Expert Speak India Matters
Published on Mar 23, 2018
The big idea that has got lost in all debates in the financial sector is the consumer. Refocussing the regulatory objective on bringing the consumer back in the centre of the regulatory architecture rather than on ownership and control would help.
The regulatory opportunity in the Nirav Modi-PNB crisis

Never waste a good crisis. And as the ongoing financial scam allegedly involving Nirav Modi and Punjab National Bank (PNB) officials mushrooms into a regulatory blame-shifting between Reserve Bank of India (RBI) and Ministry of Finance (MoF), what we have is a ‘perfect crisis’. It has all the necessary ingredients — high stakes, institutional break-down, specific crimes, loose regulation, political cries to pin responsibility, opportunities for reform. Don’t be distracted by the ongoing blame-shifting between RBI and MoF — these are mere public stances, face-savers in a tiny game between maintaining a squeaky-clean regulatory image by RBI on one side and an unhealthy positive-headline-chasing by MoF on the other. The big issues lie behind these games.

A good crisis is one that exposes institutional holes and regulatory vacuums, and closes them with policy changes such as amendments, rules, regulations and leads to the establishment of a more efficient system. Already, the debate has shifted from the specifics of the crisis to one of larger regulatory issues that have been hanging for a long time. Economic agent Nirav Modi and intermediary PNB are mere symptoms in a mammoth disease of governance gaps — they are destined to come again, and again, and again.


A good crisis is one that exposes institutional holes and regulatory vacuums, and closes them with policy changes such as amendments, rules, regulations and leads to the establishment of a more efficient system.


We have seen several such crises in India’s financial sector. When the 1992 Securities Scam exposed RBI and its oversight on foreign banks, the Central Bank’s regulatory framework was strengthened. The same year, poor standards of disclosure and surveillance led to the Securities and Exchange Board of India getting a statutory status. Lack of transparency for investors on the Bombay Stock Exchange introduced computer-based order-matching trading through the creation of the National Stock Exchange in 1994. We need to use the symptoms of the ongoing crisis to fix the systemic regulatory disease.

In the current crisis, the policy question is: who governs public sector banks (PSBs) — RBI, MoF or both? As a corollary, what is the division of powers between RBI and MoF in the regulation of PSBs? Further, should such regulatory gaps exist? In an ideal world, between an alleged perpetrator Nirav Modi and suspected collusion within PNB, the path forward would have been fairly simple: use KYC (know your customer) norms to join the dots, use Aadhaar to follow the money and bring the accused before the law. Why is this such a big deal? Division of regulatory powers leads to silos, prevents focussed oversight and through it blurs accountability. The public spat between Patel and Finance Minister Arun Jaitley, each lobbing the accountability ball in the other’s court, reduces the seriousness of the crisis.

In a nutshell, the ongoing scam is as follows. In collusion with officials of PNB, diamond trader Nirav Modi and his uncle Mehul Choksi allegedly used a regulatory loophole to get letters of undertaking (LoU) from the bank without having the required securities and trade records. The value of the scam adds up to Rs 12,700 crore; that’s little more than what officials are speculating to be the annual cost of Modicare. On its part, possibly as a knee-jerk, RBI has discontinued the practice of issuing LoUs and Letters of Credit for imports into India <1>. More action is expected.

What makes this scam a ‘perfect crisis’ is the fact that Nirav Modi is out of India, leaving the government in general, Prime Minister Narendra Modi in particular and RBI Governor Urjit R. Patel as the regulatory face twiddling their thumbs in the face of a harsh Opposition crying murder. The political noise around this scam has raised the stakes. To a nation tired of scams in the previous UPA regime, this crisis is a reminder that things haven’t, and possibly won’t, change. To a Government claiming the delivery of clean governance, this is a dark spot. To an oversight regime, lacuna in the regulatory framework is showing.

The pressure on the system is building. On 14 March 2018, Urjit Patel delivered a ‘what-can-I-do?’ speech at the Gujarat National Law University in Gandhinagar. Although the trigger of this speech was the “latest fraud in the Indian banking sector”, the issues he raised took the fraud as a case study to highlight the governance architecture of PSBs. In a carefully planned lecture titled ‘Banking Regulatory Powers Should Be Ownership Neutral’, Patel laid bare the innards of banking regulation of PSBs <2>. This was not a spontaneous answer to a reporter’s question, a clarification to a Parliamentary Standing Committee or even an internal discussion at its Board meeting. The 4,387-word lecture reads like a scholar’s well-reasoned paper, with impeccable citations, sound arguments.


