in accordance with guidelinesissued by RBI for grant of acknowledgement for acquisition ofshares. These measures were intended to further enhance the efficiency ofthe banking system by increasing competition.

y The initial minimum paid-up capital for a new bank was kept at Rs. 200crore. The initial capital was required to be to Rs.300 crore within threeyears of commencement of business. The aggregate foreign investment inprivate banks from all sources ( FDI, FII, NRI) cannot exceed 74 per cent.

y Mergers and amalgamations are a common strategy adopted forrestructuring and strengthening banks internationally. Although theconsolidation process through mergers and acquisitions of banks in Indiahas been going for several years it gained momentum in late 1990s. Withincreased liberalisation, globalisation and technological advancement, theconsolidation process of Indian banking sector is likely to intensify in thefuture, thereby imparting greater resilience to the financial system. The

Reserve Bank ensures that mergers and amalgamation enhance thestability of the banking system. Thus, the guidelines issued by RBI onMay 11, 2005 laid down the process of merger and determination of swapratio.

3.2 Licensing of foreign banks

India issues a single class of banking licence to banks and hence does not placeany undue restrictions on their operations merely on the ground that in somecountries there are requirements of multiple licences for dealing in local

currency and foreign currencies with different categories of clientele. Banks inIndia, both Indian and foreign, enjoy full and equal access to the payments andsettlement systems and are full members of the clearing houses and paymentssystem.

Procedurely, foreign banks are required to apply to RBI for opening theirbranches in India. Foreign banks application for opening their maiden branch isconsidered under the provisions of Sec 22 of the BR Act, 1949. Before granting


23/50

any licence under this section, RBI may require to be satisfied that theGovernment or the law of the country in which it is incorporated does notdiscriminate in any way against banks from India. Other conditions asenumerated in para 2.5 above are required to be fulfilled.

Unlike the restrictive practices of certain foreign countries, India is liberal inrespect of the licensing and operation of the foreign bank branches as illustratedby the following :

y India issues a single class of banking licence to foreign banks and doesnot place any limitations on their operations. All banks can carry on bothretail and wholesale banking.

y Deposit insurance cover is uniformly available to all foreign banks at anon-discriminatory rate of premium.

y The norms for capital adequacy, income recognition and assetclassification are by and large the same. Other prudential norms such asexposure limits are the same as those applicable to Indian banks.

3.3 Opening of branches in India by Foreign banks

The policy for approving foreign banks applications to open maiden branch andfurther expand their branch presence has been incorporated in the Roadmap forpresence of Foreign banks in India indicated in the Press Release datedFebruary 28, 2005 as well as in the liberalized branch authorisation policyissued on September 8, 2005. The branch authorisation policy for Indian bankshas been made applicable to foreign banks subject to the following:

y Foreign banks are required to bring an assigned capital of US $25 millionup front at the time of opening the first branch in India.

y Existing foreign banks having only one branch would have to complywith the above requirement before their request for opening of secondbranch is considered.

y Foreign banks may submit their branch expansion plan on an annualbasis.

y In addition to the parameters laid down for Indian banks, the followingparameters would also be considered for foreign banks :

o Foreign banks and its groups track record of compliance andfunctioning in the global markets would be considered. Reportsfrom home country supervisors will be sought, wherever necessary.

o Weightage would be given to even distribution of home countriesof foreign banks having presence in India.

o The treatment extended to Indian banks in the home country of theapplicant foreign bank would be considered.


24/50

o Due consideration would be given to the bilateral and diplomaticrelations between India and the home country.

o The branch expansion of foreign banks would be consideredkeeping in view Indias commitments at World Trade Organisation(WTO). Licences issued for off-site ATMs installed by foreign

banks are not included in the ceiling of 12.

In terms of Indias commitment to WTO, as a part of market access, India iscommitted to permit opening of 12 branches of foreign banks every year. Asagainst these commitments, Reserve Bank of India has permitted upto 17- 18branches in the past. The Bank follows a liberal policy where the branches aresought to be opened in unbanked/under-banked areas. Off-site ATMs are notcounted in the above limit. Including off-site ATMs, foreign banks are having (as on October 15, 2007) place of business at 933 locations ( 273 branches + 660off site ATMs).

The procedure regarding approval of proposals for opening branches of foreignbanks in India has been simplified and streamlined for the sake of expeditiousdisposal.

A licence under the provisions of B.R. Act, 1949 enables the foreign banks tocarry out any activity which is permissible to a bank in India. This is in contrastwith practices adopted in many countries, where foreign banks can carry outonly a limited menu of activities.

