Differentiated Bank Licences and Issues with New Licenses in India

The Indian financial system currently consists of commercial banks, co-operative banks, financial institutions and non-banking financial companies (NBFCs).

The commercial banks can be divided into categories depending on the ownership pattern, viz. public sector banks, private sector banks, foreign banks.

While the State bank of India and its associates, nationalised banks and Regional Rural Banks are constituted under respective enactments of the Parliament, the private sector banks are banking companies as defined in the Banking Regulation Act. The cooperative credit institutions are broadly classified into urban credit cooperatives and rural credit cooperatives.

Which act governs the licensing of Banks?

In India, licensing of banks comes under Banking Regulation Act, 1949 and there is an extant policy relating to bank licensing, both Indian and foreign banks international experience and practice on limited bank licensing.

What was the system before Banking Regulation Act, 1949 ?

• Prior to the enactment of Banking Regulation Act, 1949, the provisions of law relating to banking companies formed a part of the general law applicable to companies and were contained in Part XA of the Indian Companies Act, 1913.
• These provisions were first introduced in 1936, and underwent two subsequent modifications, which proved inadequate and difficult to administer.
• It was recognised that while the primary objective of company law is to safeguard the interests of the share holder, that of banking legislation should be the protection of the interests of the depositor. It was therefore felt that a separate legislation was necessary for regulation of banking in India.
• With this objective in view, a Bill to amend the law relating to Banking Companies was introduced in the Legislative Assembly in November, 1944 and was passed on 10th March, 1949 as the Banking Companies Act, 1949. By Section 11 of the Banking Laws (Application to Cooperative Societies) Act, 1965, the nomenclature was changed to the Banking Regulation Act, 1949.

The Reserve Bank of India has been entrusted with the responsibility under the Banking Regulation Act, 1949 to regulate and supervise banks’ activities in India and their branches abroad. While the regulatory provisions of this Act prescribe the policy framework to be followed by banks, the supervisory framework provides the mechanism to ensure banks’ compliance with the policy prescription.

What kind of a company can carry on Banking Business in India?

In terms of Sec 22 of the B.R.Act, no company shall carry on banking business in India, unless it holds a license issued in that behalf by Reserve Bank and any such license may be issued subject to such conditions as the Reserve Bank may think fit to impose. Before granting any licence, RBI may require to be satisfied that the following conditions are fulfilled:

1. That the company is or will be in a position to pay its present or future depositors in full as their claims accrue;
2. That the affairs of the company are not being , or are not likely to be, conducted in a manner detrimental to the interests of its present or future depositors;
3. That the general character of the proposed management of the proposed bank will not be prejudicial to the public interest or the interest of its depositors;
4. That the company has adequate capital structure and earning prospects;
5. That having regard to the banking facilities available in the proposed principal area of operations of the company, the potential scope for expansion of banks already in existence in the area and other relevant factors the grant of the licence would not be prejudicial to the operation and consolidation of the banking system consistent with monetary stability and economic growth;

The guidelines for licensing of new banks in the private sector were first issued by the Reserve Bank of India (RBI) on January 22, 1993. The revised guidelines for entry of new banks in private sector were issued on January 3, 2001.

What is the foreign investment limit in private banks in India?

• The foreign investment limit from all the sources in private banks was raised from a maximum of 49 per cent to 74 per cent in March 2004.
• In 2005, in consultation with the Government of India, the Reserve Bank released a roadmap detailing the norms for the presence of foreign banks in India. The Reserve Bank also issued comprehensive guidelines on Ownership and Governance in private sector banks. The broad principles underlying the policy framework were to ensure that the ultimate ownership and control of private sector banks is well diversified.
• Further, the fit and proper criteria have to be the over-riding consideration in the path of ensuring adequate investments, appropriate restructuring and consolidation in the banking sector. No single entity or group of related entities would have shareholding or control, directly or indirectly, in any bank in excess of 10 per cent of the paid up capital of the private sector bank.
• Any higher level of acquisition will be with the prior approval of RBI and in accordance with guidelines issued by RBI for grant of acknowledgement for acquisition of shares. These measures were intended to further enhance the efficiency of the banking system by increasing competition.

What is the minimum paid-up capital for a new bank?

• The initial minimum paid-up capital for a new bank was kept at 200 crore. The initial capital was required to be to Rs.300 crore within three years of commencement of business.
• The aggregate foreign investment in private banks from all sources ( FDI, FII, NRI) cannot exceed 74 per cent.

Are there any classes of banking licenses in India?

No. India issues a single class of banking licence to banks and hence does not place any undue restrictions on their operations merely on the ground that in some countries there are requirements of multiple licences for dealing in local currency and foreign currencies with different categories of clientele. Banks in India, both Indian and foreign, enjoy full and equal access to the payments and settlement systems and are full members of the clearing houses and payments system.

How Foreign Banks can open a branch in India?

• Procedurally, foreign banks are required to apply to RBI for opening their branches in India.
• Before granting any licence under this section, RBI may require to be satisfied that the Government or the law of the country in which it is incorporated does not discriminate in any way against banks from India.
• Foreign banks are required to bring an assigned capital of US $25 million up front at the time of opening the first branch in India.
• Existing foreign banks having only one branch would have to comply with the above requirement before their request for opening of second branch is considered.
• Foreign banks may submit their branch expansion plan on an annual basis.

