The Banking Regulation Review: India
The Reserve Bank of India (RBI), as the central bank of the country, was set up in April 1935 on the basis of the recommendations of the Hilton Young Commission, under the aegis of the Reserve Bank of India Act 1934 (the RBI Act). Since then, the RBI's functions and focus have evolved in response to the changing economic environment and encompass core central banking functions such as pan-India monetary policy, bank supervision and regulation, foreign exchange control management, oversight of the payments system and development of the financial markets.
In addition to the RBI Act, the primary legislation governing banks in India is the Banking Regulation Act 1949 (the BR Act). Additionally, the RBI periodically issues various circulars, directions and guidelines to be followed by banks.
Depending on whether the companies licensed to carry out banking business in India have been listed in the Second Schedule to the RBI Act or not, banks in India may be scheduled banks or non-scheduled banks. Scheduled banks are further categorised as cooperative banks, whether urban (UCB) or rural, and commercial banks, which include public sector banks (PSBs), private sector banks (PVBs) (including domestic PVBs and foreign banks) and regional rural banks (RRBs). Recent entrants into the banking sector include small finance banks (SFBs) and payment banks (PBs), which may be scheduled or non-scheduled. In addition, certain development banks have also been set up under special statutes, such as National Bank for Agriculture and Rural Development and National Housing Bank.
The Indian banking system consists of 12 PSBs, 22 PVBs, 46 foreign banks, 56 active RRBs, approximately 1,485 urban cooperative banks and 96,000 rural cooperative credit institutions. As at 31 March 2020, there were 221,579 ATMs, 57.7 million credit cards and 828.6 million debit cards in India.2 Further, powered by the recent digital financial inclusion movement in India, total bank account penetration in the Indian adult population has more than doubled since 2011, to 80 per cent.3
Based on asset size alone, the five largest PSBs in India are State Bank of India, Bank of Baroda, Punjab National Bank, Canara Bank and Bank of India, and the five largest PVBs in India are HDFC Bank Limited, ICICI Bank Limited, Axis Bank Limited, Kotak Mahindra Bank Limited and IndusInd Bank Limited.4
Overall, profitability of PVBs worsened in 2019 compared with the previous year, although this was higher than the profitability of PSBs. In contrast, PSBs have been more successful in reducing their losses, building on the improvements in their asset quality. However, interest income has accelerated, and non-interest income has been revived for commercial banks, leading to an upswing in overall profitability.5
Recently, banks' capacity to lend has been severely affected because of mounting non-performing assets (NPAs). However, the enactment of the Insolvency and Bankruptcy Code 2016 (IBC) has been a game changer in the resolution of stressed assets, and, to support the IBC framework, the RBI also instituted a remedial framework through the Prudential Framework Circular of 7 June 2019, which envisages the time-bound implementation of a resolution plan, failing which disincentives in the form of additional provisions will kick in. Further, in the wake of the coronavirus pandemic, the Resolution Framework for Covid-19 related Stress of 6 August 2020 provided lenders with a limited-time window to implement a resolution plan in respect of eligible corporate exposures. As a result of these and other efforts to improve banking asset quality, there has been a decline in gross NPA ratios.6
There is increased focus on financial inclusion and on increasing the level of penetration of banking services to unserved and underserved areas. In particular, leveraging the latest technology to develop state-of-the-art national payments infrastructures and digitisation platforms is on the RBI's policy agenda.
The ongoing spate of privatisation and consolidation of PSBs is also a significant step for the banking industry. In August 2019, the Indian government announced the mergers of eight major PSBs in India. This was the biggest public banking sector restructuring since the nationalisation of 14 private banks in July 1969 and was intended to improve governance and accountability of the affected PSBs.
The regulatory regime applicable to banks
i Banking business and licensing requirements
Banks in India are required to obtain a licence from the RBI to carry on banking business in India. 'Banking business', as per Section 6 of the BR Act, refers to acceptance of public deposits for the purpose of lending or investment, which would be repayable and capable of withdrawal, and includes guarantee and indemnity business, discounting, dealing in negotiable instruments, underwriting, participating or managing of any issue, and other incidental activities.
On-tap banking licences (rather than banking by invitation licences) were introduced in 2016, subject to the bank complying with conditions such as: (1) the ability to pay present and future depositors in full as their claims accrue; (2) conducting banking affairs in a manner not detrimental to the interests of present or future depositors; (3) adequate capital structure and earnings prospects; and (4) maintenance of public interests. Additionally, depending on the nature of the banking business, specialised requirements may also apply. The RBI has the power to revoke or cancel the licence if a bank fails to meet the conditions or if the bank ceases to carry on banking operations in India.
