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Regulatory framework

Key policies

What are the principal governmental and regulatory policies that govern the banking sector?

The Indian banking sector is regulated by the Reserve Bank of India Act 1934 (RBI Act) and the Banking Regulation Act 1949 (BR Act). The Reserve Bank of India (RBI), India’s central bank, issues various guidelines, notifications and policies from time to time to regulate the banking sector. In addition, the Foreign Exchange Management Act 1999 (FEMA) regulates cross-border exchange transactions by Indian entities, including banks.

Primary and secondary legislation

Summarise the primary statutes and regulations that govern the banking industry.

India has both private sector banks (which include branches and subsidiaries of foreign banks) and public-sector banks (ie, banks in which the government directly or indirectly holds ownership interest). Banks in India can primarily be classified as:

  • scheduled commercial banks (ie, commercial banks performing all banking functions);
  • cooperative banks (set up by cooperative societies for providing financing to small borrowers); and
  • regional rural banks (RRBs) (for providing credit to rural and agricultural areas).

Recently, the RBI has also introduced specialised banks such as payments banks and small finance banks that perform only some banking functions.

The key statutes and regulations that govern the banking industry in India and particularly scheduled commercial banks are as follows:

RBI Act

The RBI Act was enacted to establish and set out functions of the RBI. It grants the RBI powers to regulate the monetary policy of India and lays down the constitution, incorporation, capital, management, business and functions of the RBI.

BR Act

The BR Act provides a framework for supervision and regulation of all banks. It also gives the RBI the power to grant licences to banks and regulate their business operation.

FEMA

FEMA is the primary exchange control legislation in India. FEMA and the rules made thereunder regulate cross-border activities of banks. These are administered by the RBI.

Other key statutes

The other key statutes include:

  • the Negotiable Instruments Act 1881;
  • the Recovery of Debts Due to Banks and Financial Institutions Act 1993;
  • the Bankers Books Evidence Act 1891;
  • the Payment and Settlement Systems Act 2007;
  • the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002; and
  • the Banking Ombudsman Scheme 2006.

Public sector banks are regulated by the BR Act and the statute pursuant to which they have been nationalised and constituted. These include:

  • banks constituted under the Banking Companies (Acquisition and Transfer of Undertakings) Act 1970 or the Banking Companies (Acquisition and Transfer of Undertaking Act) 1980; and
  • the State Bank of India and subsidiaries and affiliates of the State Bank of India constituted and regulated by the State Bank of India Act 1955 and the State Bank of India (Subsidiary Banks) Act, 1959 respectively.

Unless otherwise specified, this chapter focuses on the regulatory regime governing private sector banks.

Regulatory authorities

Which regulatory authorities are primarily responsible for overseeing banks?

The RBI supervises and is responsible for managing the operation of the Indian financial system. In addition to issuing regulations and guidelines for banking operations, it also administers the provisions of the RBI Act, the BR Act and FEMA. It has wide discretionary powers and is authorised to inspect and investigate the affairs of banks and to impose penalties in the event of non-compliance.

Government deposit insurance

Describe the extent to which deposits are insured by the government. Describe the extent to which the government has taken an ownership interest in the banking sector and intends to maintain, increase or decrease that interest.

The deposits placed with various banks are insured by the Deposits Insurance and Credit Guarantee Corporation (DICGC), which is a subsidiary of the RBI and is governed by the Deposits Insurance and Credit Guarantee Corporation Act 1961. The DICGC insures all deposits such as savings, fixed, current, recurring, etc, except the following:

  • deposits of foreign governments;
  • deposits of central and state governments;
  • inter-bank deposits;
  • deposits of the state land development banks with state cooperative banks;
  • any amount due on account of any deposit received outside India; and
  • any amount that is specifically exempted with prior RBI approval.

Each depositor of a bank is insured up to a maximum amount of 100,000 rupees. The premium for such deposit insurance is borne by the relevant bank.

In the past, the government of India (GOI) has nationalised a number of major commercial banks. There are currently 19 commercial banks that were nationalised in two phases: in the 1960s and 1980s. While the GOI has not made any moves for further nationalisation of banks, the BR Act gives the GOI the power to acquire undertakings of an Indian bank in certain situations, such as breach of banking policy by the bank. In addition, the GOI also establishes RRBs (which are primarily controlled by the GOI, directly or indirectly) in different states from time to time, as it considers necessary.

Since the early 1990s, the government has generally liberalised regulations and encouraged private sector involvement in the banking sector. Measures taken include:

  • providing banking licences to private banks;
  • granting licences to set up different types of banks such as payments banks, small sector banks and universal banks; and
  • encouraging foreign banks to convert to wholly owned subsidiaries (WOS) with consequential liberalisation of branch licensing restrictions.

At present, the foreign direct investment (FDI) limit in private sector banks is 74 per cent. At all times, at least 26 per cent of the paid-up capital will have to be held by residents, except in regard to a WOS of a foreign bank. In public sector banks, the FDI limit is 20 per cent. The RBI is currently in discussions with various stakeholders for liberalising the sector and permitting 100 per cent foreign direct investment in private banks.

Transactions between affiliates

Which legal and regulatory limitations apply to transactions between a bank and its affiliates? What constitutes an ‘affiliate’ for this purpose? Briefly describe the range of permissible and prohibited activities for financial institutions and whether there have been any changes to how those activities are classified.

Transactions with affiliates (referred to as related-party transactions (RPTs)) are mainly regulated by the Companies Act 2013 (CA 2013). If the bank is a listed company, it will also need to comply with the norms set out for RPTs in the SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015 (the Listing Regulations). Related parties include:

  • directors (or their relatives);
  • key managerial personnel (or their relatives);
  • subsidiaries;
  • holding companies; and
  • associate companies.

The relevant regulations set out separate thresholds and approval requirements (usually approval from board of directors or shareholders, or both) for entering into an RPT. CA 2013 and the Listing Regulations also provide exemptions to certain types of transactions from such compliance (eg, a transaction between a company and its WOS is exempted from the requirement of obtaining board or shareholder approval under CA 2013 and the Listing Regulations). Further, transactions entered into in the ordinary course of business and on an arm’s-length basis are exempted from the approval requirements under CA 2013.