Apart from the above, the following points are also considred by RBI before granting license to Foreign banks to operate in India:

1. Track Record of bank
2. Equal distribution of home countries of foreign banks in India
3. Treatment given to Indian banks in that country of which the bank is.
4. Bilateral Relations between India and the country of which the bank is.

What are other features of Banking Licenses in India?

• India issues a single class of banking licence to foreign banks and does not place any limitations on their operations. All banks can carry on both retail and wholesale banking.
• Deposit insurance cover is uniformly available to all foreign banks at a non-discriminatory rate of premium.
• The norms for capital adequacy, income recognition and asset classification are by and large the same.
• Other prudential norms such as exposure limits are the same as those applicable to Indian banks.

What are India’s commitments to WTO in this regard?

• In terms of India’s commitment to WTO, as a part of market access, India is committed to permit opening of 12 branches of foreign banks every year.
• Against these commitments, Reserve Bank of India has permitted up to 17- 18 branches in the past.
• The RBI follows a liberal policy where the branches are sought to be opened in unbanked/under-banked areas.
• Off-site ATMs are not counted in the above limit.

Are the Foreign Banks restricted to do only some activities in India?

• A licence under the provisions of B.R. Act, 1949 enables the foreign banks to carry out any activity which is permissible to a bank in India.
• This is in contrast with practices adopted in many countries, where foreign banks can carry out only a limited menu of activities.

What are the Requirements for Foreign Banks for Priority Sector lending?

• As against the requirements of achieving 40 per cent of net bank credit as target for lending to priority sector in case of domestic banks, it has been made mandatory for the foreign banks to achieve the minimum target of 32% of net bank credit for priority sector lending.
• Within the target of 32%, two sub targets in respect of advances (a) to small scale sector (minimum of 10%), and (b) exports (minimum of 12%) have been fixed.
• The foreign banks are not mandated for targeted credit in respect of agricultural advances. There is no regulatory prescription in respect of foreign banks to open branches in rural and semi-urban centres.

Priority sector lending regime for foreign banks been causing some discomfort for some of the foreign banks. For example, some of the foreign banks find it difficult to fulfil even the less rigorous target of 32 per cent in respect of priority sector advances.

What is the concept of Differentiated licensing?

• Differentiated licensing refers to the system of different licenses for different sub sectors of Banking sector such as limited banking licence, commercial banking license etc.
• There are many countries where different licences are issued for commercial banking, savings bank, rural banks or credit unions .
• In certain counties no distinction is made between domestic and foreign banks. Thus, there is no widely accepted recommended model available internationally.

Advocates of this system say that many banks keep the plain vanilla banking as a small necessary adjunct. Further, banks providing services to retail customers have different skill sets and risk profiles as compared to banks which mainly deal with large corporate clients, so there should be a system of differentiated licensing. In India, present situation where every bank can carry out every activity permissible under Section 6 of Banking Regulation Act, 1949 (Universal Banking) has the following implications, relevant to the subject under consideration :

• For a wholesale bank dealing with corporate clients only, it becomes a costly adjunct to maintain a skeleton retail banking presence. Moreover it becomes difficult for such a bank to meet priority sector obligations and obligations for doing inclusive banking.
• Retail banks may have to create risk management and regulatory compliance structures which are more appropriate to wholesale banks, thus resulting in non-optimal use of resources.
• Similar supervisory resources are devoted to banks with different business profiles. This may also result in non-optimal use of supervisory resources.
• Some banks find it difficult to provide ‘ no frills’ facility to economically disadvantaged. For them the more liberal licensing regime causes a different set of problems.

But why India can not adopt differentiated licensing?

• In India, the penetration of banking services is very low. Less than 59 % of adult population has access to a bank account and less than 14 % of adult population has a loan account with a with a bank.
• Under such circumstances, it would be incorrect to create a regime where banks are allowed to choose a path away from carrying banking to masses.
• Apart from this, the priority sector lending is important for banks. The revised guidelines on priority sector lending have rationalized the components of priority sector.
• To enable the banking system to operate at optimum efficiency, and in the interest of financial inclusion, it is necessary that all banks should offer certain minimum services to all customers, while they may be allowed sufficient freedom to function according to their own business models.

What are the current issues regarding new bank licences?

• In recent past there have been some differences between the finance ministry and the Reserve Bank of India (RBI) on new bank licences.
• Most of these issues have been resolved but two outstanding issues, the extent of foreign ownership and the time within which promoters have to dilute their holding, remain. The RBI is soon to come up with final guidelines before the end of the current financial year.

Why new bank licenses are a sensitive issue?

India is an under banked country. The objective of the licensing regime is that basic principles of bank ownership and governance, viz the ‘fit and proper’ criteria, are not diluted.

The industrial licensing has long been scrapped but licensing in banking industry are still there and RBI decides of who is ‘fit and proper’ to run a bank. The reason is that nowhere in the world is banking an unlicensed activity. Second, banks are fiduciary institutions; they hold deposits of the public in trust. Their financial health has serious implications not only for the stability of the entire financial system but also the economy. The financial crisis has brought home quite graphically that banks (and quasi or shadow banks) are quite different from manufacturing companies. The collapse of even a single bank can bring an entire economy to its knees, if it is large enough to affect the entire system.

Month: Current Affairs - November, 2011