Under a special dispensation, on 5 December 2019 the RBI issued guidelines for on-tap licensing of SFBs, after gaining from the experience of the earlier SFB licensing regime introduced in 2014, with minimum paid-up voting equity capital/net worth requirements of 2 billion rupees. For primary UCBs desirous of voluntarily transitioning into SFBs, the initial requirement of net worth has been set at 1 billion rupees, which will have to be increased to 2 billion rupees within five years of the date of commencement of business. All eligible PBs have been permitted to apply for conversion into SFBs after five years of operation. However, in a report released in November 2020 (the IWG Report),7 an internal working group constituted by the RBI in June 2020 has, inter alia, recommended that the minimum initial paid-up voting equity capital/net worth required to set up a new SFB be increased to 3 billion rupees, and for UCBs transiting to SFBs, the initial paid-up voting equity capital/net worth should be 1.5 billion rupees, which should be increased to 3 billion rupees within five years. The IWG Report also recommended that the minimum initial capital requirement for licensing new banks should be enhanced from 5 billion rupees to 10 billion rupees for universal banks. Because SFBs would also target small ticket and underbanked borrowers, this new regime is being positioned as a game changer in the small lending space to supplement the work UCBs have been doing in the past.
In May 2017, branches of banks were redefined as 'banking outlets' for the purpose of harmonising the treatment of different forms of bank presence including those in underserved areas. A banking outlet now covers all points of service delivery by banks, whether full-time or part-time, including all branches, extension counters and satellite offices. This relaxation is a significant step for facilitating financial inclusion and providing flexibility to banks on their choice of delivery channel.
The RBI's permission is no longer required to open banking outlets in Tier 1 to Tier 6 centres.8 However, it has mandated that banks must open 25 per cent of these outlets in unbanked rural centres (Tiers 5 and 6) that do not have any bricks-and-mortar structure for a scheduled bank, local area bank or cooperative bank to carry out core banking customer transactions. Further, banks with this general permission may shift, merge or close all banking outlets at their discretion, but the merger, closure or shifting of any rural outlets or sole semi-urban outlets requires approval from the relevant district committee. RRBs are required to obtain prior approval from the RBI for opening bricks-and-mortar branches in Tier 1 to 4 centres (as per the Indian Census 2011). For Tier 5 and 6 centres, RRBs have general permission for opening banking outlets, with post facto reporting. In March 2020, the requirement of prior RBI approval for branch expansion of SFBs during the first three years of operating was eliminated. SFBs now also have general permission to open banking outlets, subject to the condition that at least 25 per cent of their banking outlets are in unbanked rural centres.9
ATMs, e-lobbies, bunch note acceptor machines, cash deposit machines, e-kiosks and mobile branches fall outside the purview of banking outlets. These can, therefore, be set up by banks at centres or places of their choosing.
As has been observed during the past few years, branch expansions into rural areas remained relatively passive because the business correspondent (BC) model,10 coupled with an emphasis on digitisation and modernisation of technological infrastructure, has progressively subdued the need to set up bricks-and-mortar branches. The BC regime gained popularity in urban, as well as rural, areas. Further, the growth in the number of basic savings deposit accounts and deposits mobilised through BCs remained higher than for those generated in physical bank branches.11
ii Legal structures for banking entities
Banks must be set up as companies (including foreign companies). As such, domestic banks are also subject to the purview of the Indian Companies Act 2013 (CA) to the extent applicable, and if such banks are listed on a stock exchange in India, additional trading or listing rules apply.
At present, foreign banks, if eligible, are allowed by the RBI to set up business in India through a single mode of presence (i.e., either through a branch model or a wholly owned subsidiary (WOS) model). In particular, the WOS would be given near-national treatment, including in the opening of branches, as the WOS structure was deemed to be more financially stable given the lessons learned from the economic crisis of 2007–2009. Owing to incentives given for the subsidiarisation model, the presence of foreign banks in India increased during 2018 and 2019.
In recent years, there has been increased focus by the RBI and the government on consolidating, recapitalising and providing technological assistance to other banking sector players; namely, to RRBs, cooperative banks, SFBs and PBs, as these banks represent the key to greater financial inclusion.
RRBs were formed under the RRB Act 1976 with the objective of providing banking facilities to small farmers, agricultural labourers, artisans and other rural impoverished citizens. Cooperative banks, on the other hand, play a crucial role in extending financial inclusion through their geographic and demographic outreach. Following the failure of certain cooperative banks in the recent past, the Banking Regulation Amendment Act 2020 was passed by the Rajya Sabha, the upper house of the Indian parliament, in its September 2020 session. The Act has several provisions that will have a long-standing impact on the banking industry. It has amended the BR Act and extended its boundaries over the conduct of cooperative banks, including provisions for supervision and audits by the RBI. Up until the amendment came into force, cooperative banks were regulated under a dual regulatory framework, with the Registrar of Cooperative Societies regulating the administrative aspects of these banks, including the control of management, elections and audit-related matters, and the RBI regulating the aspects pertaining to liquidity, such as licence, maintaining cash reserve, statutory liquidity and capital adequacy ratios, and inspection. Following the amendment: the BR Act would apply to all the cooperative banks except primary agricultural credit societies or cooperative societies whose principal business is long-term financing for agricultural development; and RBI would have the power to relax the ceiling on share and security issuance to existing members of cooperative societies and to supersede the board of directors of primary and multistate cooperative banks. The amendment also brings in the concept of issuing various categories of securities by UCBs, to raise capital, including special shares and preference shares. However, the amendments lack clarity in relation to the treatment of these special shares and preference shares and on how voting rights associated with these shares will be dealt with by RBI (if at all).