As against the requirements of achieving 40 per cent of net bank credit as target

for lending to priority sector in case of domestic banks, it has been mademandatory for the foreign banks to achieve the minimum target of 32% of netbank credit for priority sector lending. Within the target of 32%, two subtargetsin respect of advances (a) to small scale sector (minimum of 10%), and (b)exports (minimum of 12%) have been fixed. The foreign banks are notmandated for targeted credit in respect of agricultural advances. There is noregulatory prescription in respect of foreign banks to open branches in rural andsemi-urban centres.

IV. Differentiated Bank Licensing- Examining Pros and Cons

A. Arguments in Favour of Adopting a Differentiated bank Licensing

4.1 With the broadening and deepening of financial sector, it is observed thatbanks are slowly migrating from a situation in the past where the number ofbanking services offered by the banks was limited and all banks provided all theservices to a situation where banks are finding their niche areas and mainlyproviding services in their chosen areas. Many banks keep the plain vanilla


25/50

banking as a small necessary adjunct. It is widely recognized that banksproviding services to retail customers have different skill sets and risk profilesas compared to banks which mainly deal with large corporate clients.

The present situation where every bank can carry out every activity permissible

under Section 6 of Banking Regulation Act, 1949 has the followingimplications, relevant to the subject under consideration :

y For a wholesale bank dealing with corporate clients only, it becomes acostly adjunct to maintain a skeleton retail banking presence. Moreover itbecomes difficult for such a bank to meet priority sector obligations andobligations for doing inclusive banking.

y Retail banks may have to create risk management and regulatorycompliance structures which are more appropriate to wholesale banks,thus resulting in non-optimal use of resources.

ySimilar supervisory resources are devoted to banks with differentbusiness profiles. This may also result in non-optimal use of supervisoryresources.

y The priority sector lending regime for foreign banks indicated inparagarph 3.3 has been causing some discomfort for some of the foreignbanks. For example, some of the foreign banks find it difficult to fulfileven the less rigorous target of 32 per cent in respect of priority sectoradvances.

y Some banks find it difficult to provide ' no frills' facility to economicallydisadvantaged. For them the more liberal licensing regime causes adifferent set of problems.

It appears that given an opportunity, some of the banks may like to follow aniche strategy rather than competing as full service all purpose banks.

2. On the other hand, there are some factors which point towards desirability ofcontinuing with the existing system of universal banking:

y In India, the penetration of banking services is very low. Less than 59 %of adult population has access to a bank account and less than 14 % ofadult population has a loan account with a with a bank. Under such

circumstances, it would be incorrect to create a regime where banks areallowed to choose a path away from carrying banking to masses.

y Priority sector lending is important for banks. The revised guidelines onpriority sector lending have rationalized the components of prioritysector. For the first time, investments by banks in securitised assets,representing loans to various categories of priority sector, shall be eligiblefor classification under respective categories of priority sector (direct orindirect) depending on the underlying assets, provided the securitised


26/50

assets are originated by banks and financial institutions and fulfil theReserve Bank of India guidelines on securitisation. This would mean thatthe banks' investments in the above categories of securitised assets shallbe eligible for classification under the respective categories of prioritysector only if the securitised advances were eligible to be classified as

priority sector advances before their securitisation. These measures wouldmake it easier to comply with the priority sector lending requirements bythose banks which had faced some difficulties in this regard.

y The business model adopted by such niche banks depends heavily onample inter-bank liquidity. Any shock leading to liquidity crunch cantranslate into a run on the bank. This situation has been clearly illustratedrecently in UK in the case of Northern Rock Bank.

V. International experience and practice

International experience and practices of licensing procedure followed in majorjurisdictions by the respective regulators have been studied and we havegrouped them into two viz limited banking licence - equally applicable both fordomestic and foreign banks and limited bank license-different for domestic andforeign banks. In addition, there are countries where different licences areissued for commercial banking, savings bank, rural banks or credit unions . Incertain counties no distinction is made between domestic and foreign banks.Thus, there is no widely accepted recommended model availableinternationally.

VI. Way forward

It may be seen that one of the major objectives of banking sector reforms hasbeen to enhance the efficiency and productivity of the banking system throughcompetition. It is also aim of authorities to provide banking services tomaximum number of people. To enable the banking system to operate atoptimum efficiency, and in the interest of financial inclusion, it is necessary thatall banks should offer certain minimum services to all customers, while theymay be allowed sufficient freedom to function according to their own businessmodels. Thus, it will be prudent to continue the existing system for the timebeing. The situation may be reviewed after a certain degree of success in

financial inclusion is achieved and Reserve Bank is more satisfied with thequality and robustness of the risk management systems of the entire bankingsector.


