Understanding Indian Banking Sector

& Banking Institutions Regulation

Dr. Prashant S. Desai.,
Assistant Professor of Law,
National Law School of India University,
Bangalore-560 072
Email prashantdesai@nls.ac.in

Contents
1. Understanding the term banking
2. Quick overview of Indian banking sector
its evolution and development
3. The regulation of banks (with India as
focal point)

What is bank or banking?

As the modern bank performs variety of
functions it is difficult to give an
accurate definition of it
Therefore there is no one universally
accepted definition
Economists have offered different
definitions of bank

However
By referring to many major definitions we
can say
Banks accept deposits from the public;
Banks advance loans to the needy person; and
Also perform those permitted agency functions

Rather than accepting such a

oversimplified summing up several
people write that banks deal in cash
and credit as its main purpose

Few more references

Bank as a body corporate or a noncorporate that has been recognized by
the Bank of England to accept deposits
as defined by that Act
The Banking Act, 1987 (England)

 Banking Regulation Act, 1949

banking means the accepting, for the
purpose of lending or investment, of
deposits of money from the public,
repayable on demand or otherwise, and
withdrawable by cheque, draft, order or
otherwise.

What are the functions of a bank?

PART II

The functions of bank

Acceptance of Deposits
Advancing loans
Investment of funds
Promote use of cheques
Other agency functions
Banking related agency functions
Other utility agency functions

Acceptance of deposits
Two types of deposits
Demand deposits; and
Time deposits

However now there are many hybrid

deposits are also available

Advancing of loans
Advances can be broadly classified as
Advances with security
Advances without security

Investment of funds
Besides loans & advances banker also
invest a part of its surplus funds in
government securities
In India, the banks are mandated to
invest a part of their funds in government
and other approved securities
Though the returns are not high funds
are near liquid but also secure for risk
perspective

Agency functions banking related

Transfer of funds
Collecting customers funds (cheques)
Purchase & sale of shares and securities (for
its customers)
Collecting dividends on the shares of the
customers
Payment of premium
Acting as trustee and executor
Income tax consultancy

Agency functions utility related

Safe custody of valuable goods
Issuing of travelers cheque
Giving information about its customers on
various issues
Collection of statistics
Accepting bills of exchange on behalf of
customers
Underwriting of company debentures
Giving advice on financial matters

Indian banking sector its evolution &

development
PART III

 British brought the modern concept of

banking to India
But the concept of banking was known to
us
Banking was used in synonymous with money lending
Vedic literature records the details of banking
transactions
Manusmrithi speaks about deposits, pledge, loans
and interest rates etc.,
Sons pious obligation to discharge the loan of the
father

The beginning of Indian modern banking

Bank of Hindustan in 1770 [when
Alexander & Co., agency house started]
The Bank of Calcutta [ established by East
India Company in 1806]
The break-through in 1860 introduction
of limited liability to banks

The interim period of 1906 to 1913

The influence of swadeshi movement
the following banks were started

Peoples Bank of India Ltd.,

The Bank of India Ltd.,
The Central Bank of India Ltd.,
Indian Bank Ltd.,
The Bank of Baroda Ltd.,

The period ended with the crash of 191317 overtaking these initiatives

Establishment of Imperial Bank

Three presidency banks of Calcutta,
Bombay and Madras were merged into
Imperial Bank
Vide the Imperial Bank of India Act, 1920
The same became State Bank of India
later

Establishment of Reserve Bank of India

It was given the right of note issue
Was also to act as bankers bank the
function which it took-over from Imperial
Bank
However, Imperial Bank was allowed to
operate as the agent of RBI, especially in
those places where RBI had no branches
Initially RBI was a shareholders bank but
was nationalized in 1948

Establishment of State Bank of India

Vide State Bank of India Act, 1955 [which
overtook Imperial Bank]
The bank which commands approximately 25% of
total banking sector business
With highest bank network in India

SBI Subsidiaries
SBI (Subsidiary Banks) Act, 1959

The Bank of Bikaner

The Bank of Indore
The Bank of Jaipur
The Bank of Mysore
The Bank of Patiala
The Bank of Travancore
The Bank of Hyderabad

The banking scenario @ 60s

Overall mismanagement of banks
Major chunk of advances to
Large;
Medium; and
Big industrial houses only

Uncovered priority sectors like

Small scale industries;
Agriculture;
Exports etc.,

The banking scenario @ 60s

Composition of bank management
Industrialist directors
Conflicting interests with their ventures
Indiscriminate lending to their own industrial
establishments

The immediate response

Introduction of social control
Approach
Establishment of National Credit Council (NCC)
Legislative Control through amendment to the
Banking Regulation Act, 1949

