Banks in India comprise:

  • scheduled commercial banks (i.e., commercial banks performing all banking functions, which will include both government-owned banks and private banks, and branches or subsidiaries of foreign banks);
  • cooperative banks (set up by cooperative societies to provide financing to small borrowers);
  • regional rural banks (RRBs) (these are government banks set up at local levels to provide credit to rural and agricultural areas);
  • small finance banks (these banks have been set up to undertake basic banking activities with a focus on lending to sectors and geographical areas which are not being serviced by other banks); and
  • payments banks (these banks have been set up to undertake payment and remittance-related activities and accepting small deposits).

Government oversight: In the past, the government has nationalised a number of major commercial banks. While the government has not made any moves for further nationalisation of banks, the government has the power to acquire undertakings of an Indian bank in certain situations, including for breach of applicable regulations. The government has also been (and is in the process) of merging various public sector banks to strengthen the balance sheets of the banks, and also has plans to reduce government stakes in the public sector banks as part of its disinvestment plans.

Foreign banks: There are about 45 foreign banks that have already set up banking operations in India. While foreign banks are currently operating through branch models in India, guidelines have been issued in the year 2013, which require foreign banks to operate through either a wholly owned subsidiary (WOS) incorporated in India, or through branches set up in India. Further, foreign banks which have been set up in India after August 2010 would be required to operate in India through a WOS incorporated in India in the event that the ownership structure of the foreign bank was complex, or the business of the said bank was significant, or the host country regulations were not satisfactory. Under these guidelines, foreign banks were also incentivised to operate through a WOS located in India, as they would be treated on par with Indian banks.

Foreign investment: At present, the foreign direct investment (FDI) limit in private sector banks (other than WOS of foreign banks) is 74% (for acquiring a stake beyond 49%, government approval would be required). In public sector banks, the FDI limit is 20%.

Apart from banks referred to above, the banking system in India also comprises non-banking financial companies (NBFCs) and housing finance companies (HFCs), which perform similar functions to those of scheduled commercial banks, but are not regulated in the same manner.

Given that NBFCs are not as stringently regulated as banks in India, the appetite for setting up/funding NBFCs, by domestic as well as foreign investors, has been increasing in recent times. For foreign investors having a plan to participate in the debt markets in India on a long-term basis, it does make sense to set up an NBFC, as it provides more flexibility in relation to funding that may not be available by participating as a foreign lender/investor in the debt markets.

Unless specified otherwise, this chapter will focus on the regulatory regime governing scheduled commercial banks in the private sector.

Regulatory architecture: Overview of banking regulators and key regulations

The key regulator for the banking system in India is the Reserve Bank of India (RBI). The RBI is the central bank of India, and the primary regulatory authority for banking. An entity intending to carry out banking business in India must obtain a licence from the RBI. The RBI has wide-ranging powers to regulate the financial sector, including: prescribing norms for setting up and licensing banks (including branches of foreign banks in India, and whether a foreign bank should be set up in India under the branch model or a WOS model); corporate governance; prudential norms; and conditions for structuring products and services. India has several other financial sector regulators, including the: (i) National Housing Board (NHB), which is the regulatory authority for HFCs in India; (ii) Securities Exchange Board of India (SEBI), which is the regulatory authority for the securities market in India; and (iii) Insurance Regulatory and Development Authority of India (IRDAI), which regulates the insurance sector.

The key statutes and regulations that govern the banking industry in India are: the Reserve Bank of India Act, 1934 (RBI Act); the Banking Regulation Act, 1949 (BR Act); and the Foreign Exchange Management Act, 1999 and the rules and regulations issued thereunder (FEMA).

RBI Act: The RBI Act was enacted to establish and set out the functions of the RBI. The RBI Act empowers the RBI to issue rules, regulations, directions and guidelines on a wide range of issues relating to the banking and the financial sector.

