Banking Law

[By Karma Shah and Diya Vaya] The authors are third year students at the Gujarat National Law University. Introduction Our nation is facing a massive issue of Non-Performing Assets (hereinafter “NPAs”). Put simply, an NPA is any bank asset or receivable that has stopped making payments to the bank and has remained unpaid for a specified amount of time. The Reserve Bank of India (hereinafter “RBI”), in its Master Circular, dated 30th August, 2001, has given an extensive definition of NPAs, which aids Indian banks in identifying and treating NPAs. In this definition, the RBI has specified the period after which assets stop giving returns as a meagre 90 days. NPAs are a threat to the Indian economy, as due to the strict prudential norms set by the RBI with respect to NPAs, banks have virtually stopped lending. This has led to the downfall of economic growth. An increase in NPAs leads to several unfavourable outcomes for the economy as a whole. These include, but are not limited to first, lower profit margins for banks and an increase in rates by banks for achieving a higher profit margin, second, reduction of liquidity in the organised financial sector, third, increased work-load on the judiciary, leading to an increased social cost to the society and lastly, stressed balance sheets of banks, less return to investors, and other such tangential issues. To combat this threat to the nation’s economy, Ms. Nirmala Sitharaman (hereinafter “the finance minister”) proposed the introduction and setting up of ‘bad banks’ in the 2020-2021 Union Budget. Moreover, most recently, i.e., on 16th September 2021, the finance minister laid down the framework for the National Asset Reconstruction Company Ltd. (hereinafter “NARC”), India’s first ‘bad bank’. This blog aims to, first, explain the meaning of bad banks and their crucial need in the contemporary Indian economy. Second, examine the recent framework establishing bad banks laid down by the finance minister, and third, analyze the impact on the banks and the national economy. Bad Banks – Meaning and Function Bad banks are those institutions that, simply put, buy the NPAs and bad loans of banks and other financial institutions in exchange for cash and/or securities. The first-ever bad bank set up in the world was by Mellon Bank in the USA. In practice, a bad bank plays the role of asset reconstruction. It buys the NPAs, bad loans, and other risky assets from various financial institutions, specifically banks. The bad bank then manages and recovers these over time. Hence, contrary to a conventional bank, their core and primary function is the recovery of NPAs and bad loans. Banks essentially isolate and divide their assets into two separate categories. One category contains the illiquid assets, including the NPAs, risky securities, non-strategic assets from businesses that are no longer beneficial to the bank, non-performing loans, and other high-risk or troubled assets. The second category contains the good and beneficial assets that perform well and represent the bank’s core business. A bad bank, a corporate structure, takes the NPAs and bad loans of such banks and provides cash and/or government securities in return. This allows the bank to clear their balance sheets, infuse themselves with liquidity, and helps them focus on their core business instead of trying and recovering the NPAs. The Critical Need for Bad Banks in the Indian Economy  The Covid-19 pandemic has led to an unprecedented negative impact on our economy. Cash flow has reduced, leading to issues of loan repayments, tax payments, and interest payments. Furthermore, NPAs have been blocking the progress of our economy since the last decade. In such a desperate financial scenario, the need of introducing bad banks in the Indian Economy was critically felt due to the following reasons: First, primarily to resolve the NPA crisis. NPAs have been a constant obstacle preventing the Indian economy from unleashing its true potential. NPAs have started to drastically increase in Indian Banks since 2013, forming almost 10% of the loans provided by the banks. As per RBI, NPAs of all the scheduled commercial banks have increased from 2.35% in 2011 to 8.21% in 2021, amounting to an increase of almost 250% in a decade. Moreover, due to the onset of Covid-19, RBI has presented a warning in its July 2021 Financial Stability Report that the gross NPA ratio may increase to 9.80 percent by March 2022 under the baseline scenario; and to 11.22 percent under a severe stress scenario. India has the third-highest gross NPA ratio. When a bank has a high NPA ratio, it spends a high percentage of its profits covering consequential losses incurred due to the high NPAs. This creates a