BANKING LAW AND PRACTICE

Banking in India is mainly governed by the Banking Regulation Act 1949

and the Reserve Bank of India Act 1934. The RBI and the Government of
India exercise control over the banks.

Business of Banking
Definition of Banking: - Banking is defined in Section 5(B) of the Banking
Regulation Act, as accepting the deposit of money from public for the
purpose of lending or investment. Such deposit may be repayable on demand
and withdrawal by cheque, demand draft or otherwise.

Under Section 49(A) of the Banking Regulation Act, no person other than a
bank is authorized to accept deposits, withdrawals, and etc. The savings
bank scheme run by the government and any other person notified by the
government are exempted from this prohibition.

Acceptance of deposits by non-banking entities: - There are also non-

banking companies, firms and other association of persons who accept
deposits from the public which are regulated by the Reserve Bank under the
directions issued by it under Chapter 3(B) of the RBI Act 1934. Other
companies are regulated by the Central Government under Section 58(A) of
the Companies Act 1956.

License for Banking: - In India, it is necessary to have a license from the

RBI under Section 22 of the Banking Regulation Act, for carrying on the
business of banking. Every banking company has to use the word BANK.

Permitted Businesses: -

• Borrowing, raising or taking up of money.

• Granting and issuing of letters of credit, traveler’s cheques and
circular notes.
• Buying, selling and dealing in bullion and dollar.
• Negotiating of loans and advances.
• Collecting and transmitting of money and securities.
• Acting as an agent of the government.
• Contracting for public and private loans.
• Acquire, hold and deal with any property that may form the security.
• Acquire, construct and maintain any building for its own purposes.

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Prohibited Businesses: - Section 8 of the Banking Regulation Act prohibits
a banking company from engaging directly or indirectly in trading activities
and undertaking trading risks except under Section 6(1) of the act where a
bank can release the security given to it or held by it against a loan.

Constitution of Banks
Banks in India fall under the following categories:

1. Body Corporate constituted under Special Status.

2. Company registered under Indian Companies Act, 1956.
3. Cooperative Societies registered under the Cooperative Societies Act.

Public Sector Banks: - The public sector banks including nationalized

banks, statutory bodies and Regional Rural Banks (RRBs) fall in the first
category. The Regional Rural Banks are constituted under Regional Rural
Banks Act 1974.

Banking Companies: - A banking company may be a company constituted

under the Indian Companies Act 1956 which transacts the business of
banking. The Banking Companies Act 1956 or the Banking Regulation Act
governs these banking companies.

Cooperative Banks: - A cooperative bank is a cooperative society

registered under the Central Act, or the Multi-Units Cooperative Societies
Act or under the State Act, governing cooperative societies and carrying on
banking business.

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THE RESERVE BANK OF INDIA ACT 1934
RBI as India’s Central bank was established under the RBI Act 1934 as on
1st April 1935 and was nationalized on 1st Jan 1949. It is a corporate body.
The ministry of finance however owns the bank by its directive right. The
bank has special powers and obligations for serving the national interest.

Organization of RBI
The RBI consists of the following 2 boards: -
1. Local Board
2. Central Board of Directors
• Governor
• Deputy Governor
• Executive Director
i. Central Office Department
ii. Training Establishment

Objectives of The RBI Act 1934

1. Provide note-issuing authority: - The RBI has a right to issue currency

notes except one rupee notes which the ministry of finance issues. RBI has
the following advantages from this objective: -
• It brings uniformity in note issue.
• It makes possible the supervision of state effectively.
• It is easier to control and regulate the credit in accordance with the
requirement of the economy.
• It keeps the faith of the public in the paper currency.

2.Government’s Bank: - As the banker to the government, the RBI

manages the banking needs of the government. It has to maintain and
operate the government’s deposit accounts. It collects receipts of funds and
makes payment on the behalf of the government. For conducting ordinary
banking business of the central bank, the bank is not entitled to any
remuneration. It holds cash balances of the government free of interest. For
the management of the public debt, the bank is entitled to a commission.

3. Banker’s bank: - RBI is the banker to the banks (Commercial Banks,

Cooperative Banks and Regional Rural Banks). This relationship is
established once the name of the bank is included in the Schedule 2 of the
RBI Act 1934. RBI is empowered to include in the Schedule 2, the name of
the bank that carries on the business of banking in India and that satisfies the
following conditions under Section 42(6)

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 a) It must have a paid up capital and reserves of an aggregate value of
not less than Rs. 5 lakhs.
b) It must satisfy the Reserve Bank that its affairs are not being
conducted in a manner detrimental to the interest of its depositors.
c) It must be a
• State Cooperative Bank
• Company under Indian Companies Act 1956.
• An institution notified by the Central Government in this
behalf.
• Corporation or a company incorporated by or under any law in
force in any place outside India.