The more recent players, SFBs and PBs, have a smaller operational scale than RRBs and cooperative banks, but also fewer regulatory constraints. SFBs were set up in 2016 to offer basic banking services such as accepting deposits and lending to the underserved sections, including small businesses, marginal farmers, micro and small enterprises (MSEs) and the unorganised sector. PBs were established to improve financial inclusion by specifically harnessing technology services via mobile telephony. Unlike SFBs, PBs cannot undertake lending activities and their design is functionally equivalent to that of prepaid instrument (digital wallet) providers. However, since the RBI issued the 'Guidelines for on “tap licensing” of Small Finance Banks in the Private Sector' in December 2019, all eligible PBs may apply for conversion into SFBs after five years of operation. It is pertinent to note that this conversion option has not been welcomed by the industry because of the lack of clarity in relation to the regime, including in terms of: (1) the process for promoter identification by UCBs prior to conversion; (2) how investments in UCBs would be treated upon conversion; and (3) whether capital infusion by a group of promoters would be permitted.
Further, with respect to PBs, in 2020 the RBI issued draft guidelines for setting up a self-regulatory organisation (SRO),12 to set and enforce rules and standards for participants in the digital payments industry, and a new umbrella entity (NUE),13 to act as a settlement agency for digital payments. There are other SROs in the banking industry, including the Indian Banks' Association, which almost operates like an SRO for Indian banks. Along similar lines, the digital payments sector will also have an SRO that will be a recognised industry body for these companies. Currently, the Payments Council of India operates as a representative body for digital payment companies, and the larger fintech ecosystem is also represented by the Fintech Convergence Council. These bodies, if they apply for the licence, could transform into SROs, with due approval from the RBI. With respect to NUEs, the RBI wants to create multiple entities similar to the National Payments Corporation of India (NPCI), to reduce the concentration risk on the NPCI; however, it is pertinent to note that, unlike the NPCI, NUEs could be 'for profit' entities.
i Relationship with the prudential regulator
As a 'banker to banks' and as 'lender of last resort', the RBI directly controls the prudential regulation of banks, introducing norms for income recognition, asset classification and provisioning for the advance portfolios of banks, and ensuring consistency and transparency in published accounts.
The BR Act specifically requires banks to maintain books and records in a particular manner and file the same with the regulatory authority on a periodic basis. The RBI's directives on know your customer (KYC) and anti-money laundering provide for transactional and identification records to be maintained for a minimum period of 10 years from the date of transaction and 10 years from the cessation of relationship with the client, respectively. The provisions for production of documents and availability of records for inspection by shareholders as stipulated under the CA and the rules thereunder also apply to banks.
Further, for more effective supervision over the burgeoning NPA situation, the RBI has set up the Central Repository of Information on Large Credits to collect, store and disseminate data reporting entities' exposure to the borrower (as individuals or as a group, or both) under various heads, including 'special mention accounts' with aggregate debt exposure of 50 million rupees and above.
The RBI is empowered under the BR Act to conduct periodical on-site inspections on matters relating to banks' portfolios, risk management systems, internal controls, credit allocation and regulatory compliance, at regular intervals. Further, the RBI also conducts on-site supervision of selected branches with respect to their general operations and foreign exchange transactions. To this end and to enable off-site monitoring and surveillance by the RBI, banks are also required to periodically report to the RBI on these and other aspects.
ii Management of banks
The appointment, reappointment or termination of the appointment of a chairperson, managing director, full-time director or chief executive officer of a bank shall have effect only if made with the prior approval of the RBI.
No amendments in relation to (1) the maximum permissible number of directors or the appointment, reappointment or termination of the appointment or remuneration of a chairperson, managing director, full-time director or chief executive officer of a bank; or (2) the remuneration of the chairperson, managing director, full-time director, any other director or chief executive officer shall have effect unless approved by the RBI. The RBI is also empowered to remove a chairperson, managing director or full-time director from office on the grounds of public interest or the interests of depositors or in securing proper management of the bank. The relevant provisions of the CA relating to appointment and remuneration of managerial personnel shall not apply to such matters that require RBI approval.
The RBI may, at any time, in the interest of the public, banking policy, depositors or the bank itself, pass certain orders in writing, such as:
- convening board and general meetings to discuss any matter in relation to the bank, including the election of new directors;
- requiring the bank to discuss any relevant matter with an officer of the RBI, and submit relevant disclosures;
- appointing one or more RBI officers as observers of the bank;
- making such changes to the management of the bank as it deems necessary; and
- superseding the board of directors of a banking company for a period of six to 12 months.
