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Executive Summary

The funding of independent regulatory agencies varies from jurisdiction to jurisdiction, but there are three basic methodologies. The issue, however, is inextricably linked to the quality of regulation, since adequacy of resources, both human and technical is the sine qua non of quality regulation. Moreover, in most, although not all, jurisdictions, and Anguilla appears to be in the mainstream in this regard, the overall level of funding is derived from determining the agencys revenue requirement for the fiscal year and then either backing out the formula (e.g. a % of regulated revenues) for obtaining the funds, or a precise amount to be levied. The most common method for funding regulation, and perhaps the most logical, is by assessing the costs of regulation to the regulated companies, and then allowing them to simply pass those costs directly on to the consumers. It is logical because it internalizes regulatory costs to the regulated sector, treats regulatory assessments as fees for service rather than taxes, is a stable, reliable source of funds, is easy to administer, is consistent with regulatory independence, and is transparent on its face. The second most utilized method is through an appropriation from general tax revenues. That methodology is less common because it facilitates, even though it does not always attract, political interference in the operation of the agency, may not be as reliable or stable as assessments, and does not internalize regulatory costs into the sector. The third, and least common methodology, is specific fees for services/activities. While fees, as a basic method for funding regulation have the advantage of sending the most accurate price signals, and is perhaps most protective of agency independence, the methodology has the highest transaction costs, and may yield less stability and reliability in a revenue stream. Fess, however, can be a very useful mechanism for providing supplemental funds for agencies when required for specific purposes. While the fees methodology, by its very nature, allocates costs specifically to the companies causing the costs to be incurred, and the general tax revenue, by its very nature, obviates the need to allocate costs among users, the assessment methodology does require the adoption of cost allocation principles. The options for allocating is to apply assessments universally to all companies in the sector or defined sub-sector, to apply assessments only to bottleneck facilities in the sector, or to do so consistent with cost causation. The first method, while commonly

applied, appears facially nondiscriminatory, but in reality may have consequences in terms of inadvertently impacting competition and may not send accurate price signals as regarding the actual costs of regulation. Imposing regulatory assessments only on bottleneck facilities is easy to administer and may or may not be by-passable, but also tends to distort price signals by cost socialization. The third option, specific allocation of costs on companies causing the work to be done is, of course, the fees methodology of raising revenues. While regulatory agency independence is a critically important element of effective regulation, it is largely a concept that applies to the substance of regulation. The issues involving financial operations of agencies, however, are generally subject to normal governmental controls and oversight related to overall levels of spending, fiscal controls, and operating efficiencies. Assuring proper use of funds, appropriate accounting, prudent management of resources, auditing activities, and the like are perfectly legitimate, and commonly accepted forms of governmental oversight of regulatory agencies. On the other hand, use of such oversight to punish or reward agencies for their substantive decisions would be improper. Similarly, a governmental use of regulatory agency powers or funding to meet general obligations of the government would be similarly inappropriate. Finally, in general, regulatory agencies, with the exception of those funded through general tax revenues, are generally funded through revolving accounts in which surpluses at the end of fiscal cycles are either returned to those who paid money in, or held in escrow for their future use. Even in those jurisdictions where surplus funds are returned to the treasury, governments generally do not rely on such windfalls and certainly do not plan on receiving them. Moreover, because the regulatory agencies do not have any liabilities that are demonstrably greater than other organs of the state, and because they often possess or can obtain special assessment powers for unforeseen, but perhaps, costly special projects, surplus funds or specialof regulatory agency budgets. contingency accounts are not typically part

A. Introduction This report was commissioned by the Public Utilities Commission of Anguilla as a part of a dialogue with the Government over the best way to finance and manage the budget of the agency. It is part of an effort by both the Commission and the Government of Anguilla to approach these questions in a thoughtful and informed way, as well as to assure that whatever decisions taken are consistent with best international standards and practice. The report is not designed to be an exhaustive survey of the international experience to date of regulatory agency funding and budgeting, but rather to be a representative sampling of the issues encountered in financing regulatory agencies. It purports to offer a sampling, through analysis, statutes, and anecdotal case experiences, of the options available to the Government as well as the policy questions that ought to be fully considered in deciding how best to approach agency funding questions. The report is designed to assist the agency and the Government to have a highly informed dialogue on the finance and budget questions before them. B. General Policy Considerations The funding and budgeting of independent regulatory agencies raise policy questions that are Some what different from those governing the funding of line government functions. To be sure, some of the issues are the same, for example: prioritizing missions, assuring adequacy of resources for performing responsibilities, maintaining budget accountability and oversight, managing resources efficiently, and adhering to strong ethical standards in regard to the stewardship of public resources. Unlike other government departments, however, regulatory agencies, because of their independence and high technical requirements, have characteristics unique to them for budget and finance purposes. While these unique policy considerations will be more fully discussed in the following four sections of the report, it is worth highlighting the issues of independence and high technical requirements. Because the economic sectors overseen by regulatory agencies require a large infusion of capital, and the investors who might provide that capital are highly sensitive to the investment environment, it is essential that the regulation be administered by highly competent professionals in ways which are reasonable, transparent, and pursuant to known, recognized, and reasonably predictable principles and rules. For most investors, that means that decisions are

