An extract from The Banking Regulation Review, 11th Edition

Introduction

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 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 20 PSBs, 22 PVBs, 44 foreign banks, 45 active RRBs, 1,544 urban cooperative banks and 96,248 rural cooperative credit institutions. As at 31 March 2019, the total number of ATMs in India had increased to 221,579, and the total number of debit card and credit cards had increased to 858 million and 47.1 million, respectively. 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.

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, YES Bank Limited and IDBI Bank Limited.

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.

Recently, banks' capacity to lend has been severely affected because of mounting non-performing assets (NPAs). However, the recent 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 has also instituted a remedial framework through the Prudential Framework Circular dated 7 June 2019, which envisages a time-bound implementation of a resolution plan, failing which disincentives in the form of additional provisions will kick in. As a result of these and other efforts to improve banking asset quality, there has been a decline in gross NPA ratios.

There is increased focus on financial inclusion, and to increase 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 is the biggest public banking sector restructuring since the nationalisation of 14 private banks in July 1969, and is 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.

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. 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.

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.

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, and are characterised by the dual control of the RBI and respective state governments or central government.

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 pre-paid instrument (digital wallet) providers.