Powers of RBI

1. As supervisory and controlling authority over banks

a) Licensing of Banking Companies: - Section 22 requires every

banking company to hold a license from the RBI.
b) Permission for opening branches: - Section 23 requires every
banking company to take reserve bank’s prior permission for opening
a new place of business and to change the location.
c) Permission to inspect Banking Companies: - Under Section 35, the
RBI inspects any Banking Company and its books and accounts.
d) Power to issue directions: - Under Section 35(A), RBI has the power
to issue directions to the Banking Companies in the public interest.

2. As custodian of cash reserves of commercial banks: - All commercial

banks keep a part of their cash balance as deposit with the Central Bank of
the Country. They withdraw from the cash reserves during the busy season
and pay in the surplus funds during the slack season. Due to this function,
Central Bank is called Banker’s Bank.

3. Custodian of Foreign Balances of the Country: - The Reserve Bank in

most of the countries maintains both gold as well as foreign currencies as
reserves against note issue and also to meet adverse balance of payments
with any other country.

4. Lender of the Last Report: - Reserve Bank does not refuse to

accommodate any eligible commercial bank needing funds.
5. Controller of Credit: - RBI has the power to control credit operations of
commercial banks. It attempts to influence and control volume of bank
credit and also to stabilize business condition of the country.

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6. Central clearance and accounts settlement: - Since commercial banks
have their surplus cash reserves deposited in the Reserve Bank. It is now
easier to deal with each commercial bank separately and settle the claims of
each bank on the other through book keeping entries in the books of the
RBI.

Monetary Policies of RBI

The policy followed by a central bank to control credit is known as monetary
policy. Expansion of the currency will create inflation and vice-versa. The
Central Bank can control the volume of currency notes directly since it is
itself responsible for the total volume of the notes issued to the public at any
point of time.

Objectives of Monetary Policy

• Neutral Money
• Exchange rate stability
• Stability of prices and removal of business cycle
• Full employment
• Economic Growth

Methods/ Measures to Control Credit

A) Quantitative Measures
1) Bank Rate Policy: - When a commercial bank invests all of its available
funds or when its cash reserves tend to fall below the legal minimum
requirement, it may obtain additional cash from the central bank. The
commercial bank either rediscounts some of its eligible bills with the central
bank or it may borrow cash from RBI against eligible securities. For this
service the Central Bank charges at a rate, which is called Bank Rate or
Discount Rate.

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Assumptions

• The lending rate of the Commercial Bank is related to the discount

rate of the Central Bank.
• Commercial Banks normally approach the Central Bank when they
require additional funds.
• They possess eligible securities in sufficient quantity.
• Rise in the interest rate will restrict borrowing and investment and
vice-versa.
• Prices, wages, employment are all flexible, so that they can expand or
contract.

Limitations

• Relation between bank rate and interest rate sometimes may not exist.
• Non-Existence of eligible bills.
• Practice of rediscounting.
• No direct relation between interest rate and investment.

Conclusion

The Bank rate policy is generally understood to be successful in controlling

inflation but not so successful in arresting deflationary situation.

2) Variable Reserve Requirement

Cash Reserve Ratio (CRR) is calculated as

Net Demand Liabilities = Current Deposit + Saving Deposit + Time Deposit

3) Statutory Liquidity Ratio (SLR): - According to Section 24, the SLR

refers to that proportion of the aggregate deposit, which the commercial
banks are required to keep with themselves in liquid form. The Commercial
Banks generally make use of this money to purchase government securities.
The RBI is empowered to raise the ratio up to 40% of aggregate deposits of
commercial banks.

4) Open Market Operations: - This policy refers to sale and purchase of the
securities by the RBI to the commercial banks. A sale of security to the
commercial bank results in a fall in the total cash reserves. With reduced
cash reserves, the commercial bank can only create lower volume of credit.

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Uses

• To support the Bank Rate Policy and make it effective.

• To support the government securities.
• It influences the internal prices and wages and thus the Balance of
Trade and Balance of Payment.
• To offset the seasonal movement of money and credit in the economy.

Limitations

It may not be useful to control deflation and bring about business revival
because during the period of recession and falling prices, the bank will not
expand credit deposit and keep higher cash reserves.