RPTs by a bank must be disclosed in the bank’s annual accounts in accordance with Indian generally accepted accounting principles. In addition, banks are prohibited from entering into certain RPTs under the BR Act. For example, a bank cannot give loans or advances to, or on behalf of, or remit any amounts due to it by:

  • any of its directors (or spouse or minor children of such a director);
  • any partnership firm in which any of its directors is interested as a partner, manager, employee or guarantor;
  • any company or subsidiary or holding company of a company in which any of its directors is interested as a director, managing agent, manager, employee or guarantor, or in which a director (together with its spouse and minor children) holds interest of more than 500,000 rupees or 10 per cent of the paid-up capital of the company, whichever is lower; and
  • any individual in respect to whom a director is a partner or a guarantor.

An approval from the board of the bank will be required for any loans given to relatives of any directors of that bank or directors or relatives of directors of any other bank.

Further, all transactions between a bank and a subsidiary or mutual fund sponsored by it should be on an arm’s-length basis. The bank will need to evolve appropriate strategies and undertake regular review of the working of the subsidiary or mutual fund to ensure this.

Regulatory challenges

What are the principal regulatory challenges facing the banking industry?

The key regulatory challenges are as follows.

Basel III implementation

Indian banks are required to fully comply with the Basel III Capital Regulations (Basel Regulations) by 31 March 2019. Most of the public-sector banks will need additional capital infusion to meet the higher capital requirements, which will consequently reduce the return on equity. As a result, government support will be required, which may exert significant pressure on the government’s fiscal position.

Specialised banking

The RBI has currently granted approximately 10 small finance bank licenses and approximately seven payments of bank licences. While the RBI has set up the mechanism for the use of these licences, the current provision of these services seems to be falling short of catering to the unbanked sectors that include rural areas and other underdeveloped and unorganised sectors. Further reorientation of regulatory and supervisory resources is likely needed to widen access to these systems, in light of the wider objective of financial inclusion.

Asset quality

The quantity of net non-performing assets (NPAs) of Indian banks has been increasing significantly. The RBI has, over the years, taken significant measures, both regulatory and structural, in order to tackle this issue. However, the rise in NPAs continues to be one of the most fundamental threats to the banking sector (see question 24 for a brief on the measures being taken).

Priority sector lending and NPAs

The RBI requires banks to provide mandatory credit to certain weaker sections of society and sets out targets for the same. In the past, banks have struggled to meet these targets. These sectors often yield low profits, and they adversely impact banks’ profitability.

Separately, the agricultural sector (one of the main sectors for priority lending) has a high level of NPAs. The new measures introduced by the RBI to reduce stressed assets, as mentioned above, do not take into account agricultural NPAs.

Challenges from the cashless economy

The shift to a cashless economy has brought with it a specific set of issues, which primarily revolve around access. The RBI has taken concerted measures such as setting up an e-wallet linked to the unique identification number system (AADHAAR) set up (akin to the social security number structure in the United States) and encouraging retailers, as well as other local businesses, to provide discounts and cash-back schemes for using electronic means of payment. There is a severe lack of infrastructure in most parts of the country for such payment systems to be used regularly, ranging from a functional internet connection to the sophistication of its users. Recently, privacy concerns, and legal challenges on this basis, have been raised. While these issues are currently being grappled with, there is a long way to go before India becomes a cashless economy.

Enforcement of the new insolvency regime

The IBC, which was brought into effect in December 2016, has been in operation for a year and a notable shift has been seen in the approach of the RBI, as well as creditors, in bringing action against defaulters. The National Company Law Tribunal and the National Company Law Appellate Tribunal have provided judgments that have helped clarify some points that were unclear in the IBC itself. While the jurisprudence is gradually developing, the Ministry of Finance has been quick to identify the challenges and update the IBC with regulations aimed to make the process more efficient. It remains to be seen if the IBC process actually keeps pace with increasing NPAs, therefore improving the status of banks as creditors within the Indian financial system.

Consumer protection

Are banks subject to consumer protection rules?

Banks in India are subject to consumer protection laws that act as an alternative and speedy remedy to approaching courts, a process that can be expensive and time-consuming.

The Consumer Protection Act 1986 (the Consumer Protection Act) is the primary legislation governing disputes between consumers and service providers. The relationship between a bank and its customer is regarded as that of a consumer and service provider, therefore bringing them under the ambit of the Consumer Protection Act. A three-tier mechanism has been established to deal with complaints:

  • district forum: this operates at the district level and deals with consumer complaints of a value not exceeding 2 million rupees;
  • state commission: this operates at the state level and deals with consumer complaints of a value between 2 million rupees and 10 million rupees. It also hears appeals against the orders passed by the district forum; and
  • national commission: this operates at the national level and deals with consumer complaints of a value exceeding 10 million rupees. It also hears appeals against the orders passed by the state commission. An appeal from the order of the national commission can be directed to the Supreme Court of India.

In addition, banks are also subject to the Banking Ombudsman Scheme for the purpose of adjudication of disputes between a bank and its customers. The scheme provides for a grievance redressal mechanism enabling speedy resolution of customer complaints in relation to services rendered by banks. The banking ombudsman is a quasi-judicial authority appointed by the RBI to deal with banking customer complaints relating to deficiency of services by a bank and facilitate resolution through mediation or passing an award. A complaint under the scheme has to be filed within one year of the cause of action having arisen.

Future changes

In what ways do you anticipate the legal and regulatory policy changing over the next few years?

The Financial Resolution and Deposit Insurance Bill 2017 (the Bill) proposes to set up a comprehensive recovery and resolution regime for the financial sector companies and to substitute the present regime for deposit insurance, systematically important banks etc. The Bill, if passed and implemented, would amount to a comprehensive reform of the bank recovery and resolution regulations in India and create a wholly new regime covering the sector. The Bill contains detailed provisions on monitoring and assessment of banks’ health and proactive planning for distress scenarios, including insolvency events. The new law will mean a more active monitoring of banks with certain key powers being transferred from the RBI to the resolution corporation. The Basel III capital norms would also be fully implemented by 2019, which would mark an end to a long and significant transition phase for the banking sector. Specialised banks such as payments banks and small finance banks are being set up to promote financial inclusion. We may see further policy changes to encourage the spread of the banking sector in currently underbanked areas.