27/50

Negotiable Instruments ACT

There are certain documents which are freely used in commercial transactions.

The word negotiable means transferable from one person to another in return for

consideration. Instrument means a written document by which a right is createdin favour of some person.

A negotiable instrument is a document which entitles a person to a sum of

money and which is transferable from one person to another by mere delivery or

by endorsement and delivery.

S.13says that a negotiable instrument means a promissory note, bill of exchange

or cheque payable either to order or to bearer.

Characteristics of a negotiable instrument

1. Freelytransferable: The property in a negotiable instrument passes fromone person to another by delivery, if the instrument is payable to bearer,and if is payable to order, it is done by endorsement.

2. Titleofholderfreefromalldefects: A person taking an instrumentbona fide and for value, known as a holder in due course, gets theinstrument free from all defects in the title of transferor. He is not in anyway affected by any defect in the title of transferor or any prior party.

3. Recovery: The holder in due course can sue upon a negotiable instrumentin his own name for the recovery of the amount.

4. Presumptions: Certain presumptions apply to all negotiable instruments,which are as follows:

a. Consideration: Every negotiable instrument is presumed to have beenmade, drawn, accepted, endorsed, negotiated or transferred forconsideration. This would help a holder to get a decree from a Courtwithout any difficulty.

b. Date: Every negotiable instrument bearing a date is presumed to havebeen made or drawn on such date.

c. Timeofacceptance: When a bill of exchange is accepted, it ispresumed that it was accepted within a reasonable time of its date and

before maturity.d. Timeoftransfer: every transfer of negotiable instrument is presumed to

be made before its maturity.e. Orderofendorsements: each endorsement is presumed to be in the

order in which they appear thereon.f. Stamp: When an instrument has been lost, it is presumed that it was

duly stamped.g. Holderpresumedtobeholderinduecours


28/50

Notes, Bills and cheques

Promissory Note

A promissory note is an instrument in writing containing an unconditional

undertaking, signed by the maker, to pay a certain sum of money only to or toorder of a certain person or to the bearer of the instrument.

The person who makes the promissory note and promises to pay is called the

maker.

The person to whom the payment is to be made is called the payee.

Examples: I promise to pay to B or order Rs. 500.

I acknowledge myself to be indebted to B in Rs. 1,000 to be paid on demand,

for value received.

Essential elements of a promissory note:

1. Writing: The instrument must be in writing. Mere verbal engagement topay is not enough.

2. Promisetopay: The instrument must contain an express promise to pay.3. Definiteandunconditional: The following instruments signed by A are

not promissory notes:I promise to pay B a sum of Rs. 500, when convenient or able.

I promise to pay B Rs. 500 on Ds death, provided D leaves me enough to

pay that sum.

4. Signedbythemaker: The instrument must be signed by the makerotherwise it is incomplete and of no effect.

5. Certainsumofmoney:6. Promisetopaymoneyonly: If the instrument contains a promise to pay

something other than money or something in addition to money, it cannot

be a promissory note.7. It may be payable on demand or after a definite period of time.

Lack of any requirements mentioned in s.4 will not make a document a

promissory note.


29/50

BILL OF EXCHANGE

S. 5. A bill of exchange is an instrument in writing containing an unconditional

order, signed by the maker, directing a certain person to pay a sum of moneyonly to, or to the order of, a certain person or to the bearer of the instrument.

Parties to a bill: There are three parties i.e. drawer, drawee and the payee.

The person who gives the order to pay or who makes the bill is known as

drawer.

The person who is directed to pay is called the drawee.

The person to whom the payment is to be made is called the payee.

In some cases, the drawer and the payee may be one and the same person.

The drawer or the payee who is in possession of the bill is called the holder. The

holder must present the bill to the drawee for acceptance.

Essential Elements

1. It must be in writing.2. It must contain an order to pay.3. The order must be unconditional.4. It requires three parties i.e., drawer, drawee and payee.5. The parties must be certain.6. It must be signed by the drawer.7. The sum payable must be certain.8. It must contain an order to pay a certain sum of money.9. A bill must be affixed with the necessary stamp.

Distinction between a bill of exchange and a Promissory Note

1.Number of parties: In a note there are two parties, in a bill there are threeparties.

2. Promiseororder: A note contains an unconditional promise to pay; a billcontains an unconditional order to pay.

3. Debtorandthecreditor: The maker of the note is a debtor and thedrawer of a bill is the creditor.


30/50

4. Positionofthemaker: A note cannot be made payable to the makerhimself, where as in case of bill, the drawer and the payee may be one andthe same person.