The RBI has directed PVBs to undertake a process of due diligence to determine the suitability of candidates for appointment or reappointment as a director on the board of directors of a bank, based upon qualification, expertise, track record, integrity and other relevant factors. Additionally, at least half the board of a PVB must comprise independent directors. Moreover, for foreign banks that have adopted the WOS model: (1) at least 50 per cent of their directors must be Indian residents (with at least one-third being Indian national residents); (2) the chief executive officer must be an Indian resident; and (3) at least two-thirds of directors must be non-executive directors.
To ensure minimum political intervention and transparency, the following are not eligible to be members of a PSB's board:
- members of Parliament, state legislatures or local governments;
- statutory auditors of PSBs; and
- persons on the board of any other bank, financial institution or other competing body.
The decision-making process in banks is participative and conducted as per the procedural guidelines for board and shareholders' meetings stipulated in the CA. Moreover, it is expected that the RBI will soon issue guidelines on corporate governance for regulated entities to align the current regulatory framework with global best practices while being mindful of the context of the domestic financial system.
To prevent misaligned remuneration and incentive schemes for bank managers and employees, in November 2019 the RBI directed that a substantial proportion of compensation of full-time directors, chief executive officers, material risk-takers and control function staff (i.e., at least 50 per cent), should be variable and paid on the basis of individual, business unit and firm-wide measures that adequately measure performance. The total variable pay shall be limited to a maximum of 300 per cent of the fixed pay. Moreover, if variable pay is up to 200 per cent of the fixed pay, a minimum of 50 per cent of the variable pay should be via non-cash instruments; and if variable pay is above 200 per cent, a minimum of 67 per cent of the variable pay should be via non-cash instruments.
For senior executives, deferral arrangements for a minimum of 60 per cent of the total variable pay must invariably exist for the variable pay, regardless of the quantum of pay, and should also be subject to clawbacks in the case of subdued or negative financial performance of the bank. These guidelines will be applicable to PVBs, including local area banks, SFBs and PBs, as well as to foreign banks operating in a WOS structure, for pay cycles beginning from and after 1 April 2020.
In light of the failure and mismanagement of various UCBs in the recent past, the RBI has introduced another layer of management for UCBs. The RBI has issued guidelines on constituting boards of management (BOMs) in UCBs, which shall assist the UCBs' boards of directors in steering the UCBs. The roles and responsibilities of the BOMs are akin to the directors of UCBs, albeit in an advisory capacity.
iii Regulatory capital and liquidity
The RBI has set out the minimum capital adequacy standards for banks based on the guidelines of the Basel Committee on Banking Supervision. The RBI Basel III Capital Regulations became effective on 1 April 2013 and were fully implemented by 31 March 2020, in a phased manner. Under RBI guidelines, the minimum total capital to risk-weighted assets ratios to be maintained for three years from commencement of operations are as follows:
- for PVBs: 9 per cent
- for PSBs: 12 per cent: and
- for WOS-model foreign banks: 10 per cent.
These percentages are all higher than the Basel III prescription.
Presently, a bank's capital comprises Common Equity Tier 1 (CET1) capital and Common Equity Tier 2 (CET2) capital with a restriction that CET2 capital cannot be more than 100 per cent of CET1 capital. CET1 capital typically comprises ordinary equity shares, with or without voting rights, and innovative instruments up to 15 per cent thereof. CET2 capital may be in the form of debt capital instruments and preference shares capital instruments, as long as these instruments have certain loss absorption features. Further, the RBI has permitted banks to raise Additional Tier 1 capital in the form of perpetual non-cumulative preference shares and certain types of debt capital instruments that have principal loss absorption through either conversion into common shares at an objective pre-specified trigger point or a write-down mechanism, which allocates losses to the instrument at a pre-specified trigger point.
The Basel III framework prescribes two minimum liquidity standards: the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). While the LCR promotes short-term resilience of banks in dealing with potential liquidity disruptions lasting for 30 days, the NSFR requires banks to fund their activities with stable sources of funding over the time horizon extending to one year. The former has been implemented in India since 1 January 2015 and the latter – defined as the ratio of available stable funding to required stable funding – has been effective since 1 April 2020.
Other Basel-prescribed capital reserves required to be maintained include the cash reserve ratio, as a percentage of banks' demand and time liabilities (DTL), by way of a balance in an interest-free current account with the RBI, and the statutory liquidity ratio (SLR), a percentage of DTL to be maintained by way of liquid assets such as cash, gold or approved unencumbered securities, against which banks may avail funds from the RBI on an overnight basis under the marginal standing facility. Similar capital adequacy requirements or buffers also apply to WOS-model foreign banks.
iv Recovery and resolution
There is no separate resolution framework for failed banks in India. Even the IBC, which is a comprehensive reform of the legislative framework for insolvency and bankruptcy, does not directly cover bankruptcy of 'financial firms' such as banks, insurance companies and stock exchanges, and instead empowers the central government to notify the same.14 Further, for any winding-up petition against a bank, RBI approval would be required. Specifically, in terms of resolution of development or cooperative banks, the RBI's powers are further limited.