BR Act: The BR Act provides a framework for supervision and regulation of all banks. It also gives the RBI the power to grant licences to banks and regulate their business operation. The BR Act also sets out details of the various businesses that a bank in India is permitted to engage in.

FEMA: The FEMA is the primary legislation in India which regulates cross-border transactions and related activities. FEMA and the rules made thereunder are administered by the RBI.

In addition thereto, the following regulations also govern banking in India: the Bankers Books Evidence Act 1891; the Recovery of Debts Due to Banks and Financial Institutions Act 1993; the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002; the Payment and Settlement Systems Act 2007; and the various guidelines, directions and regulations issued by the RBI and the NHB from time to time.

The key RBI regulations which are important in connection with regulation of banks, are as follows:

  • RBI circulars dealing with capital adequacy and provisioning requirements, being the Master Circular – Prudential Guidelines on Capital Adequacy and Market Discipline-New Capital Adequacy Framework (NCAF) dated July 1, 2015, as amended from time to time; the Master Circular – Prudential Norms on Capital Adequacy – Basel I Framework dated July 1, 2015, as amended from time to time; and the Master Circular on Basel III Capital Regulations dated July 1, 2015, as amended from time to time.
  • RBI directions dealing with ownership of banks being Master Direction – Ownership in Private Sector Banks, Directions, 2016 dated May 12, 2016, as amended from time to time.
  • RBI circular dealing with setting up of branches and subsidiaries by foreign banks, being the Scheme for Setting up of WOS by foreign banks in India issued on November 06, 2013 as amended from time to time.
  • RBI circular dealing with setting up of new banks, being the Guidelines for 'on tap' Licensing of Universal Banks in the Private Sector dated August 1, 2016.
  • RBI circular dealing with setting up of small finance banks, being the Guidelines for Licensing of 'Small Finance Banks' in the Private Sector dated November 27, 2014.
  • RBI circular dealing with setting up of payment banks, being the Guidelines for Licensing of 'Payments Banks' dated November 27, 2014.
  • RBI circular on external commercial borrowings, being the Master Direction – External Commercial Borrowings, Trade Credit, Borrowing and Lending in Foreign Currency by Authorised Dealers and Persons other than Authorised Dealers dated January 01, 2016 as amended from time to time (ECB Regulations).

In relation to banking operations, there are certain restrictions applicable to end use of the loans and advances provided by banks, including in relation to funding real estate and capital market transactions and speculative transactions, as well as for on lending to other financial institutions, which use the funds for any of these purposes.

Further, one key requirement for licensing of banks in India is that each bank has to have adequate exposures to the 'priority sector'. The term 'priority sector' comprises activities which have national importance and have been assigned priority over other sectors for the development of India and includes categories like agriculture, micro, small and medium enterprises, education and housing. By ensuring that one of the most important pillars of the economy, being the banking system, is engaged with the priority sector, the government hopes that the economy itself is moulded in a direction which serves all sections of society.

The economic policies in India, including regulation of the banking system, are also influenced due to its membership of international economic organisations such as BRIICS, the G20 summit and treaties and agreements entered into on account of India being a member of the General Agreement on Trade in Services (GATS) under the World Trade Organisation (WTO).

Recent regulatory themes and key regulatory developments in your jurisdiction

Post the economic crisis in 2008, the RBI came out with a slew of measures to buttress the banking system and improve the quality of its assets. Some of these measures include:

The guidelines for securitisation of assets have been substantially modified to bring in requirements relating to seasoning and retention / minimum holding period and minimum retention. Also, complicated securitisation structures like synthetic securitisations, and securitisations of credit card receivables, have been prohibited.

The RBI has been issuing a flurry of directions in relation to methods of identifying bad assets and resolution in connection therewith. While the initial regulations were detailed in nature as to resolution of a bad asset, with the coming into force of the new bankruptcy code, the RBI has now restricted the regulations on large stressed assets to reporting and provisions, and now requires banks to use the provisions of the new bankruptcy code for resolution of such large stressed assets.