made on a substantive merit basis and not based on short term political consideration. In order to provide that assurance, regulatory agencies are typically given a degree of independence in carrying out their responsibilities that other organs of the government do not enjoy. While the question of independence and its full meaning is a complicated subject on which much has been written, for purposes of this report, it is sufficient to note that the methods and practices employed in the financing of, and budgeting for, the agency should be mindful of the importance of the agencys independence and avoiding signals to investors or consumers of anything to the contrary. As will be noted below, the financial independence of regulatory agencies is a widespread, although by no means universal, practice. In specific regard to the high technical requirements, regulatory agencies have to compete in the same labor pool from which the private, regulated companies draw their talent. They also have to be able to procure and operate very sophisticated equipment and programs that allow them to keep pace with the companies they regulate. Any inability to recruit and retain highly qualified personnel, or to use required equipment, is highly likely to have adverse effects on the quality of consumer protection and effectiveness of regulation in general. Thus, in looking at finance and budget matters, it is essential to be mindful of the need for the agency to achieve and consistently maintain the requisite level of professional competence and technical capability. Coclution When a market is not competitive, there is a need for regulators. Their role is to balance the interests of various stakeholders. Business organizations can use a monopoly position to create extremely high added value for the benefit of their shareholders, employees etc. Customers need to be protected by limiting these monopoly powers. At the same time, it is necessary for the businesses to price their products at a sufficient margin. Regulatory bodies are established in countries according to the policy of the government with different types of authorities. Regulatory rules are designed to meet government objectives. Those rules should be understood by the regulator and the regulated industry. When the players in regulated market have significant market power, the regulator has to focus on price or tariff controls or control on quality of service. Certain social objectives such as availability and affordability of services to particular groups like disabled or people in rural areas, cannot be achieved from macroeconomic objectives of the government. Therefore regulatory bodies are established to control and monitor these areas. Actions can be taken by regulatory authorities to assist the development of market segments where there is scope for competition.

Objectives of regulatory authorities can be classified under the following:


y y y

To protect customers from monopoly power To promote social and macroeconomic objectives To promote competition

History The Reserve Bank of India is the central bank of the country. Central banks are a relatively recent innovation and most central banks, as we know them today, were established around the early twentieth century. The Reserve Bank of India was set up on the basis of the recommendations of the Hilton Young Commission. The Reserve Bank of India Act, 1934 (II of 1934) provides the statutory basis of the functioning of the Bank, which commenced operations on April 1, 1935.

Hilton Young Commission

Board of Directors

Share RBI RBI RBI Telegram Certificates Commencement Nationalisation History

The Bank was constituted to


y y y

Regulate the issue of banknotes Maintain reserves with a view to securing monetary stability and To operate the credit and currency system of the country to its advantage.

The Bank began its operations by taking over from the Government the functions so far being performed by the Controller of Currency and from the Imperial Bank of India, the management of Government accounts and public debt. The existing currency offices at Calcutta, Bombay, Madras, Rangoon, Karachi, Lahore and Cawnpore (Kanpur) became branches of the Issue Department. Offices of the Banking Department were established in Calcutta, Bombay, Madras, Delhi and Rangoon. Burma (Myanmar) seceded from the Indian Union in 1937 but the Reserve Bank continued to act as the Central Bank for Burma till Japanese Occupation of Burma and later upto April, 1947. After the partition of India, the Reserve Bank served as the central bank of Pakistan upto June 1948 when the State Bank of Pakistan commenced operations. The Bank, which was originally set up as a shareholder's bank, was nationalised in 1949.

An interesting feature of the Reserve Bank of India was that at its very inception, the Bank was seen as playing a special role in the context of development, especially Agriculture. When India commenced its plan endeavours, the development role of the Bank came into focus, especially in the sixties when the Reserve Bank, in many ways, pioneered the concept and practise of using finance to catalyse development. The Bank was also instrumental in institutional development and helped set up insitutions like the Deposit Insurance and Credit Guarantee Corporation of India, the Unit Trust of India, the Industrial Development Bank of India, the National Bank of Agriculture and Rural Development, the Discount and Finance House of India etc. to build the financial infrastructure of the country. With liberalisation, the Bank's focus has shifted back to core central banking functions like Monetary Policy, Bank Supervision and Regulation, and Overseeing the Payments System and onto developing the financial markets. A Brief History of Public Debt in India

An early debt instrument issued by the East India Company

An early debt instrument issued by the East India Company

A Government Promissory Note issued by the Princely State of Travancore

A Government Stock Certificate Issued by the Princely State of Hyderabad

Towards the eighteenth century, the borrowing needs of Indian Princely States were largely met by Indigenous bankers and financiers. The concept of borrowing from the public in India was pioneered by the East India Company to finance its campaigns in South India (the Anglo French wars) in the eighteenth century. The debt owed by the Government to the public, over time, came to be known as public debt. The endeavours of the Company to establish government banks towards the end of the 18th Century owed in no small measure to the need to raise term and short term financial accommodation from banks on more satisfactory terms than they were able to garner on their own. The incentive to set up Government banks (read central banks), had a lot to do with debt management. Public Debt, today, is raised to meet the Governments revenue deficits (the difference between the income of the government and money spent to run the government) or to finance public works (capital formation). Borrowing for financing railway construction and public works such irrigation canals was first undertaken in 1867. The First World War saw a rise in India's Public Debt as a result of India's contribution to the British exchequer towards the cost of the war. The provinces of British India were allowed to float loans for the first time in December, 1920 when local government borrowing rules were issued under section 30(a) of the Government of India Act, 1919. Only three provinces viz., Bombay, United Provinces and Punjab utilised this

sanction before the introduction of provincial autonomy. Public Debt was managed by the Presidency Banks, the Comptroller and Auditor-General of India till 1913 and thereafter by the Controller of the Currency till 1935 when the Reserve Bank commenced operations. Interest rates varied over time and after the uprising of 1857 gradually came down to about 5% and later to 4% in 1871. In 1894, the famous 3 1/2 % paper was created which continued to be in existence for almost 50 years. When the Reserve Bank of India took over the management of public debt from the Controller of the Currency in 1935, the total funded debt of the Central Government amounted to Rs 950 crores of which 54% amounted to sterling debt and 46% rupee debt and the debt of the Provinces amounted to Rs 18 crores. Broadly, the phases of public debt in India could be divided into the following phases. Upto 1867: when public debt was driven largely by needs of financing campaigns. 1867- 1916: when public debt was raised for financing railways and canals and other such purposes. 1917-1940: when public debt increased substantially essentially out of the considerations of 1940-1946: when because of war time inflation, the effort was to mop up as much a spossible of the current war time incomes 1947-1951: represented the interregnum following war and partition and the economy was unsettled. Government of India failed to achieve the estimates for borrwings for which credit had been taken in the annual budgets. 1951-1985: when borrowing was influenced by the five year plans. 1985-1991: when an attempt was made to align the interest rates on government securities with market interest rates in the wake of the recommendations of the Chakraborti Committee Report. 1991 to date: When comprehensive reforms of the Government Securities market were undertaken and an active debt management policy put in place. Ad Hoc Treasury bills were abolished; commenced the selling of securities through the auction process; new instruments were introduced such as zero coupon bonds, floating rate bonds and capital indexed bonds; the Securities Trading Corporation of India was established; a system of Primary Dealers in government securities was put in place; the spectrum of maturities was broadened; the system of Delivery versus payment was instituted; standard valuation norms were prescribed; and endeavours made to ensure transparency in operations through market process, the dissemination of information and efforts were made to give an impetus to the secondary market so as to broaden and deepen the market to make it more efficient. As at the end of March, 2003, it is estimated that the combined outstanding liabilities of the centre and state governments amounted to Rs 18 trillion which worked out to over 75 percent of the country's gross domestic product (GDP). In India and the world over, Government Bonds

