SUMAN VISHWAKARMA
SOCIAL CONTROL OVER BANKING SEMINAR SEMINAR SUBMITTED SUBMITTED TO THE UNIVERSITY UNIVERSITY OF MUMBAI FOR L.L.M DEGREE SEM 3RD IN BUSSINESS. BY.SUMAN VISHWAKARMA UNDER THE GUIDENCE THE GUIDENCE OF PROF. OF PROF. MR.SANJAY JADHAV MR.SANJAY JADHAV DEPARTMENT DEPARTMENT OF LAW, OF LAW, UNIVERSITY OF UNIVERSITY OF MUMBAI 2012 TO 2013 04‐Sep‐13
The banks are the custodians of savings and powerful institutions to provide credit. They mobilize the resources from all the sections of the community by way of deposits and channelize them to industries and others by way of granting loans. In 1955 the Imperial Bank of India was nationalized and SBI was constituted.
Background The banks are the custodians of savings and powerful institutions to provide credit. They mobilise the resources from all the sections of the community by way of deposits and channelize them to industries and others by way of granting loans. In 1955 the Imperial Bank of India was nationalised and SBI was constituted. It was observed that commercial banks were directing their advances to the large and medium scale industries and the priority sectors such as agriculture, small-scale industries and the exports were neglected. The chairmen and directors of banks were mostly industrialists and many of them were interested in sanctioning large amount of loans and advances to the industries with which they were connected. To overcome these deficiencies found in the working of the banks, the Banking Laws (Amendment) Act was passed in December 1968 and came into force on 1-2-1969. It is known as the scheme of 'social control' over the banks. The then deputy Prime Minister, Mr. Morarji Desai made a statement in the Parliament on the eve of introducing the bill to amend the banking laws Act. He explained that the aim of social control was, "to regulate our social and economic life so as to attain the optimum growth rate for our economy and to prevent at the same time monopolistic trend, concentration of economic power and misdirection of resources". The following are the main provisions of this amendment, Bigger banks had to be managed by whole time chairman possessing special knowledge and practical experience of the working of a banking company or of finance, finance, economics or business administration. administration. The majority of directors had to be persons with special knowledge or practical experience in any of the areas such as accountancy, agriculture and rural economy, banking, co-operative, economics, finance, law, small scale industries etc.The banks were also prohibited from making any loans or advances, secured or unsecured to their directors or to any companies in which they have substantial interest. The growth of commercial banking during the first three plan periods has been lopsided. Without demanding proper security some banks were diverting funds to large and medium industries.
Background The banks are the custodians of savings and powerful institutions to provide credit. They mobilise the resources from all the sections of the community by way of deposits and channelize them to industries and others by way of granting loans. In 1955 the Imperial Bank of India was nationalised and SBI was constituted. It was observed that commercial banks were directing their advances to the large and medium scale industries and the priority sectors such as agriculture, small-scale industries and the exports were neglected. The chairmen and directors of banks were mostly industrialists and many of them were interested in sanctioning large amount of loans and advances to the industries with which they were connected. To overcome these deficiencies found in the working of the banks, the Banking Laws (Amendment) Act was passed in December 1968 and came into force on 1-2-1969. It is known as the scheme of 'social control' over the banks. The then deputy Prime Minister, Mr. Morarji Desai made a statement in the Parliament on the eve of introducing the bill to amend the banking laws Act. He explained that the aim of social control was, "to regulate our social and economic life so as to attain the optimum growth rate for our economy and to prevent at the same time monopolistic trend, concentration of economic power and misdirection of resources". The following are the main provisions of this amendment, Bigger banks had to be managed by whole time chairman possessing special knowledge and practical experience of the working of a banking company or of finance, finance, economics or business administration. administration. The majority of directors had to be persons with special knowledge or practical experience in any of the areas such as accountancy, agriculture and rural economy, banking, co-operative, economics, finance, law, small scale industries etc.The banks were also prohibited from making any loans or advances, secured or unsecured to their directors or to any companies in which they have substantial interest. The growth of commercial banking during the first three plan periods has been lopsided. Without demanding proper security some banks were diverting funds to large and medium industries.
Bank branches were opened only in big cities. Rural areas were neglected. Banks made discrimination between private sector and public sector between rural and urban and between agriculture, trade and industry. The banks were financing those industries which were producing luxury goods. The government felt that this type of growth was not in consonance with planning. The growth appeared to be defiant in many respects. There was a growing demand for the bank credit for the development of agriculture, industry and self-employment. So it was essential for the banking system to attract savings. Therefore, the government felt that need for social banking as against capitalist banking. A scheme of social control was introduced in 1967. The government enacted Banking Laws Amendment Act in 1968.This act has given more power to the government to control banking. The objectives of this Act was to ensure more equitable distribution of the resources of the banking system. The priority sectors like agriculture, small-scale industry, public sector and self-employment were to receive their due share in obtaining bank finance. Apart from this the banks are required to reconstitute their board of directors . The government set up National credit council in 1968. The Finance Minister was the chairman and the Governor of the Reserve Bank was the vice chairman of the council. The main functions of the National credit council were: 1. assessing the volume of credit required for the economy as a whole. 2. providing guidelines for the distribution of credit to the priority sector. 3. ensuring equitable distribution of credit in the economy.
