Aishwarya Sivaramakrishnan
The cooperative sector in financial services is seen as an important medium of financial inclusion…it is based upon the principle of mutual help… However, this principle is under threat.
Financial cooperatives are an important pillar in the banking sector and cater to a large section of the population in both urban and rural parts of India. Cooperative banking as a system in India emerged in the 18th century and was recognised as a formal banking system in the year 1966. Cooperatives in the Indian financial sector have a wide range of coverage and can be classified into various segments. Each segment has a different purpose and a mode of operation. The following flowchart gives a brief idea about its structure.
Source: Compiled by the Author
Cooperative credit institution can be classified into urban and rural co-operative credit banks. Though the name itself suggests the area that it caters to, urban cooperative banks also cater to semi-urban areas. Urban cooperative banks are further classified into scheduled and non-scheduled. Scheduled cooperative banks can be defined as the banks that are included in the second schedule of the Reserve Bank of India Act, 1934 (RBI Act). Other banks which provide financial service but are not included in the second schedule are not regulated by RBI Act, 1934. The banks under urban cooperatives can either function in a single state or have its branches across multiple states. This article explores how scheduled urban cooperative banks function.
Urban Cooperative Banks (UCBs) were created primarily to cater to small businesses, traders and small borrowers in urban and semi-urban non-agricultural areas. They operate on the principal of mutual help and democratic decision making. In other words, the members of the cooperative are also the owners of the cooperative. Loan is extended only to the members; however, deposits are accepted from non-members. Since the members are also the owners, each member enjoys equal vote in the decision making power of functioning of the cooperative. In addition to the above, the membership to cooperatives is unrestricted .
Today, cooperative societies are registered under either the State Cooperative Societies Act of the state concerned or Muti-state Cooperative Societies Act, 2002. They are regulated by the registrar of cooperative society of the concerned state as well as the Reserve Bank of India (RBI). The duality of this control will be discussed in detail later.
The Punjab and Maharashtra Co-operative Bank Scam
After the scam which put the Punjab and Maharashtra Co-operative Bank (PMC Bank), a UCB, under the limelight in 2019, there have been demands for a change in the regulatory mechanism of cooperatives.
The PMC fraud involves three parties, the HDIL promoter – Wadhwans – the Managing director of PMC bank and the auditor. The bank has been accused with a fraud of INR 2500 Crores which are bad loans.
75% of PMC’s credit exposure was towards one client, the HDIL. This was in gross contravention of the capital adequacy ratio norms which does not permit more than 40% of the credit exposure of the bank to a single entity.
21,049 fake accounts were used to hide the exposure which was brought to light by the Economics Offences Wing. In addition to this, the auditor appointed by the Managing Directors, Thomas and Singh, have close relations with the Wadhwans. The auditor of the PMC bank has had several business dealings with the promoter of HDIL – a clear conflict of interest. The three parties together have been involved in the PMC scam, which has 81 branches in Mumbai alone. The scam resulted in limited withdrawal of cash by the depositors and utter disappointment by them for the lack of proper regulatory tools to ensure smooth functioning of the financial services. As the story of this scam is similar to that of many other frauds being committed by UCBs, it has been felt that there is a need to overhaul the regulatory practices associated with UCBs in order to ensure the safety of public money.
UCBs vis Public and Private Sector Banks
It is pertinent to understand and contrast appointment of the board and role of auditors in UCBs with that of public sector banks and private sector banks.