5. Acceptance: A note requires no acceptance as it is signed by the personwho is liable to pay. A bill after sight or after a certain period must be

accepted by the drawee before it is presented for payment.6. Payabletobearer: A note cannot be drawn payable to bearer. A bill can

be so drawn.7. Noticeofdishonour: In case of dishonor of a bill either by non

acceptance or by non payment, due notice of dishonour must be given toall the persons who are to be made liable to pay. This includes the drawerand the prior endorsers. But in case of dishonour of a note no such noticeis required to be given to maker.

CH

EQUE

A cheque is a bill of exchange drawn upon a specified banker and payable on

demand and it includes the electronic image of a truncated cheque and a cheque

in the electronic form.

A cheque in the electronic form means cheque which contains the exact mirror

image of a proper cheque, and is generated, written and signed in a secure

system ensuring the minimum safety standards with the use of digital signature

and asymmetric crypto system.

A truncated cheque means a c heque which is truncated during the course of a

clearing cycle, either by the clearing house or by the bank whether paying or

receiving payment.

A cheque is a species of a bill of exchange with two additional qualifications:

1. It is always drawn on a specified banker, and

2. It is always payable on demand.

All cheques are bill of exchange, but all bills of exchange are not cheques. Acheque must have all the essential requisites of a bill of exchange. But it does

not require acceptance as it is intended for immediate payment.


31/50

Crossing of cheques

There are two types of cheque, open cheques and crossed cheques.

Opencheque: A cheque which is payable in cash across the counter of a bank

is called an open cheque. When such a cheque is in circulation, a great riskattends it. If its holder loses it, its finder may go to the bank and get the

payment.

A crossedcheque: A crossed cheque is one on which two parallel transverse

lines with or without the words &co. are drawn. The payment of such a

cheque can be obtained only through a banker. Thus crossing is a direction to

the drawee banker to pay the amount of money on a crossed cheque generally to

a banker so that the party who obtains the payment of the cheque can be easily

traced. A crossed cheque affords security and protection to the owner of the

cheque.

Types of crossing:

1. General crossing,2. Special crossingGeneralcrossing: A cheque is said to be crossed generally where it bears

across its face an addition of

a. The words and company between two parallel transverse lines,b. Two parallel transzverse lines simply.Specialcrossing: Where a cheque bears across its face an addition of the name

of a banker, the cheque is deemed to be crossed specially. The payment of a

specially crossed cheque can be obtained only through particular bank whose

name appears across the face of the cheque, between the two transverse lines.

Restrictivecrossing: Another type of crossing known as restrictive crossing

has developed out of business usage. In this type of crossing the words A/c

Payee is added to the general or special crossing.

The words A/c Payee on a cheque are a direction to the collecting banker thatthe amount collected on the cheque is to be credited to the account of the payee,

Notnegotiablecrossing (S.130): the effect of the words not negotiable on a

crossed cheque is that the title of the transferee of such a cheque cannot be

better than that of the transferor. The addition of the words not negotiable does

not restrict further transferability of the cheque. It takes away the main feature


32/50

of negotiability. Any one who takes a cheque marked not negotiable takes it at

his own risk.

Who may cross a cheque (S.126):

1.

The drawer2. The holder3. The banker: where a cheque is crossed specially, the banker to whom it is

crossed may again cross it especially to another banker for collection.

Parties to a Negotiable Instrument

Minors: As the minors agreement is void, he cannot bind himself by becoming

a party to a negotiable instrument. But he may draw, endorse, deliver and

negotiate a negotiable instrument so as to bind all parties except himself.Further, the instrument does not become void merely because a minor is a party

to it. It remains binding on all the other parties to it.

HOLDER AND HOLDER IN DUE COURSE

Holder (s.8):

The holder of a promissory note, bill of exchange or cheque means any person

entitled in his own name:

a. To the possession there of, andb. To receive or recover the amount due there to.

Where a person obtains possession of an instrument by theft or under a forged

endorsement, he is not a holder, as he cannot obtain or recover the payment 0f

the instrument.

Holder in due course (S. 9):

Any person is a holder in due course if he fulfils the following conditions:

1. That, for consideration, he became the possessor of the negotiableinstrument.

2. That he became the holder of the instrument before its maturity.3. That he became the holder of the instrument in good faith i.e. without

sufficient cause to believe that any defect existed in the title of the personfrom whom he derived the title.


33/50

Privileges of a holder in due course

1. Liability of prior parties: Every prior party to a negotiable instrument isliable to a holder in due course until the instrument is duly satisfied.