Bank regulations are a form of government regulation which subject banks to certain requirements, restrictions and guidelines. This regulatory structure creates transparency between banking institutions and the individuals and corporations with whom they conduct business, among other things. Given the inter connectedness of the banking industry and the reliance that the national (and global) economy hold on banks, It is important for regulatory agencies to maintain control over the standardized practices of these institutions. Supporters of such regulation often hinge their arguments on the "too big to fail" notion. This holds that many financial institutions(particularly investment banks with a commercial arm) hold too much control over the economy to fail without enormous consequences . This is the premise for government bailouts, in which government financial assistance is provided to banks or other financial institutions who appear to be on the brink of collapse. The belief is that without this aid, the crippled banks would not only become bankrupt, but would create rippling effects throughout the economy leading to systemic failure. India has a long history of both public and private banking . Modern banking in India began in the 18th century, with the founding of the English Agency House in Calcutta and Bombay. In the first half of the 19th century, three Presidency banks were founded. After the 1860 introduction of limited liability, private banks began to appear, and foreign banks entered the market. The beginning of the 20th century saw the introduction of joint stock banks. In 1935, the presidency banks were merged together to form the Imperial Bank of India, which was subsequently renamed the State Bank of India.
The post independence period witnessed massive growth in the Indian banking system. The first step taken in this direction was nationalization of the Reserve Bank of India in 1948. It changed the outlook of the Reserve Bank by giving them the status of monitoring authority to regulate and control the socio-economic activities laid down by the government. In order to have sound and balanced growth of banking business in the country, The Reserve Bank of India Act, 1949 was passed to have control of the Reserve bank over the banking industry. In 1955, the Imperial Bank of India was nationalized under the name of State Bank of India. The scheme of social control was initiated by the government in the year 1967. Followed by it, the government nationalized 14 major banks which held a deposit of around Rs 50 crores on 19th July 1969 and 6 more banks which held deposit of around Rs 200 crores on 15th April 1980. This process was done to ensure more equitable and purposeful distribution of the credit. Besides the above developments, financial institutions were established for meeting the specialized needs. These include Industrial Development Bank of India (IDBI), Industrial Credit and Investment Bank of India for meeting the long – term financial needs of the large scale operations. Similarly for meeting the requirements of the Small Scale Industries (SSIs), State Financial Corporation (SFC), Small Industries Development (SIDC) and Small Industries Development Bank of India (SIDBI) have been established. The National Bank for Agriculture and Rural Development (NABARD), Land Development Bank (LDB), Regional Rural Bank (RRB) etc. has been established for taking care of the credit needs in the agriculture sector.
NATIONALIZATION. Barely four months after the third meeting of the National Credit Council, on 9 July 1969, Indira Gandhi sent a note to the Congress Working Committee through Fakhruddin Ali Ahmed, who was the Minister for Industrial Development, suggesting the nationalization of major banks. This c ame as a complete surprise, for the prevalent belief in Congress circles was that What was most disturbing for the Reserve Bank was the impression that was created in the media that it was opposed to nationalization. This perhaps had to do with the personality of Jha himself, and with the fact that the Bank had striven hard to make a success of the social control experiment. As Vice Chairman of the National Credit Council, Jha ensured that a large number of documents were submitted on different aspects of social control. The Bank had substantial inputs in the work of the groups formed by the Council. It also helped to provide the secretariat for the Council, and to create in March 1969 a cell attached to the Banking Commission. These actions by themselves did not imply that Jha was opposed to nationalization of major Indian banks. All the oral accounts point out that while Jha did not favour bank nationalization, he did not openly articulate his personal view on the subject. The real issue was summed up by I.G. Patel in his book, Glimpses of Indian Economic Policy: An Insider’s View: ‘For me, one consequence of nationalization was controversy once again about my jurisdiction and that of my department. A new banking department was created in the ministry under A. Bakshi from the RBI, an old leftist and acerbic friend of Haksar who could obviously be more relied upon to run nationalized banks than L.K. or I.G.’ (p. 137). As Patel’s quote shows, Jha was identified with forces that did not figure in the leftist groups that considered social control as an apology and a dilatory tactic to prevent the state from gaining the commanding heights of Indian finances. After the legal tangle over nationalization was temporarily sorted out, Jha convened a Rural Credit Survey Committee commercial banks only provided 0.9% of the total volume of advances and loans to the agricultural sector (Reserve Bank of India 2008a). Rural India continued to rely mostly on moneylenders that charged them very high interest rates on their loans.
The government had to make some major changes to promote equal socio-economic development. The Government of India nationalized the Imperial Bank of India, with the purpose of, “extension of banking facilities on a large scale, more particularly in the rural and semi-urban areas, and for diverse other public purposes.” The State Bank of India Act (1955) renamed the Imperial Bank of India as the State Bank of India (SBI). However to prevent it from being under administrative pressure its ownership was vested with the RBI. SBI underwent rapid expansion and opened 416 branches in 5 years all over the country (Reserve Bank of India2008a). The security that the government owned SBI helped it compete against deposits in safe avenues such as the post offices and savings at home. Five years later in 1960 eight more banks were nationalized and they formed the subsidiaries of the State Bank of India. With the nationalization of these eight banks one third of the banking sector was under the direct control of the government. The Indian banking system had made considerable progress since independence: (1) bank failures had decreased, (2) bank presence in the country increased, (3) banking legislation had a stronger foundation, and (4) deposits had increased. However, the benefits had still not flowed in their entirety to the general public, because credit was not reaching sectors that most needed it, and the banking industry did not have a national presence, because of its concentration in metropolitan and urban areas. On December 1967, through the Banking Laws Amendment Act (Reserve Bank of India 2008), the idea of social control was introduced. The main objective of social control was to achieve: (1) bank credit allocation to the right sectors, (2) prevent misuse of bank funds, and (3) use banks to promote and help finance socioeconomic development. The National Credit Council was established in 1968 to help allocate credit according to the Five Year Plan priorities .In 1969 by putting into effect the Banking Companies (Acquisition and Transfer of Undertakings) Ordinance, fourteen banks were nationalized. ‟
Nationalization led to major structural changes in the banking sector of India. Branch expansion was accompanied by development of priority sectors of the economy, with credit being directed towards these sectors contrary to profit motives of the banks. The Credit Guarantee Corporation of India Ltd. was established for providing guarantees against the risk of default in payment, which increased the number of loans to smaller borrowers by the banks. .