In 2017, the RBI revised the prompt corrective action frameworks for banks, which sets out the manner in which the RBI will assess the capital adequacy, asset quality and profitability of banks and can suggest corrective actions in relation thereto. Pursuant to such revisions, 11 public sector banks were put under this framework, and reports have been emerging that the banks put under the framework are now showing positive results.

The RBI has also introduced the recommendations of the BASEL committee in relation to strengthening the banking system. The same is being implemented in a phased manner. The Basel III regulations were introduced in April 1, 2013; banks are required to comply with its phases, and the said regulations are required to be fully implemented by banks by March 31, 2019.

In addition to the above, the following developments are also worth noting:

The RBI has, in the year 2016, introduced regulations for on-tap licensing of banks, as opposed to its earlier policy of deciding when to invite applicants to set up banks. This was introduced after the RBI introduced regulations for setting up small finance banks and payments banks. While small finance banks appear to be flourishing, the payments banks set-up does not appear to have met the expectations at the time the regulations were introduced.

The Insolvency and Bankruptcy Code, 2016 was introduced to govern insolvency and related matters for all debtors, except financial service providers (which would include banks, NBFCs and HFCs), and the idea was to bring about a similar code for financial service providers, with appropriate modifications to reflect their regulatory regime. However, the same has not been brought into force as yet, and therefore there is currently a vacuum in relation to insolvency laws (which are creditor-driven) which would apply to financial service providers. To fill this gap, the Financial Resolution and Deposit Insurance Bill 2017 provided a detailed mechanism for the assessment of the financial condition of financial service providers and manner of resolution for stressed financial service providers; however, the said bill was withdrawn in the second half of 2018. Given the mismanagement alleged against IL&FS Limited, which is registered as an NBFC, there has been a clamour for commencing discussions and introducing a special statute to govern the resolution of stressed 'financial service providers'.

The government has started focusing on digital innovations in the finance space. The fintech industry comprises a variety of financial businesses such as online peer-to-peer lending, wealth management & asset management platforms, mobile payments platforms and money/remittance transfer, etc. The RBI in 2017 came up with master directions for NBFCs in relation to peer-to-peer lending for governing this segment. The RBI and the government have also been taking necessary steps to promote digital transactions in order to promote a cashless economy. As recently as January 2019, the RBI constituted a committee (Committee on Deepening of Digital Payments) to review the existing status of digitisation of payments in the country, identify the current gaps in the ecosystem and suggest ways to bridge them.

Bank governance and internal controls

Every bank in India is expected to be set up in the form of a company, save and except for foreign banks, which are allowed to operate in India through branches. The BR Act sets out the key provisions to be complied with by each banking company in relation to the constitution of its board, the criteria for appointment of its directors, and the role of the board. Some of them are:

  • Directors must have professional or other experience, and at least 51% of the board must have special knowledge or practical experience in the identified fields like accountancy, banking and economics. Of these directors, at least two must have special knowledge in agriculture and rural economy, co-operation or small-scale industry.
  • A bank director must not have a substantial interest in, or be connected with (as an employee, manager or managing agent) any company or firm carrying on trade, commerce or industry which is not a small-scale industrial concern.
  • Directors of banks are not allowed to own a trading, commercial or industrial concern.
  • Directors of banks cannot hold office continuously for a period exceeding eight years, except for the chairman or a full-time director.
  • A bank cannot have a director that is a director of another bank, unless the director is appointed by the RBI.
  • A bank cannot have more than three directors who are directors of companies which are together entitled to exercise voting rights exceeding 20% of the total voting rights of the bank's shareholders.
  • Each bank must appoint one director as chairman of the board. A full-time chairman manages the bank's affairs, subject to the superintendence, control and direction of the board.

Further, the appointment, re-appointment or termination or remuneration of a chairman, a managing or whole-time director, manager or chief executive officer, and any amendment of it, requires prior approval of the RBI, in accordance with the BR Act.