have, from time to time, have not only adopted innovative methods for rasing resources (legalised wagering contracts like the Prize Bonds issued in the 1940s and later 1950s in India) but have also been used for various innovative schemes such as finance for development; social engineering like the abolition of the Zamindari system; saving the environment; or even weaning people away from gold (the gold bonds issued in 1993). Normally the sovereign is considered the best risk in the country and sovereign paper sets the benchmark for interest rates for the corresponding maturity of other issuing entities. Theoretically, others can borrow at a rate above what the Government pays depending on how their risk is perceived by the markets. Hence, a well developed Government Securities market helps in the efficient allocation of resources. A countrys debt market to a large extent depends on the depth of the Governments Bond Market. It in in this context that the recent initiatives to widen and deepen the Government Securities Market and to make it more efficient have been taken.

Premium Prize Bonds issued by Government of India

The Finance Minister inaugurating the Premium Prize Bonds

The Bihar Zamindari Abolition Compensation Bonds represented the use of Government Bonds to help undertake social engineering initiatives.

Brief History of Deposit Insurance in India The Corporate Logo of the Deposit Insurance Corporation as it appeared on the first Annual Report. The PDF file of the first annual report (3.8 MB)

Deposit insurance, as we know it today, was introduced in India in 1962. India was the second country in the world to introduce such a scheme - the first being the United States in 1933. Banking crises and bank failures in the 19th as well as the early 20th Century (1913-14) had, from time to time, underscored the need for depositor protection in India. After the setting up of the Reserve Bank of India, the issue came to the fore in 1938 when the Travancore National and Quilon Bank, the largest bank in the Travancore region, failed. As a result, interim measures relating to banking legislation and reform were instituted in the early 1940s. The banking crisis in Bengal between 1946 and 1948, once again revived the issue of deposit insurance. It was, however, felt that the measures be held in abeyance till the Banking Companies Act, 1949 came

into force and comprehensive arrangements were made for the supervision and inspection of banks by the Reserve Bank.

It was in 1960 that the failure of Laxmi Bank and the subsequent failure of the Palai Central Bank catalyzed the introduction of deposit insurance in India. The Deposit Insurance Corporation (DIC) Bill was introduced in the Parliament on August 21, 1961 and received the assent of the President on December 7, 1961. The Deposit Insurance Corporation commenced functioning on January 1, 1962 .

The Deposit Insurance Scheme was initially extended to functioning commercial banks. Deposit insurance was seen as a measure of protection to depositors, particularly small depositors, from the risk of loss of their savings arising from bank failures. The purpose was to avoid panic and to promote greater stability and growth of the banking system - what in todays argot are termed financial stability concerns. In the 1960s, it was also felt that an additional the purpose of the scheme was to increase the confidence of the depositors in the banking system and facilitate the mobilisation of deposits to catalyst growth and development.

When the DIC commenced operations in the early 1960s, 287 banks registered with it as insured banks. By the end of 1967, this number was reduced to 100, largely as a result of the Reserve Bank of Indias policy of the reconstruction and amalgamation of small and financially weak banks so as to make the banking sector more viable. In 1968, the Deposit Insurance Corporation Act was amended to extend deposit insurance to 'eligible co-operative banks'. The process of extention to cooperative banks, however took a while it was necessary for state governments to amend their cooperative laws. The amended laws would enable the Reserve Bank to order the Registrar of Co-operative Societies of a State to wind up a co-operative bank or to supersede its Committee of Management and to require the Registrar not to take any action for winding up, amalgamation or reconstruction of a co-operative bank without prior sanction in writing from the Reserve Bank of India. Enfolding the cooperative banks had implications for the DIC - in 1968 there were over 1000 cooperative banks as against the 83 commercial banks that were in its fold. As a result, the DIC had to expand its operations very considerably.

The 1960s and 1970s were a period of institution building. 1971 witnessed the establishment of another institution, the Credit Guarantee Corporation of India Ltd. (CGCI). While Deposit Insurance had been introduced in India out of concerns to protect depositors, ensure financial stability, instill confidence in the banking system and help mobilise deposits, the establishment of the Credit Guarantee Corporation was essentially in the realm of affirmative action to ensure that the credit needs of the hitherto neglected sectors and weaker sections were met. The essential concern was to persuade banks to make available credit to not so creditworthy clients.

In 1978, the DIC and the CGCI were merged to form the Deposit Insurance and Credit Guarantee Corporation (DICGC). Consequently, the title of Deposit Insurance Act, 1961 was changed to the Deposit Insurance and Credit Guarantee Corporation Act, 1961. The merger was with a view to integrating the functions of deposit insurance and credit guarantee prompted in no small measure by the financial needs of the erstwhile CGCI.

After the merger, the focus of the DICGC had shifted onto credit guarantees. This owed in part to the fact that most large banks were nationalised. With the financial sector reforms undertaken in the 1990s, credit guarantees have been gradually phased out and the focus of the Corporation is veering back to its core function of Deposit Insurance with the objective of averting panics, reducing systemic risk, and ensuring financial stability. Brief History of Urban Cooperative Banks in India

The term Urban Co-operative Banks (UCBs), though not formally defined, refers to primary cooperative banks located in urban and semi-urban areas. These banks, till 1996, were allowed to lend money only for non-agricultural purposes. This distinction does not hold today. These banks were traditionally centred around communities, localities work place groups. They essentially lent to small borrowers and businesses. Today, their scope of operations has widened considerably.