The interest rate paid by the banks on deposits. The nationalization phase was marked by stringent controls on the banking industry. As of September 22nd, 1990 the Cash Reserve Ratio was 15.00% and the Statutory Liquidity Ratio was 38.5% (Reserve Bank of India), combined they amounted to 53.5% of all demands and liabilities being saved in liquid government securities or as cash with the RBI. The banks were being used by the government to fund their projects for economic development. This led the banks to be unprofitable forcing the government to adopt changes and thus, came about the reforms of 1991 led by the Narasimham Committee. There are two main approaches to banking regulation. One endpoint is government. ownership of the banking industry and the other endpoint is free banking system. Barth, Caprio and Levine (2008) describe the two main approaches as the “Public Interest Approach” and the “Private Interest View of Regulation.” In India up until 1991 there was an increased amount of government regulation in the banking industry, and social control over the banks was mandated successful. Social control in banking would realize if the banks to manage to allocate resources efficiently while mobilizing credit in all sectors including the marked out priority sectors. Barth,Caprio and Levine (2008) define socially efficient as, “that the banking system allocates resources in a way that maximizes output,while minimizing variance, and is distributionally preferred.” The government of India initially put in process the policy of social control to help regulate, stabilize and expand the banking system. The government had good intentions, and it led to a banking system that spanned across the nation and was undergoing fewer banking failures, and actually making profits while lending to priority sectors.
THE SECOND ROUND
Nationalization that incorporated six more banks, and increased government regulation, made the banking system very inefficient and unprofitable; Joshi and Little (1997) said, “By 1991, the country had erected an unprofitable, inefficient, and financially unsound banking sector.” There are various ways a government can interfere with the banking system of an economy, and the Indian government, participated in all the below mentioned measures. Barth, “rate of economic growth within those states accelerated and quality of bank lending improved.” Caprio and Levine (2008) outline the main ones as: (1) restrictions on banks, (2) entry, (3) capital requirements, (4) supervisory powers, (5) safety net support the, (6) market monitoring and (7) government ownership. (1) Restrictions on Banks: It can be in the form of activity restrictions. It is critical to impose activity restrictions on banks, and that helps define the term bank. Regulatory restrictions can decrease efficiency of the banks and reduces their ability to diversify their income streams and decrease overall risk of operations. A cross country data study by Barth, Caprio a nd Levine (2001) finds that greater regulatory restrictions lead to a higher probability of a country suffering from a major bank crisis and lower banking sector efficiency. The Indian banks operated under many regulatory restrictions which limited their activities in off balance sheet activities. (2) Entry restriction: Governments have control over the banking system by regulating the entry of new private and foreign banks. Jayaratne and Strahan (1998) have performed studies that suggest when US created a more competitive environment by removing branching restrictions ,The Indian government had placed restrictions on entry of foreign banks and private banks. These banks required government licenses to operate in India.
In 1993 the RBI permitted private entry into the banking sector, but imposed restrictions on branch expansion. Various studies have shown that entry restrictions are not favorable for the banking industry. (3) Capital Requirements: In addition to entry restrictions, governments can enforce regulations on minimum capital requirements. It can affect risk taking activities and it helps create a pseudo overall economy. with the benefits derived from imposition of capital requirements by the government. (4) Supervisory Powers and Market Monitoring: It can be combined into one category and it refers to official supervision of banking activities in the country. Developing countries usually have directed credit programs and high reserve and liquidity requirements, this helps provide a cushion in times of crisis and as they liberalize these requirements, the banks need to have proper supervision of their activities. However, the private interest view argues otherwise. However there are not many studies on this that promote either view. The private interest view argues that excessive supervision can lead to corruption by government officials. It also says that government employees have no motivation to work in the government as the government pays them lesser than private banks and they would be willing to take bribes to produce a good report on a bank. India has instituted agencies that monitor banks performance. RBI also has supervisory powers and it places them in effect by looking at the financial statements of banks on a regular basis through the course of the year. ‟
(5) “Safety Net Support”: It has two main parts, one being the “lender of the last resort” and the other an “explicit deposit insurance system.” Proponents of the private interest view feel that it is a moral hazard and present several other ways to protect small depositors.
The objectives of bank regulation, and the emphasis, vary between jurisdictions. The most common objectives are: Prudential —to reduce the level of risk to which bank creditors are exposed (i.e. to protect depositors)
1. Systemic risk reduction —to reduce the risk of disruption resulting from adverse trading conditions for banks causing multiple or major bank failures 1. Avoid misuse of banks—to reduce the risk of banks being used for criminal purposes, e.g. laundering the proceeds of crime. 2. To protect banking confidentiality. 3. Credit allocation—to direct credit to favored sectors. 4. It may also include rules about treating customers fairly and having corporate social responsibility(CSR).
