Urban Banking

8/6/2019 Urban Banking

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(TIMSR) Urban Banking

Executive Summary

1. Background

The urban cooperative banking sector has witnessed phenomenalgrowth during the last one and a half decades. Certain infirmities have,however, manifested in the sector resulting in erosion of publicconfidence and causing concern to the regulators as also to the wellfunctioning units in the sector. One of the factors significantly affectingthe financial health of the Urban Cooperative Banks (UCBs) is theirinability to attract equity / quasi equity investments. At present, UCBshave limited avenues for raising such funds and even their sharecapital can be withdrawn. Against this backdrop, an announcementwas made in the Annual Policy Statement for the year 2006-07 toconstitute a Working Group to examine the issue of share capital of UCBs and identify alternate instruments / avenues for augmenting thecapital funds of UCBs. Accordingly, a Working Group was constitutedunder the Chairmanship of Shri N. S. Vishwanathan, Chief GeneralManager-in-Charge, Urban Banks Department, Reserve Bank of India.

2. Methodology

The Group deliberated on the various issues relating to its terms of reference on the basis of presentations made by its members. It also

met Chairmen/ CEOs of a few medium/ large UCBs. The areasdeliberated included international practices and structures for issue of bonds by cooperatives, adaptability of the provisions of IndianCompanies Act, 1956 for issue of preference shares, State Governmentperspective on the issues involved and provisions of select StateCooperative Societies Acts and Multi State Cooperative Societies Act,2002 pertaining to issuance of shares and debentures including theirtransferability, SEBI Act, 1992 and Securities Contract Regulation Act,1956 (SCRA).

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3. Findings

The Group observed that a large number of UCBs are short of the

prescribed regulatory capital. Out of 217 UCBs with deposits of overRs.100 crore, 30 banks, i.e. 15% of the banks in the sample wereundercapitalized. Therefore, the need for analyzing the issues involvedin and identification of alternate sources of capital cannot be over-emphasized.

There were legal and structural issues affecting enhancement of capitalof UCBs. They are governed by the respective Cooperative SocietiesAct of the State under which they are registered; besides there are 33UCBs registered under the Multi State Cooperative Societies Act (MultiState Act). While the Acts are in essence similar, they differ in detailsin respect of several matters including those relating to freedom toraise and price various financial instruments. The financial instrumentsissued by UCBs cannot be listed on a stock exchange.

In certain countries the financial intermediaries in the cooperativesector are strong and socially effective. The federated structure incountries such as Netherlands (Rabobank Group), France (CreditAgricole Group) and Finland (OKO Group) lent financial strength to allthe cooperative entities forming part of the structure. While the federalarrangement differed in details, it revolved around a strong apex level

entity, which had even supervisory powers and responsibility. Bringingsuch a system in India would require an enabling legislativeframework. Further, in some countries including Netherlands, TrustPreferred Securities (TPS) are used to raise long term stable funds.Trust preferred securities are undated cumulative preferred securitiesissued out of a special purpose vehicle (SPV), usually a trust formedby a bank holding company (BHC). The SPV would issue preferredsecurities to the prospective investors. There is no legal bar on MultiState UCBs raising funds through this process excepting the limitplaced on the extent to which funds can be raised by way of debentures. To enable other banks to raise funds through TPS, thestates concerned may be required to bring suitable amendments in theActs to facilitate formation of trust by UCBs.

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Brief History of Urban Cooperative Banks in India

The term Urban Co-operative Banks (UCBs), though not formally

defined, refers to primary cooperative banks located in urban andsemi-urban areas. These banks, till 1996, were allowed to lend moneyonly for non-agricultural purposes. This distinction does not holdtoday. These banks were traditionally centred around communities,localities work place groups. They essentially lent to small borrowersand businesses. Today, their scope of operations has widenedconsiderably.

The origins of the urban cooperative banking movement in India canbe traced to the close of nineteenth century when, inspired by thesuccess of the experiments related to the cooperative movement inBritain and the cooperative credit movement in Germany suchsocieties were set up in India. Cooperative societies are based on theprinciples of cooperation, - mutual help, democratic decision makingand open membership. Cooperatives represented a new andalternative approach to organisaton as against proprietary firms,partnership firms and joint stock companies which represent thedominant form of commercial organisation.

Urban Banking Sector - A Bird's eye-view

The High Power Committee on Urban Co-operative Banks constitutedby RBI in 1999, has aptly commented that the co-operative creditendeavour was the first ever attempt at micro credit dispensation inIndia. UCBs were essentially designed to tap the resources of lowerand middle income groups and extend credit support to their economicactivities. Over a century old urban, co-operative credit movementtoday has a network of 2,084 urban co-operative banks with 7,368branch outlets spread over the country. Their total deposit sourcesaggregated Rs.71,701 crore and outstanding loans accounted for Rs-45,856 crore as at the end of June 2000.

The deposits of UCBs are equivalent to 9% of commercial banks'deposits. Few states such as Maharashtra, Gujarat, Karnataka, AndhraPradesh and Tamil Nadu account for over 80% of urban co-operativebanks presence and 75% of their total deposits. Predominantconcentration of Urban Co-operative Banks in these 5 states is mainlyon account of emergence of strong co-operative leadership. UCBsnormally confine their area of operation to localised geographical

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regions. But over a period of time, their area have crossed thefrontiers of districts and in some cases the states of their registration.The client profile of UCBs predominantly comprises priority sector

segments viz. Small business establishments, SSIs, retail traders,professional, self-employed persons and SRTOs, etc. who would notnormally find it easy to have access to large commercial banks. Thereare weak banks in the total population of UCBs. But most of the banksmay be rated as satisfactory to very good. Many of them are highlycomputerized. We should, therefore, judge each entity on itsperformance. Wrong doings by a few should not make us berate theentire lot as it would hurt the honest managements who should in factget encouragement.

As regards their regulation, which has become a subject of intensedebate in the recent past, UCBs essentially being co-operativesocieties are governed by their respective state governments out of the powers derived from respective State Co-operative Societies Acts.Being banking institutions, they are also governed by the ReserveBank of India by virtue of powers conferred on it under the BankingRegulations Act. As UCBs are member driven institutions, everymember has to have stake in the capital and irrespective of amember's shareholding, each member has only one vote.

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Draft Vision Document for Urban Co-operative Banks

Urban Co-operative Banks (UCBs) are an important part of the

financial system in India. It is, therefore, necessary that the UCBsemerge as a sound and healthy network of jointly owned,democratically controlled, and ethically managed banking institutionsproviding need based quality banking services, essentially to themiddle and lower middle classes and marginalized sections of thesociety.

This document sets out the broad approach and strategies that need tobe adopted to actualize this vision.

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Objective

In the light of above, the broad objectives of the document can

be set out as under: -

i. To rationalize the existing regulatory and supervisory approachkeeping in view the heterogeneous character of entities in the sector.

ii. To facilitate a focused and continuous system of supervisionthrough enhanced use of technology.

iii. To enhance professionalism and improve the quality of governance in UCBs by providing training for skill up-gradation as alsoby including large depositors in the decision making process /management of banks.

iv. To put in place a mechanism that addresses the problems of dualcontrol, given the present legal framework, and the time consumingprocess in bringing requisite legislative changes.

v. To put in place a consultative arrangement for identifying weakbut potentially viable entities in the sector and provide a framework fortheir being nurtured back to health including, if necessary, through aprocess of consolidation.

vi. To identify the unviable entities in the sector and provide an exitpath for such entities.

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The Operating Environment

Urban cooperative banks form a heterogeneous group in terms of

geographical spread, area of operation, size or even in terms of individual performance. As such, development of the urbancooperative banking institutions into safe and vibrant entitiesrequires the small banks in the group to be insulated from systemicshocks by emphasizing their cooperative character. Further, theweak banks may have to be strengthened as a group, through aprocess of consolidation that may entail mergers/ amalgamations of viable entities and exit of the unviable ones, if there are no otheroptions available. It is also felt that it is necessary to set up asupervisory system that is based on an in-depth analysis of theheterogeneous character of the urban cooperative banks and onethat is in tandem with the policy of strengthening the sector.

Regulatory Environment

The urban co-operative banks are regulated and supervised by StateRegistrars of Co-operative Societies, Central Registrar of Co-operativeSocieties in case of Multi-state co-operative banks and by ReserveBank. The Registrars of Co-operative Societies of the States exercisepowers under the respective Co-operative Societies Act of the States inregard to incorporation, registration, management, amalgamation,reconstruction or liquidation. In case of the urban co-operative bankshaving multi-state presence, the Central Registrar of Co-operativeSocieties, New Delhi, exercises such powers. The banking relatedfunctions, such as issue of license to start new banks / branches,matters relating to interest rates, loan policies, investments,prudential exposure norms etc. are regulated and supervised by theReserve Bank of India under the provisions of the Banking RegulationAct, 1949(AACS). Various Committees in the past, which went intoworking of the UCBs, have found that the multiplicity of command

centers and the absence of clear-cut demarcation between thefunctions of State Governments and the Reserve Bank have been themost vexatious problems of urban cooperative banking movement.This duality of command is largely responsible for most of thedifficulties in implementing regulatory measures with the requiredspeed and urgency and impedes effective supervision.

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Proposed Operating Framework

The entities in the sector display a high degree of heterogeneity interms of their deposit/ asset base, area of operations and nature of business. A system of differentiated regulatory and supervisory regimeas opposed to a ‘one size fits all” approach may be more appropriate,keeping in view the vastly differentiated entities comprising the sector.The broad principles governing RBI regulation over UCBs could largelyfollow the principles as under:

A. Unit Banks (Simplified regulatory regime)

Unit banks, in particular, the smaller among them, essentially capture

the basic concept and spirit of cooperative banking since they functionfrom a single office/ branch and cater to the clientele in and aroundtheir place of business. As such, they have a natural ability to relateto the customer, have the local feel and flavour and consequentlymodulate their business strategy to meet the local aspirations. Sincesmall unit banks with deposits below, say, Rs.50 crore epitomise thebasic tenets of cooperative banking, less stringent regulations could beconsidered for such banks. For example, CRAR could be replaced bythe simpler form of minimum capital requirement viz. Net OwnedFunds to NDTL ratio which is easier to compute for the small bankswhile serving the purpose adequately. At the same time, keeping in

view their ability to assess and absorb risks, appropriate limitationslike a lower level of single and group exposure limit could beprescribed for these banks to contain their concentration risk.Similarly, the exposure by such banks to sensitive sector should bechecked, as these banks lack the wherewithal, in terms of expertise,technology and financial strength to sustain exposure to capital market / real estate etc. As such, keeping in view the nature and size of theiroperations, appropriate relaxations like a lower prescribed minimuminvestment in G-Sec (in view of their inability to access market) andrestrictions necessary to insulate them from systemic shocks may be

introduced for such banks. Ideally the unit banks should work within asmall geographical area and accordingly the Unit banks to be eligiblefor the simplified regulatory regime shall conform to this requirementby rolling back their business in far off locations. The suggestedsimplified regulatory prescriptions are given in Annexure - vi.