Since 1996, UCBs are regulated by two regulatory bodies. The role of issuing licenses to the banks and the area of its operations are regulated by the RBI under the Banking Regulation Act, 1949. In addition to this, the capital adequacy ratio and the rate of interests to be charged are also regulated under the same Act. However, registration, appointment of the board and audit and liquidation falls under the ambit of Registrar of Cooperatives under the state government or the Multi-State Cooperative Societies Act. Therefore, there is a duality of regulation for the UCBs. Let us contrast this with Private Banks. The appointment of the board is regulated by the RBI under the Banking Regulation Act, 1934. A detailed examination of the difference in appointment of the board brings to light the problem with the existing system of appointment for UCBs.
| Parameter | Private Banks | Public Sector Banks | Urban Cooperative Banks |
| Composition of the board | Not less than 51% of the Board of directors shall include persons with special knowledge or professional experience. The board of directors should not have any substantial interest with any employee, managing agent or manager in any company. Banks are required to take due diligence and fit and proper criteria for appointment of the directors. | The board must consist of Whole time directors, government nominee directors and RBIs nominee director, workmen and non-workmen directors and elected directors. Number of elected shareholding is based upon the public shareholding in the banks with an upper limit of 3 for nationalised banks if shareholding exceeds 32%. Due diligence and fit and proper criteria would also form basis of appointment | There can be a maximum of 21 directors. They are elected by the members of the cooperative. The state and the central government can also nominate the directors if they have stake in the cooperative, however nomination is limited to one third of the board of directors when the stake is more than 51%. |
The table above summarises the composition of the boards under the key banking pillars of India and indicates that greatest lapses in the composition of the board are with UCBs. The lapses start from the specialisation that the board members possess in UCB banks. There are no criteria like that of private or public sector banks, such as specialised knowledge or professional experience, due diligence or fit and proper criteria to be a member of the board. The members of the board entail position of authority and responsibility. They are responsible for the administration, smooth functioning and financial viability of the organisation. With UCBs expanding and catering to large audience at multiple states, fit and proper criteria and specialisation in banking services should be made non-negotiable.
The other key lapse in the functioning of the board is the appointment of directors in the board by the nomination of the state government. This brings influence of politics in the banking system and creates a breeding ground for crony capitalism. Business and politics share a close nexus although at a small scale. The same problem is that of public sector banks at a larger scale and at a national level. This calls for a stricter scrutiny in appointment of management of board to avoid conflict of interest.
The role of auditors in the functioning of the UCBs is also an important point to debate and compare with that of the commercial banks. Private and public sector banks have rigorous measures adopted for the purpose of auditing. There are three levels of audit that commercial banks undergo – statutory, internal and concurrent audit. However, for the UCBs, the audit measures are very weak, calling for an overhaul of the audit system. At present, there is requirement for an annual audit report by the UCB which does not fall under the ambit of the RBI.
How cooperative are the cooperatives?
As of March 2019, UCBs cater to a depositor base of 8.60 crore and have 1544 branches. UCBs are ambitious and have high aspirations of competing with commercial banks. They have expanded their services to the customers but continue to demand relaxations in regulations. This gives rise to several decisions to be made with regards to the UCBs, with the foremost pertaining to the line of business for them to operate. Once this decision is made, the benchmark in terms of size of the business, capital requirement needed to be set up and the change in regulatory regime required with rapid expansion happening in the current scenario need to be deliberated upon.
With the functioning of the bank based on a namesake democratic process, it is pertinent to question whether this system should be allowed to continue or not?
The cooperative sector in financial services was seen as an important medium of financial inclusion. As discussed, it is based upon the principle of mutual help and providing access to loans to its members and also safeguarding their deposits. However, this principle is under threat. The cooperative sector accepts deposits from non-members but provides loans only to its members. Concentration of risk exposure to a single member is the biggest threat to the financial viability of the cooperative. In the case of PMC bank scam, the risk exposure was concentrated in HDIL. Although this was done through tampering and creating false bank accounts, such practices go unnoticed because of relaxed regulatory practices and division of regulatory powers. This also puts the depositor’s money at stake, which is normatively the chief concern. Therefore this brings rise to another important question as to what should be the appropriate size up to which the UCB must be allowed create credit without undue risk to the system?