The origins of the urban cooperative banking movement in India can be traced to the close of nineteenth century when, inspired by the success of the experiments related to the cooperative movement in Britain and the cooperative credit movement in Germany such societies were set up in India. Cooperative societies are based on the principles of cooperation, - mutual help, democratic decision making and open membership. Cooperatives represented a new and alternative approach to organisaton as against proprietary firms, partnership firms and joint stock companies which represent the dominant form of commercial organisation.

The Beginnings

The first known mutual aid society in India was probably the Anyonya Sahakari Mandali organised in the erstwhile princely State of Baroda in 1889 under the guidance of Vithal Laxman also known as Bhausaheb Kavthekar. Urban co-operative credit societies, in their formative

phase came to be organised on a community basis to meet the consumption oriented credit needs of their members. Salary earners societies inculcating habits of thrift and self help played a significant role in popularising the movement, especially amongst the middle class as well as organized labour. From its origins then to today, the thrust of UCBs, historically, has been to mobilise savings from the middle and low income urban groups and purvey credit to their members - many of which belonged to weaker sections.

The enactment of Cooperative Credit Societies Act, 1904, however, gave the real impetus to the movement. The first urban cooperative credit society was registered in Canjeevaram (Kanjivaram) in the erstwhile Madras province in October, 1904. Amongst the prominent credit societies were the Pioneer Urban in Bombay (November 11, 1905), the No.1 Military Accounts Mutual Help Co-operative Credit Society in Poona (January 9, 1906). Cosmos in Poona (January 18, 1906), Gokak Urban (February 15, 1906) and Belgaum Pioneer (February 23, 1906) in the Belgaum district, the Kanakavli-Math Co-operative Credit Society and the Varavade Weavers Urban Credit Society (March 13, 1906) in the South Ratnagiri (now Sindhudurg) district. The most prominent amongst the early credit societies was the Bombay Urban Co-operative Credit Society, sponsored by Vithaldas Thackersey and Lallubhai Samaldas established on January 23, 1906..

The Cooperative Credit Societies Act, 1904 was amended in 1912, with a view to broad basing it to enable organisation of non-credit societies. The Maclagan Committee of 1915 was appointed to review their performance and suggest measures for strengthening them. The committee observed that such institutions were eminently suited to cater to the needs of the lower and middle income strata of society and would inculcate the principles of banking amongst the middle classes. The committee also felt that the urban cooperative credit movement was more viable than agricultural credit societies. The recommendations of the Committee went a long way in establishing the urban cooperative credit movement in its own right.

In the present day context, it is of interest to recall that during the banking crisis of 1913-14, when no fewer than 57 joint stock banks collapsed, there was a there was a flight of deposits from joint stock banks to cooperative urban banks. Maclagan Committee chronicled this event thus:

As a matter of fact, the crisis had a contrary effect, and in most provinces, there was a movement to withdraw deposits from non-cooperatives and place them in cooperative institutions, the distinction between two classes of security being well appreciated and a preference being given to the latter owing partly to the local character and publicity of

cooperative institutions but mainly, we think, to the connection of Government with Cooperative movement.

Under State Purview

The constitutional reforms which led to the passing of the Government of India Act in 1919 transferred the subject of Cooperation from Government of India to the Provincial Governments. The Government of Bombay passed the first State Cooperative Societies Act in 1925 which not only gave the movement its size and shape but was a pace setter of cooperative activities and stressed the basic concept of thrift, self help and mutual aid. Other States followed. This marked the beginning of the second phase in the history of Cooperative Credit Institutions.

There was the general realization that urban banks have an important role to play in economic construction. This was asserted by a host of committees. The Indian Central Banking Enquiry Committee (1931) felt that urban banks have a duty to help the small business and middle class people. The Mehta-Bhansali Committee (1939), recommended that those societies which had fulfilled the criteria of banking should be allowed to work as banks and recommended an Association for these banks. The Co-operative Planning Committee (1946) went on record to say that urban banks have been the best agencies for small people in whom Joint stock banks are not generally interested. The Rural Banking Enquiry Committee (1950), impressed by the low cost of establishment and operations recommended the establishment of such banks even in places smaller than taluka towns.

The first study of Urban Co-operative Banks was taken up by RBI in the year 1958-59. The Report published in 1961 acknowledged the widespread and financially sound framework of urban co-operative banks; emphasized the need to establish primary urban cooperative banks in new centers and suggested that State Governments lend active support to their development. In 1963, Varde Committee recommended that such banks should be organised at all Urban Centres with a population of 1 lakh or more and not by any single community or caste. The committee introduced the concept of minimum capital requirement and the criteria of population for defining the urban centre where UCBs were incorporated.

Duality of Control

However, concerns regarding the professionalism of urban cooperative banks gave rise to the view that they should be better regulated. Large cooperative banks with paid-up share capital and reserves of Rs.1 lakh were brought under the perview of the Banking Regulation Act 1949 with effect from 1st March, 1966 and within the ambit of the Reserve Banks supervision. This marked the beginning of an era of duality of control over these banks. Banking related functions (viz. licensing, area of operations, interest rates etc.) were to be governed by RBI and registration, management, audit and liquidation, etc. governed by State Governments as per the provisions of respective State Acts. In 1968, UCBS were extended the benefits of Deposit Insurance.

Towards the late 1960s there was much debate regarding the promotion of the small scale industries. UCBs came to be seen as important players in this context. The Working Group on Industrial Financing through Co-operative Banks, (1968 known as Damry Group) attempted to broaden the scope of activities of urban co-operative banks by recommending that these banks should finance the small and cottage industries. This was reiterated by the Banking Commisssion (1969).

The Madhavdas Committee (1979) evaluated the role played by urban co-operative banks in greater details and drew a roadmap for their future role recommending support from RBI and Government in the establishment of such banks in backward areas and prescribing viability standards.

