An extract from The Banking Regulation Review, 12th Edition
Prudential regulationi Relationship with the prudential regulator
As a 'banker to banks' and as 'lender of last resort', the RBI directly controls the prudential regulation of banks, introducing norms for income recognition, asset classification and provisioning for the advance portfolios of banks, and ensuring consistency and transparency in published accounts.
The BR Act specifically requires banks to maintain books and records in a particular manner and file the same with the regulatory authority on a periodic basis. The RBI's directives on know your customer (KYC) and anti-money laundering provide for transactional and identification records to be maintained for a minimum period of 10 years from the date of transaction and 10 years from the cessation of relationship with the client, respectively. The provisions for production of documents and availability of records for inspection by shareholders as stipulated under the CA and the rules thereunder also apply to banks.
Further, for more effective supervision over the burgeoning NPA situation, the RBI has set up the Central Repository of Information on Large Credits to collect, store and disseminate data reporting entities' exposure to the borrower (as individuals or as a group, or both) under various heads, including 'special mention accounts' with aggregate debt exposure of 50 million rupees and above.
The RBI is empowered under the BR Act to conduct periodical on-site inspections on matters relating to banks' portfolios, risk management systems, internal controls, credit allocation and regulatory compliance, at regular intervals. Further, the RBI also conducts on-site supervision of selected branches with respect to their general operations and foreign exchange transactions. To this end and to enable off-site monitoring and surveillance by the RBI, banks are also required to periodically report to the RBI on these and other aspects.ii Management of banks
The appointment, reappointment or termination of the appointment of a chairperson, managing director, full-time director or chief executive officer of a bank shall have effect only if made with the prior approval of the RBI.
No amendments in relation to (1) the maximum permissible number of directors or the appointment, reappointment or termination of the appointment or remuneration of a chairperson, managing director, full-time director or chief executive officer of a bank; or (2) the remuneration of the chairperson, managing director, full-time director, any other director or chief executive officer shall have effect unless approved by the RBI. The RBI is also empowered to remove a chairperson, managing director or full-time director from office on the grounds of public interest or the interests of depositors or in securing proper management of the bank. The relevant provisions of the CA relating to appointment and remuneration of managerial personnel shall not apply to such matters that require RBI approval.
The RBI may, at any time, in the interest of the public, banking policy, depositors or the bank itself, pass certain orders in writing, such as:
- convening board and general meetings to discuss any matter in relation to the bank, including the election of new directors;
- requiring the bank to discuss any relevant matter with an officer of the RBI, and submit relevant disclosures;
- appointing one or more RBI officers as observers of the bank;
- making such changes to the management of the bank as it deems necessary; and
- superseding the board of directors of a banking company for a period of six to 12 months.
The RBI has directed PVBs to undertake a process of due diligence to determine the suitability of candidates for appointment or reappointment as a director on the board of directors of a bank, based upon qualification, expertise, track record, integrity and other relevant factors. Additionally, at least half the board of a PVB must comprise independent directors. Moreover, for foreign banks that have adopted the WOS model: (1) at least 50 per cent of their directors must be Indian residents (with at least one-third being Indian national residents); (2) the chief executive officer must be an Indian resident; and (3) at least two-thirds of directors must be non-executive directors.
To ensure minimum political intervention and transparency, the following are not eligible to be members of a PSB's board:
- members of Parliament, state legislatures or local governments;
- statutory auditors of PSBs; and
- persons on the board of any other bank, financial institution or other competing body.
The decision-making process in banks is participative and conducted as per the procedural guidelines for board and shareholders' meetings stipulated in the CA. Moreover, it is expected that the RBI will soon issue guidelines on corporate governance for regulated entities to align the current regulatory framework with global best practices while being mindful of the context of the domestic financial system.
To prevent misaligned remuneration and incentive schemes for bank managers and employees, in November 2019 the RBI directed that a substantial proportion of compensation of full-time directors, chief executive officers, material risk-takers and control function staff (i.e., at least 50 per cent), should be variable and paid on the basis of individual, business unit and firm-wide measures that adequately measure performance. The total variable pay shall be limited to a maximum of 300 per cent of the fixed pay. Moreover, if variable pay is up to 200 per cent of the fixed pay, a minimum of 50 per cent of the variable pay should be via non-cash instruments; and if variable pay is above 200 per cent, a minimum of 67 per cent of the variable pay should be via non-cash instruments.
For senior executives, deferral arrangements for a minimum of 60 per cent of the total variable pay must invariably exist for the variable pay, regardless of the quantum of pay, and should also be subject to clawbacks in the case of subdued or negative financial performance of the bank. These guidelines will be applicable to PVBs, including local area banks, SFBs and PBs, as well as to foreign banks operating in a WOS structure, for pay cycles beginning from and after 1 April 2020.