situation of decelerating the cash flow in the economy, reducing the lending frequency of the banks and ultimately affecting the economy as a whole. . In this scenario, NARC is a much-needed expert entity required to fuel the economy’s growth, provide capital to banks and resolve the financial crisis. Second, to provide support to the Insolvency and Bankruptcy regime (hereinafter “IBC”). The IBC was enacted with the objective of debt recovery and reducing the NPAs in the economy, among others. However, it did not perform as per expectations. Furthermore, it is argued that the IBC and associated debt recovery mechanisms are still at a nascent stage in India. For IBC to resolve all issues of NPAs plaguing our economy it requires greater judicial capacity, manpower and time. This can be provided by the bad bank, which creates a separate entity for quicker and more efficient one-time resolution and debt recovery. Now, banks need not worry about debts and can focus on strengthening the economy. Furthermore, the appreciable role played by bad-banks in other countries is the greatest testimony of its potential to resolve the issue of NPA’s in India and accelerate economic growth. Hence, a bad bank is necessary to tackle the issue of the large stock of NPAs in the economy as a one-time solution. Impact of the recent framework on Banks and Indian Economy On September 16, 2021, the finance minister set

[By Tushar Chitlangia & Vipasha Verma]  The authors are students at the National Law University Odisha.  Introduction The Reserve Bank of India (RBI) released a Consultative Document on Regulation of Microfinance on June 14, 2021 (Document). Microfinance is a type of banking service which provides loan to small borrowers at favourable terms. Prima facie, the major policy changes the Document aims is abolishing the inconsistency of a regulatory framework and dealing with the issue of over-indebtedness of the borrowers. However, the Consultative Document presents some challenges that need to be detailed out. RBI has recommended assessment of household income, while also capping outstanding loans at 50%of household income. Additionally, the Document suggests that requirement that 50% of the loan portfolio of the Non-Banking Financial Company-Micro Finance Institutions (NBFC-MFIs) is to be advanced for income generation activities, should be abolished. Further, it increases the limit of minimum of Net Owned Fund (NOF)requirement, which raises certain issues for NBFC-MFIs in an economy ravaged by the pandemic. Conversely, the Consultative Document also recommends sagacious policies such as abolition of external benchmarking for NBFC-MFIs, and of the interest rate ceilings. In this post, the authors present a critical review of the key policy changes introduced by the Document and provide suggestions at the institutional level to smoothen the implementation of these policies over the years. Assessment of Household Income In the past five years, the pool of borrowers in the microfinance sector of India has doubled, to around 5.8 crore. However, roughly 1 in every 20 Indian is indebted to a lender. Default risks are substantially high due to the lenders inability to predict borrower cash-flows during and after each cycle. Take for instance, the case of Assam, where micro-lenders classified borrowers with more than five loans as eligible for another. This is typically due to dependence of lenders primarily on information furnished by the borrowers on assets, income, and expenditure. These declarations are mostly of poor quality and not necessarily the best indicators of eligibility as the target demography are low-income households, wherein income varies with seasons and in most cases, assets do not generate cash. It is therefore, essential, to institute a robust cash-flow assessment mechanism. Micro-lenders adopt the practice of “lending to the limit”, which implies that outstanding loan (including interest) will be till 50% of that household’s income. The Document further underlines a few “criterion of income assessment”, but ultimately relies on Board policies of the micro-lenders. Due to the prescriptive nature of limits and the open-endedness of the criterion, micro-lenders have no real incentive or assume liability beyond adhering to them on surface level. Therefore, RBI must consider establishing a uniform policy to mandate all micro-lenders to carry out income assessments under a legal obligation. Instead of dependence on unverifiable declarations, this policy must include adding cross-checks of primary and secondary sources of income, a consumption roster with questions broken down into relevant purchase periods, and data check points (based on cross-checks) to capture informal