The political noise around this scam has raised the stakes. To a nation tired of scams in the previous UPA regime, this crisis is a reminder that things haven’t, and possibly won’t, change.


To buffer his point about the “fundamental fissures” in the regulation of PSBs, Patel leaned on the Financial Sector Assessment Programme (FSAP) conducted by the International Monetary Fund (IMF) and the World Bank. FSAP’s 19 January 2018 Detailed Assessment of Observance of the BASEL Core Principles for Effective Banking Supervision observed weaknesses around the independence of RBI and the inherent conflict of interest when supervising PSBs. “The RBI’s legal powers to supervise and regulate PSBs are also constrained — it cannot remove PSB directors or management, who are appointed by the government of India, nor can it force a merger or trigger the liquidation of a PSB; it has also limited legal authority to hold PSB Boards accountable regarding strategic direction, risk profiles, assessment of management, and compensation,” it stated <3>, while recommending legal reforms to “ensure a level playing field in supervisory enforcement.”

The FSAP assessment further noted that the influence the RBI may exercise on banks’ governance through Section 21 of BRA — power of RBI to control advances by banks — placement of RBI representatives on banks’ Boards, and the RBI’s very limited authority under the other Banking Acts, as well as the custom to “hold the PSB Boards accountable has become problematic <4>.” Under the law and according to custom, the RBI cannot hold PSB Boards accountable for assessing and — when necessary — replacing weak and nonperforming senior management and government-appointed Board members, it stated.

A first reading of Patel’s arguments, stemming from RBI expressing its “anger, hurt and pain at the banking sector frauds and irregularities,” compels us to believe that the restrictions placed on RBI by law makes it helpless when it comes to governing PSBs. Section 51 of the BRA, for instance, clearly lists out the application of the law on PSBs. Patel described this as “complete removal or emaciation of RBI powers on corporate governance” of PSBs. “This legislative reality has in effect led to a deep fissure in the landscape of banking regulatory terrain: a system of dual regulation, by the Finance Ministry in addition to RBI.”

But a closer reading of the BRA and the related laws — notably the State Bank of India Act, 1955; the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970; and the Bank Nationalisation Act, 1980 — shows that the truth lies in a grey zone, that Patel is right but not completely. For instance, under the SBI Act the RBI has no role in appointing the Board, which is “guided by directions of Central Government.”. However, the Chairman of the Board, and the (at most four) Managing Directors are appointed by Government “in consultation with the Reserve Bank”. In PSBs functioning under the Banking Companies (Acquisition and Transfer of Undertakings) Act, Directors are appointed by the Central Government but, again, “after consultation with the Reserve Bank.” Likewise for several other provisions (See Box 2). “Consultations with” RBI may not be a regulatory binding. But they leave a trail. And when a scam breaks out, and an investigation is initiated, these trails will not go unnoticed. So, while being legally accurate, Patel is ignoring the practical expression of this accuracy. Unless, of course, Patel is saying that the government is not consulting it at all.

In a nutshell, there are five laws governing 27 PSBs (See Box 1). These include specific laws such as the State Bank of India (SBI) Act of 1955 under which SBI was formed and functions, and broader laws on bank nationalisation — the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970 that governs 14 banks and the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980 that oversees six banks..

The question that emerges is: why have this loose and unbinding legal arrangement in the first place, when a sharper law can help consolidate powers and ensure greater accountability? A more efficient financial architecture would be to bring all PSBs under RBI’s singular regulatory umbrella, as the P.J. Nayak-chaired May 2014 Report of The Committee to Review Governance of Boards of Banks in India has recommended <5>. It suggested a legislative direction — to amend the Banking Companies (Acquisition and Transfer of Undertakings) Acts of 1970 and 1980, the SBI Act,1955, and the SBI (Subsidiary Banks) Act, 1959 — that brings all PSBs under the Companies Act and be regulated by the RBI, which would include the appointment of Chairmen and Directors. It also recommended the creation of a Bank Investment Company to which the government’s investments in PSBs would be transferred.

