Resilience and Regulation: How India’s Banking System Thrives Amidst Crisis

[By Shobhit Shukla]

The author is a student of Maharashtra National Law University, Mumbai.

 

In an effort to stop more damage in the banking industry, US regulators on May 1, 2023 seized struggling First Republic Bank and immediately sold all of its deposits and the majority of its assets to the nation’s largest bank, JPMorgan Chase. In the past few months, this is just another example of a bank collapsing post-COVID-19, adding it to the long list of major banks around the world such as Credit Suisse, Silicon Valley Bank, and Signature Bank. India however has remained a shelter during this global financial crisis. This is not unprecedented however, a similar outcome was also seen in 2008 where India with its domestic institutions, supported by good regulatory policies, displayed resilience uncanny to any other jurisdiction. This is remarkable because in the banking sector, unlike other industries, perception affects a majority of the business. As is the case in the current crisis, customers may run on the bank and cause liquidity problems, if they think the banks are about to declare bankruptcy. This perception by the customers has been at the core of the issue regarding the recent collapse of the banking sector around the world, therefore analysing the country’s banking system, with recent regulations to contain this becomes imperative.

With reference to this, the article will examine recent measures that the regulator has implemented to lessen perception-based banking in India. In the age of startups and digitization, it will also examine how secure Indian banks have historically performed, particularly in response to some specific policy and judiciary measures. The article analyses the extent to which the government and the regulator have been involved with keeping the sector in check. Lastly, the article will analyse various case laws and their effect on the sector in India, and while also appreciating the regulator for its notable achievements, the article will conclude with some recommendations for what lies ahead.

Introduction

The Indian banking system has shown remarkable resilience in the face of various crises, such as the 2008 global financial crisis, and the recent post-COVID-19 pandemic banking crisis around the world. This resilience is attributable to a range of factors, including strong regulatory oversight, sound risk management practices, and a conservative approach to lending.  In recent years, the Reserve Bank of India (“RBI”), government, and judiciary have taken several steps to address issues related to the resilience of the Indian banking system. The RBI has issued several circulars and master directions aimed at strengthening the banking system and improving its resilience. For instance, in February 2021, the RBI issued a circular on the ‘Resolution Framework 2.0 for COVID-19 Related Stress’, which aimed to provide relief to borrowers affected by the pandemic and prevent the build-up of Non-Performing Assets (“NPAs”) in the banking system. The RBI has also taken measures to improve the governance and accountability of banks. In August 2020, the RBI issued a ‘Governance in Commercial Banks’ circular, which outlined the roles and responsibilities of board members and senior management in ensuring effective governance and risk management in banks. In addition, the government has taken steps to strengthen the banking system through legislative reforms. In September 2020, the government passed the Banking Regulation (Amendment) Act, 2020, which aimed to improve the regulation and supervision of cooperative banks in India. Lastly, even the judiciary has also played a role in curbing issues related to the resilience of the banking system. Overall, these efforts are aimed at ensuring that the banking system remains stable and resilient, even during times of economic stress and uncertainty.

Policy-Based Measures

  • Capital Adequacy

One of the key measures of a bank’s resilience is its capital adequacy. Capital adequacy refers to the ability of a bank to absorb losses and continue to operate. In India, the RBI has set minimum capital adequacy norms for banks, which are in line with the Basel III framework. The minimum capital adequacy ratio (CAR) for banks is set at 9%, with a minimum Tier I capital ratio of 6%. The RBI’s guidelines on capital adequacy require banks to maintain capital levels that are commensurate with the risks they undertake. The guidelines require banks to assess their capital needs based on their risk profile and to maintain a buffer above the minimum regulatory requirement. Banks are also required to maintain capital conservation buffers, which are designed to ensure that banks have adequate capital during periods of stress.

  • Risk Management

Sound risk management practices are critical for ensuring the resilience of banks. In India, the RBI has put in place a range of guidelines and regulations to ensure that banks adopt sound risk management practices. The RBI’s guidelines on risk management cover various aspects, including credit risk, market risk, operational risk, and liquidity risk. The guidelines require banks to conduct regular stress tests to assess the impact of adverse economic scenarios on their portfolios. The RBI’s guidelines on market risk management require banks to adopt appropriate risk management policies and practices to manage their exposure to market risk. The guidelines require banks to conduct regular stress tests to assess the impact of adverse market scenarios on their portfolios.

  • Liquidity Risk

Liquidity risk refers to the risk of not being able to meet obligations as they fall due. In India, the RBI has put in place regulations to ensure that banks have adequate liquidity buffers to manage their liquidity risk. The RBI’s guidelines on liquidity risk management require banks to maintain a liquidity coverage ratio (LCR) of at least 100%. The LCR is designed to ensure that banks have sufficient high-quality liquid assets to meet their obligations during a 30-day stress scenario.

Judiciary’s Perspective

The Banking Regulation Act, 1949 (“the Act”), is the primary legislation governing the banking system in India. The Act provides for the regulation and supervision of banking companies in India and is designed to ensure the stability and soundness of the banking system. The Act also provides for the regulation of the business of banking and sets out the powers and duties of banks. The Act requires banks to maintain adequate capital levels, to adopt sound risk management practices, and comply with the directions of the RBI.

The Indian judiciary has also played a significant role in strengthening the regulatory framework for banks by establishing the power of the RBI to regulate and supervise banks and validating the regulatory framework put in place by the RBI. In Reserve Bank of India vs. Peerless General Finance and Investment Co. Ltd., the Supreme Court held that the RBI had the power to issue directions to non-banking financial companies (“NBFCs”) under Section 45-I of the Reserve Bank of India Act, 1934, thereby establishing the power of the RBI to regulate and supervise NBFCs in India. Similarly, in Ashok Mahajan vs. State of Maharashtra, the Supreme Court affirmed the power of the RBI to issue directions to banks for the resolution of NPAs under Section 35AA of the Banking Regulation Act, 1949, and held that the RBI’s circular on the resolution of NPAs was valid and enforceable.

However, the judiciary’s role in regulating banks is not without controversy. In Dharani Sugars and Chemicals Ltd. vs. Union of India, the Supreme Court held that the RBI’s circular on the resolution of stressed assets was ultra vires and set it aside. Nevertheless, the court also held that the RBI had the power to issue directions to banks for the resolution of stressed assets under Section 35AA of the Act, thereby reaffirming the RBI’s regulatory powers. Similarly, in Keshavlal Khemchand and Sons Pvt Ltd & Ors v. Union of India & Ors., the Supreme Court upheld the validity of the RBI’s circular on the classification of NPAs, holding that banks were required to comply with it, and held that the RBI had the power to issue directions to banks under Section 35A of the Act.

Conclusion

In conclusion, the regulatory framework put in place by the RBI, supported by the Banking Regulation Act, has played a critical role in ensuring the stability and soundness of the banking system. The Indian judiciary has also played a vital role in strengthening the regulatory framework for banks by establishing the power of the RBI to regulate and supervise banks and validating the regulatory framework put in place by the RBI. The RBI has taken several steps to further strengthen the banking system and make it more resilient at times of crisis, including introducing capital adequacy norms, conducting regular asset quality reviews and stress tests, and implementing prompt corrective action norms. All these measures have helped to ensure that the banking system in India remains stable, self-sufficient, and free from perception-based volatility. Therefore, while the Indian banking system has shown remarkable resilience, it is essential to continue to strengthen the regulatory framework and address the challenges that could potentially impact its stability. These measures by various stakeholders have helped to ensure that the banking system remains stable, self-sufficient, and free from perception-based volatility, which is critical for the overall health of the economy.

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