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B. All Banks (other than unit banks with deposits less than Rs.

50 crore)

Regulatory prescriptions, as applicable to commercial banks should beapplicable in all respects to banks falling in this category. However, forthese banks the extant relaxations for UCBs could remain in force forthe period already prescribed. Further, it is suggested that as a matterof principle, there should not be any unscheduled Multi State Bank.This could be operationalised through the Central Registrar of Cooperative Societies, which could ensure that a bank is scheduledbefore it is granted registration under the Multi State Co-operativeSocieties Act. In order to ensure that all scheduled banks are also, asfar as possible, strong enough to support themselves and a fewsmaller UCBs around them, the RBI could prescribe appropriate normsfor scheduling of cooperative banks. Further, banks in this categorywhich comply with the prescribed regulatory requirements can beextended facilities and privileges as are presently available to thecommercial banks of comparable size.

The existing scheduled banks, both under Multi State and StateCooperative Societies Act, which do not meet the prescribed criteriaand do not comply with the prudential and regulatory regimen akin tothat of commercial banks, could be excluded from the second scheduleto the RBI Act through a time bound corrective action framework As a

corollary, the existing non-scheduled Multi State Banks could also berequired to close their branches/withdraw from any business outsidethe principal State of their activity.

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Supervision

The number of unit banks with deposits under Rs. 50 crore constitute33 percent of UCBs and account for less than 6 percent of deposits of the sector. These banks, limited by their size / type of operations,pose lower systemic risks and could be supervised by a combination of simplified off-site surveillance system of the RBI and on-site audit bythe state governments. Based on these reports, Reserve Bank of India,at its discretion, could conduct inspection of such banks, which,however would not be normally covered under its regular schedule of inspection. The increased dependence on off-site surveillance of RBIand on-site supervision by RCS in respect of the small unit bankswould provide increased flexibility to the RBI to deploy its supervisory

resources to the larger and more risky banks.

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.Agenda of Reforms

The urban co-operative banking sector being an integral part of

financial system, RBI has brought in a series of reforms in it. Therecent Mdhava Rao Committee which is also called High PowerCommittee (HPC) on UCBs, has dwelt extensively on certain regulatoryissues related to UCBs' licensing policy, future set up of weak andunlicensed banks, application of capital adequacy norms, resolution of conflicts arising of dual control over UCBs, etc. RBI has accepted theserecommendations and implemented them. However, issues related todual control necessitate legislative changes to State and Central Actsand there is hardly any progress in this area. In the backdrop of thepresent scenario, future agenda for reforms in urban co-operativebanking sector, as I perceive is four fold:

(a) Aligning urban co-operative banking sector with the rest of thefinancial system

(b) Deciding the future of weak entities

(c)Improving governance

(d) Resolving the issues emanating from dual control

(a) Aligning UCB sector with rest of financial system

Unlike the other segments of co-operative credit sector, UCBs todayundertake multifarious banking activities. Some of them have alsobeen permitted to undertake forex and merchant banking activities.There is a view emerging in the recent past that UCBs being membersof payment system, beneficiaries of deposit insurance scheme andenjoying unlimited access to public deposits, it is an imperativenecessity to apply exactly the same regulatory rigours to UCBs asapplicable to commercial banks. While broadly agreeing with thisargument. I feel that their institutional frame work, size of operations

and balance sheet, nature of business, product mix and above all theskill levels, may have necessarily to be kept in view while deciding onthe supervisory and regulatory rigours. Therefore, withoutundermining the regulatory efficacy, there is a need to fine-tune theprudential prescription. The view expressed by my distinguished

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colleague, Deputy Governor Dr. Y.V. Reddy, in the context of implementation of Financial Standards and Codes in India is equallyapplicable in UCBs' adoption of prudential standards. He said "although

the notion of a code of good practices is intuitively appealing, thetemptation to prescribe universally valid model codes which do notallow for differences in institutional development, legislative framework and more broadly, different stages of development must beavoided". Notwithstanding cultural differences between UCBs andcommercial banks, RBI has been gradually attempting at regulatoryconvergence for both. To begin with, in 1993, RBI introduced IncomeRecognition and Asset Classification Norms to UCBs. In 1995, theprudential exposure norms to single/group borrowers were also madeapplicable to them. However, introduction of capital adequacy normswas delayed due to statutory limitations on UCBs' right to raiseunlimited capital but these are also now going to be implemented from31 March 2002, in a phased time-frame. The future agenda forreforms as. I visualise should focus on these following issues:

(i) Today, main risk exposure of UCBs is not the credit risk but interestrates risk. Most of the UCBs interest rates particularly on deposits areout of sync with the rest of the banking sector. In this backdrop,observance of Risk and Asset Liability Management guidelines assumesimportance. RBI has recently constituted a Working Group to evolveguidelines keeping in view the specifics of UCB sector. The Group is

expected to submit its recommendations very soon.

(ii) As market discipline is an important supervisory tool in approach tonew Capital adequacy framework, prescription of disclosure standardsfor UCBs, perhaps is of imminent necessity. UCBs, therefore, should beable to disclose their level of owned funds, unimpaired networth,CRAR. Gross/Net NPAs, operating results, ROA. compliance withreserve requirements, per employee productivity, etc. with balancesheet figures. This issue is engaging the attention of RBI.

(iii) Strengthening the audit systems is of paramount concern for RBIas it is an important tool in its supervisory kit. It had taken a lead inappointing an expert panel in 1995 for reforming the audit systems invogue in UCBs. The panel suggested professionalisation of audit,mandatory concurrent audit for larger banks, redesigning audit format,etc. RBI had accepted these recommendations and advised States toinitiate measures. Unfortunately, many state governments have yet torespond positively despite Five years of persistent persuasion by RBI.

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(iv) Yet another important issue which is engaging the attention of theobservers of co-operative banking movement is defining the frontiersof UCBs. Whether they should have unlimited access to inter-bank

markets ? Whether their reach should be nation-wide ? Whether theycan have access to capital market ?

In view of special role assigned to UCBs, in the recent Monetary andCredit Policy Statement made by the Governor, it was decisively statedthat they should not have unrestricted access to inter-bank markets asresorting to this avenue is essentially to meet their temporary liquiditymismatches rather than raising short term resources to fund their longterm assets. By their sheer volatile nature, neither capital market norits instruments can be investment avenues for UCBs who arerepresentatives of small depositors. As regards their area of operation,we have very recently taken a decision to allow only such UCBs withRs. 50 crores owned funds to go beyond their state of jurisdiction.

(v) Whether UCBs membership of Payment System should beunconditional ?

This issue has come into focus in the wake of Madhavpura MercantileCo-operative Bank crisis. In case of commercial banks, in the event of payment crisis, CRR balances would be available besides SLRsecurities, whereas in respect of UCBs, their SLR investments need not

entirely be in Government Securities and in case of non-scheduledbanks maintenance of CRR balances with RBI is not mandatory.Whether a system can be evolved whereby fire-walls can be erected toavert payment crisis of co-operative banks by way of lodgingcertain ..Government Securities, mandatory cash deposits withclearing houses for meeting payment obligations in the event of liquidity crisis ? Whether such an act would further pre-empt" theresources of UCBs? Or these deposits would constitute part of SLRfunds? This issue needs extensive enquiry.

Well these are issues which require informed deliberations forcrystalising into policy inputs.

(b) Future set-up of weak Banks

The sheer number of weak banks which is well over 200 is a cause of concern. In a large number of eases licenses have already beencancelled and the banks have closed down. This process is taken up

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very cautiously so as not to create panic in the society. 'Closure isdecided only after all other options are exhausted. Level of capital,history of losses and size of NPAs are some of the factors which weigh

with us in taking a decision on closure. Possibilities of rehabilitation areinvariably explored before such a decision is arrived at. Rehabilitationmay involve the following strategies :

(a) Registrars should direct the co-operative courts for speedyrecovery process and execution of decreesb) Unviable branches should either be relocated or closed downc) Avenues should be explored for the bank getting additional capitald) Merger with a well-managed bank. However, a forcible mergershould be strictly avoided.

(c) Improving Governance

It is extremely important-that there .is a mechanism to ensure that aneffective system of internal governance is in place. Chief Executiveshould be a person of clean image and display a professional attitude.Board should consist of knowledgeable persons who are aware of theirresponsibilities as board members. There should be a board levelcommittee which should focus attention on the Findings of audit andinspection teams and ensure compliance thereof. The Committeeshould also ensure compliance with various regulatory instructions

issued by RBI as also state governments. It is ultimately the board'sresponsibility that all prudential norms of governance are observed bythe bank.

(d) Dual control dilemma

Duality of command over UCBs perhaps has become an intense issueof debate in co-operative circles Academics, co-operators and bankersmade vociferous representations to the Madhava Rao Committee thatdual control over UCBs must end as that was instrumental in stiflingtheir growth. Narsimham Committee II had also unequivocallyrecommended for ending dual control regime over UCBs. Is dualcommand the causative factor for the ills of UCBs? Is it an impedimentin effective supervision over them ? Having been closely associatedwith the regulation of the cooperative banking structure for quite sometime. I am indeed inclined to agree with the Madhava Rao Committeerecommendation on this issue. The Committee aptly observed "... thatdual control regime, per se, need not cause any hindrance to the

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growth of urban banking movement. It is the absence of clear cutdemarcation between functions of RBI and that of State Govt. thatadversely affects the smooth functioning of UCBs.'' Most of the issues

emanating out of dual control regime is due to overlapping jurisdictionof RBI and state governments. It, therefore, recommendeddemarcation of banking related functions and such of those whichwarrant only state governments' action, RBI has concurred with itsrecommendations and is impressing upon the state governments forbringing in legislative 'amendments. Duality in command does come inthe way of effective supervision. In the case of commercial banks RBIhas all the wherewithal under Banking Regulation Act for dealing withcrucial aspects of functioning of commercial banks. In the case of co-operative banks, however, many areas which directly relate tosupervision over them have been kept beyond RBI's authority.Situation gets somewhat messy as may be indicated by a fewillustrations as follows:

(i) RBI has no authority to deal with delinquent management in acooperative bank. This requires intervention of the Registrar of Cooperative Societies.