Similar recommendations were made a year earlier by the B.N. Srikrishna-chaired 22 March 2013 Report of the Financial Sector Legislative Reforms Commission (FSLRC) that sought the corporatisation of all PSBs <6> by converting them into companies under the Companies Act to “level the playing field” and “rationalise the merger/amalgamation provisions by bringing them with a single unified framework under the BRA.” This report also argued for a “uniform rule of law” to be followed by banks, irrespective of ownership. These included the separation of the position of Chairman and Managing Director and full compliance with listing norms of SEBI and stock exchanges <7> and concluded that “laws relating to banking should be ownership neutral and should provide a level playing field” for all banks <8>.

This leads us to another troubling issue of the government’s conflict of interest in the governance of PSBs — between the government as a shareholder and the government as a banker, as a banking service provider and a public goods provider through the same banks, as a lawmaker and a law executor, as an oversight provider to private banks through RBI and a more direct oversight for PSBs. Public ownership of banks inspires confidence in the financial system, said former RBI Governor Duvvuri Subbarao <9>. In that case, should PSBs be regulated and governed on the same parameters as private banks that have profit as their prime if not sole objective?

Should they be an instrument to be used for political goals like rural penetration, priority sector lending, waivers and so on or should they, like private banks, pursue shareholder returns? Subbarao argues that publicly owned banks render accountability to the government and to the democratic institutions. The government, therefore, judges them on criteria quite different from those used by the market. This perception of a government-backed institution being safer and more accountable shows that we as a nation do not believe in the rule of law but the rule of ownership — that a government institution, being safer, needs a different set of rules. If the regulatory system is strong, every bank will be safe. If not, as in the case of insurance for instance, no institution will serve consumers. In fact, the big idea that has got lost in all debates in the financial sector is the consumer. Refocussing the regulatory objective on bringing the consumer back in the centre of the regulatory architecture rather than on ownership and control would help, as the FSLRC recommendations highlight.

Should they be an instrument to be used for political goals like rural penetration, priority sector lending, waivers and so on or should they, like private banks, pursue shareholder returns?

It is clear that neither the RBI nor the MoF is completely right. Trapped in the legislative quagmire of lawmakers’ inelegant legislations, the solution lies in Parliament being able to breakdown these disparate laws and the clauses in them into a cohesive legal system that gives the authority — and the accompanying accountability — to RBI, an ownership clarity and its role to the government and less policy tensions between the two. While Patel need not have raised the issue in public and worked with MoF to fix the problem, that the issue is now out in the open for a wider debate is a good thing, both financially as well as politically, for the regulator, the government — and the people.

Reading the political stances, there seems to be an underlying will to fix financial crises in general, scams in particular and the Nirav Modi and PNB fiasco immediately. It is not that solutions are missing — the previous UPA government laid some ideas on the table, the incumbent NDA government has all of them before it. The path is fairly clear. All we need are legal amendments that catalyse these changes and usher in a well-designed regulatory architecture, where all banks are regulated by RBI. Thus empowered, it will push a greater accountability on the Central Bank and give operational clarity to PSBs. Of course, political influence on loan disbursement and bureaucratic perks like guest houses and cars could vanish.

27 PSBs, five laws, open accountability

There are five laws that oversee the functioning of 27 PSBs and have provisions to govern various aspects of their operation, in addition to the Banking Regulation Act. Creating regulatory turfs that are unhealthy the sector, these are: 1. The State Bank of India (SBI) Act, 1955, under which SBI has been established. 2. The State Bank of India (Subsidiary Banks) Act, 1959, under which five banks — State Bank of Bikaner and Jaipur, State Bank of Indore, State Bank of Mysore, State Bank of Patiala, State Bank of Travancore — have been established. 3. The State Bank of Hyderabad Act, 1956, under which State Bank of Hyderabad has been established. 4. The Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970, under which 14 banks have been established — Central Bank of India, Bank of India, Punjab National Bank, Bank of Baroda, UCO Bank, Canara Bank, United Bank of India, Dena Bank, Syndicate Bank, Union Bank of India, Allahabad Bank, Indian Bank, Bank of Maharashtra, and Indian Overseas Bank. 5. The Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980, under which six banks have been established — Andhra Bank, Corporation Bank, New Bank of India, Oriental Bank of Commerce, Punjab and Sind Bank, and Vijaya Bank.