EVALUTION. PRIVATE OWNERSHIP, NATIONALIZATION AND DISINVESTMENT Effects of these reforms on the private and public banking system Credit structure and setting up of institutional framework for providing longterm finance to agriculture and industry. Banking sector, which during the pre—independence India was catering to the needs of the government, rich individuals and traders, opened its door wider and set out for the first time to bring the entire productive sector of the economy – large as well as small, in its fold. During this period number of commercial banks declined remarkably. There were 566 banks as on December, 1951; of this, number scheduled banks was 92 and the remaining 474 were non-scheduled banks. This number went down considerably to the level of 281 at the close of the year 1968. The sharp decline in the number of banks was due to heavy fall in the number of non-scheduled banks which touched an all time low level of 210. The banking scenario prevalent in the country up-to—the year 1968 depicted a strong stress on class banking based on security rather than on' purpose. Before 1968, only RBI and Associate Banks of SBI were mainly controlled by Government. Some associates were fully owned subsidiaries of SBI and in the rest, there was a very small shareholding by individuals and the rest by RBI. EXPANSION PHASE (1968-1984) The motto of bank nationalization was to make banking services reach the masses that can be attributed as "first- banking revolution". Commercial banks acted as vital instruments for this purpose by way of rapid branch expansion, deposits mobilization and credit creati on. Penetrating into rural areas and agenda for geographical expansion in the form of branch expansion continued. The second dose of nationalization of 6 more commercial banks on April 15, 1980 further widened the phase of the public sector banks and therefore banks were to implement all the government sponsored programmes and change their attitude in favour of social banking, which was given the highest priority.
This phase witnessed socialization of banking in 1968. Commercial banks were viewed as agents of change and social control on banks. However, inadequacy of social control soon became apparent because all banks except the SBI and its seven associate banks were in the private sector and could not be influenced to serve social interests. Therefore, banks were nationalized (14 banks in 1969 and 6 banks in 1980) in order to control the heights of the economy in conformity with national policy and objectives. This period saw the birth and the growth of what is now termed as directed lending’ by banks. It also saw commercial banking spreading to far and wide areas in the country with great pace during which a number of poverty alleviation and employment generating schemes were sought to be implemented through commercial banks. Thus, this period was characterized by the death of private banking and the dominance of social banking over commercial banking. It was hardly realized that banks 'were organizations with social responsibilities but not social organizations. This period also witnessed the birth of Regional Rural Bank (RRBS) in 1975 and NABARAD in 1982 which had priority sector as their focus of activity. Although number of commercial banks declined from 281 in 1968 to 268 in 1984, number of scheduled banks shot up from 71 to 264 during the corresponding period, number of non-scheduled banks having registered perceptible decline from 210 to 4 during the period under reference. The rise in the number of scheduled banks was, as stated above, due to the emergence of RRBS. The fifteen years following the banks’ nationalization in 1969 were dominated by the Banks’ expansion at a path breaking pace. As many as 50,000 bank branches were set up; three-fourths of these branches were opened in rural and semi-urban areas. Thus, during this period a distinct transformation of far reaching significance occurred in the Indian banking system as it assumed a broad mass base and emerged as an important instrument of socio-economic changes. Thus, with growth came inefficiency and loss of control over widely spread offices. Moreover, retail lending to more risk-prone areas at concessional interest rates had raised costs, affected the quality of assets of banks and put their profitability under strain. The competitive efficiency of the banks was at a low ebb. Customer service became least available commodity. Performance of a bank/banker began to 61 be measured merely in terms of growth of deposits, advances and other such targets and quality became a casualty.
The progress of branch expansion is presented in the Table: BRANCH EXPANSION SINCE 1969 TO 1991 Year 1969 1980 1991
Total No. of Branches 8262 32419 60,220
Rural Branches 1833 15105 35206
Semi-urban Branches 3342 8122 11,344
It can be seen from the Table 4.1 that the total number of bank branches increased eight-fold between 1969 to 1991. The bulk of the increase was on account of rural branches which increased from less than 2000 to over 35000 during the period. The percentage share of the rural and semi-urban branches rose from 22 and 4 respectively in 1969 to 45 percent and 25 percent in 1980 and 58 per cent and 18 percent in 1991. The impact of this phenomenal growth was to bring down the population per branch from 60,000 in 1969 to about 14,000. The banking system thus assumed a broad mass-base and emerged as an important instrument of social-economic changes. However, this success was neither unqualified nor without costs. While the rapid branch expansion, wider geographical coverage has been achieved, lines of supervision and control had been stretched beyond the optimum level and had weakened. Moreover, retail lending to more risk-prone areas at concessional interest rates had raised costs, affected the quality of assets of banks and put their profitability under strain.