With an aim to provide for a consolidated time-bound framework for reorganisation and insolvency resolution of companies, partnership firms and individuals, the code is being brought into force in a phased manner (see question 6). It is envisaged that the code will be fully implemented by 2017. As an additional measure to protect the interests of the consumer, the RBI proposes to adopt a comprehensive consumer protection framework in relation to the activities conducted by all financial institutions (and not just banks). This proposal is currently in the planning stage and there is no visibility regarding its implementation.

A shift towards a cashless economy has been observed following the demonetisation in November 2016, and the 2017-18 Budget proposes certain additional changes towards this end. By way of example, cash transactions over a limit of 300,000 rupees have been prohibited subject to certain conditions, there is a strong impetus towards increasing digital transactions and promoting use of internet-based payment gateways by providing discounts and concessions specifically to transactions undertaken digitally.

Over recent years, the government has taken several measures to liberalise FDI into India, with a view to promote the ease of doing business. As stated in question 4, there is a move to permit 100 per cent FDI in private banks. It is uncertain what regulatory changes will need to be made in case there is a change in the ratio of public and private sector banks in India with the added value of increased foreign investment.

Supervision

Extent of oversight

How are banks supervised by their regulatory authorities? How often do these examinations occur and how extensive are they?

The RBI conducts periodic audits and also acts as a consumer disputes ombudsman for retail banking. Based on its findings, and sometimes suo moto, the RBI also supervises the Indian banking system through various methods such as on-site inspection, surveillance and reviewing regulatory filings made by the banks.

Each year, the RBI conducts an on-site financial inspection of a bank’s books of accounts, loans and advances, balance sheet and investments. Following this, the RBI issues supervisory directions to banks highlighting the major areas of concern. Banks are then required to draw up an action plan and implement corrective measures to comply with the inspection findings.

The RBI also monitors compliance on an ongoing basis by requiring banks to submit detailed information periodically under an off-site surveillance and monitoring system. Based on this, the RBI analyses the financial health of banks between two on-site inspections and identifies banks that show financial deterioration that thereby require closer supervision.

Additionally, the RBI conducts:

  • quarterly discussions with the banks’ executives on issues emanating from analysis of off-site surveillance, status of compliance with annual inspection findings and new products introduced by banks; and
  • bi-annual meetings with the chief executive officers of the banking groups identified as financial conglomerates.

The RBI has taken special initiatives to supervise weaker banks such as quarterly monitoring visits to banks displaying financial and systemic weaknesses, appointment of monitoring officers and direct monitoring of problem areas in housekeeping.

Enforcement

How do the regulatory authorities enforce banking laws and regulations?

The RBI issues directions from time to time to ensure compliance with the banking statutes and rectify non-compliance, if any. In the case of non-compliance with regulatory requirements, the RBI may impose a variety of sanctions, including fines, orders for the suspension of a bank’s business and cancellation of the bank’s banking licence.

What are the most common enforcement issues and how have they been addressed by the regulators and the banks?

The most common enforcement issues are discussed below:

  • Deterioration of asset quality of the banking system: Deteriorating asset quality is often attributable to poor underwriting by bank staff while undertaking credit appraisal of the projects. The RBI conducts ad hoc asset quality reviews of banks’ assets. Based on this review, the RBI issues directions to banks for them to comply with capital adequacy norms (see question 18). Additionally, the RBI has directed banks to take other corrective measures such as conversion of debt into equity and has permitted longer repayment schedules for long-term projects. In light of the demonetisation measures, there is speculation that the asset quality review that is generally conducted at the end of the financial year will be postposed to the next financial quarter.
  • Deficiencies in compliance with know-your-customer (KYC) anti-money laundering (AML) norms by banks: In 2013, investigations carried out by the Cobrapost media portal exposed serious violation of KYC and AML norms leading to imposition of a total fine of 500 million rupees by the RBI on 22 banks. To combat such a breach, the RBI is also considering imposing operational curbs on banks in addition to the monetary fines. The RBI has advised banks to undertake employee training programmes on KYC and AML policy as violations have often been attributable to the staff’s lack of familiarity with, and ability to monitor compliance with, the KYC and AML policy.
  • Mis-selling of financial and structured products: A wide range of complex structured financial products were being sold by banks to unsophisticated customers (such as retail and individual customers) without providing sufficient information. In 2011, the RBI imposed a total fine of 19.5 million rupees on 19 banks for mis-selling derivative products to clients and failing to match the complexity of products to clients with appropriate risk profiles and determining whether clients have appropriate risk management policies prior to investing in these products. The RBI has framed a Charter of Customer Rights as overarching principles to protect customers, pursuant to which banks must formulate board-approved customer rights policies and conduct periodic reviews.
  • Internal fraud: In 2015, investigations revealed a sum of 60,000 million rupees being routed to Hong Kong for non-existent imports through Bank of Baroda, leading to the arrest of certain bank employees. To combat fraud, the RBI has issued instructions for banks to take corrective measures, such as investing in data analytics and intelligence, gathering and maintaining internal vigilance and undertaking employee background checks. Further, a central fraud registry has been established, which acts as a centralised database to detect such fraud. Some banks have set up internal investigation teams to probe fraud allegations and implement anti-fraud controls.
  • Financial inclusion: For meeting financial inclusion targets, the RBI observed that banks were incorrectly classifying their contingent liabilities and off-balance sheet items (such as letters of credit, bank guarantees, and derivative instruments). The RBI asked banks to immediately declassify such credit facilities with retrospective effect. Failure to meet the priority sector lending targets results in penalties and can hamper regulatory approvals in the future.

Resolution

Government takeovers

In what circumstances may banks be taken over by the government or regulatory authorities? How frequent is this in practice? How are the interests of the various stakeholders treated?

The RBI can conduct compulsory amalgamations:

  • in the public interest;
  • in the interests of depositors of a bank;
  • to secure proper management of a bank; or
  • in the larger interests of the banking system.

