SLIDE 2B

THE BANK REGULATORYENVIRONMENT

The Bank Regulatory EnvironmentOutline/Learning Objectives :Importance of Banks in the economyBasic Principles of BankingWhy banks are regulated?Why do banks fail?Banking Sector Reforms in IndiaBanking Laws & RegulationsKey Words/Terminologies/Glossary.

Importance of Banks in an EconomyBanks are important economic institutions chanellising savings into productive investments, act as catalyst in economic development and capital formationBanks are custodians of public moneyBulk of the funds of the bank are deposits from public which are unsecured borrowings hence banks are highly leveraged institutions (size of bank capital is very small)A failure of a bank will have a domino or cascading effect on the whole banking and financial system (because of interconnected/inter-bank lending and borrowing) leading to systemic crisis/collapse of the banking and financial system and possible social anarchy In a globalised economy, banks are susceptible to wide spread risk

BASIC PRINCIPLES OF BANKING

Principle of Intermediation

Principle of Prudence

Principle of Liquidity

Principle of Profitability

Principle of Solvency

Principle of Trust

Why are banks regulated? - 1A reasonable regulation of banking system is essential to check the imprudence of the players which can erode the confidence of the public in the banking system. The financial system deals with peoples money and it is necessary to generate, maintain, and promote the confidence and trust of the people in the banking system at all times and with great care by preventing and curbing all possibilities of misuse and even imprudence by any of the players of the financial system. Thus, the rationale behind the regulation of the financial/banking system is :

Why are banks regulated? - 2To Prevent disruption of the economyPrudential regulation to ensure safety and soundness : KYC-AML Norms for Opening Deposit Account and Giving Loans, Lending Norms/Loan Policy, Prudential Credit and Capital Market Exposure NormsPrevent large scale failures that would affect economic activityReduce systemic risk wherein bank failures are potentially contagious. Such shocks could be domestic or international in scope.To generate, maintain and promote confidence and trust of the public in the financial/banking systemTo protect investors/depositors interests by adequate/timely disclosure by the institutions and access to information by the investors/depositors : Norms on Disclosure and Transparency of Balance Sheet and Income StatementTo ensure macroeconomic and financial market stability

Why are banks regulated? - 3To Prevent disruption of the economyTo ensure that financial markets/Institutions/Banking System are both fair, efficient, fundamentally strong, sound/healthy and resilient to absorb/withstand any unexpected shocks : Prudential Norms on Capital Adequacy and Accounting for Income recognition, Asset classification & ProvisioningTo prevent unfair practices to protect the interests of the ultimate suppliers (depositors) and users of savings (borrowers) : Fair Practices codes for Depositors & BorrowersTo ensure that the participants measure up to the rules of the market place Guard against deposit insurance lossesProtect small depositors by providing government deposit insurance (FDIC)Moral hazard problem of deposit insurance causes banks to have incentives to take risks with potential losses borne by the government.Achieve desired social goalsPrevent discrimination in lending, support to Priority Sector like loans for Agriculture, MSMEs, housing , education, micro-finance, Exports

Why do banks fail?Credit risk, interest rate risk, foreign exchange risk, bank runs, and fraudThe small capital base of banks makes them sensitive to negative earnings. Banks use loan loss reserves to absorb expected losses on loans and from other sources. However, unexpected losses must be charged against equity capital and can cause the bank to become insolvent and/or closed by regulators.Financial repression by the government by means of excessive control of the banking sector can raise failure risk.Bank runs occur when many depositors suddenly withdraw their funds from banks. While uninsured deposits are especially at risk, insured deposits may be withdrawn also.Fraud includes theft as well as lending to customers favored by friendship or political interest rather than economic profit for the bank.

Banking Laws & Regulations - 1Banking Regulation Act, 1949RBI Act, 1934SBI Act, 1955 & State Bank Subsidiaries Act, 1958Banking Companies (Acquisitions & Transfer of Undertakings) Act, 1970/1980Bankers Book of evidence Act, 1891Negotiable Instruments (NI) Act, 1882Indian Limitation Act, 1963Indian Contract Act, 1872

Banking Laws & Regulations - 2Indian Stamp Act, 1889Indian Registration Act, 1899Transfer of Properties Act, 1858Indian Companies Act, 1956Recovery of debts due to Banks and FIs Act, 1993 (DRT Act)Consumer Protection Act (COPRA), 1985Legal Services Authorities Act, 1987 (Lok Adalats)SARFAESI Act, 2002 (NPA Recovery Act)Banking Ombudsman Scheme, 2006BCSBI Scheme, 2006

THE STATUTORY FRAMEWORKThe Banking Regulation Act, 1949

Sec. 5 (b) defines Banking :the accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise, and withdraw-able by cheque, draft order or otherwise.

THE STATUTORY FRAMEWORKThe Banking Regulation Act, 1949 Lays down principles for the constitution of the board of directors and appointment of a chairman of a bank Lays down the procedure of winding up of a banking company and the procedure of amalgamation of banking companiesRegulation on payment of dividends by Banks Voting rights of a shareholder in a banking company is limited to a ceiling of 10% (Sec. 12 of BR Act) irrespective of shareholding

THE STATUTORY FRAMEWORKThe Banking Regulation Act, 1949 Licensing of banks and Opening of new BranchesMinimum paid-up capital and reserves requirements for obtaining a banking license. Regulatory & Supervisory powers of RBI Regulatory Restrictions on Bank Lending

REGULATORY RESTRICTIONS ON BANK LENDINGNo loan can be granted ag. the security of banks own shares or partly paid shares of a company (Sec. 20 of BR Act, 1949)No bank can hold shares in company as pledgee, mortgagee or absolute owner in excess of 30% of the paid up capital of that company or 30% of the Banks paid up capital and reserves, whichever is less (Sec. 19 of BR Act, 1949)No bank can grant loans to a director or to a company in which a director or manager is interested as a partner/manager/employee/guarantor.No bank can grant loans against CDs, FDs issued by other banks and MMMF unitsBanks should not sanction a new or additional loan facilty to borrowers appearing in the RBIs list of Willful Defaulters for a period of 5 years from the date of publication of the list by RBI.

KEY WORDS/TERMINOLOGIES/GLOSSARYCapital formation, Leveraged Institution, Systemic Crisis, Bank Failure Principle Intermediation, Prudence, Liquidity, Profitability, Solvency & Trust

SARFAESI Act, DRT Act, Limitation Act, Lok Adalat