PRIVATE OWNERSHIP
The underprovision of credit to small-scale industry was one of the key reasons cited for nationalization in 1969: thus, it might in fact be the case that while the public sector banks provide relatively little credit to SSI firms, private banks are even worse. In the next sub-section we examine the effect of bank ownership on bank allocation of credit. Bank Ownership and Sectoral Allocation of Credit As mentioned above, an important rationale for the Indian bank nationalizations was to direct credit towards sectors the government thought were underserved, including small scale industry, as well as agriculture and backward areas. Ownership was not the only means of directing credit: the Reserve Bank of India issued guidelines in 1974, indicating that both public and private sector banks must provide at least one-third of their aggregate advances to the priority sector by March 1979. In 1980, it was announced that this quota would be increased to 40 percent by March 1985. Sub-targets were also specified for lending to agriculture and weaker sectors within the priority sector. Since public and private banks faced the same regulation, in this section we focus on how ownership affected credit allocation. The comparison of nationalized and private banks is never easy: banks that fail are often merged with healthy nationalized banks, which makes the comparison of nationalized banks and non-nationalized banks close to meaningless. The Indian nationalization experience of 1980 represents a unique chance to learn about the relationship between bank ownership and bank lending behavior. The 1980 nationalization took place according to a strict policy rule: all private banks whose deposits were above a certain cutoff were nationalized.18 After 1980, the nationalized banks remained corporate entities, retaining most of their staff, though the board of directors was replaced by nominees of the Government of India. Both the banks that got nationalized under this rule and the banks that missed being nationalized, continued to operate in the same environment, and face the same regulations and therefore ought to be directly comparable .Even this comparison between banks just nationalized and just not nationalized may be invalid, because policy rule means that banks nationalized in 1980 are larger than the banks that. remained private. If size influences bank behavior, it would be incorrect to attribute all differencesbetween nationalized and private sector banks to nationalization. In this section, based on Cole, we adopt an approach in the spirit of regression discontinuity design, and compare banks that were just above the 1980 cut off to those that were just below the 1980 cutoff, while control- 18While the 1969 was larger, and also induced a discontinuity,
We do not use it because many of the banks just below the cut-off in 1969 were nationalized in 1980. One policy option that is being discussed is privatization. The evidence from Cole, discussed above, suggests that privatization would lead to an infusion of dynamism in to the banking sector: private banks have been growing faster than comparable public banks in terms of credit, deposits and number of branches, including rural branches, though it should be noted that in our empirical analysis, the comparison group of private banks were the relatively small ”old” private banks.48 It is not clear that we can extrapolate from this to what we could expect when the State Bank of India, which is more than an order of magnitude greater in size than the largest “old” private sector banks. The “new ” private banks are bigger and in some ways would have been a better group to compare with. However while this group is also growing very fast, they have been favored by regulators in some specific ways, which, combined with their relatively short track record, makes the comparison difficult. Privatization will also free the loan officers from the fear of the CVC and make them somewhat more willing to lend aggressively where the prospects are good, though, as will be discussed. Later, better regulation of public banks may also achieve similar goals. Historically, a crucial difference between public and private sector banks has been their willingness to lend to the priority sector. The recent broadening of the definition of priority sector has mechanically increased the share of credit from both public and private sector banks that qualify as priority sector. The share of priority sector lending from public sector banks was 42.5 percent in 2003, up from 36.6 percent in 1995. Private sector lending has shown a similar increase from its 1995 level of 30 percent. In 2003 it may have surpassed for the first time ever public sector banks, with a share of net bank credit to the priority sector at 44.4 percent to the priority sector.49 Still, there are substantial differences between the public and private sector banks. Most notable is the consistent failure of private sector banks to meet the agricultural lending subtarget, though they also lend substantially less in rural areas. Our evidence suggests that privatization will make it harder for the government to get the private banks to comply with what it wants them to do.
However it is not clear that this reflects the greater sensitivity of the public banks to this particular social goal. It could also be that credit to agriculture, being particularly politically salient, is the one place where the nationalized banks are subject to political pressures to make imprudent loans. Finally, one potential disadvantage of privatization comes from the risk of bank failure. In the past there have been cases where the owner of the private bank stripped its assets, and declared that it cannot honor its deposit liabilities. The government is, understandably, reluctant to let banks fail, since one of the achievements of the last forty years has been to persuade people that their money is safe in the banks. Therefore, it has tended to take over the failed bank, with the resultant pressure on the fiscal deficit. Of course, this is in part a result of poor regulation–the regulator should be able to spot a private bank that is stripping its assets. Better enforced prudential regulations would considerably strengthen the case for privatization. On the other hand, public banks have also been failing the problem seems to be part corruption and part inertia/laziness on the part of the lenders. As we saw above, the cost of bailing out the public banks may well be larger (appropriately scaled) than the total losses incurred from every bank failure since 1969 All numbers are from various issues of Report on Trends and Progress of banking in India.