For this purpose, the RBI, after declaring a moratorium in relation to the distressed bank, prepares a draft scheme of amalgamation, which is sent to the depositors, shareholders and creditors of the bank for comments. This scheme, among others, may provide for a change in the management of the bank and a reduction of rights of members, depositors and creditors.

The final scheme is placed before the two houses of parliament and, if approved, is eventually sent to the GOI for implementation.

Separately, upon receiving a report from the RBI, the GOI may acquire or transfer a bank’s undertaking to a transferee bank if the bank fails to comply with the RBI’s directions or if the bank is being managed in a manner detrimental to the depositors’ interests. The bank being acquired will be given a hearing prior to the acquisition. The GOI may, in consultation with the RBI, frame a scheme for the change of the management of the bank, the continuance of the employment of the employees, the payment of compensation to the shareholders of the bank and other ancillary matters. The principles for payment of compensation to the shareholders of the acquired bank and the method of computation of compensation are provided in the BR Act.

In addition, the RBI has wide powers in appropriate cases to:

  • require banks to make changes in their management as the RBI considers necessary;
  • remove any chairman, director, chief executive officer or other employee of a bank;
  • appoint additional directors to the board of directors of a bank; and
  • supersede the board of directors of a bank for a maximum period of 12 months and instead appoint an administrator.

Most amalgamations following the last wave of the nationalisation era were undertaken for the purpose of merging financially distressed banks with healthy public-sector banks.

The proposed Bill would, however, empower the resolution corporation to become the administrator of any bank that is facing material risks to its viability or where its failure is imminent. In such a scenario, the resolution corporation would have sweeping powers to resolve the bank concerned in manner that it deems fit.

Bank failures

What is the role of the bank’s management and directors in the case of a bank failure? Must banks have a resolution plan or similar document?

See question 15. The RBI issued a report in 2014 that envisaged that while all banks will eventually prepare recovery or resolution plans (RRPs) to deal with distress or failure and in the initial stages, only D-SIBs would have to prepare RRPs. The report also contemplated the establishment of a financial resolution authority under a separate legislative framework that would work with the relevant bank and the RBI to oversee drafting and implementation of RRPs. In spite of the fact that the RBI has designated two banks as D-SIBs, no legislation has been passed and a financial resolution authority is yet to be established.

The existing framework envisages that the RBI or the GOI in consultation with the RBI will intervene to resolve a failed bank. This can be done on an ad hoc basis and through a range of powers such as appointing and removing directors or employees of banks (or both), prohibiting banks from entering into particular transactions and ordering termination of contracts, and in extreme cases of failure, acquiring the entire business and undertakings of the bank itself or transferring the same to another bank. Typically, it is the RBI that will exercise its resolution powers to merge a distressed bank with a healthy bank.

Apart from recovery and resolution of a bank, the existing framework also provides for resolution by liquidation. The RBI can make an application to the High Court for the winding-up of the bank where:

  • the bank has failed to comply with statutory requirements;
  • has been prohibited from accepting fresh deposits;
  • if, in the opinion of the RBI, the continuance of the bank is prejudicial to the interests of its depositors or the bank is unable to pay its debts;
  • a compromise sanctioned by a court cannot be worked satisfactorily; or
  • the High Court had earlier issued a moratorium in respect of the bank.

Are managers or directors personally liable in the case of a bank failure?

Managers and directors may be held personally liable if a bank fails, but only in certain circumstances, namely, where there has been a breach by the bank of the provisions of the BR Act leading to a failure of the bank, or where a director fails to meet the duties imposed on him or her in his or her capacity as a director under the law.

If a bank contravenes the BR Act, all persons who at the time of the contravention were in charge of, and responsible to, the bank, for the conduct of the business of the bank, are deemed to be guilty unless they prove that the contravention occurred without their knowledge or that they exercised due diligence to prevent the same. Where it is proved that the bank committed a contravention with the consent or connivance of, or it is attributable to any gross negligence by, a director or a manager, such director or manager is also deemed guilty of such contravention.

CA 2013 regards an ‘officer who is in default’ as liable for any penalty whether by way of imprisonment, fine or otherwise. The definition includes the manager, full-time directors and directors who are aware of contraventions (through participation in board meetings or upon receiving proceedings of the board) but fail to object to the same or through whose consent or connivance the contravention has taken place.

CA 2013 codifies the duties of the directors and imposes higher standards of governance on independent directors. Therefore, where directors or managers have not performed their duties as set out above, they can be held personally liable and be punished with fines.

Where a bank is being wound up or is undergoing a restructuring scheme, the court can:

  • publicly examine a person whom the official liquidator has reported as having caused a loss to the bank;
  • (in the case of winding-up) summarily try an offence committed under CA 2013 or the BR Act by a director or a manager; and
  • require a manager or director to repay or restore any property of the bank that the director has retained or misapplied or in respect of which the director has committed a breach of trust.

Planning exercises

Describe any resolution planning or similar exercises that banks are required to conduct.

There are no stand-alone or specific bank recovery and resolution planning or living wills requirements applicable in India at the moment. However, some aspects of recovery planning have been built into the capital adequacy and assessment norms as well as the risk management and business continuity planning requirements. RBI also uses its general supervisory powers to direct banks to prepare recovery plans on a case-by-case basis. For banks whose financial health deteriorates below certain trigger points, the RBI’s prompt corrective action framework is followed (see questions 17 and 18). One of the possible actions for stressed banks is to implement a pre-agreed plan with the RBI (see question 13).

One key provision of the proposed Bill is to impose mandatory recovery and resolution planning requirements across the financial sector for entities that reach certain levels of risk to viability. The Bill uses the terms restoration plan and resolution plan. The restoration plan would have to be submitted to the RBI while the resolution plan would be submitted to a specialist financial sector resolution corporation that would be formed. The two plans would have to be refreshed on an annual basis and all material changes would have to be notified by the concerned bank to the appropriate body. In a resolution scenario, the resolution corporation shall have the powers to unilaterally modify the resolution plan of the bank concerned.

Capital requirements

Capital adequacy

Describe the legal and regulatory capital adequacy requirements for banks. Must banks make contingent capital arrangements?