The Hate Working Group (1981) desired better utilisation of banks' surplus funds and that the percentage of the Cash Reserve Ratio (CRR) & the Statutory Liquidity Ratio (SLR) of these banks should be brought at par with commercial banks, in a phased manner. While the Marathe Committee (1992) redefined the viability norms and ushered in the era of liberalization, the Madhava Rao Committee (1999) focused on consolidation, control of sickness, better professional standards in urban co-operative banks and sought to align the urban banking movement with commercial banks.

A feature of the urban banking movement has been its heterogeneous character and its uneven geographical spread with most banks concentrated in the states of Gujarat, Karnataka, Maharashtra, and Tamil Nadu. While most banks are unit banks without any branch network, some of the large banks have established their presence in many states when at their behest multi-state banking was allowed in 1985. Some of these banks are also Authorised Dealers in Foreign Exchange

Recent Developments Over the years, primary (urban) cooperative banks have registered a significant growth in number, size and volume of business handled. As on 31st March, 2003 there were 2,104 UCBs of which 56 were scheduled banks. About 79 percent of these are located in five states, - Andhra Pradesh, Gujarat, Karnataka, Maharashtra and Tamil Nadu. Recently the problems faced by a few large UCBs have highlighted some of the difficulties these banks face and policy endeavours are geared to consolidating and strengthening this sector and improving governance. Early Issues Paper Money, as we know it today, was introduced in India in the late Eighteenth Century. This was a period of intense political turmoil and uncertainty in the wake of the collapse of the Mughal Empire and the advent of the colonial powers. The changed power structure, the upheavals, wars, and colonial inroads led to the eclipse of indigenous bankers, as large finance in India moved from their hands to Agency Houses who enjoyed state patronage. Many agency houses established banks. Among the early issuers, the General Bank of Bengal and Bahar (1773-75) was a state sponsored institution set up in participation with local expertise. Its notes enjoyed government patronage. Though successful and profitable, the bank was officially wound up and was short lived. The Bank of Hindostan (1770-1832) was set up by the agency house of Alexander and Company was particularly successful. It survived three panic runs on it. The Bank of Hindostan finally went under when its parent firm M/s Alexander and Co. failed in the commercial crisis of 1832. Official patronage and the acceptance of notes in the payment of revenue was a very important factor in determining the circulation of bank notes. Wide use of bank notes, however, came with the note issues of the semi-government Presidency Banks, notably the Bank of Bengal which was established in 1806 as the Bank of Calcutta with a capital of 50 lakh sicca rupees. These banks were established by Government Charters and had an intimate relationship with the Government. The charter granted to these banks accorded them the privilege of issuing notes for circulation within their circles. Notes issued by the Bank of Bengal can broadly be categorised in 3 broad series viz: the 'Unifaced' Series, the 'Commerce' Series and the 'Britannia' Series. The early notes of the Bank of Bengal were unifaced and were issued as one gold mohur (sixteen sicca rupees in Calcutta) and in denominations deemed convenient in the early 19th Century, viz., Rs. 100, Rs. 250, Rs. 500, etc.

Unifaced Notes of the Bank of Bengal The Bank of Bengal notes later introduced a vignette represented an allegorical female figure personifying 'Commerce' sitting by the quay. The notes were printed on both sides. On the obverse the name of the bank and the denominations were printed in three scripts, viz., Urdu, Bengali and Nagri. On the reverse of such notes was printed a cartouche with ornamentation carrying the name of the Bank. Around the mid nineteenth century, the motif 'Commerce' was replaced by 'Britannia'. The note had intricate patterns and multiple colours to deter forgeries.

Commerce Series

Brittania Series The second Presidency Bank was established in 1840 in Bombay, which had developed as major commercial centre. The Bank had a checkered history. The crisis resulting from the end of the

speculative cotton boom led to the liquidation of Bank of Bombay in 1868. It was however reconstituted in the same year. Notes issued by the Bank of Bombay carried the vignettes of the Town Hall and others the statues of Mountstuart Elphinstone and John Malcolm.

Note issued by the Bank of Bombay The Bank of Madras established in 1843 was the third Presidency Bank. It had the smallest issue of bank notes amongst Presidency Banks. The notes of the Bank of Madras bore the vignette of Sir Thomas Munroe, Governor of Madras (1817-1827). The other private banks which issued bank notes were the Orient Bank Corporation established in Bombay as the Bank of Western India in 1842. Its notes featured the Bombay Town Hall as vignette. The Commercial Bank of India established in 1845 in Bombay (also an Exchange Bank) issued exotic notes with an interblend of Western and Eastern Motifs. The bank failed in the crash of 1866. The paper currency Act of 1861 divested these banks of the right to note issue; the Presidency Banks were, however, given the free use of Government balances and were initially given the right to manage the note issues of Government of India.
Draft Guidelines for Licensing of New Banks in the Private Sector

Over the last two decades, the Reserve Bank licensed twelve banks in the private sector. This happened in two phases. Ten banks were licensed on the basis of guidelines issued in January 1993. The guidelines were revised in January 2001 based on the experience gained from the functioning of these banks, and fresh applications were invited. The applications received in response to this invitation were vetted by a High Level Advisory Committee constituted by the Reserve Bank, and two more licences were issued.

The January 2001 guidelines indicated that the Reserve Bank will consider licensing more banks after three years following a review of the working of the private sector banks. However, this was deferred owing to a variety of factors including our experience with the new banks and the fact that the banking sector was going through a phase of consolidation.

Finance Ministers Budget Announcement

The Finance Minister made the following announcement in his budget speech for 2010-11 with regard to licensing of new banks:

The Indian banking system has emerged unscathed from the crisis. We need to ensure that the banking system grows in size and sophistication to meet the needs of a modern economy. Besides, there is a need to extend the geographic coverage of banks and improve access to banking services. In this context, I am happy to inform the Honourable Members that the RBI is considering giving some additional banking licences to private sector players. Non Banking Financial Companies could also be considered, if they meet the RBIs eligibility criteria.