PROTECTION OF DEPOSITORS
As stated earlier, financial intermediation by commercial banks has played a key role in India in supporting the economic growth process. An efficient financial intermediation process, as is well known, has two components: effective mobilization of savings and their allocation to the most productive uses. In this chapter, we will discuss one part of the financial intermediation by banks: mobilization of savings. When banks mobilize savings, they do it in the form of deposits, which are the money accepted by banks from customers to be held under stipulated terms and conditions. Deposits are thus an instrument of savings. Since the first episode of bank nationalization in 1969, banks have been at the core of the financial intermediation process in India. They have mobilized a sizeable share of savings of the household sector, the major surplus sector of the economy. This in turn has raised the financial savings of the household sector and hence the overall savings rate. Notwithstanding the liberalization of the financial sector and increased competition from various other saving instruments, bank deposits continue to be the dominant instrument of savings in India. provides a description of the most standard instruments of bank regulation: deposit insurance, capital adequacy requirements and lender of last resort. These three policies are linked one with the other. Deposit insurance protects the smallest depositors from a bank bankruptcy and prevents bank runs. Capital adequacy requirements are necessary in order to make sure that bank managers follow a responsible credit policy, in the absence of an effective control on the part of depositors. Lender of last resort policies further reduce the risk of banks bankruptcies providing banks with Emergency Liquidity Assistance facilities that are designed to avoid that temporary situations
Safety of deposits
At the time of depositing money with the bank, a depositor would want to be certain that his her money is safe with the bank and at the same time, wants to earn a reasonable return.The safety of depositors' funds, therefore, forms a key area of the regulatory framework for banking. In India, this aspect is taken care of in the Banking Regulation Act, 1949 (BR Act). The RBI is empowered to issue directives/advices on several aspects regarding the conduct of deposit accounts from time to time. Further, the establishment of the Deposit Insurance Corporation in 1962 (against the backdrop of failure of banks) offered protection to bank depositors, particularly small-account holders. This aspect has been discussed later in the Chapter. Deregulation of interest rates The process of deregulation of interest rates started in April 1992. Until then, all interest rates were regulated; that is, they were fixed by the RBI. In other words, banks had no freedom to fix interest rates on their deposits. With liberalization in the financial system, nearly all the interest rates have now been deregulated. Now, banks have the freedom to fix their own deposit rates with only a very few exceptions. The RBI prescribes interest rates only in respect of savings deposits and NRI deposits, leaving others for individual banks to determine. Deposit policy
The Board of Directors of a bank, along with its top management, formulates policies relating to the types of deposit the bank should have, rates of interest payable on each type, special deposit schemes to be introduced, types of customers to be targeted by the bank, etc. Of course, depending on the changing economic environment, the policy of a bank towards deposit mobilization, undergoes changes.
Types of Deposit Accounts
The bank deposits can also be classified into (i) demand deposits and (ii) time deposits. (i) Demand deposits are defined as deposits payable on demand through cheque or otherwise. Demand deposits serve as a medium of exchange, for their ownership can be transferred from one person to another through cheques and clearing arrangements provided by banks. They have no fixed term to maturity. (ii) Time deposits are defined as those deposits which are not payable on demand and on which cheques cannot be drawn. They have a fixed term to maturity. A certificate of deposit (CD), for example, is a time deposit Certificate of Deposit
A Certificate of Deposit (CD) is a negotiable money market instrument and is issued in dematerialized form or as a Usance Promissory Note, for funds deposited at a bank or other eligible financial institution for a specified time period. Guidelines for issue of CDs are currently governed by various directives issued by the RBI, as amended from time to time. CDs can be issued by (i) scheduled commercial banks (SCBs) excluding Regional Rural Banks (RRBs) and Local Area Banks (LABs); and (ii) select all-India Financial Institutions that have been permitted by the RBI to raise short-term resources within the umbrella limit fixed by RBI. Deposit amounts for CDs are a minimum of Rs.1 lakh, and multiples thereof. Demand and time deposits are two broad categories of deposits. Note that these are only categories of deposits; there are no deposit accounts available in the banks by the names 'demand deposits' or 'time deposits'. Different deposit accounts offered by a bank, depending on their characteristics, fall into one of these two categories. There are several deposit accounts offered by banks in India; but they can be classified into three main categories: 1.Current account 2.Savings bank account 3.Term deposit account
Deposit Insurance:
Deposit insurance helps sustain public confidence in the banking system through the protection of depositors, especially small depositors, against loss of deposit to a significant extent. In India, bank deposits are covered under the insurance scheme offered by Deposit Insurance and Credit Guarantee Corporation of India (DICGC), which was established with funding from the Reserve Bank of India. The scheme is subject to certain limits and conditions. DICGC is a wholly-owned subsidiary of the RBI. 1. Banks insured by the DICGC All commercial banks including branches of foreign banks functioning in India, local area banks and regional rural banks are insured by the DICGC.22 Further, all State, Central and Primary cooperative banks functioning in States/Union Territories which have amended the local Cooperative Societies Act empowering RBI suitably are insured by the DICGC. Primary cooperative societies are not insured by the DICGC. 2 Features of the scheme When is DICGC liable to pay? In the event of a bank failure, DICGC protects bank deposits that are payable in India. DICGC is liable to pay if (a) a bank goes into liquidation or (b) if a bank is amalgamated/ merged with another bank. Methods of protecting depositors' interest There are two methods of protecting depositors' interest when an insured bank fails: (i) by transferring business of the failed bank to another sound bank23 (in case of merger or amalgamation) and (ii) where the DICGC pays insurance proceeds to depositors (insurance pay-out method).