That being said, the BR Act confers significant powers on the RBI (with or without consultation with the central government) to exercise control over, or make changes to, the management of the board of a failed bank. The RBI may also be appointed as the liquidator for winding-up the bank or apply to courts to suspend a mismanaged bank's business.
Bank deposit insurance was introduced in India in 1962 pursuant to the Deposit Insurance and Credit Guarantee Corporation Act 1961. The Deposit Insurance and Credit Guarantee Corporation, a WOS of the RBI, insures deposits of up to 100,000 rupees of all commercial banks in India, including foreign banks, local area banks, RRBs and most cooperative banks. At present, each depositor in a bank is insured up to a maximum of 100,000 rupees for both principal and interest amount.
Bearing in mind the serious market disruption risks that may arise from the failure of any bank in India, interest in promulgating the Financial Resolution and Deposit Insurance Bill 2017 (FRDI) has rekindled. The FRDI proposes to create a unified framework for monitoring financial firms such as banks and to establish a 'resolution corporation' that would be responsible for supervising the resolution or liquidation processes of failed banks.
Section 45 of the BR Act was amended by the 2020 amendments to the BR Act, enabling the RBI to enact a scheme for reconstruction or amalgamation of entities for the purpose of protecting the interests of depositors and the public at large, or to ensure proper management, without imposing a moratorium on the bank. The amendment could enable banks under moratorium to discharge their liabilities and make payments under the scheme and protect the financial system at large from being disrupted by the placing of distressed banks under moratorium.
Conduct of business
In recent years, the responsibility on banks to protect customer data has increased, whether as a result of the enhanced degree of care required under the Information Technology Act 2000, read with the Information Technology (Reasonable Security Practices and Procedures and Sensitive Personal Data or Information) Rules 2011, or as a result of the global harmonisation required under the European Union's General Data Protection Regulation. In India, the Personal Data Protection Bill 2019 (the PDP Bill) has also been tabled before Parliament for consultation. In addition, the Ministry of Electronics and Information Technology has devised a framework for governing non-personal data. If data relates to customers' identification, additional guidelines stipulated by the Unique Identification Authority of India, the NPCI and directives periodically issued by the RBI also apply.
Exceptions to such confidentiality arise with respect to disclosures and periodic reporting to be made to RBI by the banks, including with respect to any borrowers and promoters that are wilful defaulters, and reporting of any NPAs, fraud, suspicious transactions and cyber security failures.
The RBI has prescribed priority sector lending areas for all scheduled banks to include the agriculture, MSE, education, housing, social infrastructure, export credit and renewable energy sectors. Currently, the total priority sector lending target for domestic banks is 40 per cent of adjusted net bank credit (ANBC) or credit equivalent amount of off-balance sheet exposure, whichever is higher. ANBC is calculated as outstanding bank credit minus bills rediscounted with the RBI and other approved financial institutions plus permitted non-SLR bonds or debentures in the held-to-maturity category plus other eligible investments.
Banks are liable for multiple penalties under the RBI Act and the BR Act, for breach of any statutory provisions thereof or of any circulars and directions as periodically issued by the RBI. Criminal liability under corresponding provisions of the Indian Penal Code 1860 would also apply to such banks, for example, on the grounds of fraud, misappropriation of funds, cheating, forgery and criminal breach of trust. In addition, the RBI has the power to suspend, revoke or cancel banking licences or impose additional supervisory restrictions and limitations on the deviant bank.
In addition to banking, the RBI permits scheduled commercial banks (SCBs) (other than RRBs) to engage in certain kinds of financial services, which include dealing in credit information, operation of payment systems, stock exchanges or depositories, securitisation or asset reconstruction, merchant banking, portfolio management, stock broking, investment advisory, business of credit rating agency, collective investment schemes, pension fund management and authorised dealing in foreign exchange. Such banks can also make equity investments in other companies undertaking such financial services, or the banks' subsidiaries.
Banks must maintain tiered capital compliant with Basel III. Further, SCBs (excluding RRBs), most cooperative banks and authorised dealers in foreign exchange are permitted to participate in call or notice money markets, both as borrowers and lenders, and to obtain funding from the money market through instruments such as commercial paper, certificates of deposit and non-convertible debentures of original or initial maturity of up to one year.
The liquidity adjustment facility (LAF) is a facility extended by the RBI to SCBs (excluding RRBs) and authorised dealers in foreign exchange to avail of liquidity if required or to park excess funds with the RBI in the operation of LAF conducted by way of repurchase agreements, with the RBI being the counterparty to all the transactions.
