Section 12B Banking Regulation Act: Ownership of Private Banks

A banking licence is a licence to use other people's money. The person who controls a bank therefore controls a pool of deposits that is many times his own stake in it, and the temptation to lend that pool to himself is the oldest problem in banking. Every rule in this note exists to answer it. The law limits how much of a bank one person may own, requires approval before a significant stake is acquired, tests the acquirer for fitness, caps voting rights separately from shareholding, and keeps industrial houses out of banking altogether.

1. The statutory foundation

• Section 12(1) requires the subscribed capital of a banking company to be not less than half its authorised capital, and the paid up capital not less than half the subscribed, and confines the capital to ordinary or equity shares together with such preference shares as the Reserve Bank's guidelines permit.
• Section 12(2) caps the voting rights of any one shareholder. The main clause fixes the ceiling at ten per cent of the total voting rights of all shareholders, and the proviso, inserted in 2013, permits the Reserve Bank to raise it in a phased manner to twenty six per cent.
• Section 12B, inserted in 2013, requires the previous approval of the Reserve Bank before any person acquires or agrees to acquire shares or voting rights which, together with those already held, would take him to or beyond the prescribed percentage. The Reserve Bank may grant approval on such conditions as it thinks fit, and must be satisfied that the applicant is fit and proper.
• Section 36AA empowers the Reserve Bank to remove a chairman, director, chief executive or other officer where it is necessary in the public interest or to prevent the affairs of the bank being conducted in a manner detrimental to depositors or to the bank.

2. Licensing: from windows to a tap

Figure 1: Thirty years of licensing policy

New private sector banks were first permitted in 1993, after twenty four years in which no licence had been granted. A second round followed in 2001 and a third in 2013. Each was a window: applications were invited within a period, considered together, and the window closed. The difficulty with a window is that it forces a comparative assessment between applicants who happen to apply at the same moment, and it makes entry depend on the regulator's timetable rather than on the applicant's readiness.

The Guidelines for on tap licensing of universal banks in the private sector, issued on 1 August 2016, replaced the window with a continuous process. An application may be made at any time and is assessed on its own merits.

The conditions of a universal banking licence

• Eligible promoters are resident individuals and professionals with ten years of experience at a senior level in banking and finance; private sector entities or groups owned and controlled by residents with a ten year record; and non-banking financial companies owned and controlled by residents with a ten year record.
• Large industrial houses are excluded as promoters. A group with total assets of fifty billion rupees or more is ineligible if the non-financial business accounts for forty per cent or more of its assets or gross income. Such a group may nonetheless invest up to ten per cent in a bank.
• Minimum paid up voting equity capital of five hundred crore rupees, with net worth never falling below that figure.
• A non-operative financial holding company is required where the promoter has other group entities, and the promoter group must hold at least fifty one per cent of that holding company. It is not required for an individual promoter or a standalone entity with no other group entities.
• The promoter must hold at least forty per cent of the paid up voting equity capital, locked in for five years from the commencement of business, and the promoter group's holding must come down to fifteen per cent within fifteen years.
• Aggregate foreign investment is governed by the policy on foreign direct investment, the present limit being seventy four per cent, subject always to the minimum promoter holding.
• The bank must be listed within six years of commencing business.
• It must meet the priority sector targets applicable to existing domestic scheduled commercial banks, and must open at least twenty five per cent of its branches in unbanked rural centres, meaning centres with a population up to nine thousand nine hundred and ninety nine.

Figure 2: Two licences compared on their entry conditions

3. Why industrial houses are kept out

This is the most contested question in Indian banking policy, and both sides of it carry real weight.

1. The case against entry is connected lending. A bank owned by an industrial group has an owner who is also a borrower, and the group's need for finance will not stop at the point where prudence would. The risk is not that a loan will be made dishonestly but that it will be made on terms no unconnected borrower would get, and that the appraisal will be performed by people the borrower appoints. Supervision cannot easily detect this, because the transactions are individually defensible. The international experience, including in India before nationalisation, is unfavourable.
2. The case for entry is capital. Indian banking needs very large amounts of equity, the Government is constrained in what it can supply to the public sector banks, and industrial groups are among the few domestic sources of capital at that scale. On this view the answer to connected lending is a strong framework of related party rules, consolidated supervision and a holding company structure, not a prohibition.

The Internal Working Group that reviewed ownership and corporate structure reported in 2020 and recommended, among other things, that large corporate and industrial houses be permitted as promoters, but only after amendments to the Banking Regulation Act, 1949 to strengthen the supervision of large conglomerates. It also recommended raising the long run promoter cap from fifteen to twenty six per cent, a uniform fifteen per cent cap for non-promoter shareholders, raising the entry capital for a universal bank from five hundred to one thousand crore rupees and for a small finance bank from two hundred to three hundred crore rupees, and permitting well run non-banking financial companies with assets of fifty thousand crore rupees or more to convert into banks after ten years of operation.

4. The shareholding framework of 2023

The Directions and Guidelines on acquisition and holding of shares or voting rights in banking companies, issued on 16 January 2023, consolidate the position.