2. Negotiable instrument without consideration: If the negotiableinstrument gets into the hands of a holder in due course, he can recoverthe amount on it from any of the prior parties thereto.

3. Conditional delivery: If a bill is negotiated to a holder in due course, theparties to the instrument cannot avoid liability on the ground that thedelivery of the instrument was conditional.

4. Instrument cleansed of all defects: Once a negotiable instrument passesthrough the hands of a holder in due course, it cleansed of its defects,since, the holder himself was not a party to fraud. For example, a bill,originally obtained by fraud from the drawer, gets into the hands of A, aholder in due course. A endorses the bill to B by way of gift. B can sue

the acceptor for he stands on As title.5. Instrument obtained by unlawful means or unlawful consideration:

Asagainst holder in due course,the person liable to pay on a negotiableinstrument cannot contend that he had lost it or that it was obtained fromhim by means of an offense or fraud or for an unlawful object.

6. Estoppel against denying original validity of instrument7. Endorser not permitted to deny the capacity of prior parties: the endorser

of a negotiable instrument cannot deny the signature or capacity tocontract of any prior party to the instrument.

Negotiation

One of the essential characteristics of a negotiable instrument is that it is freely

transferable from one person to another. This transfer may take place by

negotiation.

Methods of transfer by negotiation:

1.Negotiation by delivery: An instrument payable to bearer is negotiable bydelivery there of. Example: A is the holder of a negotiable instrument

payable to bearer. He delivers it to Bs agent to keep it for B. Theinstrument has been negotiated.

2.Negotiation by endorsement and delivery: An instrument payable to orderis negotiable by the holder by endorsement and delivery thereon.


34/50

Endorsement

In the Negotiable Instrument Act endorsement means the writing of a persons

name on the face or back of negotiable instrument or on a slip of paper annexed

there to, for the purpose of negotiation. The person who so signs the instrument

is called the endorser. The person to whom the instrument is endorsed is called

the endorsee.

Who may endorse: The first endorsement of an instrument can be made by the

payee. Subsequent endorsements can be made by any person who becomes the

holder of the instrument.

Kinds of endorsement:

1. Blank or general endorsement: An endorsement is said to be blank orgeneral if the endorser signs his name on the face or back of theinstrument. In this case the bill may be passed merely by delivery. Ablank endorsement does not specify any endorsee and the instrumentbecomes payable to bearer even though originally it was payable to order.

2. Full or special endorsement: If an endorser signs his name and adds adirection to pay the amount mentioned in the instrument to, or to theorder of, a specified person , the endorsement is said to be a fullendorsement

3. Restrictive endorsement: An endorsement is said to be restrictive when itprohibits or restricts the further negotiability of the instrument.

4. Partial endorsement: When an endorsement purports to transfer theendorsee a part of the amount only, the endorsement is said to be partial.It is not valid. For example, A is a holder of a bill for Rs. 10,000. Heendorses it Pay B or orders.5, 000. This is a partial endorsement and isinvalid for the purpose of negotiation.

5. Conditional endorsement: An endorsement is conditional or qualified, if itlimits or negatives the liability of the endorser. It may be in the followingways:

a. Sans recourse endorsement: The holder of a bill may endorse it in sucha way that it does not incur the liability of the endorser. He can do so by

adding the words Sans recourse. For example, Pay A or order withoutrecourse to me or Pay A or order at his own risk.

b. Liability dependent upon a contingency: For example, Pay A or order onhis marriage with B.


35/50

SARFAESI act

Background

With an aim to provide a structured platform to the Banking sector formanaging its mounting NPA stocks and keep pace with international financialinstitutions, the Securitisation and Reconstruction of Financial Assets andEnforcement of Security Interest (SARFAESI) Act was put in place to allowbanks and FIs to take possession of securities and sell them. As stated in theAct, it has enabled banks and FIs to realise long-term assets, manage problemsof liquidity, asset-liability mismatches and improve recovery by takingpossession of securities, sell them and reduce non performing assets (NPAs) by

adopting measures for recovery or reconstruction. Prior to the Act, the legalframework relating to commercial transactions lagged behind the rapidlychanging commercial practices and financial sector reforms, which led to slowrecovery of defaulting loans and mounting levels of NPAs of banks andfinancial institutions.