Who regulates PSBs — RBI or the Government?

RBI Governor has pitched the debate about the loose regulation of public sector banks (PSBs). He says, RBI is unable to regulate PSBs. The Ministry of Finance has shot back saying RBI has enough powers to regulate. The truth lies somewhere in between. Select examples of who regulates the various aspects of PSBs:

1. Appointing the management

Sections 17, 18 and 19 of the SBI Act are unambiguous about there being no role of RBI in appointing the Board. The management is entrusted to a Central Board, while the Central Board is “guided by directions of Central Government”. But Section 18 also states that the Central Board consists of a Chairman, at most four Managing Directors, and other Directors, all whom are appointed by the Government “in consultation with the Reserve Bank”. Other directors are appointed by the shareholders. Under Sections 9(3)(a) and 9(3)(b) of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970, every PSB will have not more than four Directors appointed by the Central government “after consultation with the Reserve Bank, and one Director who is an official of the Central Government to be nominated by the Government. Likewise, in Section 9(3)(1) of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980, Directors can be appointed by the Central Government “after consultation with the Reserve Bank”. Section 19(a) of the SBI Act ensures that the Chairman of the bank is appointed by the Central Government “in consultation with the Reserve Bank”. Section 19(b) of the SBI Act empowers the Government to appoint managing directors “in consultation with the Reserve Bank”. Sections 9(3)(a), 9(3)(c), 9(3)(f), 9(3)(g) of the Banking Companies (Acquisition and Transfer of Undertakings) Act empowers the Central Government to appoint Directors “after consultation with the Reserve Bank”. Section 9(3B) empowers the RBI to remove a Director.

2. Appointing additional directors

Section 19B of the SBI Act gives RBI to appoint additional directors, if it deems fit in the interest of banking policy, in public interest, or in the interests of SBI’s depositors, who will hold the office “during the pleasure of the Reserve Bank”. Likewise, Section 9A of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970 and Section 9A of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980, empower the RBI to appoint additional directors.

3. Removing the management

Section 36AA(1) of BRA gives RBI the power to remove managerial and other persons from office. This is not applicable to PSBs. However, under Section 3B of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970, RBI is empowered to remove a director. Likewise, under Section 9(3B) of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980, RBI can remove a director. Under Section 24 of the SBI Act, the power lies with the Central Government but “after consulting the Reserve Bank”. Section 10B(6) of BRA gives RBI the power to remove the Chairman and Managing Director of a bank. This is not applicable to PSBs. In the case of SBI, that power vests with the Central Government under Section 24 of the SBI Act, 1955 — but “after consulting the Reserve Bank”.

4. Superseding the Board

Section 36ACA(1) of BRA gives RBI the power to supersede the Board of Directors “in certain cases”. This is not applicable to PSBs. However, under Section 18A(1) of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970, that power vests with the Central government but “on the recommendation of the Reserve Bank”. Likewise, in the case of SBI, the government is empowered under Section 24A of the SBI Act, 1955 — but “on the recommendation of the Reserve Bank”. Section 18A the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980, makes the same provision.

5. Suspension of business

Section 45 of BRA gives RBI the power to apply to Central government for suspension of business by a bank and prepare a scheme of reconstitution of amalgamation and mergers. This is not applicable to PSBs. However, under Section 3 of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970, all changes in the capital of PSBs are done by the Central government but in “consultation with the Reserve Bank”. Section 35 of the SBI Act empowers the Government to acquire the assets and liabilities of another bank, “in consultation with the Reserve Bank”.

6. Penalties

Sections 46 and 47A of BRA allow RBI to penalise officials for various offences. These include wilfully making a false statement in a balance sheet (penalty: imprisonment of upto three years or fine of Rs 1 crore or both), or not furnishing information s/he is supposed to (penalty: fine of Rs 20 lakh). This is not applicable to an officer of the government or RBI, nominated or appointed as director of SBI, any corresponding new bank (PSBs established under Section 3 of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970, or under Section 3 of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980), a Regional Rural Bank, any subsidiary bank or a Banking company.

7. Branch closure

Section 16(3) of the SBI Act ensures that no branch that was in existence when SBI was called the Imperial Bank may be “closed without the previous approval of the Reserve Bank”. Section 16(5) states that new branches would be established “in consultation with the Reserve Bank” and no branch be closed “without the previous approval of the Reserve Bank”. Ideally, this need not be regulated at all — if a bank feels there is little business and it is not viable, the decision should be taken by the bank’s management, not by a regulator.