loans. Further, micro-lenders must adopt cash-flow based underwriting, such a process would require lenders to capture details of occupational profiles, income flows, expense flows, and debt flows of the entire household, either directly or through the use of proxies and questions and combining these with information from credit bureau records. This would allow lenders to assess sustainability of the income under adverse conditions. RBI, by enumerating assessment processes in detail will increase adherence and limit a risky customer base going into the future. Consumption Loans Microfinance is an innovation that fosters entrepreneurship. It allows recipients to develop a wide range of productive activities that generate revenues. However, in the recent years, it has been observed that customers have had little success. There are increasing levels of indebtedness owing to repayment inability. The major reasons for which have been: first, using credit loans for consumption purposes, and second, borrowing from multiple sources (mostly informal) to service debt, and the deteriorating effect of cumulative debt is worse since they earn no profit. The document has abolished the limit of minimum percentage of loans to be lent for income-generation activities, citing that most borrowers depend on micro-lenders for consumption needs. However, the Malegam Committee, in its report, had observed that the main objective of micro-credit is to move its customer base out of poverty by using the loan for income-generating activities and developing a stable income. Further, it had argued that credit used for consumption purposes might increase the financial burden on the poor due to over indebtedness. Unless customers are able to progress from lower to higher incomes, they may become permanently dependent on the bank. Therefore, there is significance in income-generation activities. The RBI, by abolishing this limitation, allows micro-lenders to forego assessments that were an essential element of providing microcredit, such as evaluation of the clients’ business model for profit-generation, and providing workshops for entrepreneurship expertise. This is because any incentive to uphold the purpose of microcredit is lost. The RBI has mentioned that microcredit as consumption loans is essential in the Indian context. But without income generation there will be minimal income sustainability. It is imperative that RBI enforces the creation of different loan products for unplanned/consumption expenses, through an appropriate mix of savings and micro-insurance products through policy and guidelines. RBI, by reinstating a limit, will ensure that the micro-lending sector does not dilute to a basic personal loans bank. NOF Requirement The document leaves the doors open to consider whether the extant minimum NOF requirement for NBFC-MFIs should be increased or not. The current minimum NOF requirement for NBFC-MFIs is Rs. 5 crores (and Rs. 2 crores for the NBFC-MFIs located in the North-East region). A Discussion Paper released by RBI on January 22, 2021,suggested that the minimum NOF requirement for all NBFCs, including NBFC-MFIs, should be increased to Rs. 20 crores. The reasons given were that there are high costs to be incurred to maintain the necessary IT infrastructure, and there is a need for the NBFCs to be

[By Ujjwal Jain] The author is a third year student of Tamil Nadu National Law University. One of the most important functions of any central bank is to formulate and execute monetary policy. In our case, the Reserve Bank of India (“RBI/Bank”), the banking regulator and India’s central bank, is statutorily entrusted with this responsibility.[i] Monetary policy refers to the policy of the central bank with regard to the use of monetary instruments under its control to primarily achieve the goals of price stability, which is a precondition for sustainable growth. Some of the monetary instruments include repo rate and reverse repo rate[ii] and they influence the cost and availability of money in the economy.[iii] The RBI had recently (in April 2020) reduced the reverse Repo Rate without convening and consulting the Monetary Policy Committee. The author analyses the statutory prescriptions which the RBI has violated in doing so and contemplates for a possible solution. Legal Background The preamble of the RBI Act, 1934 (“RBI Act”) enunciates that the rationale for constituting the central bank is to secure monetary stability in India, secured by way of monetary policy.  