(ii) Making investments out of surplus resources being clearly abanking function should be entirely within the decision making powersof cooperative banks subject to RBI guidelines but this needs approval

of the Registrar.

(iii) Similarly, writing off an unrealisable debt also requires permissionof the Registrar.

(iv) There was an instance where on request made by RBI, theRegistrar superseded the board of a cooperative bank. Butsubsequently the State Government in its wisdom annulled Registrar'sorders and restored the Board. It is strange but true.

(v) It is open for a bank whose licence has been cancelled to appeal tothe government. RBI is required to appear before the AppellateAuthority. Often RBI is advised to review its decision. It is a matter of satisfaction, however, that RBI's decisions have been supported bygovernment and in no case RBI's decision has been struck down.Nevertheless the exercise has to be gone through.

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I feel there are 3 ways of resolving dual control issues :

(a) One approach is by bringing in the subject of cooperation under

concurrent list so as to enable the Union Government to legislate inmatters pertaining to cooperative banking. But such a move involvesamendments to the Constitution.

(b) Another way of approaching this issue is the states enactingprogressive legislations thereby making Registrars confine their actsonly to register and accept byelaws. As a result, dual command overUCBs will be ceased automatically Though a lead has been taken bythe Governments of Andhra Pradesh and Karnataka in this direction,most of the slates are yet to follow. Even in Andhra Pradesh andKarnataka, it does not make any change in the status of existing banksunless they are registered under the new legislation. Unless a uniforminitiative is taken by all the states, perhaps it would be difficult toremove irritants of dual control regime.

(c) Yet another approach is to demarcate the regulatory roles of stategovernments and RBI in the State Acts, as suggested by the MadhavaRao Committee. I rather tend to agree with this approach since it isbest way to resolve dual control "dilemma. There have also beensuggestions that the Banking Regulation Act, which is a central statutemay be amended in a manner that it enables RBI to assume certain

powers which are at present available to state governments under therespective State Cooperative Societies Act, However, the legal advicegiven to RBI does not support such a move.

Here I would like to make it clear that while RBI is in favour of endingthe dual control, as far as Madhavpura episode is concerned, theimmediate cause of its problems did not arise out of the presentregime of dual control. What happened in the case of Madhavpura wasostensibly due to lack of observance of prudential banking practices.

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Licensing Policy of New Urban Cooperative Banks

Present Licensing Policy3.1 The existing licensing policy of RBI is broadly based on the recommendation

of the Marathe Committee.11

At present, organisation of a new UCB is allowed othe basis of the need and future potential for mobilisation of deposits anpurveying of credit, so that the new institution becomes a viable proposition ansatisfies the felt banking needs of local people. To determine the need anpotential for UCBs, presence only of urban cooperative banks functioning at given centre is taken into account and presence of all other banking network excluded. This is done as the clientele of UCBs are supposed to be distinct frothose of commercial banks. Another criterion for determining the adequacy obanking network is to take into account the average population served by thexisting UCBs. The present policy also prohibits organisation of UCBs in the rurcentres on account of distinct credit delivery system already in place for rurcentres.

Approach of the Committee3.2 The Committee observes that there are no quantifiable, objective criteria fodetermining the need for an UCB in a given area. The Committee has also notethe recommendations of the Marathe Committee, which felt that "the ReservBank may address itself to the task of prescribing quantitative definitions for thkey indicators like `need', `potential' and `adequacy' or otherwise of th`banking cover'. The Marathe Committee was of the view that while "need" fothe organisation of a new UCB refers to concepts such as population coverag

spatial and geographical spread of existing banks etc., the "potential" criteriorelates to an assessment whether, in the area of operation proposed, the neentity would be able to achieve the norms of viability within a reasonable perioof time. Marathe Committee also felt that the determining basis for such aassessment should be the `credit gap' in the functional area and suggested thfollowing guidelines for assessing the same.

i) Industrial activity present and proposed; setting up of new industrialestates etc;ii) Level of trading activity; emerging markets and market yards;iii) Sub-urban areas - existing and proposed;iv) Existing banking network, deposits, advances, credit-deposit ratio;v) Average population served by existing bank offices.

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3.3 The Committee has examined these factors in the context of asubstantially deregulated regime and policy posture of RBI with reference toorganisation of new Private Sector Banks and Local Area Banks (LABs). The

Committee is of the view that in a market driven regime, focus of theregulator should be on strong start-up capital, compliance to prudentialnorms, adherence to CRAR ab initio and professional character and integrityof management. If these factors are given due weightage before grantinglicence for a banking entity, there may not be any need to prescribe otherparameters.

3.4 While responding to the questionnaire on this issue, a section of urbancooperative banks, their federations, and state cooperative banks havesuggested that ‘credit gap' criterion should be a determining factor toestablish the need for a bank, in a given locale specific. The Committee hasexamined this aspect and in its view, ‘credit gap' in a given area cannot bedetermined on unidentifiable parameters. The concept has to be welldefined, structured and universally acceptable. Hence, in the absence of precise, measurable and scientific tools to determine exact quantum of creditgap, prescription of ‘credit gap' criterion for assessing the need, will onlyresult in a laborious exercise without any tangible results. The suggestionthat the credit gap may be determined on the basis of Potential LinkedCredit Plan (PLP) of NABARD has also been examined by the Committee. Theobjective behind the preparation of Potential Linked Credit Plan is to bring tothe notice of the planners, government, developmental agencies, bankers,

farmers, private sector agencies etc, the need for infusion of specificinfrastructure and non credit inputs to facilitate planned development of thedistrict. The focus of PLP is essentially on rural development with the thruston district as a whole. Since UCBs initially start at an urban centre, it isdifficult to arrive at credit gap of an exclusive urban locale from PLP. Giventhe weak conceptual relevance of ‘credit gap', the Committee is not inclinedto agree with this criterion for determining the need for a new urbancooperative bank at a given centre.

3.5 Yet another suggestion put forth by respondents to the questionnaire

circulated by the Committee is, that the adequacy or otherwise of bankingnetwork at a given centre can be determined by the conventionalarithmetical formula viz., Average Population Per Bank Office (APPBO). TheAPPBO is arrived at by application of following formula :

Population of a given centreNo. of banks offices (branches)

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3.6 At present, RBI is following this norm and if the Average Population PerBank Office (excluding commercial and other banking network) at a givencentre is less than 10000, the centre is deemed to be adequately banked.

The Committee has tried to assess the merits of this norm. In the opinion of the Committee, adequacy of banking network, at a given centre, cannot begauged purely by statistical or arithmetical formula like APPBO. To a greatextent, it depends on the level of economic activity, infrastructure, degree of urbanisation, buoyancy of service sector and the credit absorption capacityof the centre as a whole. These factors are not static and keep changing withreference to govt. policy, entrepreneurial capabilities and emergence of neweconomic activities. A cursory glance at urban banking network in 5 districtsof Maharashtra viz. Pune, Nasik, Sangli, Satara and Kolhapur revealspresence of a large network of UCBs. By application of APPBO norm most of the towns in these districts at present appear to be over banked. Still thecooperative initiative has not diminished. It is understood that RBI continuesto receive applications from promoters for organisation of new banks and foropening branches in these districts. On the other hand, in the states likeOrissa and Bihar, there are as few as 14 and 6 UCBs respectivelynotwithstanding the liberal policy stance of RBI. Given the thin presence of urban banking sector in these states, it appears that there is scope for thegrowth of urban cooperative banking movement. But, disparity in thepresence of urban banking movement point to the fact that adequacy of banking network cannot be gauged exclusively by mechanical application of APPBO. Rightly, no such norm is applied by RBI while giving approval for

organisation of new Commercial Banks or Local Area Banks. Moreover,excluding the non-urban banking sector in an area for gauging adequacy of banking network may not be an objective criterion. Selective prescription of population criterion only for UCBs leads to imposing artificial barriers ontheir growth besides going against the principle of equity.

3.7 The Committee feels that the licensing policy should not only betransparent but also precise and objective. The procedures have to besimple and minimal. In this context, the Committee agrees with the coreprinciples enunciated by the Basle Committee on Banking Supervision that

"the licensing authority must have the right to set criteria and rejectapplications for establishments that do not meet the standards set. Thelicensing process at a minimum should consist of an assessment of thebanking organisations, ownership, structure, directors and seniormanagement, its operative plan and internal controls, and its projectedfinancial condition, including its capital base".12 Thus, licensing processshould be minimal but rigorous. Further, in a market driven system, the

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regulator is neither expected to carry out such an exercise to assess theviability of a bank nor it has the wherewithal to go into micro level

assessment of an individual entity. Moreover, if the viability norms to beachieved within a specified period are stipulated, once a bank is licensed andstarts operating, there is no practical way in which compliance with suchnorms can be enforced. The Committee is, therefore, of the view that theregulator has only to lay down appropriate entry point norms and leave theissue of need, potential and viability of a bank to the promoters' judgement.

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Chapter I

Introduction and Approach

1. Introduction

1.1 The urban cooperative banking system has witnessed phenomenalgrowth during the last one and a half decades. From 1307 urbancooperative banks (UCBs) in 1991, the number of UCBs rose to 2105in the year 2004. Deposits increased from Rs.8,600 crore to overRs.1,00,000 crore, while advances had risen from Rs.7,800 crore toover Rs.65,000 crore during the same period. Along with thisspectacular growth certain infirmities have, however, manifested in thesector resulting in erosion of public confidence and causing concern tothe regulators as also to the well functioning units in the sector. Asignificant step in the recent past for addressing the problems of UCBswas the formulation of the draft Vision Document, which was placed inthe public domain in March 2005.

1.2 One of the factors significantly affecting the financial health of theUCBs is their inability to attract equity / quasi equity investments. Atpresent, UCBs have limited avenues for raising such funds and eventheir share capital can be withdrawn. In the context of the competitionthat the UCBs are facing from other financial intermediaries, including

the commercial banks, both on the asset and the liability sides,strengthening the ability of the banks to raise capital funds in order toexpand their business has become all the more critical for the sector.Therefore, the various steps initiated in pursuance of the proposals of the draft Vision Document for UCBs would need to be supplementedwith measures that enable them to strengthen their capital base so asto achieve the objectives set out therein.

1.3 Against this backdrop, the constitution of a Working Group toexamine the issue of share capital of UCBs and identify alternateinstruments / avenues for augmenting the capital funds of UCBs wasannounced in the Annual Policy Statement for the year 2006-07.

