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Where does the buck stop at banks?

Livemint logoLivemint 16-04-2018 Tamal Bandyopadhyay

The latest developments at two large private banks in India spotlight the role of the board of banks, the chief executive officer (CEO), corporate governance and the so-called conflict of interest.

Eliminating conflict of interest is at the heart of provisions in the Banking Regulation Act, 1949, which governs the banking companies in India. Bimal Jalan was the first Reserve Bank of India (RBI) governor to make a formal policy announcement on corporate governance in the mid-term review of the monetary and credit policy on 21 October 2001. A consultative group was set up the following month under the chairmanship of A.S. Ganguly, an industry expert and former chairman of Hindustan Unilever Ltd. Before that, in March 2001, an advisory group on corporate governance, headed by R.H. Patil—founder of NSE Ltd—had examined the relevant issues in the Indian banking industry and made recommendations to raise the governance standards. Yet another advisory group on banking supervision, chaired by former chairman of State Bank of India M.S. Verma, submitted its report in January 2003.

The mid-term review of the monetary and credit policy in November 2003 introduced the concept of “fit and proper” criteria for directors of banks, following the recommendations of the Ganguly Committee. The exercise dealt with the process of collecting information, doing due diligence and the constitution of a nomination committee of the board to scrutinize the declarations made by the bank directors.

An RBI circular, dated 24 June 2004, lays down norms for selection of directors on boards of private banks, based on their qualification, expertise, track record and integrity. At least 51% of the directors need to have special knowledge or practical experience in areas such as accountancy, agriculture and rural economy, banking, cooperation, economics, finance, law and small-scale industry. This requirement arises out of Section 10A(2)(a) of the Banking Regulation Act.

Where the buck stops

Indeed, the board plays a critical role in running a bank, but the buck stops at the managing director and CEO. Section 10B of the Banking Regulation Act makes it abundantly clear that the management of the affairs of a private bank is “entrusted” to a managing director, who exercises his powers, “subject to the superintendence, control and direction of the board of directors”.

For governance, the various committees of a bank board oversee different aspects of business, but I am not sure whether each of them is as effective as they are meant to be. For instance, the credit committee of a large private bank at this point has three members—its chairman, who is a legal expert; its managing director and CEO; and another independent director, who is a public policy specialist with expertise in water management. Apart from the managing director and CEO of the bank, do the other people have expertise to clear high-value loans? Are they there to challenge and question the decisions of the managing director and CEO, or endorse them? How many credit proposals get rejected by such a panel?

Section 36ACA of the Banking Regulation Act empowers RBI to supersede the board of directors of banks—“in public interest or for preventing the affairs of any banking company being conducted in a manner detrimental to the interest of the depositors”—but for a period not exceeding six months. The supersession of the board can be extended but not beyond 12 months. During this period, an administrator with experience in law, finance, banking, economics or accountancy needs to be appointed, but the person cannot be an officer of the central or any state government. RBI can constitute a committee of at least three people to help the administrator run the bank.

The punishment

Under Section 46 of the Act, if any bank official furnishes a false statement or suppresses facts in “any return, balance-sheet or other document”, the punishment can be imprisonment up to three years or a penalty of Rs1 crore or both. Depending on the nature of the offence, the penalty varies, and there is a provision of imposing a fine of Rs50,000 for every day during which the offence/default continues.

In all these cases, there is a legal process involved; but for certain offences, the courts have no role to play. Section 47A of the Act which defines RBI’s power to impose penalty says the central bank needs to issue a show cause notice to a bank before imposing penalty for certain offences and must offer a “reasonable opportunity of being heard” and “no complaint can be filed against any bank in any court of law in respect of any contravention or default in respect of which any penalty has been imposed”. A bank needs to pay the penalty within two weeks of receiving the RBI notice.

CEO’s appointment

Under the Banking Regulation Act, RBI’s “prior” approval is a must for appointment and reappointment of the CEO; the central bank could seek the CEO’s removal also. . Apart from solvency, it does not specify what qualities a CEO should possess, but points out what the person should not. An individual being appointed as CEO should be solvent, should not have suspended payment to creditors or settled for payment of a lesser amount and must not be convicted by a criminal court of an offence involving moral turpitude.

In the application form for RBI approval of a CEO’s appointment/reappointment, a private bank needs to explain whether the person to be appointed as CEO is subject to any of the disqualifications mentioned in Section 10B(4) of the Banking Regulation Act.

