Some bank borrowers have gone to court demanding that it quash the Reserve Bank of India (RBI) circular dated August 6, 2020 on opening current accounts . The RBI has since extended the date for compliance to October 31, 2021 .
Diversion of funds is a major reason for large non-performing assets (NPAs). Internal diversion is for non-priority purposes such as limousines, plush offices, and vanity acquisition of companies. Funds can also be diverted to other firms, owned or controlled by the same group, friends or relatives. The first is the result of misguided strategies or muddled priorities. The second is an intention to defraud lenders, other creditors, and non-controlling shareholders.
Current accounts with non-lending banks are an important channel for diversion. To prevent this, the RBI mandates a No-Objection Certificate (NOC) from lending banks before opening such accounts. Banks should verify with CRILC, the RBI credit database, and inform lenders. Banks should also obtain a NOC from the drawee bank when an account is opened through cheques.
The regulations
The intentions of the impugned circular dated August 6, 2020 are unexceptionable. Widespread non-compliance with mandated safeguards forced the RBI to bar 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.
If a borrower has no cash credit or overdraft account, a current account can be opened subject to restrictions. If the bank’s exposure is less than 10% of total borrowings, debits to the account can only be for transfers to accounts with a designated bank.
If total borrowing is ₹50 crore or more, there should be an escrow mechanism managed by one bank which alone can open a current account. Other lending banks can open ‘collection accounts’ from which funds will be periodically transferred to the escrow account.
If the borrowing is between ₹5 crore and ₹50 crore, lending banks can open current accounts. Non-lending banks can open collection accounts. If borrowing is below ₹5 crore, even non-lending banks can open current accounts. The working capital credit should be bifurcated into loan and cash credit components at individual bank levels.
Operational issues
The regulations involve many operational issues. First, if a borrower has an overdraft, how can there not be a current account? An overdraft is the right to overdraw in a current account up to a limit. Without a limit, a banker may allow a temporary overdraft.
The second issue is that the circular forecloses such operational flexibility.
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Third, why should a bank with low exposure transfer funds to another bank when it can use it to adjust other dues with it?
Fourth, share in borrowing is not static. Crossing the threshold both ways could happen often. It could be seasonal or monthly with salary payments or collection of dues. Nor are they smooth curves. Huge lumps accompany one-time heavy payments or large export proceeds.
Fifth, there is a mismatch between what a borrower needs and the regulations allow. Support of non-lending banks through current accounts in other banks is required for large accounts. The circular rules out this possibility. But such support is available when the exposure is below ₹5 crore, when it may not be required.
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Sixth, transactions in an active current account enables a bank to monitor a borrower’s account, however small. The lack of such control was why large development financial institutions of yesteryear built up huge NPAs.
Seventh, the regulation mandates splitting working capital into loan and cash credit components across all banks. Such a one-size-fits-all regulation does not factor in the purpose of the different facilities. A large company might avail itself of loans in Mumbai, but require current accounts with another bank in Assam where it might have a factory. Procrustean controls add costs with no concomitant benefits.
There are other regulatory issues. First, it is more effective to base regulation more on principles that focus on outcomes than rules content with mere compliance. Rules are not flexible, do not provide for unforeseen circumstances, and can be easily circumvented. Second, regulation needs to use more generic terms. 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 make the entire system bear the cost? Is it not better to leave management of such exceptional risks to the banks? Fourth, shouldn’t the costs of regulation be justified by the benefits? Finally, is more regulation the answer to non-compliance?
Implications for compliance
There are also implications for compliance. When regulation ignores market practices, it lacks legitimacy, a construct from neo-institutionalist literature. When legitimacy is wanting, compliance suffers. The regulatee organisations will resort to what the literature calls cosmetic or creative compliance.
Thus, a new banking practice of overdraft in fixed deposits has emerged. Another form of creative compliance could involve sanctioning unnecessary non-funded limits to artificially boost exposure. A bank could also merely rename current accounts as overdraft, as there is no bar in having a credit balance in an overdraft account. All this will have the counter-intuitive effect of diluting credit discipline rather than strengthening it.
G. Sreekumar is a former central banker