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Accordingly, a Working Group was constituted under the Chairmanshipof Shri N. S. Vishwanathan, Chief General Manager-in- Charge, UrbanBanks Department, Reserve Bank of India. The members of the group

were:

(i) Shri Anil Diggikar, Commissioner for Cooperation & Registrar of Cooperative Societies, Government of Maharashatra

(ii) Shri J.C. Sharma, Commissioner for Cooperation & Registrar of Cooperative Societies, Government of Andhra Pradesh

(iii) Shri D. Krishna, Chief Executive, National Federation of UrbanCooperative Banks and Credit Societies Ltd (NAFCUB)

(iv) Prof. Mukund Ghaisas, Chairman, Maharashtra State UrbanCooperative Banks Federation

(v) Shri K. D. Zacharias, Legal Adviser, Reserve Bank of India In placeof Dr. S. K. Sharma, who was initially the member of the WorkingGroup in his capacity as Commissioner for Cooperation & Registrar of Cooperative Societies, Government of Maharashtra.

1.4 The terms of reference of the Working Group were as under:

(i) To consider whether the paid up share capital can be treated ascore capital for capital adequacy purposes in the light of InternationalAccounting Standards Board’s standard IAS 32 and if not to suggest atime frame to implement the proposed standard.

(ii) To suggest alternative avenues for raising capital particularly in thelight of recent guidelines on newer instruments issued to commercialbanks by the Reserve Bank.

(iii) To look into international experiences of cooperative banks/ creditunions in raising capital and to suggest measures that can be

implemented in the context of primary (urban) cooperative banks inIndia.

(iv) To make such other recommendations as the Group may deemrelevant to the subject.

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A copy each of the notification on the constitution of the WorkingGroup and the nomination of Shri Anil Diggikar in place of Dr. Sharmaare given as Annex I & II respectively.

1.5. Approach adopted by the Group

1.5.1 Initially, specific responsibilities were assigned to each memberfor undertaking in-depth study of relevant issues and makingpresentations before the Group. Accordingly, the members madepresentations on the following topics:

a) International practices and structure for issue of bonds bycooperatives.

b) Provisions of the Indian Companies Act, 1956 in regard to issue of preference shares and the feasibility of their adoption for UCBs.

c) State Government perspective on issues relating to shoring up of capital base of UCBs.

d) Cooperative Societies Acts of significant states and Multi StateCooperative Societies Act and analysis of provisions of the IndianCompanies Act, 1956, securities Contract Regulation Act (SCRA), 1956and the SEBI Act, 1992 in so far as they relate to issue of various

financial instruments.

In addition, views of Chairmen/ Chief executive Officers of a few largeand medium sized UCBs were ascertained.

1.5.2 The Working Group had five meetings in which the presentationswere made and the issues raised in the presentations were discussedin detail. The major findings and the recommendations of the Groupare given in the ensuing chapters.

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CHAPTER II

Important Findings

2.1 The Group observed that a large number of UCBs are short of theprescribed regulatory capital. Out of 217 UCBs with deposits of overRs.100 crore, 30 banks had reported CRAR below 9 %, 20 of whichreported CRAR of less than 5%. Thus, 15% of the banks in the samplewere under-capitalized. The extent of under-capitalization could behigher in the smaller banks. Therefore, the need for analyzing theissues involved in and identification of alternate sources of capitalcannot be over-emphasized.

2.2 There are both legal and structural issues that affect theenhancement of capital of UCBs. Therefore the Group studied the legalissues as also a few successful international models to examine thepossibility of their being adopted in the context of the legislativeframework obtaining in India. The Group also examined a suggestionmade by NAFCUB for setting up a private screen based platform fortrading of financial instruments, counting for capital, issued by UCBs.The International Accounting Standards Board's (IASB)recommendations regarding non eligibility of share capital of cooperative societies to be treated as equity on account of it beingeligible for withdrawal was also studied with reference to the

provisions of the Cooperative Societies Acts. These issues arediscussed in the ensuing paragraphs.

2.3 Legal Framework

2.3.1 UCBs are not operating under any one single legislation, i.e.,they are governed by the respective Cooperative Societies Act of theState under which they are registered; besides there are 33 UCBsregistered under the Multi State Cooperative Societies Act (Multi StateAct). While the Acts are in essence similar, they differ in details inrespect of several matters including those relating to freedom to raiseand price various financial instruments. Extracts of relevant provisionsof a few State Acts and the Multi State Act are given in Annex III. Itmay be observed therefrom that while the Maharashtra StateCooperative Societies Act, 1960, (Maharashtra Act) has no specificprovisions as to the nature of instruments through which funds can beraised, which is left to the rules and bye-laws, the Multi State Act hasspecific provisions in this regard prescribing a limit of 25% of the

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share capital for raising funds by way of non-convertible debenturesetc. The pricing of share capital is another important issue where theprovisions of the law are not uniform. The Maharashtra Act does not

specify either the value at which the share capital has to be issued orthe value at which it should be redeemed. These are provided for inthe rules. However, the Multi State Act is specific that the share capitalcan be issued only at face value. There are also differences betweenActs on the limits up to which one can subscribe to the share capital of UCBs. In the Maharashtra Act, for example, apart from a prohibition onholding more than one–fifth of share capital of the society, a monetaryceiling of Rs.5 lakh per individual shareholder is prescribed, while inthe Multi State Act there is no such monetary ceiling. It was, therefore,evident that it may be extremely difficult to identify instruments thatare legally permissible across all Cooperative Societies Acts. However,because of concentration of UCBs in five states viz. Maharashtra,Gujarat, Karnataka, Tamil Nadu and Andhra Pradesh, making requisiteamendments in the Acts of these States and the Multi State Act wouldcover 85% of the banks by number and asset size.

2.3.2 Market for a financial instrument is enhanced by itstransferability. The Cooperative Societies Acts, in general, require thata share be transferred only to an existing member or to a personwhose application for membership has been accepted. This restrictionon transfers comes in the way of marketability and therefore,

adversely affects the liquidity of shares of UCBs.

2.3.3 Another legal aspect relates to listing of financial instrumentsissued by UCBs. As per SEBI Act, 1992 and Securities ContractRegulation Act, 1956 SCRA), for a financial instrument to be eligible tobe listed in the Stock exchange, it should have been issued by a bodycorporate as defined under theCompanies Act, 1956. A cooperativesociety is a body corporate as per the Cooperative Societies Acts.However, as per the Companies Act it is not a body corporate. As suchthe financial instruments issued by UCBs cannot be listed in a stockexchange.

2.4 International Systems

The Group analyzed the systems / structures obtaining in countrieswhere the financial intermediaries in the cooperative sector are strongand socially effective. In particular, the federated structures of

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Rabobank Group (Netherlands), Credit Agricole Group (France) andOKO Group (Finland) were examined based on literature available andinformation provided by the institutions in their web sites. The features

of Trust Preferred Securities, an instrument popular in countries likeUSA / Netherlands, were also looked into for examining their feasibilityin India. The findings of the Group in these matters are briefly outlinedin the following paragraphs.

2.5 Federated Structure

2.5.1 Rabobank Group

(i) Rabobank Group is the largest financial services provider inNetherlands and has an extensive network worldwide. RabobankGroup is a cooperative banking organization comprising RabobankNetherland, Rabobank Netherlands' local member credit institutions(Local Banks) and numerous other subsidiaries like RabobankInternational. While Rabobank Netherlands is a legal entity, theRabobank Group is not a legal entity. The cooperative structure andlocal involvement have been the cornerstones of the Group for morethan a century.

(ii) The local Rabobanks, which are cooperatives, are members of Rabobank Netherlands. Membership is subject to the Articles of

Association having been approved in advance by RabobankNetherlands. As of December 31, 2005, there were 248 LocalRabobanks as members and shareholders of Rabobank Netherlands.Further, while Rabobank Netherlands is a subsidiary of the localRabobanks, it is in fact at the head of an inverted pyramid. The LocalBanks serve their customers with the support of Rabobank Netherlandsand not vice versa. The latter provides managerial, operational andadvisory services, which include credit approvals, cost sharing andother centralized functions such as IT, human resource management,liquidity, capital and risk management, etc. Further, in accordancewith the Credit System Supervision Act, 1992, it is responsible forsupervising the financial health and professionalism of the LocalRabobanks. It also acts as treasurer to the Group and a holdingcompany of a large number of subsidiaries. Rabobank Group is treatedas a consolidated entity for regulatory and supervisory purposes.

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(iii) Local Rabobanks do not have any shareholders and as such do notpay dividends. Hence they retain all profits after net payments ontrustpreferred securities and membership certificates (Please refer

paragraph 2.6.1 and note to paragraph 3.4.2).

(iv) In accordance with the Credit System Supervision Act, 1992 aninternal Cross-Guarantee System is in place whereby certain entitieswithin the Rabobank Group are liable for the other participants'financial obligations in case of a shortfall of funds. Participating entitieswithin the Rabobank Group include Rabobank Netherlands and theLocal Rabobanks. This cross guarantee system, in a way, provides, toany bank within the structure, access to the resources of the entireGroup, facilitating support in times of need. In effect they all have joint and several liability for each other’s commitment.

2.5.2 Credit Agricole Group

(i) Originally, the Credit Agricole Group was the banker of the Frenchagricultural sector and farming communities. However, it has evolvedand broadened its activities to service all sectors of the economy andall types of clients.

(ii) The organization has a three-tier structure. There are more than2,500 Local Banks grouped into 48 Regional Banks, which in turn hold

a majority of the capital of Credit Agricole S.A., the central bank of theGroup. The Federation Nationale du Credit Agricole is therepresentative body of the Group. The Federation also offers supportand services to the Regional Banks, such as occupational training andhuman resources management. Credit Agricole S.A. is the largest bankof France having a unified, yet decentralized, organization.

(iii) The Local Banks own most of the capital of Regional Banks, andform the base of the group. The Regional Banks are co-operativeentities and undertake all banking activities. Some of the RegionalBanks have obtained funds from capital markets by issuing non-votingshares (certificats cooperatifs d’investissement). Regional Banks, viaSAS Rue La Boetie, hold a majority stake in Credit Agricole S.A. CreditAgricole S.A. in turn, holds 25% of the share capital of each RegionalBank.

(iv) As a result of Credit Agricole’s desire to embrace the market whilestrengthening its mutual identity, Credit Agricole S.A. was floated on

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the stock market in December 2001. Credit Agricole S.A. is a universalbank, present across the entire spectrum of banking and insuranceactivities. Credit Agricole S.A. represents all Group business lines and

entities, and has three main roles within the Group, i.e. leadinstitution, central banker and the entity responsible for ensuringconsistent development. It manages the treasury operations of CreditAgricole and raises and lends funds on the international capitalmarkets. It also provides many of the international services offered bythe Group as well as a number of technical and financial servicesthrough its specialized subsidiaries. Credit Agricole S.A. designs theproducts marketed by the Regional Banks and is responsible for itssubsidiaries and for international growth.