In pursuance of the budget announcement, the Reserve Bank put out a Discussion Paper on its website in August 2010 inviting feedback and comments. The Discussion Paper marshalled international practices, Indian experience, as well as the extant ownership and governance (O&G) guidelines.

The Discussion Paper covered a swathe of issues. Important among them are the following :

Eligibility criteria for applicants including importantly whether corporates be made eligible, and if so under what safeguards?

Should Non-Banking Financial Companies be allowed to convert themselves into banks or promote new banks?

What should be the appropriate entry level capital to attract serious players committed to financial inclusion?

What should be the level of promoters shareholdings at the initial formative stage of the bank and what should be the level of promoters holding in the long run to ensure diversified ownership? What should be the time frame for dilution?

With the objective of creating strong domestic banks, what should be the level of foreign shareholding in the initial stages and within what time frame the extant FDI rules should become applicable?

The Discussion Paper elicited wide response from the general public, consultants, existing banks, industrial and business houses, Non-Banking Financial Companies, Micro Finance Institutions, etc. through emails and letters. There was also extensive discussion in the media through analytical pieces as well as editorial opinion. The Reserve Bank also held discussions with important stakeholders viz. Confederation of Indian Industry (CII), Finance Industry Development Council (FIDC), Indian Banks Association (IBA), The Associated Chambers of Commerce and Industry of India (ASSOCHAM), Federation of Indian Chambers of Commerce & Industry (FICCI), Indian Merchant Chambers (IMC), Micro Finance Institutions Network (MFIN), Consultants, All India RRB Officers Federation, etc. on October 7 and 8, 2010. The gist of these comments and discussions was placed on the Reserve Banks website on December 23, 2010.

The present draft guidelines on Licensing of New Banks in the Private Sector have been framed taking into account the experience gained from the functioning of the banks licensed under the guidelines of 1993 and 2001 and the feedback and suggestions received in response to the Discussion Paper.

It may be pertinent to mention that certain amendments to the Banking Regulation Act, 1949 are under consideration of the Government of India including a few which are vital for finalization and implementation of the policy for licensing of new banks in the private sector. These vital amendments are: removal of restriction of voting rights and concurrently empowering RBI to approve acquisition of shares and/or voting rights of 5% or more in a bank to persons who are fit and proper; empowering RBI to supersede the Board of Directors of a bank so as to protect depositors interest; and facilitating consolidated supervision. The final guidelines will be issued and the process of inviting applications for setting up of new banks in the private sector will be initiated only after the Banking Regulation Act is amended as above.

2. Guidelines

(A) Eligible promoters

Only entities / groups in the private sector that are owned and controlled by residents shall be eligible to promote banks.

Promoters / promoter groups with diversified ownership, sound credentials and integrity that have a successful track record for at least 10 years in running their businesses shall be eligible to promote banks. RBI may seek feedback on applicants on these aspects from other regulators and enforcement and investigative agencies like Income Tax, CBI, Enforcement Directorate, etc. as appropriate.

Banking is essentially based on fiduciary principles as depositors money is involved. It therefore becomes imperative that the fit and proper assessment framework for bank promoters is much more comprehensive in scope as compared to other sectors. Any such framework also needs to look into the nature of activities the promoter group of the bank is predominantly engaged in. There are certain activities, such as real estate and capital market activities, in particular broking activities which, apart from being inherently riskier, represent a business model and business culture which are quite misaligned with a banking model. Post-crisis, there are concerted moves even internationally to separate banking from proprietary trading. More importantly, in India, past experience with brokers on the boards of banks has not been satisfactory. It will therefore be necessary to ensure that any entity/ group undertaking such activities on a significant scale is not considered for a bank licence. Otherwise there will be real risks of the same business approach getting transmitted to the banks as well and it will be difficult to address this only through regulations. Accordingly, entities/groups that have significant (10% or more) income or assets or both from/ in such activities, including real estate construction and broking activities taken together in the last three years, shall not be eligible to promote banks.

Applicants will be required to list group companies undertaking key business activities.

(B) Corporate structure

Promoter / promoter groups will be permitted to set up a new bank only through a whollyowned Non-Operative Holding Company (NOHC) which will hold the bank as well as all the other financial services companies regulated by RBI or other financial sector regulators. The objective is that the Holding Company should ring fence the regulated financial services

activities of the group including the new bank from other activities of the group i.e., commercial, industrial and financial activities not regulated by financial sector regulators. Thus, only nonfinancial services companies / entities and individuals belonging to the promoter group will be allowed to hold shares in the NOHC. Financial services companies belonging to the promoter group would be held by the NOHC and would not have shareholding in it.

The NOHC will be registered as a non-banking finance company (NBFC) with the Reserve Bank and will be governed by a separate set of prudential guidelines.

The NOHC will not be permitted to borrow funds for investing in companies held by it. It will just be a vehicle to hold the investments in all regulated financial sector entities on behalf of the promoter/promoter group for regulatory and prudential comfort.

(C) Minimum capital requirements and holding by NOHC

The initial minimum paid-up capital for a new bank shall be `500 crore. The actual capital to be brought in will depend on the business plan of the promoters.

The NOHC shall hold a minimum of 40% of the paid-up capital of the bank which shall be locked in for a period of five years from the date of licensing of the bank.

Shareholding by NOHC in the bank in excess of 40% of the total paid-up capital shall be brought down to 40% within two years from the date of licensing of the bank.

In the event of the bank raising further capital during the first five years from the date of licensing, the NOHC should continue to hold 40% of the enhanced capital of the bank for a period of five years from the date of licensing of the bank. Capital, other than the holding by NOHC, could be raised through public issue or private placements.

The shareholding by NOHC shall be brought down to 20% of the paid up capital of the bank within a period of 10 years and to 15% within 12 years from the date of licensing of the bank and retained at that level thereafter.

(D) Foreign shareholding in the bank

The aggregate non-resident shareholding from FDI, NRIs and FIIs in the new private sector banks shall not exceed 49% for the first 5 years from the date of licensing of the bank. No nonresident shareholder, directly or indirectly, individually or in groups, will be permitted to hold 5% or more of the paid up capital of the bank. After the expiry of 5 years from the date of licensing of the bank, the foreign shareholding would be as per the extant policy. Currently, foreign shareholding in private sector banks is allowed up to a ceiling of 74% of the paid up capital.

