SLIDE 2B

THE BANK REGULATORY

ENVIRONMENT

The Bank Regulatory

Environment
Outline/Learning Objectives :

Importance of Banks in the economy

Basic Principles of Banking
Why banks are regulated?
Why do banks fail?
Banking Sector Reforms in India
Banking Laws & Regulations
Key Words/Terminologies/Glossary.

Importance of Banks in an Economy

Banks are important economic institutions chanellising savings
into productive investments, act as catalyst in economic
development and capital formation
Banks are custodians of public money
Bulk of the funds of the bank are deposits from public which are
unsecured borrowings hence banks are highly leveraged
institutions (size of bank capital is very small)
A failure of a bank will have a domino or cascading effect on
the whole banking and financial system (because of
interconnected/inter-bank lending and borrowing) leading to
systemic crisis/collapse of the banking and financial system and
possible social anarchy
In a globalised economy, banks are susceptible to wide spread
risk

BASIC PRINCIPLES OF BANKING

Principle of Intermediation
Principle of Prudence
Principle of Liquidity
Principle of Profitability
Principle of Solvency
Principle of Trust

Why are banks regulated? - 1

A reasonable regulation of banking system is essential to
check the imprudence of the players which can erode the
confidence of the public in the banking system. The financial
system deals with peoples money and it is necessary to
generate, maintain, and promote the confidence and trust of
the people in the banking system at all times and with great
care by preventing and curbing all possibilities of misuse and
even imprudence by any of the players of the financial
system. Thus, the rationale behind the regulation of the
financial/banking system is :

Why are banks regulated? - 2

To Prevent disruption of the economy

Prudential regulation to ensure safety and soundness : KYC-AML
Norms for Opening Deposit Account and Giving Loans, Lending
Norms/Loan Policy, Prudential Credit and Capital Market Exposure
Norms
Prevent large scale failures that would affect economic activity
Reduce systemic risk wherein bank failures are potentially contagious.
Such shocks could be domestic or international in scope.
To generate, maintain and promote confidence and trust of the public in
the financial/banking system
To protect investors/depositors interests by adequate/timely disclosure
by the institutions and access to information by the investors/depositors :
Norms on Disclosure and Transparency of Balance Sheet and Income
Statement
To ensure macroeconomic and financial market stability

Why are banks regulated? - 3

To Prevent disruption of the economy

To ensure that financial markets/Institutions/Banking System are both fair,
efficient, fundamentally strong, sound/healthy and resilient to absorb/withstand
any unexpected shocks : Prudential Norms on Capital Adequacy and Accounting
for Income recognition, Asset classification & Provisioning
To prevent unfair practices to protect the interests of the ultimate suppliers
(depositors) and users of savings (borrowers) : Fair Practices codes for
Depositors & Borrowers
To ensure that the participants measure up to the rules of the market place
Guard against deposit insurance losses
Protect small depositors by providing government deposit insurance (FDIC)
Moral hazard problem of deposit insurance causes banks to have incentives to
take risks with potential losses borne by the government.
Achieve desired social goals
Prevent discrimination in lending, support to Priority Sector like loans for
Agriculture, MSMEs, housing , education, micro-finance, Exports

Why do banks fail?

Credit risk, interest rate risk, foreign exchange risk, bank
runs, and fraud
The small capital base of banks makes them sensitive to negative
earnings. Banks use loan loss reserves to absorb expected losses
on loans and from other sources. However, unexpected losses
must be charged against equity capital and can cause the bank to
become insolvent and/or closed by regulators.
Financial repression by the government by means of excessive
control of the banking sector can raise failure risk.
Bank runs occur when many depositors suddenly withdraw their
funds from banks. While uninsured deposits are especially at risk,
insured deposits may be withdrawn also.
Fraud includes theft as well as lending to customers favored by
friendship or political interest rather than economic profit for the
bank.

Banking Laws & Regulations - 1

Banking Regulation Act, 1949

RBI Act, 1934
SBI Act, 1955 & State Bank Subsidiaries Act, 1958
Banking Companies (Acquisitions & Transfer of
Undertakings) Act, 1970/1980
Bankers Book of evidence Act, 1891
Negotiable Instruments (NI) Act, 1882
Indian Limitation Act, 1963
Indian Contract Act, 1872

Banking Laws & Regulations - 2

Indian Stamp Act, 1889

Indian Registration Act, 1899
Transfer of Properties Act, 1858
Indian Companies Act, 1956
Recovery of debts due to Banks and FIs Act, 1993 (DRT
Act)
Consumer Protection Act (COPRA), 1985
Legal Services Authorities Act, 1987 (Lok Adalats)
SARFAESI Act, 2002 (NPA Recovery Act)
Banking Ombudsman Scheme, 2006
BCSBI Scheme, 2006

THE STATUTORY
FRAMEWORK
The Banking Regulation Act, 1949
Sec. 5 (b) defines Banking :
the accepting, for the purpose of lending or
investment, of deposits of money from the
public, repayable on demand or otherwise,
and withdraw-able by cheque, draft order or
otherwise.

THE STATUTORY
FRAMEWORK
The Banking Regulation Act, 1949
Lays down principles for the constitution of the board of
directors and appointment of a chairman of a bank
Lays down the procedure of winding up of a banking
company and the procedure of amalgamation of banking
companies
Regulation on payment of dividends by Banks
Voting rights of a shareholder in a banking company is
limited to a ceiling of 10% (Sec. 12 of BR Act)
irrespective of shareholding

THE STATUTORY
FRAMEWORK
The Banking Regulation Act, 1949
Licensing of banks and Opening of new
Branches
Minimum paid-up capital and reserves
requirements for obtaining a banking
license.
Regulatory & Supervisory powers of RBI
Regulatory Restrictions on Bank Lending

REGULATORY RESTRICTIONS ON
BANK LENDING

No loan can be granted ag. the security of banks own shares or partly paid
shares of a company (Sec. 20 of BR Act, 1949)
No bank can hold shares in company as pledgee, mortgagee or absolute
owner in excess of 30% of the paid up capital of that company or 30% of
the Banks paid up capital and reserves, whichever is less (Sec. 19 of BR
Act, 1949)
No bank can grant loans to a director or to a company in which a director or
manager is interested as a partner/manager/employee/guarantor.
No bank can grant loans against CDs, FDs issued by other banks and
MMMF units
Banks should not sanction a new or additional loan facilty to borrowers
appearing in the RBIs list of Willful Defaulters for a period of 5 years
from the date of publication of the list by RBI.

KEY WORDS/TERMINOLOGIES/GLOSSARY

Capital formation, Leveraged Institution,

Systemic Crisis, Bank Failure
Principle Intermediation, Prudence,
Liquidity, Profitability, Solvency & Trust
SARFAESI Act, DRT Act, Limitation
Act, Lok Adalat