On 2 May 2012, the RBI laid down guidelines for Indian banks as recommended under the Basel III Capital Accord of the Basel Committee on Banking Supervision (BCBS) and introduced the Basel Regulations. The Basel Regulations have been implemented with effect from 1 April 2013 and are going through a transitional period that lasts until 31 March 2019. The capital adequacy framework is based on three mutually reinforcing pillars: minimum capital requirements (Pillar 1), supervisory review of capital adequacy (Pillar 2) and market discipline (Pillar 3).

The minimum capitalisation requirements under Pillar 1 require banks in India to maintain a minimum capital to risk-weighted assets ratio (CRAR) of 13 per cent for the first three years of commencing operations (subject to a higher ratio specified by the RBI) and 9 per cent on an ongoing basis (against the 8 per cent requirement under the Basel II accord). CRAR is the ratio of a bank’s capital in relation to its risk-weighted assets. The requirement under Pillar 1 includes the total regulatory capital (comprising of Tier 1 and Tier 2 capital) and the different approaches for risk-weighting the assets in terms of their credit, operational and market risk (comprising of the standardised framework and basic indicator framework). Tier 1 capital, among others, consists of paid-up capital, stock surplus, statutory reserves and Tier 2 capital, among others, comprises debt capital instruments, preference share capital and revaluation reserves, etc.

In addition to the minimum 9 per cent requirement, there are contingent capital arrangements that a bank is required to make in the form of maintaining a capital conservation buffer (CCB), countercyclical capital buffer (CCCB) and Tier 1 leverage ratio.

Serial No.

Type

Ratio

1.

Capital conservation buffer

2.5 per cent

2.

Counter cyclical capital buffer

0 to 2.5 per cent

3.

Tier 1 leverage ratio

3 per cent

Payments banks are required to maintain a CRAR of 15 per cent on an ongoing basis and a minimum Tier 1 capital ratio of 7.5 per cent. These banks are not required to maintain a CCB and a CCCB ratio.

The Basel III framework applies to all scheduled commercial banks (except regional rural banks) and such banks are required to comply with the Basel Regulations on a ‘solo and consolidated basis’.

Every year commencing from April 2015, the RBI categorises some systematically important financial institutions as D-SIBs under different buckets, who are then required to maintain certain additional capital. At present, three banks, namely State Bank of India, ICICI Bank Limited and HDFC Bank Limited have been declared as D-SIBs maintaining an additional current ratio of 0.6 per cent and 0.2 per cent respectively. The RBI requires the D-SIBs to maintain an additional common equity Tier 1 capital ratio ranging from 0.2 per cent to 0.8 per cent.

How are the capital adequacy guidelines enforced?

The capital adequacy requirements are enforced under Pillar 2 and Pillar 3 of the Basel III Regulations.

Pillar 2 provides for supervision at the bank level and at the supervisory authority level.

Supervision at the bank level includes assessment of capital adequacy of banks in relation to their risk profiles by implementing an internal process called the Internal Capital Adequacy Assessment Process (ICAAP). Every bank is required to have an ICAAP, which is the bank’s procedure for identification and measurement of risks, maintaining appropriate level of internal capital in relation to the bank’s risk profile and application of suitable risk management systems. Banks are required to annually submit the ICAAP report to the RBI.

Supervision at the supervisory authority level (ie, by the RBI) makes all banks subject to an evaluation process called the Supervisory Review and Evaluation Process (SREP). Pursuant to the SREP, the RBI reviews and evaluates a bank’s ICAAP, indirectly evaluates a bank’s compliance with the regulatory capital ratios and takes remedial action if such a ratio is not maintained. The RBI may consider prescribing a higher level of minimum capital ratio for each bank under the Pillar 2 framework on the basis of their respective risk profiles and risk management systems. Failure to comply with the minimum regulatory capital requirements, may subject the bank to fines that may extend to 10 million rupees and a further penalty of 100,000 rupees for every day of default. The relevant bank may also be subject to prompt corrective action by the RBI (see question 18).

Pillar III implements market discipline through extensive disclosures by banks that allow market participants to assess risk exposure, risk assessment process and capital adequacy of a bank. Every bank should have an internal disclosure policy that is approved by the board of directors and assessed periodically. The disclosures are to be made on a half-yearly basis and should either be published in the bank’s financial statements or displayed on the bank’s website.

Undercapitalisation

What happens in the event that a bank becomes undercapitalised?

The RBI has a stringent control mechanism for monitoring the financial health and soundness of Indian banks. To this effect, the RBI has initiated a prompt corrective action plan as a measure to ensure adequacy of a bank’s internal control system in terms of three parameters: CRAR, net NPA and return on assets (ROA). The RBI has put in place certain trigger points to assess, control and take corrective action on banks that are weak and troubled. The trigger points for CRAR are:

  • CRAR less than 9 per cent but equal to or more than 6 per cent;
  • CRAR less than 6 per cent but equal to or more than 3 per cent; and
  • CRAR less than 3 per cent.

Similar trigger points have also been provided with respect to NPAs and ROAs.

Upon hitting any of the trigger points, the banks are required to immediately report to the RBI and simultaneously implement internal measures to regularise the relevant trigger point. The RBI also has the powers to initiate certain structured and discretionary actions, which, among others, include implementation of a capital restoration plan, prohibition on entering into a new line of business, imposing stringent credit and investment strategy controls and merger or amalgamation of the bank. The RBI also has the ability to impose a moratorium on the bank in the event the CRAR does not improve beyond 3 per cent, within one year or such extended period as the RBI deems fit.

Insolvency

What are the legal and regulatory processes in the event that a bank becomes insolvent?

The BR Act deals with the provisions relating to insolvency (referred to as ‘winding-up’) of banking companies (including branches of foreign banks operating in India).

Winding-up (whereby all the affairs of the banking company are wound up, assets are realised, liabilities are paid and the balance, if any, is distributed to its shareholders in proportion of their holding in the company) can either be voluntary (by members or creditors of a solvent banking company) or compulsory (by the High Court under whose jurisdiction the bank operates).

