An extract from The Banking Regulation Review, 12th Edition
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.