ohOn June 27, the government amended the laws governing cooperative banks through an ordinance – a positive step towards reforming the supervision of banks by the Reserve Bank of India and enabling a resolution.
The prescription does three things. First, it changes the way the RBI can intervene in failing banks to protect deposits. Second, it allows cooperative banks to raise capital by issuing securities. Third, and most importantly, it increases the power of the RBI over cooperative banks.
Currently, the RBI can only intervene in failing banks after placing them under moratorium. During the moratorium, depositors cannot access their funds. Naturally, this afflicts depositors who cannot access their own money. The requirement for a moratorium is the reason why, in the Yes Bank resolution, depositors had limited access to their accounts.
The ordinance changes that. Now, the RBI can intervene in a failing commercial bank (usually by merging it with another bank) without placing the failing bank in a moratorium. Depositors’ money will not be blocked. One day, they will wake up to find that their bank has been taken over by another. However, the new bank will continue to manage its accounts transparently.
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The silent banking crisis in India
The most important reform of the ordinance is the increased control by the RBI over cooperative banks. India is going through a silent banking crisis: between 2013 and 2018, 127 banks had to be closed by the RBI. Most of them could not pay their depositors. More than four lakh depositors had to be reimbursed through the deposit insurance system.
The reason this has not gained national attention is that the ones that have failed are the cooperative banks.
Spread mostly in rural India, these banks are tiny compared to the commercial banks that dominate the cityscape. However, cooperative banks serve the rural and poor people of India, so when they fail, the financial disruption in the lives of depositors is likely to be worse.
Unfortunately, it took the failure of the Punjab & Maharashtra Co-operative Bank (PMC Bank) last year to make legal changes. PMC Bank, unlike other cooperative banks, had aggressively grown in India’s financial capital, Mumbai. When it failed, it left out a large number of urban depositors, which created the political will necessary to change the system.
Who governs the cooperative banks, the states or the Center?
Co-operative banks are uncomfortable with India’s constitutional structure. The constitution, regulation and liquidation of cooperatives is a matter for state law (entry 32 of List II of the Seventh Annex), while the banking sector is supposed to be governed by laws adopted by the Union legislator ( entries 43 and 45 of List I of the Seventh Annex). The division between state and central responsibilities raises the embarrassing question: who regulates cooperative banks? States or the Union?
The problem has been rife in India since the beginning of the republic. A difficult system prevailed in the Banking Regulation Act, where the RBI would have certain powers over the banking functions of the cooperative. On the other hand, the regulation of the management of the cooperative is left to the States. States usually have a cooperative registrar (analogous to the company registrar) who exercises control over the election and dismissal of the management of cooperatives. The provisions of the Banking Regulation Act would apply in a truncated and amended manner to cooperatives, subject to numerous conditions.
The configuration makes it impossible to separate the management of the bank from the operations of the bank. If management is incompetent, or worse, robs the bank, the regulator cannot take appropriate action. The RBI must regulate the banks but cannot take any action against the management of the bank or shut it down. Top rot is beyond the control of the regulator.
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How the prescription makes a difference
The ordinance modifies this difficult tension between state laws governing cooperative management and the RBI which regulates banking functions.
From now on, the law on banking regulation (with some modifications) will take precedence over cooperative banks. The power of the RBI to remove management or make plans to merge / dissolve cooperative banks will override the power of the State Registrar of Cooperatives.
The change does not completely level the playing field between cooperative and commercial banks, but significantly reduces anomalies. With additional powers over the banks, the RBI may be in a better position to prevent a repeat of the PMC Bank scam.
Another set of provisions allows cooperative banks to issue stocks, bonds and other securities. This will allow cooperative banks to access financial markets. The provision allowing cooperative banks to raise capital through securities is another step to make them more secure. Equity acts as a buffer to protect depositors from smaller bank losses. The shareholders absorb the first losses. It is only if the losses are greater than the equity that depositors lose money. This is why the laws require that commercial banks maintain equity equal to 9-12 percent of their deposits.
Before this ordinance, cooperative banks were exempt from this obligation and generally had insufficient capital. Now, the RBI can require these cooperative banks to raise capital (like commercial banks) as they grow.
The ordinance gives the RBI more power over cooperative banks. However, for them to be better regulated and supervised, the central bank must strengthen its supervisory capacity.
His failures in detecting scams in Yes Bank and other regular commercial banks, where he had the power to do so, shows that there will still be many challenges.
Ila Patnaik is an economist and professor at the National Institute of Finance and Public Policy.
Shubho Roy is a researcher at the University of Chicago.
Opinions are personal.
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