(E) Corporate governance

To ensure sound corporate governance, it would be required that at least 50% of the Directors of the NOHC should be totally independent of the promoter / promoter group entities, their business associates, and their customers and suppliers.

No financial services entity under the NOHC would be allowed to engage in any activity that a bank is permitted to undertake departmentally. All such activities, if any, will have to be moved to the new bank subject to such conditions as RBI may specify.

RBI will have to be satisfied that the corporate structure does not impede the financial services under the NOHC from being ring fenced, that it would be able to supervise the bank and the NOHC on a consolidated basis, and that it will be able to obtain all required information from the group relevant for this purpose smoothly and promptly.

Ownership and management should be separate and distinct in the promoter / promoter group entities that own or control the NOHC. The management should be professional with adequate corporate governance standards.

The source of promoters / promoter groups equity in the NOHC should be transparent and verifiable.

(F) Business model

Applicants for new bank licences will be required to forward their business plan for the new banks along with their applications. The business models will have to address how the bank proposes to achieve financial inclusion.

The business model submitted by the applicant should be realistic and viable. In case of deviation from the stated business plan after issue of licence, RBI may consider restricting the banks expansion, effecting change in management and imposing other penal measures as may be necessary.

(G) Other conditions

Shareholding of 5% or more of the paid up capital of the bank by individuals / entities / groups will be subject to prior approval of RBI.

No single entity or group of related entities, other than the NOHC, shall have shareholding or control, directly or indirectly, in excess of 10% of the paid up capital of the bank.

The bank shall maintain arms length relationship with promoter group entities, their business associates, and the suppliers and customers of these entities. The exposure of the bank to any entity in the promoter group shall not exceed 10% and the aggregate exposure to all the entities in the group shall not exceed 20%, of the paid-up Capital and Reserves of the bank, subject to compliance with the provisions of Section 20 of the Banking Regulation Act, 1949. All exposures to promoter group entities will have to be approved by the Board.

In taking a view on whether an entity belongs to a particular promoter group or not or whether the entities are linked / related to the promoter group, the decision of RBI shall be final.

The top management of the bank shall have expertise in the financial sector, preferably, banking.

The bank should operate on Core Banking Solution (CBS) from the beginning.

The bank shall make full use of modern infrastructural facilities in office equipments, computer, telecommunications etc. in order to provide cost-effective customer service. It should have a high powered Customer Grievances Cell to handle customer complaints.

The bank shall get its shares listed on the stock exchanges within two years of licensing of the bank.

The bank shall be required to maintain a minimum capital adequacy ratio of 12% for a minimum period of 3 years after the commencement of its operations subject to such higher percentage as may be prescribed by RBI from time to time. The bank shall comply with the priority sector lending targets and sub-targets as applicable to other domestic banks, and

The bank shall open at least 25 per cent of its branches in unbanked rural centres (population up to 9,999 as per 2001 census) to avoid over concentration of their branches in metropolitan areas and cities which are already having adequate banking presence.

The promoters, their group entities, NOHC and the proposed bank shall be subject to the system of consolidated supervision by the Reserve Bank of India.

The NOHC shall not be permitted to set up any new financial services entity for at least three years from the date of licensing.

The bank will be governed by the provisions of the Banking Regulation Act, 1949, Reserve Bank of India Act, 1934, other relevant Statutes and the Directives, Prudential regulations and other Guidelines/Instructions issued by RBI and other regulators, including the regulations of SEBI regarding public issues and other guidelines applicable to listed banking companies.

The promoter / promoter group with an existing NBFC, if considered eligible for a bank licence, will have two options:

(a) Promote a new bank, if some or all the activities undertaken by it are not permitted to be undertaken by banks departmentally. In such cases, the activities undertaken by the NBFC which banks are allowed to undertake departmentally, will have to be transferred to the new bank, or

(b) Convert itself into a bank, if all the activities undertaken by it are allowed to be undertaken by a bank departmentally.

Under both options, the promoters will have to first set up a NOHC. Reserve Bank will consider allowing the new bank to take over and convert the existing NBFC branches into bank branches only in the Tier 3 to 6 centres. Existing branches of the NBFC in Tier 1 and 2 centres may be allowed to convert into bank branches only with the prior approval of RBI and subject to the existing rules / methodology applicable to domestic banks regarding opening of branches in these centres and also subject to maintaining 25% of the bank branches in unbanked rural centres (population up to 9,999 as per 2001 census) required of all new banks as specified in G(x) (b) above.

(H) Additional considerations in respect of promoter groups having 40% or more assets / income from non financial business

(a) In respect of promoter groups having 40% or more assets / income from non financial business, the following additional requirements will be applicable:

(i) The Board of the bank should have a majority of independent Directors.

(ii) The exposure of the bank to any entity in the promoter group, their business associates, major suppliers and customers shall not exceed 10% and aggregate exposure to such entities shall not exceed 20% of the paid up Capital and Reserves of the bank, subject to compliance with the provisions of Section 20 of the Banking Regulation Act, 1949. All exposures will have to be approved by the Board and all credit facilities to these entities should have a minimum tangible security cover of 150%.

(iii) The bank will have to file a return, certified by statutory auditors, on quarterly basis of all exposures including credit facilities extended to the entities in the promoter group, their business associates, and major suppliers and customers for amounts in excess of `1 crore.

(iv) Banks would be required to seek prior approval of RBI for raising paid-up capital beyond ` 1000 crore for every block of `500 crore. While examining such proposals, the RBI shall primarily look into whether the bank has indulged in connected lending and self dealing, whether the corporate governance standards are adequate, whether information from promoter group has been forthcoming to facilitate consolidated supervision and whether the Board members remain Fit and Proper.

(b) If RBI is not satisfied about compliance with the above provisions, it would take severe deterrent action as per law and licensing conditions.

3. Procedure for RBI decisions

In view of the increasing emphasis on stringent prudential norms, transparency, disclosure requirements and modern technology, the new banks need to have strength and efficiency to work profitably in a highly competitive environment.

