The facts: A troubled decade for the Rupee Cooperative Bank (2002-2013)
It was a little over a decade ago when Rupee Cooperative Bank (RCB) began to show signs of distress. In 2002, the bank faced a liquidity crisis due to non-recovery of loans, prompting RBI to appoint an administrator for the bank. This involves the bank coming under the supervision of the administrator, and is usually accompanied with the bank losing the freedom to carry on certain basic functions, such as accepting deposits or giving out loans.
In the case of RCB, after five years under the 'supervision' of administrators, fresh elections were held and a new board of directors was elected. The task at hand for the new board was to recover overdue loans of Rs 360 crore. As things turned out, they could not recover the full amount. Over the years, RBI's watchful eye on the bank did not wane. In 2011, RBI imposed a fine of Rs 5 lakh on RCB for violating its directives regarding the limits and scope of business permitted to be carried out by cooperative banks. The violations included discounting a cheque for an amount higher than Rs 25,000; and releasing a loan of over Rs 25 lakh for land purchase which exceeded the general limits set by RBI for cooperative banks. In 2012, another similar fine was imposed because RCB had unauthorisedly sanctioned cash credit facility exceeding Rs 1 lakh to four customers.
Anyone looking at the dateline of events would expect trouble to be looming large ahead. Earlier this year, with effect from close of business on 22 February 2013, RBI placed RCB under harsh restrictions, under the Banking Regulation Act, 1949. There were also restrictions on banking activities - RCB would not be able to grant or renew loans and advances, make investment, incur liability (i.e., borrow funds or accept fresh deposits), disburse or agree to disburse payments, enter into compromise or arrangement and sell, transfer or otherwise dispose of any of its properties or assets, and so on. RCB has not as yet lost its license, according to the RBI, which issued a clarification that the directions should not be construed as cancellation of banking licence.
Before the directions were issued, six directors of RCB had resigned in early February 2013 "over differences on loan recovery". A day after the directions were issued, on February 24, the six directors withdrew their resignation "to work in the interest of the bank". RBI would not have any of it, and dissolved the Board of Directors on 26 February. In its place, it appointed a two-member administrative board, chaired by a career bureaucrat, and an experienced administrator, who had earlier handled the merger of another bank with a public sector entity.
Why is this a malady?
These events have been bad for the depositors. They are now allowed to withdraw only upto Rs 1000 per account. Effectively, they have lost their money (other than what is protected under deposit insurance).
What is the source of this malady?
Cooperative banks, being cooperative societies that offer banking services, have a peculiar status in India because of how the two subjects are treated in the Constitution of India: 'cooperative societies' are a subject of state governance; whereas 'banking' is a subject of central interest.
There are legal arrangements that permit RBI to partially handle cooperative banks, but managing the failure of cooperative banks has problems:
- Long delays before RBI takes serious action: The administration of a bank is given multiple opportunities to salvage its position. RCB, for instance, showed early signs of distress in 2002, but was permitted to stay alive for over a decade before final directions were issued. The position of cooperative banks is perhaps more problematic because of the political stake involved: some of the more prominent cooperative banks failing in the recent past died a slow death because high-ranking politicians were associated with them.
- Long delays to close down the failed bank: The process of managing the failure of a bank is slow, and the tools available to RBI are limited. This problem, in theory, is shared by all failing banks. In practice, however, most failing banks have been only cooperative banks, which are therefore at the receiving end of procedural and administrative delays.
- Long delays for claim settlement: Due to the frequent failure of cooperative banks, combined with fixed deposit insurance premiums, the DICGC invariably has to pay out claims of an order far higher than premiums collected from these banks. This hits the ordinary depositors the most, who, in the case of cooperative banks, are more likely to be small depositors, from the unorganised sector, farmers, or small traders.
The Centre is not entirely powerless when it comes to cooperative banks. Under Part V of the Banking Regulation Act, RBI has some micro-prudential powers with respect to cooperative banks, similar to but significantly weaker than those it has with respect to commercial banks. But the application of these powers is made difficult, particularly in the context of winding up of cooperative banks, because of the centre-state arrangement.