The SARFAESI Act has been largely perceived as facilitating asset recoveryand reconstruction. Since Independence, the Government has adopted severalad-hoc measures to tackle sickness among financial institutions, foremostthrough nationalisation of banks and relief measures. Over the course of time,the Government has put in place various mechanisms for cleaning the bankingsystem from the menace of NPAs and revival of a healthy financial and

banking sector. Some of the notable measures in this regard include:

y Sick Industrial Companies (Special Provisions) Act, 1985 orSICA: Toexamine and recommend remedy for high industrial sickness in theeighties, the Tiwari committee was set up by the Government. It was tosuggest a comprehensive legislation to deal with the problem of industrialsickness. The committee suggested the need for special legislation forspeedy revival of sick units or winding up of unviable ones and setting upof quasi-judicial body namely; Board for Industrial and Financial

Reconstruction (BIFR) and The Appellate Authority for Industrial andFinancial Reconstruction (AAIRFR) and their benches. Thus in 1985, theSICA came into existence and BIFR started functioning from 1987.

The objective of SICA was to proactively determine or identify thesick/potentially sick companies and enforcement of preventive, remedialor other measures with respect to these companies. Measures adopted


36/50

included legal, financial restructuring as well as management overhaul.However, the BIFR SARFAESI ACT 2002: An Assessment process wascumbersome and unmanageable to some extent. The system was notfavourable for the banking sector as it provided a sort of shield to thedefaulting companies.

y Recoveries of Debts due to Banks and Financial Institutions (RDDBFI)Act, 1993: The procedure for recovery of debts to the banks and financial

institutions resulted in significant portions of funds getting locked. Theneed for a speedy recovery mechanism through which dues to the banksand financial institutions could be realised was felt. Different committeesset up to look into this, suggested formation of Special Tribunals forrecovery of overdue debts of the banks and financial institutions byfollowing a summary procedure. For the effective and speedy recovery ofbad loans, the RDDBFI Act was passed suggesting a special Debt

Recovery Tribunal to be set up for the recovery of NPA. However, thisact also could not speed up the recovery of bad loans, and the stringentrequirements rendered the attachment and foreclosure of the assets givenas security for the loan as ineffective.

y Corporate DebtRestructuring (CDR) System: Companies sometimes arefound to be in financial troubles for factors beyond their control and alsodue to certain internal reasons. For the revival of such businesses, as wellas, for the security of the funds lent by the banks and FIs, timely supportthrough restructuring in genuine cases was required. With this view, aCDR system was established with the objective to ensure timely and

transparent restructuring of corporate debts of viable entities facingproblems, which are outside the purview of BIFR, DRT and other legalproceedings. In particular, the system aimed at preserving viablecorporate/businesses that are impacted by certain internal and externalfactors, thus minimising the losses to the creditors and other stakeholders.The system has addressed the problems due to the rise of NPAs.Although CDR has been effective, it largely takes care of the interest ofbankers and ignores (to some extent) the interests of borrowersstakeholders. The secured lenders like banks and FIs, through CDRmerely, address the financial structure of the company by deferring the

loan repayment and aligning interest rate payments to suit companyscash flows. The banks do not go for a one time large write-off of loans ininitial stages.


37/50


38/50

y SARFAESI ACT 2002: By the late 1990s, rising level of Bank NPAsraised concerns and Committees like the Narasimham Committee II andAndhyarujina Committee which were constituted for examining bankingsector reforms considered the need for changes in the legal system toaddress the issue of NPAs. These committees suggested a new legislation

for securitisation, and empowering banks and FIs to take possession ofthe securities and sell them without the intervention of the court andwithout allowing borrowers to take shelter under provisions ofSICA/BIFR. Acting on these suggestions, the SARFAESI Act, waspassed in 2002 to legalise securitisation and reconstruction of financialassets and enforcement of security interest. The act envisaged theformation of asset reconstruction companies (ARCs)/ SecuritisationCompanies (SCs).

Provisions of the SARFAESI Act

The Act has made provisions for registration and regulation of securitisationcompanies or reconstruction companies by the RBI, facilitate securitisation offinancial assets of banks, empower SCs/ARCs to raise funds by issuing securityreceipts to qualified institutional buyers (QIBs), empowering banks and FIs totake possession of securities given for financial assistance and sell or lease thesame to take over management in the event of default.