As macroeconomic conditions change, a central bank may change the rates of the instruments in its monetary policy. Until 2016, a Technical Advisory Committee consisting of the Governor, Deputy Governor, and advised by external advisors would decide on the rates of various instruments. Notably, the decision(s) of the advisors were not binding on the RBI and the Governor’s decision was final. In 2016, Chapter III-F was inserted[iv] in the RBI Act by way of an amendment and a Monetary Policy Committee (“MPC”) was constituted (“2016 Amendment”).[v] The 6-member Committee was entrusted with the responsibility to determine the policy rate[vi] and its decision(s) were made binding upon the RBI.[vii] The reason for coming up with MPC can be traced to the Report of an Expert Committee[viii] which took cognizance of the ‘monopoly power’ in deciding the monetary policy and batted for communication and transparency in the monetary policy framework. It is believed that democratic societies require public institutions to be accountable.[ix] The Financial Sector Legislative Reform Commission in its Report submitted to the Ministry of Finance in March, 2013, had also echoed the same tone. It had flagged concerns of autonomy and independence and posited that achieving independence of a central bank requires appropriate institutional design and thus, recommended constituting MPC.[x] Notably, in the time before the constitution of the MPC, the Governor of the RBI was vested with enormous powers and the 2016 Amendment strived to overcome this shortcoming; thus, ensuring no abuse of power. It is noteworthy that the MPC framework is structured in such a manner that autonomy and independence of the Committee are vouchsafed. For instance, though the Central Government can “convey its views” to the MPC[xi], but the same has not been made binding upon the MPC’s or the RBI’s decision. The modus operandi of management of the RBI is enshrined in Section 7(2) of the RBI Act, which states that: “..the general superintendence and direction of the affairs and business of the Bank shall be entrusted to a Central Board of Directors which may exercise all powers and do all acts and things which may be exercised or done by the Bank.” Clearly, only with the exception to the monetary policy, the Central Board of the RBI is entrusted with over-arching powers. Do lofty ideals justify faux measures? The RBI (as prescribed[xii] in Chapter III-F, 1934 Act) convenes MPC meeting and decides upon the rates of various monetary policy instruments. The Secretary of the MPC releases the policy resolution & statement and the minutes of the MPC meeting in the manner prescribed. The RBI is then, under Section 45 –ZJ of the RBI Act, mandated to take steps to implement the decision of the MPC. Surprisingly, in April 2020, the RBI had suo moto reduced the reverse repo rate under the Liquidity Adjustment Facility (LAF) without convening & consulting the MPC. Due to the Covid-19 pandemic, which is having a cascading effect on liquidity in the market, though the above move seems to be a much-needed one, it raises eyebrows as the RBI has patently transgressed the statutory prescription by not consulting MPC. Furthermore, Regulation 5(b) of the MPC Regulations, 2016 prescribe ‘ordinarily’, 15 days’ notice should be given to the members of the MPC to convene a meeting, the Regulations also allow flexibility to convene an “emergency meeting” by giving “a 24 hours’ notice” to every member “to enable him/her to attend, with technology-enabled arrangements.”[xiii] Despite a framework which gives such great latitude that it can convene an ‘emergency meeting’, if the exigency of a situation so demands, the RBI has gone ahead and tinkered with the rates without taking MPC into confidence, thus disregarding the mandate of the RBI Act. The April 17th Notification declares the reduction of reverse repo rate in the following words:  “it has been decided to reduce the fixed-rate reverse repo rate under the LAF by 25 basis points from 4.0% to 3.75% with immediate effect. It is unclear from the statement of the RBI Governor on how the decision was reached. Ironically, the Governor concludes his statement with the following words: “…without infringing in any way on the mandate of the MPC”, but by what it has done it has committed a “regulatory overreach” and the same is ex facie contra legem, therefore, takes us back to the pre-MPC times. Can the RBI’s move be justified? At this juncture one might argue that the RBI, by virtue of the Banking Regulation Act, 1949, has been vested with the powers to issue directions to banking companies “in the public interest and in the interest of banking policy” and is also empowered to “control advances by banking companies” and every banking company shall be bound to comply with such direction(s).[xiv] This read with Section 17(15-A)[xv] of the RBI Act [which provides for the RBI to perform its duties enshrined under the RBI Act