(v) Credit Agricole S.A. owns 25% of the Regional Banks' capital andall Group interests in foreign banks and operating subsidiariesspecializing in particular business lines. In view of Credit AgricoleS.A.’s stake in the Regional Banks, 25% of the Regional Banks’ resultsare accounted for in the results of Credit Agricole S.A. using the equitymethod. Credit Agricole S.A. coordinates the implementation of commercial strategy, in particular by defining broad marketing andcommunications policy. As the Group’s lead body, it also is in charge of managing centralized savings and advances for the Regional Banksapart from audit and risk management.

2.5.3 OKO Bank Group (Finland)

(i) OKO Bank Group comprises 239 independent member cooperativebanks and the Group’s statutory central institution, OP Bank GroupCentral Cooperative. OKO Bank is the largest subsidiary of the CentralCooperative. OKO Bank is a commercial bank, which also acts as theOKO Bank Group’s central bank. The OKO Bank Group CentralCooperative and its 239 member cooperatives own 41.3% of sharesand have 55.8% of votes.

(ii) OP Bank Group Central Cooperative is the group’s know-how andservice centre. It is a cooperative owned by the member banks and itsfunction is to produce services for the member cooperative banks. Themost notable subsidiary of the Central Cooperative is OKO Bank.

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(iii) OKO Bank acts as an independent commercial bank and financialinstitution for the member cooperative banks. It has threesubsidiaries. The OKO Bank is the central financing institution of the

cooperative banks and as a commercial bank it engages in thebusiness operations set forth in the Credit Institution Act. The specialpurpose of the Bank is to promote and support, as a central financinginstitution, the activities of the cooperative banks and otherinstitutions belonging to the Cooperative Banks Group. The bank canoffer investment services as well as custodial and asset managementservices. The bank is responsible for the debts and commitments of the central institution and its member banks and other CooperativeCredit Institutions. The central institution and its other member banksare in turn responsible in the same way for this bank's debts andcommitments. The central institution has the right to issue instructionsto OKO Bank on its operations in order to ensure the Bank's liquidity,capital adequacy and risk management as well as the right tosupervise the bank's operations.

(iv) OKO Bank issues two categories of shares. Series A are intendedfor the public and are listed on the Helsinki Exchanges. Each Series Ashare entitles its holder to one vote at the general meeting of shareholders. Series K shares can only be owned by a Finnishcooperative bank and the central institution, OKO Bank Group CentralCooperative. Each Series K share gives its holder five votes. The Series

K share can be converted into Series A share upon a demand of theshareholder or, in respect of nominee-registered shares, subject tocertain conditions and the Articles of Association. The majority of Supervisory Board members are elected from among the members of the Supervisory Board of the OKO Bank Group Central Cooperative.One of their duties is to appoint the Chairman of the Executive Boardand the President.

(v) OKO Bank, through its issuance of two categories of shares,presents a hybrid model that blends the benefits of a listed entity andthose of a cooperative. While the Series A shares enable raising capitalon stock exchange, the Series K share ensures cooperative controlover the institution.

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2.5.4 Observations of the Group on the above models

The similarity in the above three models is the presence of an Apex

level entity to which the cooperatives are federated. In the Indiancontext, such an apex level entity could be either at the State level,the national level or at any other level. However, as per the provisionsof the Banking Regulation Act 1949, Reserve Bank can grant license toa primary cooperative bank as defined in Section 5(ccv) of the Act andthe Central / State Cooperative Banks as defined in the NABARD Act,1981. As the apex level entity required for the adoption of the abovemodels would not fall in any of these categories that RBI can license,the creation of such an entity would require that an enabling legislativeframework be created.

2.6 Trust Preferred Securities (TPS)

2.6.1 Trust preferred securities are undated cumulative preferredsecurities issued out of a special purpose vehicle (SPV), usually a trustformed by a bank holding company (BHC). The SPV would issuepreferred securities to the prospective investors. The SPV shall pass onthe proceeds of the preferred security issuance and loan them to theBHC. The BHC would issue debentures/subordinated note to the SPV toreflect its indebtedness to the latter. The trust preferred securitiesgenerally allow for at least twenty consecutive quarters of dividend

deferral, after which the investors have the right to take hold of thesole asset in the trust, viz. a deeply subordinated note issued by theBHC. The note, which is subordinated to all obligations of the BHCother than its common and preferred stock, has terms that generallymirror those of the trust preferred securities, except that thesubordinated debt has a fixed maturity of at least 30 years. The SPV,in the form of a Trust, is preferred to the principal issuing thesecurities directly, possibly, because of the accompanying tax benefitsfor the investor. In the U.S.A., because trust preferred securities arecumulative, the Federal Reserve Board limits them, together withdirectly issued cumulative perpetual preferred stock, to no more than25% of a BHC's core capital elements.

2.6.2 Observations of the Group

The feasibility of allowing issue of Trust Preferred Securities wasexamined and it was found that it would require UCBs to float an SPVin the form of a trust. Except for the Multi State Act, most of the other

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Cooperative Societies Acts do not specifically provide for a cooperativesociety forming an organization registered under any other Act. Assuch, in order to enable the co-operative banks registered, other than

under Multi State Act, to raise funds through TPS, the statesconcerned may be required to bring suitable amendments in the Acts.There is no legal bar on Multi State UCBs raising funds through thisprocess excepting the limit placed on the extent to which funds can beraised by way of debentures. The Group observed that through trustpreferred pool arrangements, the small BHCs have been successful inraising capital in U.S.A. It would be ideal to have such a system in theIndian context because it would help small UCBs to raise resourcesfrom the market through this route. However, this would require anenabling legislative framework.

2.7 Suggestion of NAFCUB for Separate Trading Platform

2.7.1 As mentioned in paragraph 2.3.3, the financial instrumentsissued by the cooperative banks are not eligible to be listed in theStock Exchanges. There was a view that since the equity or equity likefinancial instruments would normally have a long maturity period,absence of liquidity might come in the way of such instruments beingsubscribed to. As such a proposal was made by NAFCUB to create aseparate screen based platform under its aegis for trading of securitiesissued by UCBs. Through this platform NAFCUB sought to facilitate

issue of certain long maturity redeemable instruments. (For detailedproposal please see Annex IV).

2.7.2 The Group found that the following issues, both legal andstructural, need to be addressed first if the arrangement is to be put inplace.

(i) The platform was akin to a stock exchange. It would require aregulator on the lines of SEBI, since it would not fall within the purviewof SEBI Act.

(ii) It will require such regulator to have control on all the participantsof the "exchange". The Group found that there was no existingauthority with such powers.

(iii) It requires a mechanism by which the transactions put through inthe exchange will be reflected in the books of the various participatingbanks.

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2.8 Accounting of Share Capital

2.8.1 The exposure draft issued by International Accounting Standard

Board (IASB) on International Accounting Standard (IAS) 32, proposesthat membership shares be presented as liabilities and not equity. Therationale for the proposed treatment is that an equity instrument is acontract that evidences a residual interest in the assets of an entityafter deducting all of its liabilities, a requirement not met by sharecapital contribution of members of cooperative societies, as they canbe withdrawn.

2.8.2 The Cooperative Societies Acts provide for the share capital tobe withdrawn after a lock in period of three years subject to suchwithdrawals in a year not exceeding 10% of the share capital at thebeginning of that year. The withdrawal of capital under this provisionwould result in the violation of the normal principle of the equityholders being entitled to residual value of an entity. To this extent, theshare capital contribution in the Indian context fails the test of definition of equity referred to in IAS 32.

2.8.3 The Working Group found that share capital of UCBs hasgenerally been stable. In respect of 217 UCBs with deposits of morethan Rs.100 crore, it was observed that over a three-year periodbetween 2003-2006, the share capital remained the same or had

increased in respect of 200 banks. Moreover, at the time of liquidation,the share capital held by the members of a bank ranks junior to allother creditors. Whenever a bank with negative net worth is mergedwith a sound bank, the acquirer bank does not give any compensationto the shareholders of the target bank in preference to the depositorsand other creditors of that bank (target bank)

2.8.4 It is evident from the foregoing that while the share capitalcontributed by members has some features which are not inconsonance with those associated with equity, in practice, it has beenfairly stable and there are checks and balances to prevent it beingwithdrawn freely.

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CHAPTER III

Recommendations

3.1. At present, the sources of owned funds for UCBs are share capitalsubscribed by the shareholders and retained earnings. At the sametime, as observed in paragraph 2.1, given the presence of a number of under-capitalized banks, there was a felt need for alternate sources forlong term capital/ quasi-capital funds. Therefore, the various optionsfor raising capital funds for UCBs were examined in the context of thelegal and structural issues referred to in the preceding chapters. Therecommendations of the Group on the issues referred to it as also afew other incidental matters are elaborated in the ensuing paragraphs.

Recommendations of the Group

3.2 To remove the monetary ceiling prescribed on subscription toshare capital

3.2.1 As a prudential measure, Reserve Bank has prescribed certainminimum share to borrowings ratio. Normally, share capital of UCBs issubscribed to by the borrowers to meet this requirement. In fact,shares of UCBs are generally not purchased as an investment option.Where these are attractive as an investment, the UCBs concerned are

reluctant to issue shares as they are a costly source of funds in view of the high dividend payout by the profit making UCBs, coupled with thestatutory requirement of having to issue share only at face value, i.e.without any premium. In such cases there is a scope for arbitrage byborrowing from the bank for investment in its shares.

3.2.2 There are certain UCBs with low capital or negative net worth.Such banks do not pay dividend. Shares of such banks are not likely tobe an attractive source of investment. However, several institutionshaving close allegiance to the prominent shareholders of a UCB mightbe willing to invest in the share capital of the bank as a part of their

support to strengthen it even if it amounts to an investment withoutany return in the immediate future. The Group observed that wheresuch UCBs are able to identify potential investors, the monetary ceilingprescribed in the Acts on individual share holding comes in the way of shoring up the share capital through this route. The Group thereforerecommends that:

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The State Governments be requested to exempt the Urban

Cooperative banks from the existing monetary ceiling on

individual shareholding either through a notification or through

amendment to the Act, where necessary.

3.3 To Permit issue of Tier II bonds

3.3.1 As discussed in Chapter I, the sources for raising stable and longterm funds having equity or quasi equity characteristics are virtuallyabsent for UCBs. At the same time, in the current deregulatedenvironment and inter sector and intra sector competition, the UCBsneed access to such funds. In this context, the Group recommendsthat:

UCBs may be permitted to issue unsecured, subordinated,

non-convertible, redeemable debentures / bonds, which can be

subscribed to by those within their area of operations andoutside.

3.3.2 These bonds could have the following features.

(i) The minimum maturity of the bonds should be 10 years. Thereneed be no upper limit on maturity

(ii) The liability of the bank to the bond holders would be subordinatedto the claims of depositors and other creditors but would rank senior toshareholders, including holders of special shares (please seeparagraph 3.4 below), if any.

(iii) The bonds can have a fixed or floating interest rate. The interestrate can also be a combination of fixed and floating rates with thelatter part being linked to factors like rate of dividend declared forordinary shareholders etc.

(iv) The Bonds will not have any put option but can have a call option

exercisable by the bank, not before five years, with prior permission of the Reserve Bank, which may be granted if it does not result in theregulatory capital falling below the prescribed level.

(v) The bonds will be ordinarily redeemed upon maturity. However, inthe case of banks whose CRAR is below the prescribed minimum at thetime of redemption, since the depositors have preferential claim over

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the bondholders, the redemption of the bonds would not be permitted,except against fresh issue of such bonds.

(vi) The bonds will be subjected to a progressive discount for capitaladequacy purposes as under: Remaining Maturity Rate of discount

a) Less than one year 100%

b) More than one year and Less than two years 80%

c) More than two years and less than three years 60%

d) More than three years and less than four years 40%

e) More than four years and less than five years 20%

(vii) The bank cannot give loan against its own bonds.

(viii) The bank would normally be required to maintain CRR and SLRagainst the liabilities covered by the bonds. However, Reserve Bankmay consider granting exemption from the reserve requirements.

(ix) The bonds may be transferable by endorsement and delivery.

(x) The bonds will be treated as Tier II capital, subject to the totalTier-II capital not exceeding Tier I capital. However,

Where banks with negative net worth raise funds by way of such bonds through conversion of existing deposits, Reserve

Bank may make an exception to this rule and treat these as

part of regulatory capital even though Tier I capital is negative.

3.4 To permit UCBs to issue special shares

3.4.1 Subscription to the ordinary shares of UCBs entitle the

subscriber to the membership of the society and voting right on onemember one vote basis. The membership is restricted to the area of operations of the bank. Very often, as already mentioned in paragraph3.2.1, the shares of UCBs are not subscribed to as investment but tomeet the share-linking norms. The financially strong banks arereluctant to issue ordinary shares both because it inflates its

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membership size and also is costly. In view of the above constraints inissuing ordinary shares, the group recommends that:

UCBs may be allowed to issue special shares on specific termsand conditions. banks can also be allowed to issue these shares

at a premium, which could be approved by the respective RCS,

in consultation with RBI.

3.4.2 The broad features of the special shares could be as under:

(i) Subscription to these shares will be on a non-voting basis.

(ii) They may be issued either at par or at a premium.

(iii) These shares may be issued in predetermined quantities over aspecified period of time. They can as such be either wholly or partlyunderwritten.

(iv) They may be subscribed to by members, non-members includingthose outside the area of operations of the UCB concerned.

(v) They will be perpetual with a call option that can be exercised onlyafter ten years, with prior permission of RBI, which may be granted inthe event of the redemption not resulting in the CRAR falling below the

prescribed minimum.

(vi) They will carry return by way of dividend, which shall not be lessthan the rate of dividend paid on ordinary shares, in terms of return onface value. However they shall be subject to a lock-in clause in termsof which the issuing bank shall not be liable to pay dividend, if

a) the bank’s CRAR is below the minimum regulatory requirementprescribed by Reserve Bank ; or

b) the impact of such payment results in CRAR falling below or

remaining below the minimum regulatory requirement prescribed byReserve Bank of India. However, banks may pay dividend with theprior approval of Reserve Bank when the impact of such payment mayresult in net loss or increase the net loss, provided the CRAR remainsabove the regulatory norm.

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(vii) The amounts raised by way of special shares would be treated asTier-I capital.

(viii) The bank cannot give loan against the shares issued by itself.

(ix) These shares may be transferred by endorsement and delivery.

Note:

The Rabobank raises fund through Membership Certificates (MCs) withinfinite maturity period issued through an SPV, which is an investmentinstitution. These are tradable through the bank once in a month. Thereturns are linked to 25 interest rates of specified gilts. The RabobankNetherlands has raised a sum of Euro 5.8 billion through thisinstrument, which is considered as Tier-I capital. The detailed featuresof MCs are given in Annex V. It may be observed that the features of the special shares proposed above are fairly akin to those of MCs.Since the return is linked to performance and not to any externalbenchmark, the special shares have a greater proximity to equity thanthe MCs, which also justifies the recommendation to allow the issue of the special shares at a premium.

3.5 To permit UCBs to issue preference shares

3.5.1The Group observed that the better managed medium sizedUCBs may be provided an instrument, which is neither a debtinstrument like a bond nor a perpetual security like special sharesreferred to above. The Group, therefore, recommends that:

UCBs may be allowed to issue redeemable cumulativepreference shares on specific terms and conditions with the

prior permission of the respective RCS granted in consultationwith RBI. The funds raised through such shares may be treated

as Tier II capital.

3.5.2 The broad features of the preference shares are as under:

(i) Subscription to these shares will be on a non-voting basis.

(i) The minimum maturity of the preference shares should be 10years. There need be no upper limit for maturity.

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(ii) The dividend shall be fixed and can be cumulative.

(iii) The liability of the bank to the preference shareholders both for

dividend and principal would rank senior only to the ordinaryshareholders and holders of special share, if any.

(iv) The preference shares will not have any put option but can have acall option exercisable by the bank not before five years from the dateof issue, with prior permission of the Reserve Bank which may begranted if, inter alia, it, does not result in the regulatory capital fallingbelow the prescribed level.

(v) The preference shares will be ordinarily redeemed upon maturity.However, in the case of banks whose CRAR is below the prescribedCRAR at the time of redemption, since the depositors have preferentialclaim over the preference shareholders, the redemption would not bepermitted, except against fresh issue of such shares.

(vi) The preference shares will be subjected to a progressive discountfor capital adequacy purposes as under:

Remaining Maturity Rate of discount

a) Less than one year 100%

b) More than one year and Less than two years 80%

c) More than two years and less than three years 60%

d) More than three years and less than four years 40%

e) More than four years and less than five years 20%

(vii) The bank cannot give loan against its own shares.

(viii) The bank should create a sinking fund @ 20% of the principal inthe last five years to maturity.

(ix) The bank would be required to maintain CRR and SLR against theliabilities covered by the preference shares. However, Reserve Bankmay consider granting exemption from the reserve requirements.

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(x) The preference shares will be treated as Tier-II capital, subject tothe total Tier-II capital not exceeding Tier-I capital. However,

Where banks with negative net worth raise funds by way of such shares through conversion of existing deposits, Reserve

Bank may make an exception to this rule and treat these as

part of regulatory capital even though Tier I capital is negative.

3.6 Issues involved in raising funds through special shares and

the Group's opinion/ recommendations thereon

There are certain issues involved in accessing funds through specialshares, some of which would have relevance to tier II bonds as well.The Group’s recommendations and opinion thereon are as under:

3.6.1 Cooperative Societies Acts / Rules

(a) There is a need to amend the Multi State Act to remove the limitprescribed on raising of funds by way of non convertible debentures /bonds. Wherever such limits are prescribed in other State Acts,necessary amendments may be made. In some of the states like inMaharashtra, the limits are prescribed in the rules, in which cases thegovernment may have to exempt the UCBs from the provision oramend the rules, as required.

(b) The Group is of the opinion that issue of special shares at apremium and the rate at which dividend can be declared thereonwould not be violative of the existing provisions of the Acts / Rules inthis regard as these are applicable only to ordinary shares. However, if in any Act there is a specific bar on issue of securities other thanordinary shares, necessary amendments would be called for.

3.6.2 Public Issue and Private Placement

In terms of SEBI Regulations, a public issue requires issue of a

prospectus, appointment of Merchant Banker, etc., besides obtainingacknowledgment from SEBI. This provision would not be applicable forfunds raised through private placement. However, a private placementcannot have more than 50 investors. Since SEBI Regulations would notcover the securities issued by UCBs, the Group opines that thelimitation on the number of investors would not be applicable toinstruments issued by UCBs. In other words they may raise funds

39




through these instruments on a private placement basis without beingsubject to restrictions prescribed by SEBI.

3.6.3 Listing and Transferability

As the SEBI Act and the Securities Contracts and Regulation Act do notcover the instruments issued by the UCBs, they cannot be listed in astock exchange and to that extent free tradability would not bepossible. After due deliberations, the group came to the conclusionthat listing is not sine qua non for transferability. A financialinstrument can be transferred by endorsement and delivery.Therefore, the Group has suggested that the bonds and special sharesbe transferable by endorsement and delivery.

3.6.4 Investment by UCBs

UCBs may be permitted to invest in Tier II bonds of other UCBs.Reserve Bank may prescribe an appropriate limit linked to theinvesting bank’s and recipientbank’s Net Owned Funds.

3.6.5 Rating

Rating of an instrument may be left to the discretion of the issuer.Incidentally, commercial banks are allowed to invest in unlisted bonds

to the extent of 10% of their non-SLR investments. In this context, theGroup recommends that the

Reserve Bank may make an exception in this regard to enable

the commercial banks to invest in the special shares,

preference shares and Tier II bonds issued by UCBs within theceiling prescribed for investment in unlisted securities.

3.7 To permit UCBs to issue long maturity deposits

3.7.1 At present banks are not permitted to raise deposits for periods

over 10 years. As an alternate to Tier-II bonds and to provide asimpler method for raising long-term funds, it is recommended that

UCBs may be permitted to raise deposits of over 10 yearmaturity and such deposits can be considered as Tier II capital

subject to their meeting certain conditions.

40




3.7.2 The features to be fulfilled by the long term deposits to beeligible for being treated as Tier II capital could be as under:

(i) Minimum maturity will be 15 years.

(ii) It will be subordinated to the claims of depositors and othercreditors but would rank senior to shareholders, including holders of non-voting shares, if any and will be subject to RBI approval forrepayment which will be given as long as banks assessed CRARexceeds 9 per cent.

(iii) It should have floating rate of interest. Premature withdrawal willnot be permitted. However, banks would have the option to repayanytime after 10 years with prior permission of RBI.

(iv) The deposits will not be eligible for DICGC cover

(v) The bank cannot give loan against these deposits.

(vi) The bank would be required to maintain CRR and SLR against theliabilities covered by the deposits. However, Reserve Bank mayconsider granting exemption maintaining the reserve requirements.

(vii) These deposits will be subjected to a progressive discount for

capital adequacy purposes as proposed in paragraph 3.3.2 (vi).

(viii) These deposits will be treated as Tier-II capital, subject to thetotal Tier-II capital not exceeding Tier-I capital. However, the Grouprecommends that :

Where banks with negative net worth raise such long term

deposits through conversion of existing deposits, Reserve Bank

may make an exception to this rule and treat these as part of regulatory capital even though Tier I capital is negative.

3.8 To grant exemption from Income Tax

There are several constraints in the way of UCBs being able to raisestable long-term equity / quasi equity funds. The suggestions for issueof Tier-II bonds and special and preference shares would requireamendments to Acts / Rules which may be time consuming. In the

41




circumstances, the only source of own funds for the UCBs is retainedearnings. The Group therefore recommends that:

Reserve Bank could suggest to the Government of India todefer the application of income tax on UCBs for a period of

three years by which time, the alternate instruments may also

take concrete shape. The waiver of Income Tax can be subjectto appropriate restriction on declaration of divided to ensure

that the consequent savings are used to shore up the capitalbase.

3.9 To dispense with the share linking norms

The regulatory provision requiring a certain percentage of borrowingsto be contributed to share capital is intended to ensure a minimumcapital for theUCBs. This requirement was prescribed to ensure thatcapital was earmarked whenever a loan is disbursed so that the UCBsdid not create risk assets disproportionate to their capital. However,now that UCBs are brought under the regime of linking capitaladequacy in terms of a ratio to risk assets, prescribing a share to loanratio on a borrower-to-borrower basis may not be necessary. TheGroup therefore recommends that:

The extant instructions on share linking to loans may be

dispensed with.

3.10.1 Accounting of Share Capital

3.10.1 The various features of the share capital contribution havebeen discussed at length in paragraph 2.8. As observed therein, whilethe share capital does not have all the characteristics of equity, it hasbeen by and large stable. In respect of treatment of membercontribution as share capital, World Council for Cooperative CreditUnions (WOCCU) has, in a letter addressed to International AccountingStandards Board, suggested that the member's shares should be

deemed as equity if

(i) An entity has the unconditional right to refuse redemption of members’ shares,

or

42




(ii) An entity may be prohibited by law or its governing charter fromredeeming members’ shares if doing so would cause the number of amembers’ shares or amount of paid-in capital from members’ shares

to fall below a specified level.

3.10.2 The Group opined that the above stand taken by WOCCU islogical. In the Indian context, the Cooperative Societies' Acts providefor limiting withdrawal of share capital in a year to 10% of total sharecapital at the beginning of the year. It could be argued that this limitof 10% of share capital or the minimum lock-in period can becircumvented by non payment of residual amount of loan to the extentof share capital held. However, it needs to be understood that thisdoes not tantamount to withdrawal of capital. If the share capitalcannot be adjusted on account of non-compliance with either of thetwo conditions stipulated by law, the residual loan would be a liabilityof the borrower and would continue to accrue interest. The borrowerwould not be eligible for non-application of interest on the residualloan amount on the grounds of having share capital of like amount. Asa corollary, the said borrower would also be eligible to get dividend onhis share capital.

3.10.3 In view of the above as also the empirical evidence of sharecapital of UCBs being by and large stable, the Group recommendsthat:

Share capital contribution may continue to be treated as

equity and reckoned as Tier I capital for regulatory purposes.

3.11 Federated Structure

A reference is invited to the observations in paragraph 2.5.4 relatingto the international systems. The Group opines that creating afederated structure on the lines of the one obtaining in Netherlands orin Finland may be faced with legal hurdles as also in bringing the UCBsunder the fold of an umbrella of one organisation in view of thedifferent cultural and social settings they are now working in.However, creating a legal framework for facilitating the emergence of such umbrella organisation(s) appears to be the only long termsolution to enhance the public and depositors' confidence in the sector.As this would not only require amendments to the CooperativeSocieties Acts but also entails changes to the supervisory andregulatory practices, the Group recommends that:

43




The entire issue of creating an appropriate legislative and

supervisory framework be separately examined taking into

consideration the international experiences and systems.

3.12 Trading Platform

The Group considered the suggestion of NAFCUB for having a separatetrading platform for securities issued by UCBs. The Group noted thatthe suggestion was made by NAFCUB for providing a mechanism fortransfer of instruments and liquidity to the investors. However, theGroup has suggested a few instruments, which could be transferredthrough endorsement and delivery. As such, the legal and structuralissues referred to at paragraph 2.7.2 apart, it was of the view that theefficacy of having a separate trading platform for these securities couldbe examined, if and when, on the basis of experience gained fromissue of such instruments by UCBs, a need is felt.

44




Recent Developments

Over the years, primary (urban) cooperative banks have registered a

significant growth in number, size and volume of business handled. Ason 31st March, 2003 there were 2,104 UCBs of which 56 werescheduled banks. About 79 percent of these are located in five states,- Andhra Pradesh, Gujarat, Karnataka, Maharashtra and Tamil Nadu.Recently the problems faced by a few large UCBs have highlightedsome of the difficulties these banks face and policy endeavours aregeared to consolidating and strengthening this sector and improvinggovernance.

Source: Adapted from a paper by O.P. Sharma, formerly of the HistoryCell.

45




3.13. Concluding Remarks

3.13.1 As discussed in Chapter I, the spectacular growth of the UCB

sector has affected the performance of the banks, which has led tolarge number of banks turning weak and sick. As on March 31, 2006almost 30 % of the banks were still in Grade III and Grade IVsignifying weakness and sickness (Reserve Bank Annual Report 2005-06). The Group noted that over the last couple of years the UCBssector has been witnessing a gradual decline in terms of rate of growthof business. However, as growth of business is linked to capital, theadditional instruments suggested by the group seek to reverse thistrend and improve the growth potential of the UCBs without adverselyaffecting depositor interest. This would also facilitate the realization of the goal for strengthening the sector as set out in the draft VisionDocument for UCBs.

3.13.2 The instruments proposed by the Working Group areuniversally applicable for all UCBs. However, it could be argued thatthese do not address the problems of weak banks which may find itdifficult to raise resources through these instruments. This may not betrue in all cases. The High Networth Individuals, for example, who maybe willing to invest in UCBs for turning them around, may find, in thespecial shares and other instruments proposed, a feasible andattractive avenue. Moreover, consolidation in the sector is an effective

instrument for resolving the issues of non-viable banks. At presentthere are not many UCBs with the financial strength required to takeover other weak banks. The alternate instruments suggested wouldfacilitate the emergence of a larger number of financially strong UCBsthat would have the ability to absorb the losses occurring in theprocess of take over of weak banks. The Group opined that this wouldenable the regulators to play a proactive role in resolving, throughmergers, the problems posed by the non-viable entities.

46




Structures and Spread of UCBs

In terms of geographical spread, UCBs are unevenly distributed across

the states. Five states viz., Maharashtra, Gujarat, Karnataka, Andhra

Pradesh and Tamil Nadu account for 1523 out of 1924 banks that

presently comprise the sector. Further, the UCBs in these states account

for approximately 82% of the deposits and advances of the sector as may

be seen from the table below:

Name of the

State

No of

banks in

operation

% to

total no.

of banks

Deposits

(Rupees in

lakhs)

% of

deposits

to total

deposits

Advances

(Rupees in

lakhs)

% of

advances

to total

advances

Maharashtra 639 26.68 60,72,498 55.08 37,42,401.2 55.09

Gujarat 321 15.24 16,27,946 14.77 9,70,287.03 14.28

Karnataka 300 14.25 8,35,274 7.58 5,37,186.7 7.91

Tamil Nadu 132 6.27 3,10,521 2.82 2,12,113.28 3.12

Andhra

Pradesh

131 6.22 2,11,324 1.92 1,37,888.23 2.03

Total 1,523 2,106 90,57,563 82.15 55,99,876.5 82.44

For all UCBs in the country, the total Deposits are Rs. 1,10,25,642lakhs and total Advances are Rs. 67,93,017 lakhs

47




ANNEX I

NOTIFICATION

Working Group to Examine Issues Concerning

raising of capital by Primary(urban) Co-operative Banks

As announced in the Annual Policy Statement for the Year 2006-07, ithas been decide constitute a Working Group, as under, to examine theissues relating to treatment of paid share capital as core capital andidentifying alternate avenues for raising capital by primary (urban) co-

operative banks:

Shri N.S. Vishwanathan CGM-in-Charge,UBD, RBI

Chairman

Shri S.K. Sharma, I.A.S Commissioner forCooperation & RCSMaharashtra

Co- Member

Shri J.C. Sharma, I.A.S. Commissioner forCooperation & RCSAndhra Pradesh

Co- Member

Shri D. Krishna Chief Executive,NAFCUB Member

Shri Mukand R. Ghaisas Chairman,Maharashtra UrbanCo-operative Banks'Federation

Member

Shri K. D. Zacharias Legal Adviser, RBI Member

The terms of reference of the Working Group are as under:

48




(i) To consider whether the paid up share capital can be treated ascore capital for capital adequacy purposes in the light of IASB 32standards and if not to suggest a time frame to implement theproposed standard.

(ii) To suggest alternative avenues for raising capital particularly in thelight of recent guidelines on newer instruments issued to commercialbanks by RBI.

(iii) To look into international experiences of co-operative banks/creditunions in raising capital and to suggest measures that can beimplemented in the context of primary (urban) cooperative banks inIndia.

(iv) To make such other recommendations as the Group may deemrelevant to the subject.

The Working Group will commence its work immediately and submit itsreport by July 15, 2006 Urban Banks Department of Reserve Bank of India will provide secretarial assistance Working Group.

(V.S.Das)

Executive Director

Reserve Bank of India

April 21, 2006

49




ANNEX II

Chief General Manager-in-Charge

DO.UBD.CO.13441/09.18.200/05-06 June 28, 2006

Dear Shri

Working Group to Examine Issues Concerning raising of capital

by Primary(urban) Co-operative Banks

As announced in the Annual Policy Statement for the year 2006-07 byRBI, a Working Group had been constituted to examine the issuesrelating to treatment of paid up share capital as core capital including

avenues for raising fresh capital by primary (urban) co-operativebanks with Commissioner for Co-operation & RCS, Maharashtra as oneof its members. The 1st meeting of the Working Group was held onMay 24, 2006 and was attended among others, by your predecessorShri S.K.Sharma, IAS.

2. It gives me pleasure to invite you to join the Working Group. Thedate and venue of the next meeting will be conveyed to you shortly.

