Capital and Shareholding in Banking Companies under Sections 11 to 17

A bank lends other people's money. Its own capital is what stands between a loss on those loans and a loss to depositors, which is why the law regulates how much capital a bank must have, how it must be structured, how much of it any one person may own, and how much of each year's profit must be retained rather than distributed. The Banking Regulation Act does this in a cluster of short sections, Sections 11 to 17, which must now be read alongside the Reserve Bank's capital adequacy norms.

1. Minimum Paid-up Capital and Reserves

• The provision: Section 11 forbids a banking company to commence or carry on business in India unless the aggregate value of its paid-up capital and reserves is not less than the prescribed amount.
• Foreign companies: ₹15 lakh, rising to ₹20 lakh if the company has a place of business in Mumbai or Kolkata or both. Such a company must also deposit and keep deposited with the Reserve Bank an amount equal to that minimum, together with twenty per cent of its profit from Indian business each year.
• Indian companies: a graded scale by geography, from ₹1 lakh for a company whose places of business are in a single State, up to ₹10 lakh where the places of business are in more than one State and one of them is in Mumbai or Kolkata. A company beginning banking after 1962 requires paid-up capital of at least ₹5 lakh.
• A dead letter in substance: these figures have not been revised for more than sixty years and are now trivial. The real entry capital requirement is imposed as a condition of the licence under Section 22, at ₹500 crore for a universal bank, ₹200 crore for a small finance bank and ₹100 crore for a payments bank.

Figure 1: Four different senses in which a bank has capital

2. Capital Structure and Voting Rights

Figure 2: The controls on capital and shareholding

• The capital ratios (Section 12(1)): the subscribed capital must be not less than one half of the authorised capital, and the paid-up capital not less than one half of the subscribed capital. Where the capital is increased, the Reserve Bank may allow a period, not exceeding two years, to restore the ratios.
• Classes of shares (Section 12(1)(ii)): since the Banking Laws (Amendment) Act, 2012, the capital may consist of equity shares only, or of equity shares and preference shares, the issue of preference shares being governed by guidelines of the Reserve Bank. A preference shareholder is not entitled to the voting rights that company law would otherwise give him, which keeps control with the equity and prevents disproportionate voting classes.
• The voting ceiling: the main clause caps voting on a poll at ten per cent of total voting rights, whatever the size of the holding. The proviso, inserted by the Banking Laws (Amendment) Act, 2012, permits the Reserve Bank to raise that ceiling in a phased manner to twenty six per cent, and by notification of 21 July 2016 the Bank raised it to twenty six per cent, which is the ceiling now in force for banking companies.
• Why cap voting and not holding: the mischief is control, not ownership. A shareholder may hold a larger stake, but cannot convert it into command of the bank's lending. The device keeps a bank from becoming the treasury of its largest shareholder.
• Commission (Section 13): no banking company may pay, directly or indirectly, by way of commission, brokerage, discount or remuneration in any form in respect of shares issued by it, an amount exceeding in the aggregate two and a half per cent of the price at which the shares are issued.
• Charges on capital (Sections 14 and 14A): a banking company may not create a charge upon any unpaid capital, and may not create a floating charge on its undertaking or property without the certificate in writing of the Reserve Bank that the charge is not detrimental to the interests of depositors.
• Dividend (Section 15): no banking company may pay any dividend until all its capitalised expenses, including preliminary expenses, organisation expenses, share selling commission, brokerage, losses incurred and other items of expenditure not represented by tangible assets, have been completely written off.

3. Acquisition of Shares and Control

• Prior approval (Section 12B): no person may acquire or agree to acquire, by himself or acting in concert, shares or voting rights of a banking company which, taken with his existing holding, would result in his holding five per cent or more of the paid-up share capital or voting rights, except with the previous approval of the Reserve Bank.
• What the Bank considers: the integrity, reputation and track record of the acquirer in financial matters and compliance with tax laws; proceedings of a serious disciplinary or criminal nature; the source of funds; the shareholding structure; and whether the acquisition is in the public interest.
• Conditions and voting (Section 12B(4) to (8)): approval may be made subject to conditions, the bank may not register a transfer until compliance is confirmed, and the Reserve Bank must decide an application within ninety days. Where it finds that persons holding five per cent or more are not fit and proper, it may, after a hearing, direct that their combined voting rights on a poll shall not exceed five per cent.
• Shareholding ceilings by policy: apart from the statutory voting cap, the Reserve Bank's ownership guidelines prescribe long run shareholding limits for different categories of shareholder, with higher limits for financial institutions and diversified ownership required of promoters over time.
• Election of new directors (Section 12A): the Reserve Bank may by order require a banking company to call a general meeting to elect fresh directors in accordance with the voting rights permissible under the Act, so that a board elected on votes exceeding the ceiling can be replaced. Separately, the chairman, managing director or chief executive must report his own shareholding in the bank to the Reserve Bank under Section 12(4).