Types of deposit covered by DICGC
The DICGC insures all deposits such as savings, fixed, current, recurring, etc.
except the following types of deposits: A). Deposits of foreign Governments; B). Deposits of Central/State Governments; C). Inter-bank deposits; D). Deposits of the State Land Development Banks with the State co-operative bank; E). Any amount due on account of any deposit received outside India; F). Any amount, which has been specifically exempted by the corporation with the previous approval of RBI. Maximum deposit amount insured by the DICGC Each depositor in a bank is insured up to a maximum of Rs100,000 for both principal and interest amount held by him in the same capacity and same right. For example, if an individual had a deposit with principal amount of Rs.90,000 plus accrued interest of Rs.7,000, the total amount insured by the DICGC would be Rs.97,000. If, however, the principal amount were Rs. 99,000 and accrued interest of Rs 6,000, the total amount insured by the DICGC would be Rs 1 lakh. The deposits kept in different branches of a bank are aggregated for the purpose of insurance cover and a maximum amount up to Rs 1 lakh is paid. Also, all funds held in the same type of ownership at the same bank are added together before deposit insurance is determined. If the funds are in different types of ownership (say as individual, partner of firm, director of company, etc.) or are deposited into separate banks they would then be separately insured. Also, note that where a depositor is the sole proprietor and holds deposits in the name of the proprietary concern as well as in his individual capacity, the two deposits are to be aggregated and the insurance cover is available up to rupees one lakh maximum. Cost of deposit insurance Deposit insurance premium is borne entirely by the insured bank. Banks are required to pay the insurance premium for the eligible amount to the DICGC on a semi-annual basis.
The cost of the insurance premium cannot be passed on to the custom. Withdrawal of insurance cover The deposit insurance scheme is compulsory and no bank can withdraw from it. The DICGC, on the other hand, can withdraw the deposit insurance cover for a bank if it fails to pay the premium for three consecutive half year periods. In the event of the DICGC withdrawing its cover from any bank for default in the payment of premium, the public will be notified through the newspapers.
.
Basics of Bank Lending Banks extend credit to different categories of borrowers for a wide variety of purposes. For many borrowers, bank credit is the easiest to access at reasonable interest rates. Bank credit is provided to households, retail traders, small and medium enterprises (SMEs), corporates, the Government undertakings etc. in the economy. Retail banking loans are accessed by consumers of goods and services for financing the purchaseof consumer durables, housing or even for day-to-day consumption. In contrast, the need forcapital investment, and day-to-day operations of private corporates and the Government undertakings are met through wholesale lending. Loans for capital expenditure are usually extended with medium and long-term maturities, while day-to-day finance requirements are provided through short-term credit (working capital loans). Meeting the financing needs of the agriculture sector is also an important role that Indian banks play. 1. Principles of Lending and Loan policy Principles of lending
To lend, banks depend largely on deposits from the public. Banks act as custodian of public deposits. Since the depositors require safety and security of their deposits, want to withdraw deposits whenever they need and also adequate return, bank lending must necessarily Be based on principles that reflect these concerns of the depositors. These principles include: 1). safety 2). liquidity 3). profitability 4). and risk diversion.
Safety:
Banks need to ensure that advances are safe and money lent out by them will come back. Since the repayment of loans depends on the borrowers' capacity to pay, the banker must be satisfied before lending that the business for which money is sought is a sound one. In addition, bankers many times insist on security against the loan, which they fall back on if things go wrong for the business. The security must be adequate, readily marketable and free of encumbrances. Liquidity: To maintain liquidity, banks have to ensure that money lent out by them is not locked up for long time by designing the loan maturity period appropriately. Further, money must come back as per the repayment schedule. If loans become excessively illiquid, it may not be possible for bankers to meet their obligations vis-à-vis depositors. Profitability: To remain viable, a bank must earn adequate profit on its investment. This calls for adequate margin between deposit rates and lending rates. In this respect, appropriate fixing of interests rates on both advances and deposits is critical. Unless interest rates are competitively fixed and margins are adequate, banks may lose customers to their competitors and become unprofitable. Risk diversification: To mitigate risk, banks should lend to a diversified customer base. Diversification should be in terms of geographic location, nature of business etc. If, for example, all the borrowers of a bank are concentrated in one region and that region gets affected by a natural disaster, the bank's profitability can be seriously affected.
Loan Policy Based on the general principles of lending stated above, the Credit Policy Committee (CPC) of individual banks prepares the basic credit policy of the Bank, which has to be approved by the Bank's Board of Directors. The loan policy outlines lending guidelines and establishes operating procedures in all aspects of credit management including standards for presentation of credit proposals, financial covenants, rating standards and benchmarks, delegation of credit approving powers, prudential limits on large credit exposures, asset concentrations, portfolio management, loan review mechanism, risk monitoring and evaluation, pricing of loans, provisioning for bad debts, regulatory/ legal compliance etc. The lending guidelines reflect the specific bank's lending strategy (both at the macro level and individual borrower level) and have to be in conformity with RBI guidelines. The loan policy typically lays down lending guidelines in the following areas: 1). Level of credit-deposit ratio 2).Targeted portfolio mix 3). Hurdle ratings 4). Loan pricing 5). Collateral security
Credit Deposit (CD) Ratio Lending Rates Banks are free to determine their own lending rates on all kinds of advances except a few such as export finance; interest rates on these exceptional categories of advances are regulated by the RBI. It may be noted that the Section 21A of the BR Act provides that the rate of interest charged by a bank shall not be reopened by any court on the ground that the rate of interest charged is excessive. The concept of benchmark prime lending rate (BPLR) was however introduced in November 2003 for pricing of loans by commercial banks with the objective of enhancing transparency in the pricing of their loan products. Each bank must declare its benchmark prime lending rate (BPLR) as approved by its Board of Directors. A bank's BPLR is the Interest rate to be charged to its best clients; that is, clients with the lowest credit risk. Each bank is also required to indicate the maximum spread over the BPLR for various credit exposures.