Control of banks and transfers of banking business
i Control regime
In November 2015, the RBI issued regulations for prior approval for acquisition of shares or voting rights in PVBs, except urban cooperative banks, foreign banks and banks licensed under specific statutes. Prior RBI approval is required by any person seeking to acquire, directly or indirectly, shares or voting rights of a bank, directly or with persons acting in concert, where such acquisition results in aggregate shareholding or voting rights of such person (along with holdings of relatives, associate entities and persons acting in concert) of 5 per cent or more. In certain cases of fresh acquisition by an existing major shareholder (i.e., with shareholding above 5 per cent), the aggregate limit may be increased to 10 per cent.
The proposed acquirer must also be a 'fit and proper' person as per RBI norms. Further, recently, increased scrutiny into beneficial ownership of shareholders has been allowed under the CA, which allows piercing the corporate veil to several levels above existing capital structure of banks (including their holding companies).
Overall, the shareholding limits for banks are as follows:
- for individuals and non-financial entities (other than promoters or promoter groups), the limit is 10 per cent of the paid-up capital; however, if promoters are individuals or non-financial entities in existing banks, the shareholding limit is 15 per cent of the paid-up capital;
- for entities in the financial sector, other than regulated or diversified or listed entities, the limit is 15 per cent of the paid-up capital;
- for 'regulated, well diversified, listed entities from the financial sector' and shareholdings by supranational institutions or public sector undertakings or government, a limit of 40 per cent of the paid-up capital is prescribed; and
- a higher stake or strategic investment by promoters or non-promoters through capital infusion by domestic or foreign entities or institutions shall be permitted on a case-by-case basis under circumstances such as relinquishment by existing promoters, rehabilitation or restructuring of problematic or weak banks, entrenchment of existing promoters or in the interest of the bank or consolidation in the banking sector.
The internal working group set up by the RBI in June 2020 to review the extant guidelines on ownership and corporate structure for Indian private sector banks, in the IWG Report, inter alia, recommended that the cap of promoter shareholding in the long run (15 years) be raised to 26 per cent from the existing 15 per cent of paid-up voting equity capital. The IWG has also recommended that non-promoter shareholding may be capped at 15 per cent of paid-up voting equity capital for all shareholders.
Finally, pursuant to Section 12(2) of the BR Act, no shareholder in a bank can exercise voting rights in a poll in excess of 26 per cent of total voting rights of all the shareholders of the bank. At all times, at least 26 per cent of the paid-up capital will have to be held by residents (except in the case of WOS-model foreign banks). In the 2020 amendments to the BR Act, the application of Section 12 of the Act was extended to apply to cooperative banks with modifications. A cooperative bank may now, with the prior approval of the RBI, issue equity, preference or special shares, at face value or at a premium, and unsecured debentures, bonds or similar securities (with an initial or original maturity of not less than 10 years), to any member of the bank or any other person residing within its area of operation, subject to conditions and a ceiling, limit or restriction on the issue, subscription or transfer, as may be specified by RBI. These may be issued by way of public issue or private placement The modus operandi of these approvals and the consequent issuance of the securities is yet to be experienced, given the peculiar membership and control framework of cooperative societies.
Investments in Indian companies can be made by both non-resident and resident Indian entities. Under the Foreign Direct Investment Policy 2020, the total foreign ownership in an Indian PVB cannot exceed 74 per cent of paid-up capital under the approval route or 49 per cent of paid-up capital under the automatic route. Foreign ownership beyond 24 per cent of paid-up capital will also require shareholder approval. Similarly, the aggregate shareholding of an Indian non-resident individual cannot exceed 10 per cent of the paid-up capital of a bank, unless approved by the shareholders.
ii Transfers of banking business
In 2005, the RBI issued its first guidelines on mergers and amalgamation of two PVBs and of a bank with a non-banking financial company. For both scenarios, RBI approval is required for amalgamation before it is finally approved by a local high court. Amalgamation will also require approval from the Competition Commission of India, from an antitrust perspective.
There is no specific duty on banks to seek customer consent for amalgamations; however, as best practice, intimations are circulated to all customers well in advance, and corporate and regulatory approvals of the merger are also announced in the public domain. Continuity of customer service is also one of the considerations for the approval of the amalgamation scheme.
The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002, and related RBI guidelines issued periodically, provide for the sale or assignment of financial assets by banks and financial institutions to securitisation or asset reconstruction companies. Banks may not sell financial assets at a contingent price with an agreement to bear a part of the shortfall on ultimate realisation, and the sale is non-recourse after careful due diligence by the assignee or purchaser. However, banks may sell specific financial assets with an agreement to share in any surplus realised by the asset reconstruction company in the future. Consideration for the sale may be in the form of cash, bonds or debentures, security receipts or pass-through-certificates issued by the asset reconstruction company or trusts set up by it to acquire the financial assets.
The contractual provisions of the agreement with customers determine whether customers only have to be advised of changes in lender or service provider, or whether customer consent also has to be obtained.