4. The Reserve Fund

• A compulsory retention: the transfer is made before any dividend is declared, so shareholders cannot be paid out of profit that the statute requires the bank to keep.
• Exemption: the Central Government may, on the recommendation of the Reserve Bank and having regard to the adequacy of the paid-up capital and reserves of the company in relation to its deposit liabilities, exempt a banking company from this requirement for a specified period.
• Appropriation (Section 17(2)): where a banking company makes an appropriation from the reserve fund or from the share premium account, it must report the fact to the Reserve Bank within twenty one days, explaining the circumstances. The Reserve Bank may extend the period or condone a delay.
• Purpose: the reserve fund builds loss absorbing capital out of retained earnings. It is the oldest and simplest prudential device in the Act, and it anticipates by several decades the modern idea of a capital conservation buffer.

5. Capital Adequacy

The statutory capital provisions tell only part of the story. The operative requirement today is the risk based capital adequacy norm imposed by the Reserve Bank through directions under Section 35A, giving effect to the Basel framework. Capital is measured not against total assets but against risk weighted assets, so that a loan to a government carries less capital than an unsecured personal loan.

• Minimum capital to risk weighted assets ratio: nine per cent for Indian banks, which is higher than the Basel minimum of eight.
• Composition: common equity tier 1 of at least 5.5 per cent, tier 1 of at least seven per cent, and the remainder in tier 2.
• Capital conservation buffer: a further 2.5 per cent of common equity, which takes the effective requirement to 11.5 per cent. A bank that dips into the buffer faces restrictions on dividends and bonuses rather than an immediate breach.
• Counter cyclical buffer and leverage ratio: a counter cyclical capital buffer may be activated in a credit boom, and a leverage ratio limits total exposure against tier 1 capital regardless of risk weights.
• Domestic systemically important banks: identified annually and required to hold additional common equity according to the bucket they fall into.

6. Questions Arising

If a shareholder may hold more than the voting cap, what is the point of the cap?

The cap separates economic interest from control. A large investor may take the returns of ownership, but cannot by its votes alone carry a resolution, appoint the board or steer lending towards its own group. Since the central danger in bank ownership is connected lending, controlling the vote addresses the mischief more precisely than controlling the shareholding would. The shareholding itself is separately controlled through Section 12B approval and the Bank's ownership guidelines.

Does the reserve fund under Section 17 count as regulatory capital?

In substance, yes. The statutory reserve created under Section 17 is a disclosed free reserve built from retained earnings, and disclosed reserves of that kind form part of common equity tier 1 under the capital adequacy framework. The two requirements therefore reinforce one another: Section 17 compels the retention, and the Basel norms give the retained amount its regulatory value.

7. Quick Revision

8. Frequently Asked Questions

What is the limit on voting rights in a banking company?

Section 12(2) provides that no person holding shares may exercise voting rights on a poll in excess of ten per cent of the total voting rights of all shareholders. The proviso, inserted by the Banking Laws (Amendment) Act, 2012, allows the Reserve Bank to raise that ceiling in a phased manner from ten per cent to twenty six per cent, and the Bank raised it to twenty six per cent by notification of 21 July 2016.

Does a person need permission to buy shares in a bank?

Only beyond a threshold. Under Section 12B, the previous approval of the Reserve Bank is required for any acquisition, alone or acting in concert, that would take the person's holding to five per cent or more of the paid-up share capital or voting rights. The Bank applies a fit and proper test covering integrity, track record, source of funds and the public interest.

What is the reserve fund requirement under Section 17?

Every banking company incorporated in India must transfer not less than twenty per cent of the balance of profit of each year to a reserve fund, before any dividend is declared. The Central Government may exempt a company on the Reserve Bank's recommendation where its capital and reserves are already adequate. Any appropriation from the fund must be reported within twenty one days.

What is the minimum capital adequacy ratio for Indian banks?

Nine per cent of risk weighted assets, against the Basel minimum of eight, with common equity tier 1 of at least 5.5 per cent and tier 1 of at least seven per cent. A capital conservation buffer of a further 2.5 per cent of common equity takes the effective requirement to 11.5 per cent.

Why may a bank not pay a dividend before writing off capitalised expenses?

Because such expenses are not represented by tangible assets. Paying a dividend while they remain on the books would distribute profit that exists only on paper and would weaken the capital actually available to depositors. Section 15 therefore defers distribution until the balance sheet reflects real value.

Can a bank create a charge on its own property?

Not freely. Section 14 forbids a banking company to create a charge upon any unpaid capital, since unpaid capital is the depositors' last reserve. Section 14A forbids a floating charge on the undertaking or any property of the company unless the Reserve Bank certifies in writing that the charge is not detrimental to the interests of the depositors, and a charge created without that certificate is invalid.

Why does the law treat capital differently in a bank and in an ordinary company?

Because of who bears the loss. In an ordinary company the shareholders bear it, and they chose the risk. In a bank, capital is a thin layer sitting beneath a very large volume of deposits belonging to people who neither chose nor can price the risk, and a failure spreads to other banks through the payment and interbank markets. That is why capital must be of a prescribed amount and quality, why it must be retained under Section 17, and why its ownership and voting are controlled.

9. Related Topics and Provisions

• Licensing of banking companies (Section 22)
• Management of banking companies
• Restrictions on loans and advances (Sections 19 to 21)
• Accounts, audit and disclosure (Sections 29 to 34A)
• Basel norms and capital adequacy
• Structure of the Indian banking system