Professional banking board

Sec. 10A
At least 51% of directors shall be possessing
special knowledge, practical experience in

Accountancy;
Agriculture & rural economy;
Banking;
Cooperation;
Economics;
Finance;
Law;
Small Scale Industry
Any other matter (in the opinion of RBI useful)

Further
provided that, out of aforesaid number of
directors, not less than two shall be persons
having special knowledge or practical
experience in respect of agriculture and
rural economy, cooperation or small-scale
industry

Other mandates
Directors shall not have substantial interest
In any other company, except S.25 company
Any firm (carrying trade, commerce or industry, except
small scale industry)

Restriction on tenure
For continues period of eight years (not applicable to
Chairman)
Not to be re-elected for four years if he is removed
from his office as chairman or whole-time director

Mandate of whole time chairman

S.10B the objective was to curb
industrialists encroachment over bank
management
There shall be whole-time chairman or
managing director to manage the bank
He shall have special knowledge & practical
experience in any of the following

Working of the bank

Finance
Economics
Business administration

Restriction on loans
S.20 no loans or advances on the security
of banks own shares
No loan or advance, to
Any of its directors;
Any firm; or
Any company (except its own subsidiary or S.25
company); or
Any individual
Provided the director is interested in such entity as
partner, manager, employee or guarantor etc.,

Miscellaneous
Additional powers were conferred on RBI
to supervise and enforce social
control initiative
Punishment provided for
Obstructing any person from entering or leaving a
bank;
Holding demonstrations within the bank; and
Acting to undermine the depositors confidence in
a bank

Era of nationalization starts

July 19, 1969 14 major banks
nationalized
1980 6 more banks were nationalized
Nationalization was perceived as a major
step in achieving the socialistic pattern of
society

Modalities of nationalization
The official point
public ownership of major banks will help most
effectively the mobilization and development of
national resources and its utilization for productive
purposes in accordance with the plans and priorities

The preamble [of the first ordinance, 1969]

in order to serve better the needs of development of
the economy in conformity with the national policy and
objectives

Criticism levied against nationalization

168 days [from 1.2.69 to 19.7.69] are too
short period to declare social control
did not work
From June 1968 to March 1968 credit to
Agriculture increased from Rs.30 crores to Rs.97 crores;
Small scale industries from Rs.167 crores to Rs.222
crores

The step was determined by political

tussles and was result of inter-party
struggle

Criticism levied against nationalization

The banking industry is not nationalized in
some of socialistic countries (ex. Norway,
Sweden, Finland and Denmark etc.,)
Public control would leave the door open
for corruption and favoritism
Because of lack of competition the
quality of banking service will diminish
gradually

Legal mode
Saturday, July 19, 1969 Banking
Companies (Acquisition and Transfer of
Undertaking) Ordinance, 1969 was
passed
14 major banks (with deposit of Rs.50 crores or
more) were purported to be transferred to 14 new
body corporate viz. corresponding new banks
The machinery of management
Compensation package for shareholders

Legal mode
Monday, July 21, 1969 Ordinance was
challenged before SC
Before it was heard (on August 9, 1969)
Banking Companies (Acquisition and
Transfer of Undertakings) Act, 1969 was
passed (which repealed the ordinance)
The act was also challenged in the SC
interim injunction was granted against
the operation of the Act

Legal mode
Decision on February 10, 1970
10:1 decision by majority

The act is within the legislative competence;

but void due to the following reasons
Only restricted 14 banks were selected this a hostile
discrimination;
Although these 14 were allowed to do other business
sans assets, staff, premises and even names that was
not possible hence unreasonable restriction
The principle of determination of compensation was
illusory and irrelevant

Post SC decision
February 14, 1970 Another Ordinance
promulgated
This was followed by the Banking Companies
(Acquisition and Transfer of Undertakings)
Act, 1970
March 31, 1970 The Act receives Presidents
assent
Most of provisions were deemed to have
come into force from July 19, 1969
The enactment stood the test of
constitutionality

the branch network which was 8262 in

June 1969 expanded to 60000 by 1992 wit
major expansion (80%) in rural areas. The
average number of people served by a
branch came down from 60000 to 11000.
the development of credit is more widely
spread all over the country as against only
in advanced states. In 1969 deposits
amounted to 30% and advances to 25% of
the GDP

deposits grew from a figure of Rs.4669

crores in June 1969 to Rs.2,75,000 crores on
31.3.1993. More than 45% of the total credit
was directed to the priority sector. More
than 45% of the total deposits were used by
the government to fund its five year
plans

Era of nationalization ends

With the recommendations of
Narasimaham Committee being
accepted by the Government
Which also started the entry of foreign
banks on Indian soil

What were the recommendations?