Cooperatives are also built on the principal of democratic decision. Therefore, unlike a joint stock company where the vote for a decision is proportionate to the shareholdings, the UCBs follow principle of “one person one vote”. However, the implementation of this process is very weak and powerless. The attendance for Annual General Meetings (AGM) is usually very low and mostly there is unanimous selection of the Management. In most cases, the same management gets elected year after year. The management takes decision to foster its own personal and political goals. It has been observed that the management of the UCB typically have people with a political background or maintain strong social relations with them. With the functioning of the bank based on a namesake democratic process, it is pertinent to question whether this system should be allowed to continue or not? The lack of strong leadership and vision to ensure efficient functioning of the cooperative may call for a change in the principles of the cooperative society.
The growth of UCBs also calls for adoption of technology. Commercial banks (private and nationalized banks) form a part of the Core Banking system. This allows all the banks to maintain a track of all the depositors and creditors of the bank. Therefore, technology is an important tool used to regulate the banks and ensures checks and balances by the regulator. In the case of UCBs, they were ushered to adopt technology for capacity building and efficiency. However, they still lag behind in comparison to commercial banks in using technology for their day to day activities. Maintenance of these services entails a huge cost which may act as a deterrent in adoption of the same.
Way forward
The union government in March 2020 approved an amendment to the Banking Regulation Act, 1949 to bring multi-state cooperative banks under the watch of the RBI. Many of the recommendations of the Malegam and R. Gandhi committee1 were adopted in the amendment. It said that cooperative banks will be audited in accordance with the rules of the RBI and appointment of CEOs will require prior approval of the RBI. The RBI will also have the right to supersede the management in the case of governance failure. The RBI in order to protect the depositors from credit risk revised exposure limits for group of borrowers from forty per cent to fifteen percent. The decision has also been taken with respect to loan size to ensure the goal of financial inclusion and at the same time ensuring restriction in the overall credit creation. The union government stated that the UCBs shall have at least fifty per cent of aggregate loans and advances comprising loans of not less than 25 lakhs or 0.2 percent of tier 1 capital with a maximum limit of 1 crore. The Union Govt. also accepted separation of ownership and functioning of the UCB recommended by the RBI committee leading to the creation of BoM.
Only time can tell how well these changes translate into on ground experience.
Aishwarya Sivaramakrishnan is a final year Masters student in Public Policy from NLSIU, Bangalore. She holds a bachelors degree in Commerce from University of Delhi. She was earlier employed in CRISIL as a Research analyst and has completed a post graduate CRISIL certified program in Financial Analysis.
Aishwarya’s interest lies in financial inclusion in sectors like MSME, agriculture and microfinance institutions.
She can be reached at aishwaryask@nls.ac.in
Endnotes
1 The R. Gandhi committee and Malegam committee in the RBI have listed down recommendation in detail for the reform of the Urban cooperative banks. The above discussion does point out the need to reduce duality of control and Urban cooperatives coming under the strict scrutiny of the RBI. The committees suggest the following:
- The new UCBs should be set up only in those areas where the representation is inadequate and governance is strengthened and supervised
- The minimum networth of 50 crores should be achieved before the cooperative goes for multi-state status
- It recommended for a distinction in ownership and functioning of the bank. The UCB must have a Board of Management (BoM) in addition to the Board of Directors (BoD). The BoD will continue to function in the manner practiced as per the registrar of states, however the BoM will be responsible for laying down the broad contours of strategy. The relationship of the BoM and BoD will be similar to the relationship between supervisory and executive board.The BoM shall be allowed to direct and control day-to-day activities of the UCB with limits set by the board. The RBI will also have unfettered power to regulate the activities of the UCBs and BoMs.
- The constitution of the BoM shall be that of sub section 2 of Section 10A of the banking regulation Act of 1949. Thus this calls for a board similar to that of private banks.
- The RBI should have powers to:
- Remove from office any member of the BoM and supersede for a period of 5 years.
- Direct BoM to make changes in the management
- Direct to introduce aspects of technology
- Audit of UCB to carried out by Chartered Accountant
- BoM to follow code of corporate governance as directed by RBI.
The opinions expressed in this article are those of the author(s). They do not purport to reflect the opinions or views of NLSIU, Lokniti or its members.