The Regulations That Govern Banking in India

The banking system in India is regulated by the Reserve Bank of India (RBI), through the provisions of the Banking Regulation Act, 1949.

Some important aspects of the regulations that govern banking in this country, as well as RBI circulars that relate to banking in India, are explored below.

Exposure Limits

Lending to a single borrower is limited to 20% of the bank’s capital funds. This limit may be extended by an additional 5% with the approval of a bank's board of directors. Lending to group borrowers is limited to 25% of the bank’s eligible capital base at all times.

Cash Reserve Ratio and Statutory Liquidity Ratio

Cash Reserve Ratio (CRR)

Banks in India are required to keep a minimum of 4.5% of their net demand and time liabilities (NDTL) in the form of cash with the RBI. These deposits currently earn no interest.

The CRR needs to be maintained on a fortnightly basis, while the daily maintenance needs to be at least 95% of the required reserves.

In case of default on daily maintenance, the penalty is 5% above the bank rate applied on the number of days of default multiplied by the amount by which the amount falls short of the prescribed level.

Statutory Liquidity Ratio (SLR)

Over and above the CRR, a Statutory Liquidity Ratio of 18% of NDTL (known as the SLR) needs to be maintained in the form of gold, cash or certain approved securities.

The excess SLR holdings can be used to borrow under the Marginal Standing Facility (MSF) on an overnight basis from the RBI. The interest charged under MSF is higher than the repo rate by 25 bps, and the amount that can be borrowed is limited to 3% of NDTL.

Provisioning

Non-performing assets (NPA) are classified in three categories: substandard, doubtful and loss. An asset becomes non-performing if there have been no interest or principal payments for more than 90 days in the case of a term loan.

Provisions for NPAs

Substandard assets are those assets with NPA status for less than 12 months. After that time, they are categorized as doubtful assets. A loss asset is one for which the bank or auditor expects no repayment or recovery and is generally written off the books.

Substandard assets require a provision of 10% of the outstanding loan amount for secured loans and 20% of the outstanding loan amount for unsecured loans.

Doubtful assets require a provision for the secured part of the loan of:

• 20% of the outstanding loan for NPAs in existence less than one year
• 30% for NPAs in existence between one and three years
• 100% for NPA’s with a duration of more than three years

The unsecured portion of such loans requires a provision of 100%.

Provisions for Standard Assets

Provisioning is also required on standard assets. Provisioning for agriculture and small and medium enterprises is 0.25% and for commercial real estate it is 1% (0.75% for housing), while it is 0.4% for the remaining sectors.

Provisioning for standard assets cannot be deducted from gross NPA’s to arrive at net NPA’s. Additional provisioning over and above the standard provisioning is required for loans given to companies that have unhedged foreign exchange exposure. 

Priority Sector Lending

The priority sector broadly consists of micro- and small enterprises, and initiatives related to agriculture, education, housing and lending to low-earning or less privileged groups (classified as "weaker sections").

The lending target for domestic commercial banks and foreign banks with greater than 20 branches is 40% of adjusted net bank credit (ANBC).

ANBC is whichever is higher of:

• Outstanding bank credit minus certain bills and non-SLR bonds
• Or the credit equivalent amount of off-balance-sheet exposure (the sum of current credit exposure plus potential future credit exposure that is calculated using a credit conversion factor)

The lending target for foreign banks with less than 20 branches is 40% of ANBC.

Lending to the Ag Sector

The amount that is disbursed as loans to the agriculture sector should either be the credit equivalent of off-balance-sheet exposure or 18% of ANBC, whichever of the two figures is higher.

Lending to Micro- and Small Enterprises

Of the amount targeted for micro-enterprises and small businesses, 40% should be advanced to those enterprises with equipment that has a maximum value of 200,000 rupees, and plant and machinery valued at a maximum of half a million rupees.

Of the total amount lent, 20% should be advanced to micro-enterprises with plant and machinery ranging in value from just above 500,000 rupees to a maximum of a million rupees and equipment with a value above 200,000 rupees but not more than 250,000 rupees.

Lending to Weaker Sections

The total value of loans given to weaker sections should either be 12% of ANBC (for 2023-2024) or the credit equivalent amount of off-balance sheet exposure, whichever is higher.

Weaker sections include specific castes and tribes that have been assigned that categorization, including small farmers.

There are no specific targets for foreign banks with less than 20 branches.

Lack of Private Bank Lending

Private banks in India have often been reluctant to directly lend to farmers and other weaker sectors. One of the main reasons is concern over the disproportionately higher amount of non-performing assets from such priority sector loans.

They achieve their targets by buying out loans and securitized portfolios from other non-banking finance corporations (NBFC) and investing in the Rural Infrastructure Development Fund (RIDF) to meet their quota.

New Bank License Norms

The new guidelines state that:

• Groups applying for a license should have a successful track record of at least 10 years and the bank should be operated through a non-operative financial holding company (NOFHC) wholly owned by the promoters.
• The minimum paid-up voting equity capital has to be five billion rupees, with the NOFHC holding at least 40% of it and gradually bringing it down to 15% over 12 years. The shares have to be listed within three years of the start of the bank’s operations.
• Foreign shareholding is limited to 49% for the first five years of its operation, after which RBI approval would be needed to increase the stake to a maximum of 74%.
• The board of the bank should have a majority of independent directors and it must comply with the priority sector lending targets discussed earlier.
• The NOFHC and the bank are prohibited from holding any securities issued by the promoter group and the bank is prohibited from holding any financial securities held by the NOFHC.
• The new regulations also stipulate that 25% of the branches should be opened in previously unbanked rural areas.

Willful Defaulters

A willful default takes place in three circumstances:

1. When a loan isn’t repaid even though resources are available
2. If the money lent is used for purposes other than the designated purpose
3. If a property secured for a loan is sold off without the bank's knowledge or approval.

In case a company within a group defaults and the other group companies that have given guarantees fail to honor their guarantees, the entire group can be termed as a willful defaulter.

Willful defaulters (including the directors) have no access to funding, and criminal proceedings may be initiated against them.

The RBI updated regulations to include non-group companies under the willful defaulter tag as well if they fail to honor a guarantee given to another company outside the group.

The Bottom Line

The way a country regulates its financial and banking sectors is in some sense a snapshot of its priorities, its goals, and the type of financial landscape and society it would like to engineer.

In the case of India, the Banking Regulation Act and the regulations passed by its central bank give us a glimpse into its approaches to financial governance. They show the degree to which the country prioritizes stability within its banking sector, as well as economic inclusiveness.

Though the regulatory structure of India's banking system seems a bit conservative, this has to be seen in the context of the relatively under-banked nature of the country. The excessive capital requirements are needed to build trust in the banking sector. Priority lending targets are needed to make financial inclusion available to those to whom the banking sector generally would not lend.

Since the private banks, in reality, do not directly lend to the priority sectors, the public banks have taken up the slack. A case could also be made for adjusting how the priority sector is defined, in light of the high priority given to agriculture even though its share of GDP has been going down.