Additionally, the Deposit Insurance and Credit Guarantee Corporation (DICGC), the RBI subsidiary that pays out to depositors of failed insured banks, covers ''eligible cooperative banks'' under its deposit insurance scheme. Eligible cooperative banks, according to the DICGC Act, are those functioning in such states/union territories that have amended their Co-operative Societies Act to incorporate two features: first, that RBI may order the concerned Registrar of Cooperative Societies to wind up a cooperative bank or to supersede its committee of management; and second, that the Registrar may not take any action of its own accord for winding up, amalgamation or reconstruction of a cooperative bank without prior sanction from RBI.
The IFC solution
The Financial Sector Legislative Reforms Commission (FSLRC), through the draft Indian Financial Code (IFC) offers a solution to this malady. While other solutions are possible, the present centre-state governance arrangement allows only limited room for maneuver with regard to the resolvability of cooperative banks.
The IFC creates a Resolution Corporation, which will resolve financial service providers that show signs of financial distress. This would include those who offer banking services. The Resolution Corporation will detect financial trouble at an early stage and will be empowered with a significantly more robust set of tools to close down a failing financial service provider than the RBI is presently empowered with.
The IFC recognises that the process of resolving failed financial institutions is closely intertwined with micro-prudential regulation. Therefore, the IFC provides for a structured framework of regulatory intervention and information-sharing between the micro-prudential regulator and the Resolution Corporation. The Resolution Corporation will have a wider mandate than the present DICGC. It will be responsible for prompt resolution of trouble financial service providers and for paying compensation to the consumers of failed financial service providers.
Under the IFC, the Resolution Corporation has the duty to insure (Section 260):
(a) each consumer of a specified category of covered obligations with a covered service provider to the extent of a specified limit; and
(b) each covered service provider to the extent of a specified limit.
The IFC permits the Resolution Corporation to manage the failure of only eligible financial service providers who fall within the ambit of micro-prudential regulation. This narrower class of financial service providers are referred to as ''Covered Service Providers'' i.e. those who make covered obligations. How is this determined?
The ultimate goal of resolution is consumer protection. Keeping this goal in mind, the specified categories of covered obligations, who will fall within the ambit of the Resolution Corporation, will be determined by the Regulator, in consultation with the Resolution Corporation. The determination will be based on the following principles Ssection 260(4)) :
(a) the detriment that may be caused to consumers if obligations owed to them are not fulfilled by a covered service provider;
(b) the lack of ability of consumers to access and process information relating to the safety and soundness of the covered service provider; and
(c) the inherent difficulties that may arise for financial service providers in fulfilling those obligations.
In addition to the financial service providers who make covered obligations based on the above principles, the class of covered service providers will also include systemically important financial institutions (SIFIs).
These principles are in consonance with the test for the intensity of micro-prudential regulation that is followed in the IFC. Applying these tests on the activities of cooperative banks shows that similar obligations are made by such banks to their consumers, and they would logically be covered by the Resolution Corporation. By extension, cooperative banks that make such obligations will have to apply for Corporation insurance, and in order to do so, will have to first submit to the micro-prudential regulatory conditions set by the regulator.
Therefore, for cooperative banks, it will no longer be sufficient for RBI to be empowered to order the State Registrar of Cooperative Societies to liquidate, amalgamate or reconstruct a cooperative bank, or to supersede management. Instead, in order to be eligible for insurance from the Resolution Corporation), State governments will have to co-opt RBI as the banking regulator of cooperative banks in that state under law. Upon becoming eligible for Corporation insurance, cooperative banks would be charged premia according to their risk position. This is contrary to the present practice of collecting fixed deposit insurance premia from all eligible banks.
If the State governments do not co-opt RBI as the banking regulator under law, then banks such as RCB would not be eligible for insurance cover from the Resolution Corporation, and by corollary, may not be permitted to carry on certain types of activities that need Corporation protection (refer to the discussion earlier on specified obligations).
Cooperative banks that are regulated poorly, or not at all, because of the present dual regulatory arrangement, will continue to pose considerable risks to the soundness of the financial system until some drastic changes occur. The IFC, being a central legislation, comes with its challenges, because it is not able to directly impinge on what is otherwise a subject of state supervision under the Constitution of India. But through structural design, it is possible to compel the State governments to embrace the well-defined regulatory and supervisory expertise of an RBI and a Resolution Corporation as laid out in the IFC.
The authors are grateful to Smriti Parsheera for useful inputs.