In light of the failure and mismanagement of various UCBs in the recent past, the RBI has introduced another layer of management for UCBs. The RBI has issued guidelines on constituting boards of management (BOMs) in UCBs, which shall assist the UCBs' boards of directors in steering the UCBs. The roles and responsibilities of the BOMs are akin to the directors of UCBs, albeit in an advisory capacity.iii Regulatory capital and liquidity
The RBI has set out the minimum capital adequacy standards for banks based on the guidelines of the Basel Committee on Banking Supervision. The RBI Basel III Capital Regulations became effective on 1 April 2013 and were fully implemented by 31 March 2020, in a phased manner. Under RBI guidelines, the minimum total capital to risk-weighted assets ratios to be maintained for three years from commencement of operations are as follows:
- for PVBs: 9 per cent
- for PSBs: 12 per cent: and
- for WOS-model foreign banks: 10 per cent.
These percentages are all higher than the Basel III prescription.
Presently, a bank's capital comprises Common Equity Tier 1 (CET1) capital and Common Equity Tier 2 (CET2) capital with a restriction that CET2 capital cannot be more than 100 per cent of CET1 capital. CET1 capital typically comprises ordinary equity shares, with or without voting rights, and innovative instruments up to 15 per cent thereof. CET2 capital may be in the form of debt capital instruments and preference shares capital instruments, as long as these instruments have certain loss absorption features. Further, the RBI has permitted banks to raise Additional Tier 1 capital in the form of perpetual non-cumulative preference shares and certain types of debt capital instruments that have principal loss absorption through either conversion into common shares at an objective pre-specified trigger point or a write-down mechanism, which allocates losses to the instrument at a pre-specified trigger point.
The Basel III framework prescribes two minimum liquidity standards: the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). While the LCR promotes short-term resilience of banks in dealing with potential liquidity disruptions lasting for 30 days, the NSFR requires banks to fund their activities with stable sources of funding over the time horizon extending to one year. The former has been implemented in India since 1 January 2015 and the latter – defined as the ratio of available stable funding to required stable funding – has been effective since 1 April 2020.
Other Basel-prescribed capital reserves required to be maintained include the cash reserve ratio, as a percentage of banks' demand and time liabilities (DTL), by way of a balance in an interest-free current account with the RBI, and the statutory liquidity ratio (SLR), a percentage of DTL to be maintained by way of liquid assets such as cash, gold or approved unencumbered securities, against which banks may avail funds from the RBI on an overnight basis under the marginal standing facility. Similar capital adequacy requirements or buffers also apply to WOS-model foreign banks.iv Recovery and resolution
There is no separate resolution framework for failed banks in India. Even the IBC, which is a comprehensive reform of the legislative framework for insolvency and bankruptcy, does not directly cover bankruptcy of 'financial firms' such as banks, insurance companies and stock exchanges, and instead empowers the central government to notify the same.14 Further, for any winding-up petition against a bank, RBI approval would be required. Specifically, in terms of resolution of development or cooperative banks, the RBI's powers are further limited.
That being said, the BR Act confers significant powers on the RBI (with or without consultation with the central government) to exercise control over, or make changes to, the management of the board of a failed bank. The RBI may also be appointed as the liquidator for winding-up the bank or apply to courts to suspend a mismanaged bank's business.
Bank deposit insurance was introduced in India in 1962 pursuant to the Deposit Insurance and Credit Guarantee Corporation Act 1961. The Deposit Insurance and Credit Guarantee Corporation, a WOS of the RBI, insures deposits of up to 100,000 rupees of all commercial banks in India, including foreign banks, local area banks, RRBs and most cooperative banks. At present, each depositor in a bank is insured up to a maximum of 100,000 rupees for both principal and interest amount.
Bearing in mind the serious market disruption risks that may arise from the failure of any bank in India, interest in promulgating the Financial Resolution and Deposit Insurance Bill 2017 (FRDI) has rekindled. The FRDI proposes to create a unified framework for monitoring financial firms such as banks and to establish a 'resolution corporation' that would be responsible for supervising the resolution or liquidation processes of failed banks.
Section 45 of the BR Act was amended by the 2020 amendments to the BR Act, enabling the RBI to enact a scheme for reconstruction or amalgamation of entities for the purpose of protecting the interests of depositors and the public at large, or to ensure proper management, without imposing a moratorium on the bank. The amendment could enable banks under moratorium to discharge their liabilities and make payments under the scheme and protect the financial system at large from being disrupted by the placing of distressed banks under moratorium.