8. Conflicts of interest

Section 20(1)(b)(iii) of BRA prohibits banks from giving loans to a company where any Director of the bank is a Director, an employee, a guarantor or has a substantial interest. This does not apply to a bank where the government owns 40% or more of the capital. Under Section 64(b) of the SBI General Regulations, 1955, Directors need to disclose the names of individuals with they are connected as a guarantor, but there is no prohibition. Section 10(1)(c) of BRA prohibits a bank from being managed by a person who is a director on another company. This is not applicable to the Chairman of State Bank of India (SBI).

9. Liquidation

Section 39 of BRA makes RBI the official liquidator. This does not apply to SBI. Section 45 of the SBI Act, “Bar to liquidation of State Bank”, clearly states that “No provision of law relating to the winding up of companies shall apply to the State Bank, and the State Bank shall not be placed in liquidation save by order of the Central Government.” Likewise, Section 18 of the Banking Companies (Acquisition and Transfer of Undertakings) Act on Dissolution makes it clear that no law for winding up a PSB shall be placed in liquidation unless it is “by order of the Central Government”. The Government needs neither a recommendation from nor a consultation with the RBI.

10. Appointing auditors

Section 41(1) of the SBI Act empowers SBI’s Central Board to appoint two auditors “with the previous approval of the Reserve Bank”. Section 41(2) empowers the RBI to fix the remuneration to the auditors “in consultation with the Central Government”. Likewise, Section 10(1) of Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970, empowers the government to appoint auditors “with the previous approval of the Reserve Bank”. While there is no ambiguity about ‘powers’, we need greater clarity on what the words ‘consultation’, ‘recommendation’ and ‘approval’ mean. Further, in this mesh of laws and regulations, it becomes difficult to establish accountability. For instance, who will be accountable if the government consults the RBI, takes its recommendations and yet something goes wrong? The solution is simple — amendments in laws that give RBI all the powers to regulate PSBs. Given the state of politics, however, it will be difficult to bring in these amendments. Only a full majority in both houses of Parliament by a government that is sincere in fixing the banking sector can ensure these reforms. Until then, scams and crisis will give us little more than angst and entertainment.

<1> Discontinuance of Letters of Undertaking (LoUs) and Letters of Comfort (LoCs) for Trade Credits, Circular, Reserve Bank of India, 13 March 2018, Accessed on 14 March 2018

<2> Urjit R. Patel, Banking Regulatory Powers Should Be Ownership Neutral, Inaugural Lecture: Centre for Law and Economics, Centre for Banking and Financial Laws, Gujarat National Law University, Gandhinagar, Reserve Bank of India, 14 March 2018, Accessed on 16 March 2018

<3> India: Financial Sector Assessment Program – Detailed Assessment of Observance of the Basel Core Principles for Effective Banking Supervision, International Monetary Fund, Para 6, p 7, 19 January 2018, Accessed on 16 March 2018

<4> Ibid, Para 50, p 18

<5> Report of The Committee to Review Governance of Boards of Banks in India, Chapter 8.3, p 90, 12 May 2014, https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/BCF090514FR.pdf, Accessed on 16 March 2018

<6> Report of the Financial Sector Legislative Reforms Commission, Ministry of Finance, Government of India, Recommendation 11, p 184, https://dea.gov.in/sites/default/files/fslrc_report_vol1_1.pdf, Accessed on 16 March 2018

<7> Ibid, Recommendation 11, p 185

<8> Ibid, Recommendation 7, p 184

<9> Duvvuri Subbarao, Corporate Governance of Banks inIndia: In Pursuit of Productivity Excellence, Reserve Bank of India, Para 24, p 1390, 13 September 2011, https://rbidocs.rbi.org.in/rdocs/Bulletin/PDFs/01SPBL100811.pdf, Accessed on 16 March 2018

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Author

Gautam Chikermane

Gautam Chikermane

Gautam Chikermane is a Vice President at ORF. His areas of research are economics, politics and foreign policy. A Jefferson Fellow (Fall 2001) at the East-West ...

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Guillermina French

Guillermina French

Guillermina French Fundacin Ambiente y Recursos Naturales (FARN)

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