In addition to the provisions of the BR Act, the Companies Act, 2013 (CA 2013) sets out certain corporate governance standards, which would have to be complied with. Further, given that most banks which are incorporated in India are listed entities, there are various corporate governance standards that such banks are expected to follow under the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (SEBI LODR). Under the SEBI LODR, listed entities are required to constitute the following committees, to aid the listed entity in smooth functioning and ensuring compliance with various corporate governance policies: (i) audit committee to review compliance-related matters, including related party transactions; (ii) nomination and remuneration committee to review the remuneration policies in relation to the management from time to time; (iii) stakeholders relationship committee to specifically look into various aspects of interest of shareholders, debenture holders and other security holders; and (iv) risk-management committee to set up risk-management controls and devise risk-management policies.

Additionally, there are various guidelines issued by the RBI which govern the functioning of a bank and its management, including provisions relating to conflict of interest, having an adequate compliance team and appropriate customer redressal mechanisms. In this regard:

  • In relation to asset liability management and risk management by banks, the RBI guidelines on asset-liability management and risk management dated February 10, 1999 and October 7, 1999 respectively (as amended from time to time) would have to be adhered to. The asset liability management guidelines broadly cover management of liquidity and interest rate risks by banks, setting up of the asset-liability management committee, the reporting systems for capturing the liquidity and interest rate risks, and also the prudential limits for liquidity mismatches. The risk-management guidelines set out the benchmarks to be met while establishing integrated risk-management systems, covered management of credit risks, management of market risks, and development of a risk-management structure.
  • In relation to the staff and employees working at banks, the BR Act enables each bank to frame regulations inter alia in relation to conditions or limitations subject to which the bank may appoint, fix remuneration, and determine terms of service and conduct of employees. The RBI has issued a Master Circular on Customer Service in Banks dated July 01, 2015 (as amended from time to time) which sets out basic criteria and conduct that the staff at banks need to follow.
  • In relation to outsourcing of functions by banks, the RBI issued the Guidelines on Managing Risks and Code of Conduct in Outsourcing of Financial Services by banks dated November 03, 2006 (as amended from time to time). These guidelines set out that banks shall not outsource core management functions including internal audit, compliance functions and decision-making functions like determining compliance with know-your-customer (KYC) norms for opening deposit accounts, according sanction for loans (including retail loans) and management of investment portfolio. Further, these regulations require banks to put in place a system of internal audit to monitor all outsourced activities.

Further, RBI also inspects and supervises banking operations through on-site inspections and off site surveillance.

Bank capital requirements

The Basel III capital regulations (Basel Regulations) have been implemented in India since 1 April 2013. Appropriate transitional arrangements have been made to ensure that Basel III can be implemented smoothly. These transactional arrangements have been provided to meet the minimum Basel III capital ratios and adjustments to the capital components. Basel III capital regulations will be fully implemented in India by 31 March 2019.

All scheduled commercial banks (except regional rural banks) are required to comply with Basel Regulations and these banks are required to comply with the Basel Regulations both at solo and consolidated level.

The banks in India are required to maintain a minimum capital to risk-weighted assets ratio (CRAR). CRAR is the ratio of a bank's capital in relation to its risk-weighted assets. As per the minimum capitalisation requirements, a bank is required to maintain a CRAR of 13% for the initial three years of commencing operations (the RBI is entitled to stipulate a higher ratio) and 9% on an ongoing basis. For determining CRAR, the RBI has prescribed the following: (i) risk weights for balance sheet assets, non-funded items and other off-balance sheet exposures; (ii) minimum capital funds to be maintained as a ratio to total risk-weighted assets and other exposures; and (iii) capital requirements in the trading book.

Apart from the minimum 9% requirement set out above, banks are also required to make certain contingent capital arrangements by maintaining a capital conservation buffer (CCB) of 2.5%, countercyclical capital buffer (CCCB) of between 0 to 2.5%, and a Tier 1 leverage ratio of 4.5%.