The RBI has the power of winding-up of a banking company. An order for the winding-up of a banking company can be passed by a High Court:

  • if it is unable to pay its debts;
  • if an application has been made by the RBI; or
  • on request of the GOI.

For winding-up, every High Court appoints a liquidator (as an officer of the court) to manage the assets and liabilities of a banking company and supervise the liquidation process. The liquidator is required to submit a preliminary report to the High Court in relation to the assets and liabilities of a banking company and also make a just estimate of the liabilities of the bank. For this purpose, creditors or depositors are required to provide evidence of the debt owed to them. Secured creditors are not required to prove their debt. They may choose to stay out of the winding-up proceedings and claim the amounts owed to them from the secured assets. The secured creditors also have the option to relinquish their security and to prove their debt in the same manner as an unsecured creditor.

The law relating to the winding-up of a banking company does not apply to government banks (ie, banks largely owned by the government and classified as government banks under different statutes). A government bank can only be placed under liquidation by an order and in the manner provided by the GOI. At present, there is also some ambiguity around the competent forum for filing and prosecuting any insolvency matters covering financial services providers, including the private banks. Theoretically, it may not be possible to apply for the liquidation of a bank at the moment without a special notification from the central government.

However, if the inability to pay its debts is temporary, the banking company may apply to the relevant High Court (accompanied by a report from the RBI declaring its ability to meet its obligations and pay all debts during such moratorium period) requesting an order of moratorium for staying the commencement or continuation of all actions and proceedings against it for a period not exceeding six months.

During the moratorium period, if the RBI is of the opinion that the affairs of the banking company are being conducted in a manner detrimental to the interests of the depositors or if in the opinion of the High Court, the inability of the banking company to meet its obligations or to pay its debt is not temporary, the court may call for the winding-up of the company. Note that the RBI would invariably intervene and declare a moratorium on payments rather than allow the winding-up of banks.

In addition, if the RBI is concerned about the financial health of a banking company, it may make a recommendation to the GOI in relation to its reconstruction and amalgamation with another banking company (generally a government bank) and prepare a scheme for the same. The RBI has wide powers and can provide in such a scheme for the reduction of the interest or rights that the members, depositors and other creditors have in, or against, the banking company before its reconstruction to the extent as the RBI considers necessary in the public interest or in the interest of the members. The RBI can also issue a direction to the banking company preventing it from entering into an agreement or honouring its obligations under any agreement. On sanction by the GOI, the banking company can be amalgamated under the provisions of the BR Act. In the past few decades, the RBI has been reconstructing or amalgamating weaker banks with stronger counterparts to avoid winding-up situations.

The Bill is expected to establish clear processes to respond to a bank failure. Among other things, the Bill would require banks with potential risks to their viability to have recovery and resolution plans. The resolution plan is proposed to include details of all assets, liabilities, specifics of operations, and possible strategies, etc. As per the Bill, the resolution corporation will be the administrator of the insolvent bank who will take all the necessary steps to ensure an orderly and safe resolution and will enjoy wide powers to achieve such objectives.

Recent and future changes

Have capital adequacy guidelines changed, or are they expected to change in the near future?

India adopted the Basel I accord in April 1992. The RBI later announced the implementation of Basel II norms for internationally active banks from March 2008 and domestic commercial banks from March 2009 by way of the Prudential Guidelines on Capital Adequacy and Market Discipline - New Capital Adequacy Framework (NCAF Circular). With effect from April 2013, banks in India are now regulated by the Basel Regulations, which are still in the implementation phase so the NCAF Circular will have limited relevance for the purpose of transitional arrangements up to 31 March 2017. Since the Basel Regulations are in the implementation phase, no significant changes are currently expected in the capital adequacy guidelines. Recently, the RBI has introduced minimum capital requirement ratios to be maintained by a payments bank (see question 16). It is envisaged that the RBI may impose similar requirements for small finance banks.

The RBI had also issued draft guidelines on net stable funding ratio (NSFR) in May 2015 and the final guidelines are expected by March 2018. The draft NSFR guidelines provide guidance on the calculation of the available and required stable funding. The time frame to be considered was one year. It is possible that the final rules may prescribe the required NSFR ratio to be more than 100 per cent to ensure greater resilience in the system.

Ownership restrictions and implications

Controlling interest

Describe the legal and regulatory limitations regarding the types of entities and individuals that may own a controlling interest in a bank. What constitutes ‘control’ for this purpose?

All banks in India, whether domestic or foreign, need to obtain a banking licence from the RBI in order to commence operations. Licensing of universal banks in India is primarily governed by the BR Act and the ‘Guidelines Issued for ‘on tap’ Licensing of Banks in the Private Sector’ (also referred to as universal banks) (on-tap guidelines). The on-tap guidelines mark a shift from the previously adopted ‘stop and go’ licensing approach (under which the RBI would notify the licensing window during which a private entity could apply for a banking licence), to a continuous or ‘on tap’ licensing regime.

While the BR Act lists the requirements of a banking company to obtain a banking licence, the on-tap guidelines, in addition to other procedural requirements for eligible promoters to promote a bank through a non-operative financial holding company (NOFHC) model. Eligible promoters are defined as persons having a successful record in banking and finance for at least 10 years, who are:

  • individuals resident in India;
  • entities in the private sector that are owned and controlled by residents of India provided that if such entity has total assets of 50 billion rupees or more, its non-financial business should not account for 40 per cent or more of assets or gross income; or
  • existing non-banking financial companies (NBFCs) that are ‘controlled by residents’ and compliant with specified income and asset tests.

It is not mandatory for the bank to be set up through a NOHFC in case the promoters are individuals or standalone promoters who do not have other group entities.

This NOFHC is to be registered with the RBI as an NBFC and is required to hold the bank as well as other financial service companies of the promoter group. The capital structure of the NOFHC is required to consist of:

  • voting equity shares of 51 per cent held by promoters or companies forming part of the promoter group. If such shareholding is held by various individuals of the promoter group, each individual, together with his or her relatives and entities in which they collectively hold 50 per cent voting equity shares, can hold only up to 15 per cent of the voting equity shares of the NOFHC;
  • voting equity shares of 49 per cent must be held by public shareholders, where each individual, together with his or her relatives and entities in which they collectively hold 50 per cent voting equity shares, can hold only up to 10 per cent of the voting equity shares of the NOHFC; and
  • shareholding of the promoter group in the NOFHC should be only by individuals, non-financial service and core investment companies or investment companies in the promoter group (ie, no financial services entity is an eligible shareholder in the NOFHC).