Overall emphasis upon de-regulation
No further nationalization to be adhered to
No distinction between public and
private sector banks
Control of banking sector to be centralized
(not to be divided between RBI and
Department of Banking)
SLR and CRR should be reduced to prudent
levels

What were the recommendations?

Concessional lending to be phased out
The capital base of banks should meet
international standards
The appointment of the Chief Executive
of the banks to be de-politized

Bank regulation

Why regulate bank?

the business of banking is fraught with
dangers, arising principally from the instability
in the world economy and from human error or
misjudgment. Like any other enterprise, a bank
may be overtaken by events or may be
governed unwisely. Bank failures are, therefore
no novelty. It is interesting that Bank of
England itself faced serious financial problems
within two years of its foundation in 1964
- Sir John Clapham, The Bank of England A
History, CUP, 1994

standing & stability

two matters have to be consistently watched in
order to avoid disruption to the system. The first
may be loosely described as the general standing
of institutions carrying on banking business. One
way of achieving this object is to enact laws that
regulate banking transactions. The other is to
impose restrictions on the free entry of firms into the
mail line of banking business. The second matter
that needs to be regulated is the stability of
individual banks. This involves the introduction of
measures to ensure that banks are able to meet
their liabilities Elingers Modern Banking, 4th Edn.

Recent past
Crash of world economy of 1929-33
(interim periods of world war)
Banking crises of UK during 1973-76
life boat operation
Similar crises in Germany

Recent melt-down

Few other points

Systemic risk
Prevention of fraud
Money laundering & terrorism
Consumer protection
Competitive (or antitrust) policy

Banking regulation in India

Banking
Banking means the accepting, for the
purpose of lending or investment, of
deposits of money from the public,
repayable on demand or otherwise, and
withdrawal by cheque, draft, order or
otherwise S. 5(b)

Essential functions
Acceptance of public deposits
Lending or investment of such deposits;
and
Agency functions

Permissible banking business

Sec. 6(1)
About 15 elements

Borrowing, raising or taking up money;

Lending with or without security;
Issuance of letters of credit, travelers cheques
Dealing in bullion and specie
Dealing in stocks and shares
Underwriting
Providing of safe deposit vaults
Collecting and transmitting of money and securities

 Acting as agents of the government

Transact any kinds of guarantee and indemnity
business
Undertake and execute trusts
Acquire, construct and maintain any building for its
own purpose
Do all such things which are incidental or conducive to
the promotion or advancement of the business of the
company
Do any other business specified by the Central
Government as the lawful business of banking
company

 Further Sec. 8 prohibits specifically a

banking company from engaging
directly or indirectly in trading activities
and undertaking trading risks

Organization
Dual control
For entry
For expansion

Entry license
Sec. 22
Criteria
The capacity of the company to pay its present and
future depositors
Whether there is anything to indicate the permit
would affect the interests of the depositors
detrimentally
Impact upon the public interest
Companys capital structure and its adequacy
Other banking facilities available in the proposed area
Such other condition which RBI considers relevant

 Additional conditions for foreign banks

Whether carrying of business by the company in
India will be in pubic interest
Whether the government or the law of the country
in which the company is incorporated
discriminates in any way against banking
companies registered in India; and
Whether the company complies with the
provisions of the BR Act as applicable to foreign
companies

 The grant of license is a discretionary

administrative function Shivabhai v RBI,
AIR 1986 Guj. 19
Licence granted may be cancelled
Sec. 22(4)

Expansion
To open new branches RBI sanction is
mandatory
Sec. 23
While grant of such licences RBI may
impose appropriate conditions
There are exceptions

Capital & reserves

Sec. 12(1)
Subscribed capital of a banking company shall not
be less than half of its authorized capital;
Paid up capital shall not be less than half of its
subscribed capital
If the capital structure is changed then these
proportions shall also be changed, with in two
years

Capital composition
Narasimham Committee has
recommended for public issue
Hence, the Banking Companies
(Acquisition and Transfer of Undertakings)
Act, 1970/1980 were amended
To enable public to subscribe to the capital of the
nationalized banks up to 49% of their total capital

The State Bank of India Act, 1955 was also

suitably amended to raise public funds

Restriction on voting rights

No shareholder (of the nationalized bank)
other than the Central Government shall
be entitled to exercise voting rights in
respect of any shares held by him in
excess of one percent of the total voting
rights of all the shareholders of the
corresponding new bank

Reserve funds
Sec. 17
Creation of reserve fund (not applicable
to foreign banks)
To be created out of profit
Not less than 20% of the profits have to be
transferred to the reserve fund (before any
dividend to be declared)
However, the Central Government (on the
recommendation of RBI) may exempt the bank for
certain period of time