The year in review
i Impact of covid-19 on banks and non-bank financial companies
The Indian financial system, and banks in particular, displayed resilience in 2019 and 2020, with a strengthening of asset quality, capital positions and profitability. The RBI responded to the pandemic with aggressive policy rate cuts, massive liquidity infusion (both system-level and targeted) to distressed sectors, institutions and instruments, and moratorium as a temporary relief to borrowers, as well as a time-bound window for the restructuring of assets. As at August 2020, around 40 per cent of outstanding financial system loans (banks and non-bank financial companies (NBFCs)), availed moratorium.15 Bearing in mind the likely impact of covid-19 on financial conditions, banks, NBFCs (in particular, non-deposit taking NBFCs with an asset size of 50 billion rupees and above) and UCBs were advised to assess the impact of covid-19 on their balance sheets, asset quality, liquidity, profitability and capital adequacy for the 2020–21 financial year, under severe but plausible scenarios. This proactive assessment should help these entities in estimating likely shortfalls in capital.
ii Digital banking
Conventional bricks-and-mortar banking has given way to digital banking as technological innovations and regulatory developments have encouraged alternative cost-effective models of extensive lending and capital raising. In this regard, real-time payment systems, digital wallets, mobile banking, invoice financing (i.e., the trade receivables discounting system) and digital lending have been the most significant recent developments in the sector.16 The main developments have been as follows.
- Banks that are licensed, supervised and with a physical presence in India and that have implemented core banking solutions are permitted to offer mobile banking services to registered customers after obtaining one-off RBI approval. In December 2019, the national electronic funds transfer facility and liquidity support facility for banks was rolled out on a 24/7 basis, for ease of fund settlements.17
- One striking regulatory move by the RBI was the commencement of a pilot scheme for small-value payments in offline mode. In August 2020, the RBI announced that it wished to develop offline payments to overcome connectivity issues in remote areas of India. A pilot scheme testing offline remote and proximity payments with cards, wallets and mobile devices by authorised payment systems operators, banks and non-banks ran until 31 March 2021.18
- In January 2020, the RBI introduced a video-based customer identification process (V-CIP)19 for individuals, to enable digital onboarding of customers and to improve convenience. The use of Aadhaar authentication or offline verification and the mandatory permanent account number requirement is expected to mitigate the risks associated with the V-CIP process of onboarding customers remotely.
- The launch and operability of Unified Payments Interface (UPI) has boosted mobile banking as it allows interbank account money transfers, using only a single virtual address identifier of the user, instead of the tedious supply of sensitive personal information at every log-in. The biggest advantage of UPI is its interoperability among different banking platforms, even including overdraft accounts. In October 2020, based on the recommendations of the Committee for Analysis of QR Codes20 and stakeholder comments, the RBI decided to continue with the two interoperable quick response (QR) codes in India: UPI QR and Bharat QR. Payment system operators that use proprietary QR codes were advised to shift to one or more interoperable QR codes by 2022.
- In line with the RBI's payment system vision for 202121 for technology-driven, customer friendly and transparent and rule-based dispute redressal systems, on 6 August 202022 the RBI introduced the online dispute resolution (ODR) mechanism for resolving customer disputes and grievances arising out of digital payments. Pursuant to the ODR directive, all authorised payment system operators, including banks and non-banks, and their participants have been advised by the RBI to put in place ODR systems for resolving disputes and customer grievances.
- Changes have been made to the applicable average base rate to be charged by NBFC-Micro Finance Institutions (NBFC-MFIs).23 In supersession of the February 2014 RBI circular that stated that the interest charged by an NBFC-MFIs would be the lower of the cost of funds plus margin or the average base rate of the five largest commercial banks by assets multiplied by 2.75, in September 2020 the RBI set the average interest rate at 8.12 per cent for the quarter beginning 1 October 2020. On the last working day of every quarter, the RBI now sets the rate for the following three months, taking an average of the base rates of the country's five largest commercial banks. The RBI has introduced the base rate system to bring in more transparency in the interest-rate setting process. The base rate is the minimum rate at which lending institutions can give loans. Typically, institutions charge other components above the base rate, to arrive at the final lending rate.
There has also been major focus on customer protection, including the introduction of two-factor authentication, more stringent rules on electronic signatures and prevention of personal data leakage. As an enhanced complaint redressal mechanism, a digital ombudsman scheme was also introduced. The liability of customers for unauthorised transactions, or transactions that are unsuccessful or 'failed' due to reasons not directly assignable to the customer, was previously limited, including under the RBI's September 2019 framework on turnaround time for resolution of customer complaints and compensation across all authorised payment systems. The new PDP Bill will also provide an important turning point in the ways in which Indian banks handle data privacy, cloud computing and data localisation.
In the coming years, digital transformation in the Indian banking space is anticipated to ride on three pillars: blockchain, artificial intelligence and the internet of things. To allow banks to live test innovative products using these technologies, the RBI enabled a regulatory sandbox (RS) system in August 2019. The RS allows the regulator, innovators, banks and customers to conduct field tests on technological applications in various banking segments (such as retail payments, digital KYC and wealth management), to collect evidence on the benefits and risks of new financial innovations, while carefully monitoring and containing their risks or providing limited relaxations.