However, BPLR lost its relevance over time as a meaningful reference rate, as the bulk of loans were advanced below BPLR. Further, this also impedes the smooth transmission of monetary signals by the RBI. The RBI therefore set up a Working Group on Benchmark Prime Lending Rate (BPLR) in June 2009 to go into the issues relating to the concept of BPLR and suggest measures to make credit pricing more transparent.
Guidelines on Fair Practices Code for Lenders RBI has been encouraging banks to introduce a fair practices code for bank loans. Loan application forms in respect of all categories of loans irrespective of the amount of loan sought by the borrower should be comprehensive. It should include information about the fees/ charges, if any, payable for processing the loan, the amount of such fees refundable in the case of non acceptance of application, prepayment options and any other matter which affects the interest of the borrower, so that a meaningful comparison with the fees charged by other banks can be made and informed decision can be taken by the borrower. Further, the banks must inform 'all-in cost' to the customer to enable him to compare the rates charged with other sources of finance. Regulations relating to providing loans
The provisions of the Banking Regulation Act, 1949 (BR Act) govern the making of loans by banks in India. RBI issues directions covering the loan activities of banks. Some of the major guidelines of RBI, which are now in effect, are as follows: 1). Advances against bank's own shares: a bank cannot grant any loans and advances against the security of its own shares. 2). Advances to bank's Directors: The BR Act lays down the restrictions on loans and advances to the directors and the firms in which they hold substantial interest.
3). Restrictions on Holding Shares in Companies: In terms of Section 19(2) of the BR Act, banks should not hold shares in any company except as provided in sub-section (A) whether as pledgee, mortgagee or absolute owner, of an amount exceeding 30% of the paid-up share capital of that company or 30% of its own paid-up share capital and reserves, whichever is less. Following the recommendations of the Group, the Reserve Bank has issued guidelines in February 2010. According to these guidelines, the 'Base Rate system' will replace the BPLR system with effect from July 01, 2010.All categories of loans should henceforth be priced only with reference to the Base Rate. Each bank will decide its own Base Rate. The actual lending rates charged to borrowers would be the Base Rate plus borrower-specific charges, which will include product specific operating costs, credit risk premium and tenor premium. Since transparency in the pricing of loans is a key objective, banks are required to exhibit the information on their Base Rate at all branches and also on their websites. Changes in the Base Rate should also be conveyed to the general public from time to time through appropriate channels. Apart from transparency, banks should ensure that interest rates charged to customers in the above arrangement are non-discriminatory in nature. Guidelines on Fair Practices Code for Lenders RBI has been encouraging banks to introduce a fair practices code for bank loans. Loan application forms in respect of all categories of loans irrespective of the amount of loan sought by the borrower should be comprehensive. It should include information about the fees/ charges, if any, payable for processing the loan, the amount of such fees refundable in the case of non-acceptance of application, prepayment options and any other matter which affects the interest of the borrower, so that a meaningful comparison with the fees charged by other banks can be made and informed decision can be taken by the borrower. Further, the banks must inform 'all-in-cost' to the customer to enable him to compare the rates charged with other sources of finance.
PROMOTION OF UNDER PRIVILEGED CLASSES General principles of bank regulation
Banking regulations can vary widely across nations and jurisdictions. This section of the article describes general principles of bank regulation throughout the world. Minimum requirements Requirements are imposed on banks in order to promote the objectives of the regulator. Often, these requirements are closely tied to the level of risk exposure for a certain sector of the bank. The most important minimum requirement in banking regulation is maintaining minimum capital ratios. To some extent, U.S. banks have some leeway in determining who will supervise and regulate them. Supervisory review Banks are required to be issued with a bank license by the regulator in order to carry on business as a bank, and the regulator supervises licensed banks for compliance with the requirements and responds to breaches of the requirements through obtaining undertakings, giving directions, imposing penalties or revoking the bank's license. Market discipline The regulator requires banks to publicly disclose financial and other information, and depositors and other creditors are able to use this information to assess the level of risk and to make investment decisions. As a result of this, the bank is subject to market discipline and the regulator can also use market pricing information as an indicator of the bank's financial health.
Instruments and requirements of bank regulation Capital requirement The capital requirement sets a framework on how banks must handle their capital in relation to their assets. Internationally, the Bank for International Settlements' Basel Committee on Banking Supervision influences each country's capital requirements. In 1988, the Committee decided to introduce a capital measurement system commonly referred to as the Basel Capital Accords. [5] The latest capital adequacy framework is commonly known as Basel III. This updated framework is intended to be more risk sensitive than the original one, but is also a lot more complex. Reserve requirement The reserve requirement sets the minimum reserves each bank must hold to demand deposits and banknotes. This type of regulation has lost the role it once had, as the emphasis has moved toward capital adequacy, and in many countries there is no minimum reserve ratio. The purpose of minimum reserve ratios is liquidity rather than safety. An example of a country with a contemporary minimum reserve ratio is Hong Kong, where banks are required to maintain 25% of their liabilities that are due on demand or within 1 month as qualifying liquefiable assets. Reserve requirements have also been used in the past to control the stock of banknotes and/or bank deposits. Required reserves have at times been gold coin, central bank banknotes or deposits, and foreign currency. Corporate governance Corporate governance requirements are intended to encourage the bank to be well managed, and is an indirect way of achieving other objectives. As many banks are relatively large, with many divisions, it is important for management to maintain a close watch on all operations. Investors and clients will often hold higher management accountable for missteps, as these individuals are expected to be aware of all activities of the institution. Some of these requirements may include:
