The Case of the Reserve Bank of India Circular on Opening Current Account
An oft cited paper in the literature on regulation goes by the title “Gentle Nudge vs. Hard Shove”. The regulatory dilemma is exemplified by the recent case of the Reserve Bank circular on opening of current accounts. Years of “gentle nudges” which did not result in banks complying with instructions regarding credit discipline seem to have resulted in “hard shoves” involving more hands-on regulation.
Some bank borrowers have taken the legal course demanding quashing of the Reserve Bank of India circular dated 6 August 2020 on opening current accounts by banks. The Bank has since further extended the last date for compliance to 31 October 2021.
Diversion of funds by borrowers is a major reason for large NPAs in banks. This could happen in two ways. The first is when the borrower diverts funds intended for the sanctioned purpose for other internal but unrelated or non-priority activities. This could include buying a limousine for the CEO, plush offices or other real estate, or vanity acquisition of other companies. The second instance is wehre the borrower diverts funds could outside the firm, to other firms, whether owned or controlled by the same group, friends or relatives. The first is the result of misguided strategies or muddled priorities. The second is with an intention to defraud lenders, other creditors, and non-controlling shareholders.
Current accounts with non-lending banks are an important channel for diverting funds. To prevent such fraud and for better credit discipline, the Reserve Bank has mandated various safeguards to be observed while opening current accounts. This includes obtaining an NOC from lending banks before opening current accounts. Banks may also verify with CRILC, the RBI credit database, as to who the lending banks are, and inform them. Banks should also obtain NOC from the drawee bank when the initial deposit is by cheque.
The August 2020 circular
Widespread noncompliance with mandated precautions forced the Reserve Bank to issue its circular dated 6 August 2020 on opening current accounts in banks. It bars non-lending banks from opening current accounts for large borrowers. Thus, if borrowing is through a cash credit or overdraft account, no bank can open a current account. The borrower will have to do its normal transactions through these accounts.
If a borrowing firm has no cash credit or overdraft account, it can open a current account subject to certain restrictions. When the bank’s exposure is less than 10% of total borrowings, debits to the account can only be for transferring to accounts with a designated bank with more than 10% share.
If total borrowing is Rs. 50 crore or more, the lending banks should agree to have an escrow mechanism. The bank managing the escrow account alone can open a current account. The other lending banks can open ‘collection accounts’. Debits to the collection account can only be for transfer to the escrow account at periodical pre-agreed intervals.
If the borrowing is between Rs. 5 and 50 crore, all lending banks can open current accounts. Non-lending banks can open collection accounts. If borrowing is below Rs. 5 crore, even non-lending banks can open current accounts subject to borrower informing when exposure exceeds Rs. 5 crore.
The circular further mandates that banks bifurcate working capital credit into loan and cash credit components at individual bank levels even if there is a consortium.
The intentions of the impugned circular dated 6 August 2020 are unexceptionable. On the face of it, the regulations are apparently simple and straightforward. But, there are many operational issues.
Overdraft vs. Current Account
First, if a borrower has an overdraft facility, how can there not be a current account. In other words, if a bank cannot open a current account, how can it extend an overdraft? An overdraft facility is a current account in which a bank allows overdrawal up to a sanctioned limit. In the absence of such a pre-sanctioned limit, a bank official may allow temporary overdraft in the current account, within her discretionary powers. The fact that the impugned circular forecloses such operational flexibility is the second issue.
Third, there is a mismatch between what a borrower needs and the regulations provide. When an account is large, a lending bank might require the support of non-lending banks through current accounts with other banks operating in areas where it has no presence. The circular rules out such a possibility. But such support is available if the loan is below Rs 5 crore, when neither the borrower nor the lending bank may require such support.
Fourth, a healthy and active current account enables a bank to monitor the credit of a borrower, however small the exposure. Denying this deprives the bank of such a control. The lack of such control through oversight of day to day operations was why large development financial institutions of yesteryears built up huge non-performing assets.
Share in exposure
Fifth, why should a bank with less than 10% share in exposure allow transfer of funds to another bank when it can use the same to adjust other dues with it, such as a term loan.
Sixth, share in borrowing is not static. It could increase and decrease, crossing the threshold both ways. This can happen often, seasonally, or at the end of the month while paying salaries, collecting dues, and so on. Nor are they smooth curves. There could be huge lumps when the borrower has to make one-time heavy payments for, say, import of equipment. Or when it receives large export proceeds or income tax refunds and adjust the same against its various dues.
Term loan and cash credit components
Seventh, the regulation mandates splitting working capital into term loan and cash credit components across all banks. Such one-size-fits-all regulation does not factor in the purposes for which banks give different facilities. A large company might avail loans in Mumbai, where it is headquartered. But, it might also require current accounts with another bank in Assam to service the daily requirements of a unit located there. One could argue that the Assam account also be with the same bank. But, the Assam account might have been the result of a merger where the earlier entity had banked with a different bank for decades. Or, the Mumbai bank may not have presence in the area where the Asssam unit is operating. But, these are issues that a regulator best avoids entering into. Procrustean methods add costs to the system with no concomitant benefits.
There are a few other issues relating to the approach of regulation. First, it is important to base regulation more on principles that focus on outcomes than rules that are content with compliance. Rules are not flexible, do not provide for unforeseen circumstances, and can be easily circumvented. Second, regulation needs to use more generic terms. Certain terms such as Working Capital Term Loan might mean different things in different banks. Third, should regulation be designed to target exceptional events such as diversion of funds and fraud by a few, and make them applicable to all? Or, is it not better to leave management of exceptional risks to the banks? Fourth, shouldn’t the costs of regulation be justified by the benefits to the system? Finally, is more regulation the answer to noncompliance?
Finally, there are implications for compliance. When regulation does not take into account or is not aligned to market practices, it lacks legitimacy in the eyes of the regulatee organizations. Legitimacy is a construct from the neo-institutionalist literature, and not to be taken literally. When legitimacy is lacking, compliance suffers. It will be all the more so when it is a regulation where compliance involves actions by thousands of employees. This makes the regulatee organizations resort to what the literature calls cosmetic or creative compliance.
That is how banks have invented a new banking practice of giving overdraft in fixed deposits, referred to as FD-ODs in some news reports. A similar arrangement involving savings deposits has not emerged because commercial organizations are not eligible for opening such deposits.
Another form of creative compliance could involve sanctioning unnecessary non-funded limits to artificially boost its exposure. A bank could also merely rename current accounts as overdraft as an overdraft account could have a credit balance.
All this will have the counterintuitive effect of diluting credit discipline rather than strengthening it. That, we hope, is not an outcome that the regulator wants. In that case, there is a need to have a relook at gentle nudges with a focus on outcomes and principles based regulation.
A shorter and different version of this article appeared in The Hindu on 26 August 2021.
© G. Sreekumar 2021.
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