 For foreign banks there is no mandate

But the foreign banks
Shall deposit with RBI 20% of their profits each
year
The amount may be in cash or unencumbered
approved securities

Cash reserves
Sec. 42 (RBI Act) cash reserve to be
maintained by the Scheduled Bank (as to
be determined by RBI from time to time)
Sec. 18 (for non scheduled banks) at
least 3% of its demand and time deposits
in India

Maintenance of liquid assets

Sec. 24 mandatory maintenance of
liquid assets
Not exceeding 40% of its total demand
and time liabilities in cash, gold or
unencumbered approved securities
RBI will prescribe details

Annual accounts & audit

Sec. 29
Mandate to prepare final accounts (at
the end of each financial year)
The Balance Sheet and Profit & Loss
Account have to be prepared in
accordance with the formats prescribed
in III Schedule

Audit & auditors

Sec. 30
The Balance Sheet and Profit & Loss
Accounts have to be audited
Audit by a person duly qualified to audit
The appointment, reappointment or removal of an
auditor to be done with the prior approval of the
RBI

The audit report

Sec. 227 of Companies Act (regarding the
powers, functions and duties) are all
applicable to Banking Companies as well
Some additional information to be provided
Whether or not transactions of the company as noticed
by him were within the powers of the company
Whether or not returns from branches were adequate
for the audit
Any other matter which the auditor considers
necessary to bring to the notice of the shareholders of
the company

Publication of final accounts

Sec. 31 r/w Rule 15 [of Banking Regulation
(Companies) Rules, 1949
Final accounts are to be published in a
news paper, within a period of six months
Three copies of final accounts are to be
submitted to RBI (within 3 months)
Sec. 220 of Companies Act Final
accounts and auditors report to the
Registrar of Companies

Special audit
Sec. 30(1B)
The RBI may order for special audit
Such order may relate to any transaction or class of
transactions; or
Such period or periods as RBI may specify in the order
The RBI appoints such auditor (or can ask the regular
auditor)
The directors are binding upon the auditor of the
banking company and to make report directly to RBI
by furnishing the copy to the bank)

Amalgamation
Voluntary amalgamation
U/sec. 44A

 Procedure
Scheme has to be prepared & the same to be placed
before the shareholders (notice to all shareholders is
must)
Seeking sanction from the shareholders with 2/3rd
majority
Dissenting share holders may take out their share
value
Then the scheme has to be presented to RBI
On sanction of RBI the amalgamation may happen

Compulsory amalgamation
Induced or forced by RBI
U/Sec. 45

RBI recommends to the Central

Government

Merger of bank and NBFC

Amalgamations are governed by Ss. 391
to 394 of the Companies Act, 1956
The scheme of amalgamation has to be
approved by the High Court
June 2004 Banks were advised to obtain
the approval of RBI after the scheme of
amalgamation is approved by its board
before it is submitted to the HC for
approval

Amalgamation by government
Central Government may order for
amalgamation of two banks after due
consultation with the RBI
u/sec. 396 of Companies Act, 1956

Winding up
Suspension of business and winding up
Sec. 37

Winding up by the High Court

Sec. 38

Voluntary Winding up
Sec. 44

Suspension of business
When the bank is temporarily unable to
meet its obligations
Procedure

The bank to apply to HC u/s 37

The report of the RBI be enclosed
If not the court can take action, by calling the report
If satisfied the court can (with conditions) for all
proceedings to stay for fixed term not exceeding six
months
On passing of the moratorium order, the court may
appoint a special officer to take custody and control of
the assets, books etc., of the bank

Winding up by the HC
To be initiated by RBI by applying for
winding up
Inability to pay debts
If RBI is asked by the Central Government to make an
application
Failure to comply with requirements of Sec. 11
If the bank becomes incapable of carrying out the
banking business by rejection or cancellation of
license
Failure to comply with the requirements of the BR Act
other than Sec. 11 and continuance of such failure
beyond the period specified by RBI in this behalf

 Additional grounds for RBI

A compromise or arrangement sanctioned cant be
worked satisfactorily with or without modification; or
The returns, statements and information given by the
bank under the Act show that it cant pay its debts; or
The continuance of the banking company is prejudicial
to the interest of the depositors

Once applied by RBI the court is bound to

allow the application [Palai Central Bank
Case, AIR 1962 SC 1371]

Voluntary winding up
Not possible unless RBI certifies
The HC during this stage intervene (i) by
itself; or (ii) by the application of RBI
And may order for continuation of the business for
some time
It may even supervise the winding up proceedings