Banking being a highly leveraged business, licences shall be issued on a very selective basis to those who conform to the above requirements, who have an impeccable track record and who are likely to conform to the best international and domestic standards of customer service and efficiency. Therefore, it may not be possible for Reserve Bank to issue licences to all the applicants meeting the eligibility criteria prescribed above.

At the first stage, the applications will be screened by RBI to ensure prima facie eligibility of the applicants. RBI may apply additional criteria to determine the suitability of applications, in addition to the minimum criteria prescribed at 2(A). Thereafter, the applications will be referred to a High Level Advisory Committee to be set up by RBI.

The High Level Advisory Committee will comprise eminent personalities with experience in banking, financial sector and other relevant areas.

The High Level Advisory Committee will set up its own procedures for screening the applications. The Committee will reserve the right to call for more information as well as have discussions with any applicant/s and seek clarification on any issue as required by it. The Committee will submit its recommendations to RBI for consideration. The decision to issue an in-principle approval for setting up of a bank will be taken by RBI. RBIs decision will be final.

In order to ensure transparency, the names of the applicants and all details submitted along with the application for new bank licences will be placed on the RBI website.

The validity of the in-principle approval issued by RBI will be one year from the date of granting in-principle approval and would thereafter lapse automatically. Therefore, the bank will have to be set up within one year of granting the in-principle approval.

After issue of the in-principle approval for setting up of a bank, if any adverse features are noticed subsequently regarding the promoters or the companies/firms with which the promoters are associated and the group in which they have interest, the Reserve Bank of India may impose additional conditions and if warranted, it may withdraw the in-principle approval.

10. Conclusion on rbi Every authority concerned with Co-operative sector will have to play its part in ensuring that the aspirations of the Urban Co-operative Banking sector are nurtured in a manner that depositor interest and the public interest at large is protected. The role of RBI could, thus, be to frame a regulatory and supervisory regime that is multi-layered to capture the heterogeneity of the sector and implement policies that would provide adequate elbowroom for the sector to grow in a nondisruptive manner. The State and Central Governments could recognize that the UCBs are not just co-operative societies but they are essentially banking entities whose management structure is that of a co-operative. They should recognize the systemic impact that inefficient functioning of the entities in the sector could have. Consequently, it would be in the interest of the sector if they support, facilitate and empower the RBI to put in place mechanisms and systems that would enable these UCBs to perform their banking functions in a manner that is in the overall interest of the depositor and the public at large. Overveiw The origins of the Reserve Bank of India can be traced to 1926, when the Royal Commission on Indian Currency and Finance also known as the Hilton-Young Commission recommended the creation of a central bank for India to separate the control of currency and credit from the Government and to augment banking facilities throughout the country. The Reserve Bank of India Act of 1934 established the Reserve Bank and set in motion a series of actions culminating in the start of operations in 1935. Since then, the Reserve Banks role and functions have undergone numerous changes, as the nature of the Indian economy and financial sector changed. Originse of RBI 1926: The Royal Commission on Indian Currency and Finance recommended creation of a central bank for India. 1927: A bill to give effect to the above recommendation was introduced in the Legislative Assembly, but was later withdrawn due to lack of agreement among various sections of people.

1933: The White Paper on Indian Constitutional Reforms recommended the creation of a Reserve Bank. A fresh bill was introduced in the Legislative Assembly. 1934: The Bill was passed and received the Governor Generals assent 1935: The Reserve Bank commenced operations as Indias central bank on April 1 as a private shareholders bank with a paid up capital of rupees five crore (rupees fifty million). 1942: The Reserve Bank ceased to be the currency issuing authority of Burma (now Myanmar). 1947: The Reserve Bank stopped acting as banker to the Government of Burma. 1948: The Reserve Bank stopped rendering central banking services to Pakistan. 1949: The Government of India nationalised the Reserve Bank under the Reserve Bank (Transfer of Public Ownership) Act, 1948.
Starting as a private shareholders bank, the Reserve Bank was nationalised in 1949. It then assumed the responsibility to meet the aspirations of a newly independent country and its people. The Reserve Banks nationalisation aimed at achieving coordination between the policies of the government and those of the central bank. The functions of the Reserve Bank today can be categorised as follows: Monetary policy Regulation and supervision of the banking and non-banking financial institutions, including credit information companies Regulation of money, forex and government securities markets as also certain financial derivatives Debt and cash management for Central and State Governments Management of foreign exchange reserves Foreign exchange managementcurrent and capital account management Functions of the Reserve Bank

Box 2 Box 1 9 The Preamble to the Reserve Bank of India Act, 1934 (the Act), under which it was constituted, specifies its objective as to regulate the issue of Bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage. The objectives outlined in the Preamble hold good even after 75 years. As evident from the multifaceted functions that the Reserve Bank performs today, its role and priorities have, in the span of 75 years, changed in tandem with changing national priorities and global developments. Essentially, the Reserve Bank has demonstrated dynamism and flexibility to meet the requirements of an evolving economy. A core function of the Reserve Bank in the last 75 years has been the formulation and implementation of monetary policy with the objectives of maintaining price stability and ensuring adequate flow of credit to productive sectors of the economy. To these was added, in more recent times, the goal of maintaining financial stability. The objective of maintaining financial stability has spanned its role from external account management to oversight of banks and non-banking financial institutions as also of money, government securities and foreign exchange markets. The Reserve Bank designs and implements the regulatory policy framework for banking and non-banking financial institutions with the aim of providing people access to the banking system, protecting depositors interest, and maintaining the overall health of the financial system. Its function of regulating the commercial banking sector, which emerged with the enactment of the Banking Regulation Act, 1949, has over time, expanded to cover other entities. Thus, amendments to the Banking Regulation Act, 1949 brought cooperative banks and regional rural banks under the Reserve Banks jurisdiction, while amendments to the Reserve Bank of India Act saw development finance institutions, non-banking financial companies Banker to banks Banker to the Central and State Governments Oversight of the payment and settlement systems Currency management Developmental role Research and statistics