The RBI has licensed certain entities as payments banks. These banks are required to maintain a minimum paid-up equity capital of Rs. 100 Crore on an ongoing basis and a minimum leverage ratio of 3%. These banks are not required to maintain a CCB and a CCCB ratio.

Capital includes both Tier 1 and Tier 2 capital. Tier 1 capital, among others, includes paid-up capital, statutory reserves, stock surplus and Tier 2 capital, among others, includes debt capital instruments, preference share capital and revaluation reserves, etc.

Commencing from April 2015, every year, the RBI categorises some banks as domestic systemically important banks (DSIBs) under different brackets, which banks are then required to maintain certain additional capital. Currently, three banks, namely State Bank of India, ICICI Bank Limited and HDFC Bank Limited, have been categorised as DSIBs. These banks are required to maintain additional Tier 1 Capital (of 0.15% to 0.75% of risk-weighted assets currently, which will increase to 0.20% to 1% for the next financial year) through common equity.

For enforcing the capital adequacy requirements as per the Basel Regulations, there is supervision at the bank level as well as at the supervisory authority level. There are various disclosures that allow market participants to assess risk exposure, the risk-assessment process and capital adequacy of a bank, which help in analysing if the banks are implementing the Basel Regulations.

For supervision at the bank level, banks are required to assess the capital adequacy of banks in relation to their risk profiles. This assessment is done by implementing an internal process called the Internal Capital Adequacy Assessment Process (ICAAP). Every bank is required to have an ICAAP, which helps the banks in identifying and measuring risks, maintaining appropriate level of internal capital with respect to the bank's risk profile, and applying suitable risk-management systems. Banks are required to submit the ICAAP report to RBI on an annual basis.

For supervision at the supervisory authority level, which means supervision by the RBI, all banks are subject to an evaluation process called the Supervisory Review and Evaluation Process (SREP) undertaken by RBI. As part of SREP, the RBI reviews and evaluates a bank's ICAAP, takes remedial action if such a ratio is not maintained, and indirectly evaluates a bank's compliance with the regulatory capital ratios. The RBI may prescribe a higher level of minimum capital ratio for each bank on the basis of their respective risk profiles and risk management systems.

Rules governing banks' relationships with their customers and other third parties

Customer grievances

Banks in India are subject to consumer protection laws that act as an alternative and speedy remedy to approaching courts, a process that can be expensive and time-consuming.

The Consumer Protection Act 1986 (the Consumer Protection Act) is the primary legislation governing disputes between consumers and service providers. The relationship between a bank and its customer is regarded as that of a consumer and service provider, therefore bringing them under the ambit of the Consumer Protection Act. Any complaint under the Consumer Protection Act is dealt with in the following manner:

District forum: this deals with consumer complaints of a value not exceeding 2 million rupees.

State commission: this deals with consumer complaints of a value between 2 million

rupees and 10 million rupees. It also hears appeals against orders passed by the district forum.

"National commission: this deals with consumer complaints of a value exceeding 10 million rupees. It also hears appeals against the orders passed by the state commission. An appeal from the order of the national commission can be directed to the Supreme Court of India.

In addition, banks are subject to the Banking Ombudsman Scheme for the purpose of adjudication of disputes between a bank and its customers. The scheme provides for a grievance-redressal mechanism, enabling speedy resolution of customer complaints in relation to services rendered by banks. The banking ombudsman is a quasi-judicial authority appointed by the RBI to deal with banking customer complaints relating to deficiency of services by a bank and facilitate resolution through mediation or passing an award. A complaint under the scheme has to be filed within one year of the cause of action having arisen.

Customer on-boarding

In relation to on-boarding of any customer, banks and other financial institutions are required to follow certain customer identification procedure (referred to as know-your-customer requirements or KYC requirements) to prevent cases of fraud as well as money laundering.