The bank is mandatorily required to be listed on a stock exchange within six years of commencement of business.

Financial service entities whose shares are held by the NOFHC are not permitted to hold shares in the NOFHC.

The promoter and the promoter group or NOFHC are also required to hold a minimum of 40 per cent of the paid-up voting equity capital of the bank that shall be locked in for a period of five years. Any shareholding beyond this limit is required to be bought down to 40 per cent within five years of the date of commencement of business of the bank.

Additionally, no shareholder of a bank can exercise more than 10 per cent of the total voting rights in a bank irrespective of its actual shareholding. This may be raised at a later date to 26 per cent by the RBI. The 10 per cent voting limit applies to each person holding shares of the bank and affiliates, related parties and persons belonging to a common group are considered separate persons for this purpose.

In the event a shareholder acquires 5 per cent or more of the voting capital of the bank, prior approval from the RBI will be required (see question 26).

The RBI is likely to issue separate guidelines for small sector banks in relation to entities having a controlling interest.

Foreign ownership

Are there any restrictions on foreign ownership of banks?

Foreign investments in India are subject to restrictions and conditions imposed by the FDI policy.

A foreign company can carry out banking activities in India through:

  • a branch;
  • a WOS; or
  • a subsidiary with aggregate foreign investment up to a maximum of 74 per cent in a private bank (49 per cent through the automatic route and up to 74 per cent on approval by the government).

Indian residents are required to hold at least 26 per cent of the paid-up capital of the bank at all times (except in case of a WOS). However, the aggregate non-resident shareholding from FDI, non-resident Indians and foreign institutional investors in the new banks cannot exceed 49 per cent for the first five years from the date of licensing of the new bank.

Foreign investment of up to 20 per cent of the paid-up capital of a public-sector bank is permitted on obtaining government approval.

Investments by foreign banking entities above 10 per cent requires approval. The RBI can permit a higher holding for a single entity under exceptional circumstances such as the restructuring of problem or weak banks or in the interest of consolidation of the banking sector.

While a foreign bank is allowed to operate in India and carry out banking activities through a branch, the RBI encourages banks to follow the WOS structure and provides near national treatment in respect of branch expansion. Foreign banks that commenced operations in India after 2010 and fulfil the prescribed criteria laid down by the RBI are required to mandatorily adopt the WOS structure. Such criteria, among others, include banks declared as being systematically important by the RBI, banks with complex structures, banks that are not widely held, banks not providing adequate disclosures in their home country and likewise. Foreign banks in India operating prior to 2010 have the option to continue their banking business through the branch mode or convert into a WOS.

Implications and responsibilities

What are the legal and regulatory implications for entities that control banks?

As per the on-tap guidelines, eligible promoters and promoter groups are required to satisfy the ‘fit and proper’ criteria in order to establish a bank. The eligibility criteria vary depending on the nature of the entity. These criteria, among others, include having sound credentials and a successful track record of at least 10 years. In respect of structures using the NOFHC model, ownership and management will have to be separate and distinct in the promoter and promoter group entities that own or control the NOFHC. In addition, the major shareholders (ie, shareholders holding 5 per cent or more) have to continue to maintain ‘fit and proper’ status, during the tenure of their holding.

The NOFHC is required to hold the bank as well as other regulated financial service entities of the group. The regulated financial services entities of the group including the bank must be ring-fenced from other activities of the group (such as commercial and financial activities not regulated by financial sector regulators) and also that the bank should be ring fenced from other regulated financial activities of the group.

Only those regulated financial sector entities in which the individual promoter or group have significant influence or control will be held under the NOFHC. Apart from setting up the bank, the NOFHC shall not be permitted to set up any new financial services entity for at least three years from the date of commencement of business of the NOFHC. However, this would not preclude the bank from having a subsidiary or joint venture or associate, where it is legally required or specially permitted by the RBI.

The activities not permitted to the bank would also not be permitted to the group (ie, entities under the NOFHC would not be permitted to engage in activities that the bank is not permitted to engage in).

The promoters, their group entities, the NOFHC and the bank are subject to consolidated supervision. The RBI will have to be satisfied that the corporate structure does not impede the financial services under the NOFHC from being ring-fenced, and that it will be able to obtain all required information from the group as relevant for this purpose smoothly and promptly. To date, most foreign banks continue to operate as branches in India.

What are the legal and regulatory duties and responsibilities of an entity or individual that controls a bank?

Any entity that controls a bank will be assessed based on the ‘fit and proper’ criteria (see question 28). The shareholders have to continue to meet these criteria for the duration of the holding and the bank must furnish an annual certificate to this effect.

Shareholders also have to comply with the share acquisition and transfer provisions set out in the response to question 26. Any acquisition or transfer above the prescribed threshold will require RBI approval. As part of the approval process, the shareholder is required to furnish the details of the source of funds to the RBI.

What are the implications for a controlling entity or individual in the event that a bank becomes insolvent?

No specific implications have been prescribed for a controlling shareholder and hence the treatment will be the same as any other shareholder. In the general order of priority of payments in winding-up, the shareholders are the last to recover their investment.

In the event that the RBI chooses to carry out a reconstruction or amalgamation procedure, it has the power to severely compromise or alter the rights and interests of the shareholders (without their consent).

As per the Bill, the controlling entity or individuals (including the board of directors) would cease to have any management control over an insolvent bank or its assets. The resolution corporation would be empowered to resolve the institution as it deems fit. The controlling entities or individuals may ultimately recover their investment, depending upon the legal nature of their investment and where they stand in the hierarchy of claims.

Changes in control

Required approvals

Describe the regulatory approvals needed to acquire control of a bank. How is ‘control’ defined for this purpose?