B) Qualitative Measures
1) Margin Requirements: - The commercial banks generally advance loans
to their customers against some securities. The commercial banks do not
plan up to the full amount of the security. The RBI determines the margin
requirements against specific securities. A rise in the margin requirements
results in the contraction in the borrowing value of the security.

2) Credit Rationing: - It is a method by which the RBI seeks to limit the

maximum amount of loans and advances for some specific categories.

3) Regulation of Consumer Credit: - It is designed to check the flow of

credit for consumer durable goods. RBI uses this method to restrict or
liberalize the loan conditions to stabilize the economy.

4) Moral Suasion: - This policy will succeed only if the RBI is strong
enough to influence the commercial banks. In India, from 1949, the RBI
uses this method to bring the commercial banks fall in line with its policies
regarding credit control.

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 BANKING REGULATION ACT 1949
This act as amended up to date contains the following 5 parts.

PART I: - Preliminary (Section 1 to 5(A))

PART II: - Business of Banking Companies (Section 6 to 36(A))

PART II A: - Control and Management (Section 6 to 36(A))

PART II B: - Prohibition of Certain Activities in Relation to Banking
Companies (Section 36(AD))
PART II C: - Acquisition of the Undertakings of Banking Companies in
Certain Cases (Section 36(AE) to 36(AJ))

PART III: - Suspension of Business and Winding Up of Banking

Companies (Section 36 to 45)

PART III A: - Special Provisions of Speedy Disposal of Winding Up

Proceedings (Section 45(A) to 45(X))
PART III B: - Provisions Relating to Certain Operations of Banking
Companies (Section 45(Y) to 45(ZF))

PART IV: - Miscellaneous (Section 46 to 55)

PART V: - Main Provisions as Applicable to Cooperative Banks (Section
56)

The above details of this Act containing 56 Sections (PART I to PART V)

are important because they relate to Banking Company. The last Section 56
relates to Cooperative Banks.

1. Definition of Banking Company

The Act defines the term Banking as accepting for the purpose of investment
of deposit, of money from the public, repayable on demand and withdrawal
by cheque, draft, order or otherwise. It also defines Banking Company as
any Company that transacts the business of Banking in India.

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2. Minimum Capital Requirement
The Act describes minimum capital requirements for Banking Companies.
Banking Company incorporated outside India is required to have its paid up
capital and reserves not less than Rs. 15 lacs. But if it has a place of business
in the city of Bombay or Calcutta, it is required to have its paid up capital
and reserves not less than Rs. 20 lacs. It is also required to deposit with the
RBI at the end of each calendar year 20% of its profits earned in India. On
the other hand Banking Company within India has paid up capital and
reserves of Rs. 5 lacs, if it has business in more than one state, then Rs. 10
lacs. The subscribed capital of Banking Company should not be less than
one half of its authorized capital and the paid up capital should not be less
than one half of the subscribed capital.

3. Licensing of Banking Companies

Section 22 of the Act contains a comprehensive system of licensing of banks
by RBI. The RBI is required to conduct an inspection of the books of the
Banking Companies and issue a license only if it is satisfied. Grant of a
license depends upon maintenance of satisfactory financial position.
Banking Company having applied for a license may carry on its business
until it is served with a notice by the RBI that a license cannot be granted to
it. RBI is also empowered to cancel a license granted to Banking Company.

4. Reserve Fund
Every Banking Company incorporated in India is required to create a reserve
fund and transfer to such fund, before any dividend is declared, 20% of its
profit.

5. Cash Reserve
Every scheduled bank is required to keep minimum 3% of the total of its
time and demand liabilities with the RBI as cash reserve, which is interest
free. But a non- scheduled bank has to maintain its cash reserves either
i. With itself.
ii. In any current account opened with RBI or any bank notified by the
government.
iii. Partly in cash with itself and partly in such an account.

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6. Maintenance of Liquid Assets
Section 24 of the Act lays down minimum limit in this regard. Every
Banking Company is required to maintain in India, cash, gold or approved
securities and amount which should not, at the close of business on any day,
be less than 25% of the total of its demand and time liabilities in India. This
is also called Statutory Liquidity Ratio (SLR). RBI is empowered to set up
this ratio up to 40%.

7. Maintenance of Assets in India

Every Banking Company is required to maintain its assets equivalent to not
less than 75% of its time and demand deposits in India, at the close of the
business on the last Friday of every quarter. The Banking Company has to
pay a penalty @ 3% per annum in the case of default.