This is codified in India in terms of the provisions of Prevention of Money-Laundering Act, 2002 and the Prevention of Money-Laundering (Maintenance of Records) Rules, 2005. Under these statutory provisions, banks are required to follow certain customer-identification procedures while undertaking a transaction, by establishing an account-based relationship or otherwise monitoring their transactions. In furtherance of the principles set out therein, the RBI has also from time to time issued various guidelines to combat money laundering, and setting out detailed KYC requirements.

In terms of the regulations referred to above, banks are required to form a KYC policy which should include elements like risk management; customer-identification procedures and monitoring of transactions, etc.

The RBI has also formulated a fair practices code which sets out the guiding principles which each bank should use to arrive at an individual fair practices code, setting out the manner in which they should deal with their customers.

Other third parties – Related parties

In India, transactions with affiliates (referred to as related-party transactions (RPTs)) are essentially regulated by the CA 2013. If the bank is a listed company, it will also need to comply with the norms set out for RPTs in the SEBI LODR. Related parties, as per CA 2013, include:

  • directors (or their relatives);
  • key managerial personnel (or their relatives);
  • subsidiaries;
  • holding companies; and
  • associate companies.

The SEBI LODR and CA 2013 set out thresholds and approval requirements (usually approval from board of directors or shareholders, or both) for entering into an RPT. In relation to listed companies and certain classes of public companies, i.e. (i) public company having a paid-up share capital of Rs. 10,00,00,000/- or more; or (ii) public company having a turnover of of Rs. 100,00,00,000/- or more; or (iii) a public company having aggregate, outstanding loans, debentures and deposits of Rs. 50,00,00,000/- or more, approval of the audit committee is also required. CA 2013 and the SEBI LODR exempt certain transactions from complying with the requirement to pass shareholder resolution or board resolution, including transactions between a company and its WOS. Further, transactions entered into in the ordinary course of business, and on an arm's-length basis, are exempted from the approval requirements under CA 2013.

RPTs entered into by any bank must be disclosed in the bank's annual accounts, in accordance with accounting standards. In addition to the requirements under CA 2013 and the SEBI LODR, banks are prohibited from entering into certain RPTs under the BR Act. For example, a bank cannot give loans or advances to, or on behalf of, or remit any amounts due to it by:

- any of its directors (or spouse or minor children of such a director);

-any partnership firm in which any of its directors is interested as a partner, manager, employee or guarantor;

- any company or subsidiary or holding company of a company in which any of its directors is interested as a director, managing agent, manager, employee or guarantor, or in which a director (together with its spouse and minor children) holds interest of more than 500,000 rupees or 10% of the paid-up capital of the company, whichever is lower; and

- any individual in respect to whom a director is a partner or a guarantor.

Other third parties – NBFCs

There are restrictions in relation to funding provided to NBFCs as well as outstanding of any core banking functions to NBFCs.

Banks are not permitted to provide loans to NBFCs for certain end uses such as: discounting/rediscounting of bills (except for rediscounting of bills arising from the sale of commercial vehicles and two-wheeler and three-wheeler vehicles, subject to certain conditions); or investment of a short-term or long term nature in any company, either by way of shares/debentures etc., unsecured loans/inter-corporate deposits to/in any company, loans and advances to their subsidiaries/group entities, further lending to individuals for subscribing to Initial Public Offerings (IPOs) or for purchase of shares from secondary market.

Cross-border banking activities

Cross-border financial activities undertaken in India are governed by comprehensive frameworks such as the ECB Regulations, FEMA and the foreign direct investment (FDI) policy issued by the government from time to time, amongst others. A large number of approval items under the ECB Regulations have been deleted by the RBI to banks, which are licensed as authorised dealers (AD), and such ADs play an important role in connection with any cross-border financing transaction, whether in the form of bonds or loans. The ECB Regulations place certain end-use restrictions, limits on borrowings, procedure of raising funds, monthly reporting and other additional requirements. The ECB Regulations also govern the manner in which foreign subsidiaries or branches of Indian banks are allowed to lend to persons resident in India.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.