In the event that a shareholder (directly or indirectly) acquires 5 per cent or more of the voting equity capital of a bank, prior approval of the RBI is required. On obtaining such approval, the stake can subsequently be increased to 10 per cent (without obtaining an additional approval). However, any change in shareholding beyond 10 per cent will require fresh approval. As discussed in question 21, while the minimum voting limit by a single individual or entity is 10 per cent, this limit can be extended up to 26 per cent by the RBI. The RBI also assesses whether the shareholder is ‘fit and proper’ to be a major shareholder (see question 28).

In the event a shareholder acquires 5 per cent or more of the voting capital of a NOFHC, prior approval from the RBI will be required. The shares of a NOFHC cannot be transferred to an entity outside the promoter group.

As per the FDI policy, control has been defined to include the right to appoint a majority of the directors or to control the management or policy decisions including by virtue of shareholding or management rights, or shareholders’ or voting agreements.

Foreign acquirers

Are the regulatory authorities receptive to foreign acquirers? How is the regulatory process different for a foreign acquirer?

Regulatory authorities in India are generally receptive to foreign acquirers and the approval requirements discussed in question 26 apply equally to acquisition by residents and foreigners. As a part of this approval, the RBI is allowed to impose conditions as it may deem appropriate. Acquisition in excess of 25 per cent would, if the target bank is a listed entity, trigger the Indian takeover regulations and the acquirer would then have to make an open offer for at least a further 26 per cent of the shares in that bank.

If the applicant is a foreign entity, it must obtain prior approval of the regulator or supervisor of its country of incorporation. The RBI will grant a licence to such banks only if it is satisfied that the government or law of the country of incorporation does not discriminate in any way against Indian banks. The RBI also considers the economic, political relations and reciprocity with the home country of the parent bank, and the international ranking, international presence, home country ranking and the rating of the parent bank by a rating agency of international repute. The applicant bank should also ensure that it is subject to adequate prudential supervision as per internationally accepted standards, which includes consolidated supervision in its home country.

While generally welcoming, the RBI discourages acquisitions made for the purpose of circumventing the restrictions in place for the licensing of physical branches of foreign banks. Any acquirer will have to separately apply for new branch licences and cannot rely on simply taking over existing branches of the seller or opening new branches near the existing branches of the seller.

Factors considered by authorities

What factors are considered by the relevant regulatory authorities in an acquisition of control of a bank?

The RBI will undertake a detailed due diligence on the applicant to assess his or her ‘fit and proper’ status to be a major shareholder. The criteria for compliance with ‘fit and proper’ status vary depending on the percentage of stake acquired.

Acquisition of 5 per cent or more of shares or the voting rights of the bank

The RBI, among other things, will evaluate:

  • the applicant’s integrity, reputation and track record in financial matters (including any financial misconduct);
  • the applicant’s source of making such acquisition;
  • the applicant’s compliance with tax laws; and
  • in cases where such an applicant is a body corporate, in addition to the above, the entity’s financial strength and consistency with standards of good corporate governance are also assessed.

Acquisition in excess of 10 per cent of shares or voting rights of the bank

In addition to the factors listed above, the RBI, among other things, will closely evaluate:

  • details in relation to the conglomerate group (if any);
  • whether such an entity is a widely held, publicly listed and a well-established regulated financial entity with a good standing in the financial community;
  • whether it has stability of funds for such an acquisition including any past experience in business acquisitions;
  • the desirability of diversified ownership of banks; and
  • whether such an acquisition is in the public interest.

It is to be noted that the ‘fit and proper’ criteria set out above are just an illustrative list, and the RBI may evaluate the applicant on such other parameters it considers necessary.

Filing requirements

Describe the required filings for an acquisition of control of a bank.

The filings required for acquiring control in a bank vary according to the type of acquisition.

Acquisition of major shareholding in a bank

Every such entity must make an application to the RBI along with the prescribed declarations. The RBI will seek recommendations from the board of directors of the concerned bank.

FDI filings

Inward remittance for subscription to shares must be reported to the authorised dealer by the issuing company within 30 days of the receipt of remittance in the Advance Reporting Form along with the Foreign Inward Remittance Certificate. Upon the issuance of shares, the same must be reported by the issuing company within 30 days of issuance as per form FC-GPR. Sale of such securities held by a non-resident to an Indian resident must be reported by the Indian resident as per form FC-TRS within 60 days of the receipt of remittance.

Timeframe for approval

What is the typical time frame for regulatory approval for both a domestic and a foreign acquirer?

Any application made for an aquisition in a private sector bank between 49 per cent and 74 per cent of the stake of the banking company will require prior approval. Such application in relation to foreign investment should be approved within eight to 12 weeks from the date of application. If the proposed foreign investment exceeds 20 billion rupees, additional approval will need to be obtained from the Cabinet Committee on Economic Affairs, which may take another two to three weeks.

The RBI approval required to acquire a major shareholding, including a change of control, takes 90 days from the date of the application (the time taken by the acquirer in furnishing information sought by RBI is excluded in theory).In practice, however, it is likely that an acquisition of a majority or controlling stake in a private bank will be treated as if a fresh licence has been applied for. This process takes a significant amount of time, possibly greater than five years, although it is hoped that recent activity in this sector and the stringent guidelines for resolving applications set by the RBI itself will result in this time frame reducing considerably.

Update and trends

Update and trends

Updates and trends

See question 8. Additionally:

  • The Bill, see question 8, is one of the most closely watched developments in India. This law is expected to bring sweeping reforms for the entire financial sector in India.
  • Banks and NBFCs are required to switch to IndAS, India’s new accounting rules modelled after the IFRS. Aside from operational challenges likely to arise in implementation, these rules are likely to cause an increase in capital requirements as well.
  • The central government is seeking to infuse capital into 20 banks that are majority-owned by it to improve their financial health and to also enable them to comply with Basel III norms. This capitalisation would be in tranches and comprises bonds and other instruments.
  • The RBI is now empowered to compel banks to resolve specific non-performing assets by pursuing insolvency and other remedies. In exercise of these powers, the RBI has directed various lenders to initiate action against some of the biggest defaulters across the board and many borrowers have now been taken by the banks to the insolvency tribunals. Such pro-active regulatory initiatives are expected to continue as long as the pressures on banks’ balance sheets remain.