Outlook and conclusions
In recent years, the banking policy focus areas for the RBI have been in strengthening stressed asset resolution, modernising payment and settlement systems, and calibrating macroprudential regulations to the best international norms. The RBI's recent National Strategy for Financial Inclusion (2019–2024) has also set forth the vision, key objectives and methodologies for increasing access to broad-based, formal and affordable financial services and promoting financial literacy and consumer protection.
Further, following the global financial crisis, financial stability has also emerged as a key priority for the RBI. It has taken several policy actions in recent months, encompassing monetary and liquidity measures as well as macroprudential measures to reinvigorate domestic demand and accelerate the pace of economic growth.
It is also expected that the RBI will continue to introduce structural reforms for inflation control by maintaining price stability and lowering capital costs and increasing accountability in, and regulatory harmonisation across, banks and non-banking financial companies, in the coming years.
1 Vineetha M G and Khyati Sanghvi are partners and Pratik Patnaik is a senior associate at Samvad: Partners.
2 RBI Report on Trend and Progress of Banking in India 2019–20 (29 December 2020), https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/0RTP2020_F3D078985540A4179B62B7734C7B445C9.PDF.
4 RBI Statistical Tables Relating to Banks in India, Time-Series Publications (2019–20).
5 RBI trends report; see footnote 2.
6 RBI trends report; see footnote 2.
8 The tier system relates to an area's population (e.g., Tier 1 centres have a population of 100,000 and above, while Tier 6 centres have a population of less than 5,000).
9 'Guidelines for Licensing of Small Finance Banks in Private Sector dated November 27, 2014, Modifications to existing norms', https://rbidocs.rbi.org.in/rdocs/notification/PDFs/NT196F0C07E85E99849839CF6E370BC3D99BF.PDF.
10 Business correspondents are authorised as third-party agents by banks and deliver banking and financial services on behalf of the banks.
11 RBI trends report; see footnote 2.
12 Framework for Recognition of a Self-Regulatory Organisation for Payment System Operators, https://rbidocs.rbi.org.in/rdocs/notification/PDFs/NT583EB873C7EE0B4AEF8ACE7893E7588CDE.PDF.
13 Framework for Authorisation of pan-India Umbrella Entity for Retail Payments, https://rbidocs.rbi.org.in/rdocs/notification/PDFs/FRAMEWORKCC3A86B01E974EB3BDD6930ED922B31C.PDF.
14 On 15 November 2019, the central government introduced the Insolvency and Bankruptcy (Insolvency and Liquidation Proceedings of Financial Service Providers and Application to Adjudicating Authority) Rules 2019 to bring specific categories of financial service providers within the ambit of the Insolvency and Bankruptcy Code 2016. So far, the central government has only included non-banking financial companies with an asset size of at least 5 billion rupees as one category of financial service providers to which these rules will apply.
15 RBI trends report; see footnote 2.
16 'Indian Banking at Crossroads; Some Reflections', https://rbidocs.rbi.org.in/rdocs/Speeches/PDFs/PSBSTC161120198E89A3C818EB47A393B25529E1CE6C4D.PDF. See also Report of the Steering Committee on Fintech Related Issues (2019), Department of Economic Affairs, Ministry of Finance, Government of India, https://dea.gov.in/sites/default/files/Report%20of%20the%20Steering%20Committee%20on%20Fintech_1.pdf.
17 'Journey towards inclusive growth in India', opening remarks by Shaktikanta Das, Governor of the RBI at the Third Suresh Tendulkar Memorial Lecture, Singapore, 7 January 2020.
18 RBI, 'Offline Retail Payments using Cards / Wallets / Mobile Devices – Pilot', https://rbidocs.rbi.org.in/rdocs/notification/PDFs/NOTI22E337913692C04560A953EEC75CCF099C.PDF.
19 RBI Amendment to the KYC Master Direction, 2016, https://rbidocs.rbi.org.in/rdocs/notification/PDFs/CIRCULAR1385B2E30C2E186423CB03EDF39D6133254.PDF.
20 Report of the Committee on the Analysis of QR Code, 22 July 2020, https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/ANALYSISQRCODED11971A9B9874EAFA1A61478F461E238.PDF.
21 RBI Payment And Settlement Systems In India: Vision – 2019–2021, https://rbidocs.rbi.org.in/rdocs//PublicationReport/Pdfs/PAYMENT1C3B80387C0F4B30A56665DD08783324.PDF.
22 Online Dispute Resolution (ODR) System for Digital Payments, https://m.rbi.org.in/Scripts/BS_CircularIndexDisplay.aspx?Id=11946#:~:text=To%20begin%20with%2C%20authorised%20PSOs,systems%20by%20January%201%2C%202021.&text=This%20directive%20is%20issued%20under,(Act%2051%20of%202007).
23 RBI Circular, Applicable Average Base Rate to be Charged by NBFC-Micro Finance Institutions, https://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/PR409CB17CFDF89DA43F4B53BDD93DAD77C43.PDF.