• Major shareholding means an aggregate holding of five per cent or more of the paid up share capital or voting rights of a banking company, whether by a person acting alone or with others.
• Acquiring major shareholding requires the prior approval of the Reserve Bank under the Directions read with Section 12B, and the approval may carry conditions. If a holding falls below five per cent, fresh approval is needed to regain major shareholding.
• A person from a jurisdiction that the Financial Action Task Force has found non-compliant may not acquire major shareholding, although an existing major shareholder from such a jurisdiction is not displaced.
• Promoters are capped at twenty six per cent of paid up share capital or voting rights once the bank has completed fifteen years from commencement of business. A higher holding may be permitted before that point as a condition of the licence or under an approved dilution plan, and the Reserve Bank may permit a higher holding on the facts, for example where an existing promoter relinquishes a stake or where supervisory intervention has taken place.
• Non-promoter ceilings are ten per cent for natural persons, non-financial institutions, financial institutions connected with large industrial houses and financial institutions half or more owned or controlled by individuals, and fifteen per cent for other financial institutions, supranational institutions, public sector undertakings and the Central or a State Government.

Fit and proper

The test applied to a major shareholder is continuing rather than an entry formality. It covers integrity, reputation and track record in financial matters and compliance with tax laws; any criminal proceedings of a serious nature; the financial soundness of the applicant; the source of funds for the acquisition; the applicant's business record and any adverse regulatory finding; and whether the acquisition would give rise to an unacceptable concentration or a conflict of interest. The Reserve Bank may call for information at any time and may require a shareholder who ceases to be fit and proper to divest.

5. Foreign banks and the subsidiary question

A foreign bank may operate in India in two ways, and the policy has encouraged a shift from the first to the second.

• As a branch, which is part of the foreign parent, has no separate capital of its own in the legal sense, and is supervised by the Reserve Bank in India and by the home supervisor abroad.
• As a wholly owned subsidiary incorporated in India, which is an Indian company with Indian capital, an Indian board, and the obligations of a domestic bank including priority sector targets, and which may be allowed near national treatment in branch expansion.

The subsidiary route was framed in 2013. Its attraction to the regulator is ring fencing: a subsidiary's capital stays in India and is available to Indian depositors if the parent fails abroad. Its cost to the foreign bank is capital locked in a single jurisdiction. Foreign banks with twenty or more branches in India carry the same priority sector obligation as a domestic bank, which is the point at which the two routes converge.

6. Quick Revision

1. Shareholding and voting rights are capped separately.
2. On tap licensing replaced the window system in 2016.
3. A holding company is required only where the promoter has other group entities.
4. Large industrial houses may invest but may not promote, and the Internal Working Group's contrary recommendation was not accepted.
5. Major shareholding is five per cent, and approval is personal and may be conditioned.
6. A person from a jurisdiction found non-compliant by the Financial Action Task Force may not acquire major shareholding.
7. Fit and proper is a continuing test, and divestment may be required.
8. A wholly owned subsidiary ring fences capital in India; a branch does not.

7. Frequently Asked Questions

Why cap voting rights separately from shareholding?

Because the two serve different purposes. A shareholding cap limits economic exposure and keeps the register from concentrating; a voting cap limits control. Separating them allows a bank to raise large amounts of equity from a single investor without that investor acquiring the power to direct it, which matters because the risk the law is guarding against is not that someone will own too much of a bank but that someone will be able to tell it whom to lend to. Section 12(2) accordingly caps voting at ten per cent with power in the Reserve Bank to raise it in stages to twenty six, while the shareholding ceilings are fixed separately under the Directions.

What is a non-operative financial holding company and why is it used?

It is a company that holds the bank and the promoter's other regulated financial businesses, and which does no business of its own. The purpose is ring fencing. The bank sits beside its sister financial companies rather than under or above them, so a failure in the insurance or asset management business does not travel into the bank, and the Reserve Bank can see the whole financial group at one level. It is required under the on tap guidelines only where the promoter has other group entities, because for a standalone promoter there is nothing to ring fence and the structure would add cost without benefit.

Can a promoter be required to reduce his holding?

Yes, and that is the normal course. A promoter is required to hold at least forty per cent at entry so that he has capital at risk, and is then required to dilute over time, to twenty six per cent under the present framework once fifteen years have passed. The logic is that concentrated ownership is useful at the start, when someone must be accountable for a new institution, and undesirable later, when the bank's deposits have grown far beyond the promoter's stake. The Reserve Bank may also require divestment where a shareholder ceases to be fit and proper, independently of the ceilings.

Should industrial houses be allowed to own banks?

The arguments are finely balanced. For: Indian banking requires equity at a scale that few domestic sources can supply, the public sector is constrained by the fifty one per cent statutory floor, and a prohibition pushes the same groups into lending through non-banking financial companies where supervision is lighter. Against: an owner who is also a borrower cannot be supervised into impartiality, the transactions are individually defensible and collectively ruinous, and the Indian experience before nationalisation and the international experience since both run the same way. The Internal Working Group of 2020 took the first view subject to statutory amendment and stronger conglomerate supervision; the Reserve Bank did not accept it, and the prohibition stands.

Does the Reserve Bank's approval under Section 12B guarantee anything to the acquirer?

No. The approval is permission to hold, not a certification of the bank or of the investment, and it may be granted on conditions, for instance requiring the shareholding to be brought down over time, requiring an undertaking not to seek board representation, or restricting further acquisition. It is also continuing: the fit and proper assessment does not end at the point of approval, the Reserve Bank may call for information at any time, and a shareholder who ceases to satisfy the criteria may be required to divest. An approval that lapses because the holding fell below five per cent must be obtained afresh.

8. Related Topics and Provisions

• Licensing of banking companies and branch expansion
• Capital, reserve fund and shareholding under the Banking Regulation Act, 1949
• Management of banking companies and removal of directors
• Corporate governance in banks
• Small finance banks and payments banks
• Banking sector reform and the Narasimham Committees