Yours sincerely

(N.S.Vishwanathan)

Shri Anil Diggikar, IAS.

Commissioner for Co-operation &

RCS, Government of Maharashtra

Central Building Annexure

Pune- 411001.

50




ANNEX IV

RAISING CAPITAL THROUGH ISSUE OF ‘NON-VOTING’ SHARES

BY

URBAN CO-OPERATIVE BANKS-CONCEPT OF PRIVATEEXCHANGE

D. Krishna, Chief Executive, NAFCUB

In order for urban co-operative banks to access larger number of investors without going to the capital market, a system that wouldbring together all the members of a group of urban co-operative banksto invest in any of, or in more than one urban bank has been drawn upin this presentation. This class of investors called “non-votingshareholders” will be different from existing “regular” and “nominal” members. While like “nominal” members, the “non-votingshareholders” will also not have the voting rights, the essentialdifference will be:

(a) they can be from outside the area of operation of banks; and

(b) each investor can own “non-voting shares” of more than one urbanbank.

The salient feature of the scheme would that a bank in a small centerwith limited scope of making members from its area of operation cansell non-voting shares to a large number of investors that aremembers of other banks across the Country.

The Model

We want to create a ‘private screen based exchange’ of theirown wherein shares of Non Voting types can be issued and

traded amongst all members of participating cooperative

banks.

51




To start with, we want to restrict the number of issuing banks. So, inthe beginning only those banks having a deposit base of more than100crore and falling in Grade I or Grade II bracket in Tier II categorywill be allowed to issue the instrument. Later the other banks can also join by issuing this instrument. All the members of the issuing banks

will be allowed to participate in subscribing and trading.

So, at an initial stage we can look at an approx. number of 500 Banksissuing shares. These 500 Banks have an approx. 5 million members.If we consider that even if 2% of the members subscribe to the sharesissued then we would have an investor base of approx. 1 lakh.

Instrument

The instrument that we have proposed is a Non Voting PreferenceShare.

This is with reference to the minutes of the last meeting, wherein wehad found out that Maharashtra State Cooperative Act does not barthe issuance of Preference Shares by cooperative banks.

The features of the same are as follows:

_ Non Voting – The instrument holders would not get voting rights likeequity shareholders

_ Fixed Dividend – The instrument holders would be entitled to get afixed dividend on the face value

_ Cumulative - The dividend would be cumulative

_ Tradable/Transferable – The instrument can be traded in thesecondary market created for it

Rules and Regulations

How much to issue?

The banks would be allowed to issue a minimum of 20% of the NetOwn Funds or Rs. 1 Crore, whichever is less.

52




The maximum limit upto which banks can issue Non Voting Shares willbe 100% of their Net Owned Funds.

How much dividend should the cooperative bank pay?

The dividend would be decided by the banks on an individual basis andthe bank has an option to reset the dividend after every 3 years withcap and floor of the change being 200 basis points.

What are the Exit Options available to the investor?

_ Secondary Market – the investor can sell his/her shares on theexchange created and get out of the market

_ At the end of the 5th year of issue the investor will have a PUTOption, i.e. the investor will have an option to sell 20% of his holdingto the issuing bank at the Market Price or the Face Value, whichever islower

_ At the end of the 8th year of issue the bank will have a CALL Option,i.e. the bank will have an option to buy 20% of the Preference Sharesissued at the Market Price or the Face Value, whichever is higher

_ Starting from the 8th year, every 3rd year there would be analternate CALL/PUT Option having the above conditions

Why would the members subscribe to Non Voting PreferenceShares?

_ The members would have a chance to invest in the shares of othercooperative banks

_ The members holding these Non Voting Preference Shares would geta fixed dividend every year

_ There would be Capital Appreciation of the Non Voting PreferenceShare Value

53




To established such model a sound networking structure should alsobe in place.We have proposed a networking structure also for this model-

ISSUER

Subsidiary of

NAFCUB Exchange

DP

COOP. BANK INVESTOR

In the model we have tried to keep the shareholder at par with theequity shareholder and the depositor in term of advantage anddisadvantage.

54




ANNEX V

Features of Rabobank Membership Certificates

What are Membership Certificates?

Rabobank Memership Certificates enables one to invest in certificatesof shares in Rabobank Ledencertificaten N.V. This institution investsthe majority of its capital in subordinated loans extended to RabobankNederland. It invests the remainder of its capital in loans tocreditworthy borrowers, such as the State of the Netherlands. Thecertificates are offered exclusively to Rabobank members.

What are subordinated loans?

A subordinated loan means that if Rabobank Nederland is unable tomeet its payment obligat9ions, all creditors' claims will be paid first.Membership certificate holders will consequently only receive theirinvestment including any accumulated dividend back after thecreditors have been paid.

Returns

Rabobank Ledencertificaten N.V. is expected to pay a dividend fourtimes a year. The dividend payment is linked to the average effectivereturn on the most recent ten-year Dutch state loan. over a specified

period. Should the effective return rise, the dividend payment will risein tandem. As such there is no market risk .No or less dividend will bepaid if Rabobank fails to make a profit or make insufficient profit or if the Rabobank Group's capital position is insufficient.

Monthly buying and selling

Rabobank Membership Certificates not listed on a stock exchange andare tradable once a month via an internal market. The price is not setand depends on supply and demand. The actual trading price will beupdated each month on our site.

55




Costs

One can buy or sell Rabobank Membership Certificates each month.There are no buying costs and custody fee is not charged. The sellingcosts depend on the channel used to place order or orders:

Period to maturity –

Rabobank Membership Certificates have, in principle , an infiniteperiod to maturity. Rabobank, is, however, entitled to decide toredeem the certificates on certain specified period and every yearthereafter

56




Annexure-VI

Proposed 2 - Tiered Regulatory Regime

UCBs may be classified into the following two tiers of regulatoryregime:

Tier I:

Unit Banks with deposits upto Rs. 50 crore

Tier II

All other Banks

To determine the deposit base, the fortnightly average of the NDTLreported in the statutory returns in the preceding accounting year maybe reckoned so that a stable and reliable basis is adopted.

The prudential norms recommended for banks falling under differentTiers are as under:

(I) Tier I Banks i.e. Unit Banks with deposits less than Rs.50crore

(i) Asset classification norms:

To identify NPAs on the basis of 180 day delinquency norm for threemore years commencing March 31 2005 but build up adequateprovisions in the BDDR over the next three years such that they wouldbe able to transit to 90 day NPA norm by March 31 2008. Since the 90day norm for asset classification came into force effective March 312004, revised asset classification norm should not result in any write

back of provisions and the new norm would be applicable foridentification of NPAs in 2005 and onwards.

Note: Extant instructions would apply for agricultural loans.

(ii) Provisioning norms:

57




The provisioning norms will be as under for another three years:

Sub standard : 10%

Doubtful (up to one year) : 100% of unsecured portion plus 20% of

secured portion

Doubtful (one to three years) : 100% of unsecured portion plus 30%of secured portion

Doubtful for more than 3 years: 100% of unsecured portion plus 50%of secured portion

Loss : 100%.

Note: i) A Sub standard account will be classified as doubtful after18 months.

ii) All the above provisioning norms will apply for another 3 years.Consequently implementation of the instructions requiringclassification of substandard account into doubtful category after 12months instead of 18 months and 100 % provisioning for doubtfulassets of over 3 years would be deferred by another three years. Assuch the banks should build up adequate provisions over this period to

facilitate smooth transition.

(iii) Norms for Investment:

(iii.i) SLR: The minimum SLR holding in Government and otherapproved securities as a percentage of NDTL for non scheduled UCBsis presently 15 % for banks with NDTL of over Rs. 25 crores and 10%for the remaining non scheduled UCBs. It is observed that the smallerbanks, particularly those operating in rural, semi-urban centers, find itdifficult to make investments in G-Sec due to lack of access to themarkets. In order to meet SLR requirements, these banks often have

to purchase G-Sec at a price that is higher than prevailing marketrates, as they do not have the wherewithal to obtain information oncurrent market price of these securities, like access to PDO-NDSplatform etc.

58




While efforts will be made to enable access to securities’ marketthrough Primary Dealers, in the interregnum, these banks could beexempted from compulsory investment in G-Sec to the extent of thedeposits kept by them in SBI, Associates and Nationalised banks.

(iii.ii) Non-SLR: Present limit of 10% of total investments wouldcontinue.

(iv) Borrowings: Not to exceed 2% of deposits

(v) Capital Adequacy:

At present all UCBs are required to comply with 9% CRAR akin tocommercial banks. For easier understanding and simplification, it issuggested that CRAR in respect of Tier I banks may be replaced with aNet Owned funds to NDTL ratio. It is proposed that a NDTL to NOFratio of 15 could be prescribed.

(vi) Exposure Norms:

10% of capital funds or Rs.40 lakhs, which ever is lower for individualborrower and 20% or Rs.80 lakhs, which ever is lower, for group,would be applicable in order to contain concentration risk for the Tier Ibanks.

Off-Balance sheet exposure not to exceed 2 percent of NDTL.

(vii) Sensitive Sector Exposure:

Tier I banks should not be allowed to take any direct exposure to realestate, builders or to the capital market. However, loan for individualhousing may still be extended by these banks upto the present limit of Rs.15 lakh per individual borrower.

(viii) Audit:

Concurrent audit should be compulsory for all banks. Statutory audit

should be done using Long Form Audit Report. Statutory audit of banks with deposit base of over Rs 25 crore should be entrusted tochartered accountants.

59




TIER - II ( All other banks):

For all banks, other than unit banks with deposits upto Rs.50 crore, allregulations as applicable to commercial banks should be applied,However, for these banks the extant relaxations for UCBs could remain

in force for the period already prescribed. Further, facilities andopportunities available to commercial banks should, as far as possible,be also made available to such banks to enable them to grow andcompete with commercial banks. Banks that do not comply with theregulations should either reduce their operations to qualify for therelaxed regulations applicable for unit banks with deposits less thanRs.50 crore or may be required to convert into cooperative societies.

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Index

Sr.

No. Content

Page

No.

1 Executing Summary 1a) Backgroundb) Methodologyc) Finding

2 Brief Histroy 3 3 Bird's Eye View 4 4 Vision 5 5 Objective 6 6 Operating and Regulatory Environment 7

7 Proposed operating Framework 8

a) Unit Bankb) All bank

8 Supervision 10 9 Agenda of Reform 11

a) Aligning Urban Bankingb) Future set up of Weak Bank

c) Improving Governanced) Dual Control Dilemma

10 Licensing Policy of New Urban Banking 17

11 Introduction and Approach 21

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