This particular section deals with the “substantial interest” that a prospective CEO should not have in any other company or a partnership firm.

What is substantial interest? It is “direct” or “beneficial interest” held by the individual or spouse of such an individual, or minor child of such an individual, whether singly or taken together, in the shares of a company which exceeds Rs5 lakh or 10% of the paid up capital of the company—whichever is less. “Substantial interest” in partnership firms does not specify any value, but says the holding should not be more than 10% of the total capital subscribed by all the partners.

Who is a relative?

Against the backdrop of recent developments, at the centre stage is the definition of “relative”. Going by the provision of the Companies Act, 1956, a person is a relative of another if they are members of a Hindu undivided family—or, they are husband and wife.

Where does the buck stop at banks?: Under the Banking Regulation Act, 1949, Reserve Bank of India's 'prior' approval is a must for appointment and reappointment of the CEO. Photo: Aniruddha Chowdhury/Mint © LiveMint Under the Banking Regulation Act, 1949, Reserve Bank of India's 'prior' approval is a must for appointment and reappointment of the CEO. Photo: Aniruddha Chowdhury/Mint

Besides, Schedule 1A of the Act lists 22 relations. They are: father, mother (including step mother), son (step son), son’s wife, daughter (step daughter), father’s father, father’s mother, mother’s father, mother’s mother, son’s son, son’s wife’s son, son’s daughter, son’s daughter’s husband, daughter’s husband, daughter’s son, daughter’s son’s wife, daughter’s daughter, daughter’s daughter’s husband, bothers (step brothers), brother’s wife, sister (step sister) and sister’s husband.

Companies Act, 2013, which replaced the old Act, compressed the list; now, only eight relations feature there. They are: father (including step father), mother (step mother), son, son’s wife, daughter, daughter’s husband, brother (step brother) and sister (step sister).

The new Act got the assent of the President of India on 29 August 2013 and was notified on 30 August. Various provisions of the Act were enforced on different dates. The definition of relative was enforced on 12 September 2013. This means, till then, the old definition as outlined in the earlier Act continued.

Section 184(1) of the new Companies Act says every director at the first meeting of the board in which he participates and, subsequently, at the first board meeting in every financial year, or whenever there is any change in the disclosures already made and at the first board meeting held after such change, should disclose his interest in any company. If a director violates this provision, the punishment is imprisonment for up to one year or Rs50,000-Rs1 lakh penalty or both.

Also, the rules that define the meetings of a board and its powers dictate that the companies that are required to set up an audit committee (banks fall in this category) must ensure that if any of the members of the committee has a conflict of interest in a given case, the person should recuse himself from attending the relevant meeting. Also, every director must disclose interest in any company by giving a notice.

Finally, even where the director himself has no personal interest in any contract or arrangement but any of his relatives has, the director is deemed to be indirectly interested.

Anomalies and absurdities

Indeed, all provisions of the law as well as definitions need to be seen in the context of developments; if we take them literally, there will be many anomalies and absurdities. For instance, in 1949, when the Banking Regulation Act was framed, the value of Rs5 lakh was enormous. (I am not sure whether this amount has remained unchanged since inception of the Act)

Over time, many parts of the law have become archaic. Sections 5 and 6 of the Act list the businesses that a bank can undertake but the list does not include many contemporary business opportunities. For instance, insurance, mutual funds, management of pension funds, hire purchase, among many other businesses, do not feature in the list. The banks could get into these after the government allowed them through special notifications.

Still, all of us are curious whether the bank CEOs make all the disclosures they need to do. Most CEOs in private banks have long innings and, often, they are home-bred, rising from the ranks. This means they join the board as a director even before becoming the boss. Do they make the disclosures through their career? After all, perception about governance is as important as governance itself.

There are many ways to restore the perceived erosion of standards about governance in Indian banks—both private and public. One of them could be appointment of governance officers. Their task is very different from that of ethics officers, which some of the Indian companies, including banks, have started appointing. But then, the company secretary of a bank, to a large extent, is the governance officer in a bank. Are they doing their jobs properly?

Tamal Bandyopadhyay, consulting editor at Mint, is adviser to Bandhan Bank. His latest book, From Lehman to Demonetization: A Decade of Disruptions, Reforms and Misadventures has recently been released

His Twitter handle is @tamalbandyo.

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