The Act provides three alternative methods for recovery of NPAs, namely:

y Securitisation: It means issue of security by raising of receipts or funds bySCs/ARCs. A securitisation company or reconstruction company mayraise funds from the QIBs by forming schemes for acquiring financialassets. The SC/ARC shall keep and maintain separate and distinctaccounts in respect of each such scheme for every financial assetacquired, out of investments made by a QIB and ensure that realisationsof such financial asset is held and applied towards redemption ofinvestments and payment of returns assured on such investments underthe relevant scheme.

y Asset Reconstruction: The SCs/ARCs for the purpose of assetreconstruction should provide for any one or more of the followingmeasures: the proper management of the business of the borrower, by change in, ortake over of, the management of the business of the borrower the sale or lease of a part or whole of the business of the borrower rescheduling of payment of debts payable by the borrower enforcement of security interest in accordance with the provisions of


39/50

this Act settlement of dues payable by the borrower taking possession of secured assets in accordance with the provisions ofthis Act.

yExemption from registration of security receipt: The Act also provides,notwithstanding anything contained in the Registration Act, 1908, forenforcement of security without Court intervention: (a) any security

receipt issued by the SC or ARC, as the case may be, under section 7 ofthe Act, and not creating, declaring, assigning, limiting or extinguishingany right, title or interest to or in immovable property except in so far asit entitles the holder of the security receipt to an undivided interestafforded by a registered instrument; or (b) any transfer of securityreceipts, shall not require compulsory registration.

The Guidelines for SCs/ARCs registered with the RBI are:

y act as an agent for any bank or FI for the purpose of recovering their duesfrom the borrower on payment of such fees or charges

y act as a manager between the parties, without raising a financial liabilityfor itself;

y act as receiver if appointed by any court or tribunal.Apart from above functions any SC/ARC cannot commence or carryout otherbusiness without the prior approval of RBI.

The Securitisation Companies and Reconstruction Companies (ReserveBank) Guidelines and Directions, 2003

The Reserve Bank of India issued guidelines and directions relating toregistration, measures of ARCs, functions of the company, prudential norms,acquisition of financial assets and related matters under the powers conferredby the SARFAESI Act, 2002.

Defining NPAs: Non-performing Asset (NPA) means an asset for which:

y Interest or principal (or instalment) is overdue for a period of 180 days ormore from the date of acquisition or the due date as per contract betweenthe borrower and the originator, whichever is later;

y interest or principal (or instalment) is overdue for a period of 180 days ormore from the date fixed for receipt thereof in the plan formulated forrealisation of the assets

y interest or principal (or instalment) is overdue on expiry of the planningperiod, where no plan is formulated for realisation of the


40/50

y any other receivable, if it is overdue for a period of 180 days or more inthe books of the SC or ARC.

Provided that the Board of Directors of a SC or ARC may, on default by theborrower, classify an asset as a NPA even earlier than the period mentioned

above.

Registration:

y Every SC or ARC shall apply for registration and obtain a certificate ofregistration from the RBI as provided in SARFAESI Act;

y A Securitisation Company or Reconstruction Company, which hasobtained a certificate of registration issued by RBI can undertake bothsecuritisation and asset reconstruction activities;

y Any entity not registered with RBI under SARFAESI Act may conductthe business of securitisation or asset reconstruction outside the purviewof the Act.

Net worth of Securitisation Company or Reconstruction Company: Net worth isaggregate of paid up equity capital, paid up preference capital, reserves andsurplus excluding revaluation reserve, as reduced by debit balance on P&Laccount, miscellaneous expenditure (to the extent not written off ), intangibleassets, diminution in value of investments/short provision against NPA andfurther reduced by shares acquired in SC/ARC and deductions due to auditorqualifications. This is also called Owned Fund. Every Securitisation Companyor Reconstruction Company seeking the RBIs registration under SARFAESI

Act, shall have a minimum Owned Fund of Rs 20 mn.

Permissible Business: A Securitisation Company or Reconstruction Companyshall commence/undertake only the securitisation and asset reconstructionactivities and the functions provided for in Section 10 of the SARFAESI Act. Itcannot raise deposits.

Some broad guidelines pertaining to Asset Reconstruction are as follows:

y Acquisition of Financial Assets: With the approval of its Board ofDirectors, every SC/ARC is required to frame, a Financial AssetAcquisition Policy, within 90 days of grant of Certificate ofRegistration, clearly laying down policies and guidelines which definethe; norms, type, profile and procedure for acquisition of assets,

y valuation procedure for assets having realisable value, which could bereasonably estimated and independently valued;

y plan for realisation of asset acquired for reconstruction


41/50

The Board has powers to approve policy changes and delegate powers tocommittee for taking decisions on policy/proposals on asset acquisition.

y Change or take over of Management/ Sale or Lease of Business of theBorrower: No SC/ARC can takeover/ change the management of

business of the borrower or sale/lease part/whole of the borrowersbusiness until the RBI issues necessary guidelines in this behalf.