Submission of Monthly Return: - Every Banking Company has to submit

to RBI, a monthly return, particularly of assets maintained, within 20 days
after the end of the month.

8. Management of Banking Companies

The Act also tries to tone up with the administration and management of
banks. It lays down that no Banking Company can employ or be managed by
a managing agent or any person who has been declared as insolvent or who
takes a commission/ share of profit in the Banking Company.

a) Constitution of Board of Directors (Section 10(A)): - Every Banking

Company is required to constitute its Board of Directors in such a way that
not less than 5% of the total number of members of the board shall consist of
persons. According to Sub-section 2(A), a director of Banking Company,
other than its Chairman or whole time director, cannot hold office
continuously for a period exceeding 8 years. He is not eligible to be re-
appointed as director for a period exceeding 4 years.

b) Appointment of Chairman: - Section 10(B) provides that every banking

company will have one of its directors as its chairman from its board of
directors. He holds office for not exceeding 5 years.

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9. Opening of New Branches
a) According to Section 23 of the Act, every banking company should have
obtained prior permission from the RBI for opening a new place of business.
b) The consent of RBI is not necessary when the Banking Company changes
place for a time period not exceeding 6 months.
c) The RBI grants permission if the capital structure is adequate and the
earning prospect of the branch is good.
d) The RBI may also grant conditional license in case the permission is
revoked.

New Licensing Policy: - Till 1995, all commercial banks were permitted to
open a new branch only after getting prior approval from RBI. In 1995, this
policy was reversed. As per the new policy, banks with good financial health
need not take permission from the RBI. But now this policy again has been
reversed and according to Section 23, full freedom cannot be given to profit
making banks to open new branches.

10. Loans and Advances

In the interest of the public, RBI issues directions on the following: -
• The purpose for which advances may be made.
• The margin to be prescribed.
• The maximum amount of advances.
• The maximum amount up to which guarantees may be given.
• The rate of interests and other terms and conditions.

11. Inspection of Banks

12. Powers of RBI

The RBI has the following powers: -
• Power to issue license.
• Power to determine the credit policy.
• Power of inspection.
• Power to issue directions (Under Section 35).
• Power to control management (Under Section 38(AA)).
• Power to advice banks (Under Section 36).
• Power to assist in proposal for amalgamation.
• Power to receive return.
• Power to grant moratorium (Under Section 45).
• Power to appoint liquidator.

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Additional powers: - The RBI may require any Banking Company to call a
meeting of its directors to discuss any affair of the company.

13. Acquisition of Business (Section 36(AE) to 36(AJ))

Section 36(AE) provides for the acquisition by Banking Company on the
recommendation of the RBI. The Central Government makes a scheme for
carrying out the acquisition by the banks.

14. Winding Up the Banking Company

Banking Company can be winded up compulsorily or voluntarily in the
following situations: -
i. If the banking company is unable to pay its debt.
ii. If an application for its winding up is given by RBI.
The RBI will make an application in the following circumstances: -
i. If the Banking Company fails to fulfill the provisions of the Act.
ii. If the Banking Company fails to implement any compromise
sanctioned by the Court.
iii. If the Banking Company does not furnish the return, statement, etc to
the RBI.

15. Amalgamation of Banking Company

i. A draft scheme of amalgamation containing all the terms must be
placed before the shareholders separately and approved by a
dissolution passed by two-third of shareholders. Notice of such a
meeting must be given to every shareholder.
ii. Shareholders who have objected such scheme of amalgamation claim
the value of the share, which is determined by the RBI.
iii. Besides the approval of shareholders, RBI sanctions the resolution.
iv. A copy of this order must be sent to the Registrar of Companies.

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16. Miscellaneous Provisions
Under Section 46, the Act deals with penalties for the following: -

ACTIVITY PENALTY
Submitting false return Imprisonment for 3 years plus fine.
Failure to furnish documents during Rs. 2000, and Rs. 100 per day of
inspection delay.
Receiving deposit in contravention. 2 times the amount received.
Failure to fulfill with the provisions Rs. 2000.
of the Act.
Default is committed by a Company Every person who is responsible to
the Company shall be deemed for the
default.

Application of the Act for Cooperative Banks

Cooperative Banks were brought under Banking Law (Applicable to
Cooperative Societies Act 1965). The provision regulating the Cooperative
Banks falls under Section 56. The Act applies to all Cooperative Banks
whose paid up capital and reserves is Rs. 1,00,000 or more.

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