Ref. No.

: LEB0004

Regulatory Rhyme for a Sinking Bank

Ajay Sharma (Ajay) and Rajnish Patil (Rajnish), were IT professionals and friends and hailed from the same town. They decided to scale up higher heights of their career by putting their heads together and encashing on their public relations and experiences, which they had during their interaction with various banks while providing IT services. In the process, they discussed with a number of people and examined various options available to them in the light of the changing business environment. Economic reforms, technology and innovation have been transforming the financial markets in India. In the light of increased purchasing power of employees and boom in the consumer durables and housing sector markets, lending business appeared to be lucrative. Equally encouraging is the growing trend of people with high-end salary incomes to save money for future. Most of the employees, in order to secure their future, have plans to invest their savings in the bank as they consider the bank deposits to be safe. Ajay and Rajnish in order to realise their dream, resigned their jobs and thought of starting some business to gain on their experiences and contacts. Some of their friends, including the financial consultants, advised them to start a Non-Banking Financial Company (NBFC) which can enter into a specific segment either housing loans or leasing and hire-purchase. Some others suggested starting a banking business. A common advice received from most of the sources before entering into the fray was to study and understand the law and regulations governing banking businesses and non-banking businesses in India. They tried to explain the complex nature of banking regulations and law in India and also the role played by the Reserve Bank of India (RBI), an apex body in controlling banking transactions. Either banking or non-banking financial business the promoters have to convince, comply with relevant regulations and submit to the supervision of super regulator, RBI.

This case study was written by Dr V. Gopalakrishna, Department of Corporate Law, IBS, Hyderabad. It is intended to be used as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The case was written from generalised experiences. 2009, IBSCDC. No part of this publication may be copied, stored, transmitted, reproduced or distributed in any form or medium whatsoever without the permission of the copyright owner.

License to use for the Class of 2012, Semester II, IBS Hyderabad. Course: Legal Environment Business

Regulatory Rhyme for a Sinking Bank

Ajay and Rajnish gathered most of the information during their personal research and during discussions with the senior bank managers. Finally, they decided to start a banking business in the name of Sampada Bank and started promoting the bank. At this juncture, some more advises poured in to promote Sampada Bank as a cooperative bank as its promotion and management is easy. Some suggested starting a rural bank as a lot of money is available in villages and more particularly agriculturists require money during the crop season and recovery is not difficult. However, after prolonged deliberations they decided to incorporate a company with an objective to promote banking business. They thought that in private banking business, banking law is not stringent and they can do any business they like including the real estate business, share trading and sale of consumer durables. They inducted few more members into their company as directors in order to satisfy the capital requirement of the bank. In fact, they were looking at the proposed bank as the patron for their other proposed business ventures in which they hold the position as partners or directors. The new members were having enough knowledge and experience in the banking business and they explained that they (Ajay and Rajnish) cannot do the business as they like, but have to adhere to the banking regulations. Though they were disappointed initially, as their plans to invest in multiple ventures could not materialise, with the initial capital of INR 50 crore they applied to the RBI for licence. The RBI after verifications and after the due processes, granted the licence in 2004 to start its branch at Kukatpally, which is very near to the IT hub on which they have more expectations. Ajay and Rajnish, with their existing relations with the IT firms, could attract a number of customers to open savings, current and term deposit accounts and also lent personal and housing loans to the staff of the IT industries. Sampada Bank had a happy business during the boom period 20042008, posting huge profits and declaring good dividends for shareholders who invested in the capital through a public issue in 2006. The bank offered handsome gift schemes, multiplied return offers on longterm deposits above the market rates to sustain competition held out by several private banks and NBFCs. Deposits rose to an impressive figure of INR 600 crore by March 31st 2008 with branch network expanding to 15 in and around Hyderabad city as depositors continued to repose faith. The bank stepped up its lending to meet interest obligations and to keep itself afloat in stock market. The bank also took up several corporate governance initiatives by inducting several professionals into the board of directors including Prof. Rangnekar, dean, Kautilya Business School and visiting professor to Howard University, Prof. Dinshaw, consultant, Fidelity Tax. The bank also undertook several promotional programmes including the construction of a function hall in the native place of Rajnish, CMD at the cost of INR 1 crore. The bank appointed several agents to canvass lending business especially in home loans and consumer loans and the advances stood at INR 700 crore as on March 31st 2008. Sampada Banks efforts to enter foreign exchange business in 2007 could not however succeed as its application for dealership was kept pending at the RBI. The performance of the bank was hailed as dynamic, vibrant and progressive by the analysts, depositors and shareholders for the financial years 2004 and 2007. The bank was hit severely under an unexpected financial onslaught of economic recession during 20072008. Due to recession, the IT firms withdrew their term deposits and the savings of the employees in the sector also went down. Having lost jobs, they were not able to pay the instalments of personal and housing loans, which formed the major chunk of the advances portfolio. Some of the software companies which had accounts of their firms and employees with the bank had to close down the shutters and heavy 2

Regulatory Rhyme for a Sinking Bank

cash withdrawals were made from bank while home loan and consumer loans given to employees became defaulted. The bank reported Non-Performing Asset (NPA) position as 0.5% for March 31st.2006; 18% for March 31st 2007 and 46% for March 31st 2008. A wide gap developed between the deposits and advances and the bank started facing liquidity issue. The bank could not recover its ground in 2007 and 2008 and slipped further in the first quarter of 2009 and ended up by posting an operating loss of INR 75 crore against the capital base of INR 50 crore. It delayed its submission of final accounts to auditors until June 2009 and sought permission from the RBI for postponing the publication of balance sheet for the year 2009. With several payment defaults, it could not pay salaries for the employees for 3 months. Depositors were asked to defer their withdrawals or renew their deposits. Bank defaulted in maintaining the statutory and liquidity reserve ratios and paid huge penalty to the RBI. The affairs of the bank reached the media through aggrieved depositors and employees and more and more depositors sought withdrawals from the bank on black Friday June 19th 2009. It was virtually a run on the bank; after the media reported that a long queue of customers was there before the bank in order to withdraw their deposits. Sampada Bank had to rush to currency chest of the RBI several times during the day to draw cash and its clearing position went adverse against its balance with the RBI. Depositors formed an association and approached the Chief Minister of the State who in turn requested Union Finance Minister to probe into the affairs of Sampada Bank. Under the advice of Union Finance Minister, the RBI conducted a special audit and under Section 45(2) of Banking Regulation Act, recommended the Central Government to place the bank under moratorium on the basis of following major findings of the special audit: Asset-liability mismatch Indiscriminate lending without following Know Your Customer (KYC) norms and proper security coverage for advances Severe liquidity crunch as reflected in non-recovery of dues in loan accounts, inability to meet depositors demands and failure to maintain liquidity position as required by reserve requirements.

Central Government accepted the application submitted by RBI and declared moratorium on all banking activities of Sampada Bank w.e.f., June 26th 2009. To avoid inconvenience to small depositors, the bank was allowed to pay INR 15, 000 per account as one time payment. The depositors association launched dharnas before the Assembly and sought the revival of the bank to protect the interests of 5 lakh depositors who hail from middle class. Pensioners wanted the full payment as they did not have any other source of income. Some depositors threatened to commit suicide as marriages and education plans of their children had to be either cancelled or postponed. Several companies and Government institutions, who deposited their money, approached the RBI as the moratorium will only force them to close their establishments. In the meantime, police filed criminal cases against the directors of the bank while the independent directors resigned from their posts. Rajnish, in his press brief on July 1st 2009 announced that negotiations with Almighty Bank are going on for amalgamation and sought the cooperation of depositors and media to tide over the crisis. He assured that the majority of advances are backed by either hypothecation of consumer durables, 3

Regulatory Rhyme for a Sinking Bank

vehicles or mortgage of sites or houses and additionally by salary deduction guarantees in case of salaried class. He explained that as the major share of the defaulted loans are supported by tangible securities, entire loans will be recovered either by compromise, one time settlement schemes or by initiating legal actions in the court of law. It may take some time for recovering the amount, as such. Therefore, the deposit customers were asked to cooperate with the board of directors of the bank. Sampada Bank submitted a scheme for amalgamation with Almighty Bank to the RBI after obtaining approval of its board. However, the RBI did not find the proposal to be feasible as Almighty Bank, though running on profit for the last 20 years might not be able to absorb the huge credit portfolio with 46% of NPA and likely increase in NPA figures after full audit due to non-availability of borrowers in many cases, over valuation of security values and diversion of funds for non-banking activities promoted by the directors. The RBI also found several advances granted by the board to the firms in which the directors had interest and the firms had no capacity to repay. Further, RBI found unwarranted exposure by the bank against the credit control regulations issued by RBI from time to time. The bank resorted to liberal lending against sensitive commodities and many stock statements of borrowers were found to be false. Some of the schemes for promoting the business were found to be unethical. Misappropriation of the banks funds through donations and advertisements were also found in the audit. The RBI recommended imposing of moratorium for a period of 6 months with an advice to the Bank to recover its dues and reduce NPA level to improve the cash position. It advised the Bank to make effective use of powers available under Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests (SARFAESI) Act 2002 that facilitates Bank to: Enforce security interest under the Act for all secured advances To exercise options under Section 13(4) including sale of assets.

The bank was also advised to take immediate measures for those securities not covered by SARFAESI Act and enforceable at Banks discretion may be sold immediately. The RBI further advised Sampada Bank to explore the available criminal and civil remedies against major NPA borrowers where adequate security coverage is not available or the securities are not marketable. In the meantime, the bank should keep its documents in order and get them renewed before the set time limit to avoid any barring of suits against defaulters. The RBI also ordered the Bank to report the happenings in the banks, more particularly relating to the deposit payments, loan recoveries, cash payments and maintenance of statutory and liquidity ratios by way of reports every week. To allay the fears of depositors, the RBI promised to consider enhancing the part payment of deposits to INR 50,000, if the bank is able to recover at least INR 100 crore within the next 6 months through its aggressive recovery policies. While warning the bank not to deviate from its guidelines and advising it to report the position every week, it reserved its powers to consider any change in the top management of the bank to set the things right if no signs of recovery of bank appear in the next 2 months. To tide over the cash crisis, the RBI agreed to relax the reserve requirements and even allow the bank to sell its gilt-edged securities, maintained for statutory reserves. The RBI even offered to consider financial accommodation by rediscounting eligible trade bills of borrowers of Sampada Bank. It however, made a final point that it will not be able to bail out beyond this offer. The board of Sampada Bank is scheduled to meet in the first week of January 2010 to understand the regulatory rhyme and ponder over the future strategy of the bank. 4