y Rescheduling of Debt/ Settlement of dues payable by borrower: A policyfor rescheduling the debt of borrowers should be framed laying the broadparameters and with the approval of the Board of Directors. Theproposals should to be in line with the acceptable business plan,projected earnings/ cash flows of the borrower, but without affecting theasset liability management of the SC/ARC or commitments given toinvestors. Similarly, there should be a policy for settlement of dues withborrowers.

y Enforcement of Security Interest: For the sale of secured asset asspecified under the SARFAESI Act, a SC/ARC may itself acquire thesecured assets, either for its own use or for resale, only if the sale isconducted through a public auction.

y Realisation Plan: Within the planning period a realisation plan should beformulated providing for one or more of the measures includingsettlement/rescheduling of the debts payable by borrower, enforcementof security interest, or change/takeover of management or sale/lease of apart or entire business. The plan should clearly define the steps forreconstruction of asset within a specified time, which should not exceed

five years from the date of acquisition.

Broad guidelines with regards to Securitisation are as follows:

y Issue of security receipts: A SC/ARC can set up trust(s), for issuingsecurity receipts to QIBs, as specified under SARFAESI Act. Thecompany shall transfer the assets to the trust at a price at which the assetswere acquired from the originator. The trusteeship remains with thecompany and a policy is formulated for issue of security receipts.

y Deployment of funds: The company can sponsor or partner a JV foranother SC/ARC through investment in equity capital. The surplus

available can be deployed in G-Sec or deposits in SCBs.y Asset Classification: The assets of SC/ARC should be classified as

Standard or NPAs. The company shall also make provisions for NPAs.


42/50

Issues under the SARFAESI

Right ofTitle

A securitisation receipt (SR) gives its holder a right of title or interest in the

financial assets included in securitisation. This definition holds good forsecuritisation structures where the securities issued are referred to as Passthrough Securities. The same definition is not legally inadequate in case ofPay through Securities with different tranches.

Thin Investor Base

The SARFAESI Act has been structured to enable security receipts (SR) to beissued and held by Qualified Institutional Buyers (QIBs). It does not includeNBFC or other bodies unless specified by the Central Government as afinancial institution (FI). For expanding the market for SR, there is a need forincreasing the investor base. In order to deepen the market for SR there is aneed to include more buyer categories.

Investor Appetite

Demand for securities is restricted to short tenor papers and highest ratings.Also, it has remained restricted to senior tranches carrying highest ratings,while the junior tranches are retained by the originators as unrated pieces. Thiscan be attributed to the underdeveloped nature of the Indian market and poorawareness as regards the process of securitisation.

Risk Management in Securitisation

The various risks involved in securitisation are given below:

CreditRisk: The risk of non-payment of principal and/or interest to investorscan be at two levels: SPV and the underlying assets. Since the SPV is normallystructured to have no other activity apart from the asset pool sold by theoriginator, the credit risk principally lies with the underlying asset pool. Acareful analysis of the underlying credit quality of the obligors and thecorrelation between the obligors needs to be carried out to ascertain theprobability of default of the asset pool. A well diversified asset portfolio cansignificantly reduce the simultaneous occurrence of default.

Sovereign Risk: In case of cross-border securitisation transactions where theassets and investors belong to different countries, there is a risk to the investorin the form of non-payment or imposition of additional taxes on the incomerepatriation. This risk can be mitigated by having a foreign guarantor or by


43/50

structuring the SPV in an offshore location or have an neutral country ofjurisdiction

Collateral deterioration Risk: Sometimes the collateral against which credit issanctioned to the obligor may undergo a severe deterioration. When this

coincides with a default by the obligor then there is a severe risk of non-payment to the investors. A recent example of this is the sub-prime crisis in theUS which is explained in detail in the following sections.

LegalRisk: Securitisation transactions hinge on a very important principle ofbankruptcy remoteness of the SPV from the sponsor. Structuring the assettransfer and the legal structure of the SPV are key points that determine if theSPV can uphold its right over the underlying assets, if the obligor declare

bankruptcy or undergoes liquidation.

PrepaymentRisk: Payments made in excess of the scheduled principalpayments are called prepayments. Prepayments occur due to a change in themacro-economic or competitive industry situation. For example in case ofresidential mortgages, when interest rates go down, individuals may prefer torefinance their fixed rate mortgage at lower interest rates. Competitors offeringbetter terms could also be a reason for prepayment. In a declining interest rateregime prepayment poses an interest rate risk to the investors as they have toreinvest the proceedings at a lower interest rate. This problem is more severe incase of investors holding long term bonds. This can be mitigated by structuringthe tranches such that prepayments are used to pay off the principal and int

Final Project on Banking

Documents