Context

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.

Background

• Current accounts with non-lending banks are an important channel for diversion.
• Diversion of funds is a major reason for large non-performing assets (NPAs).
• Internal diversion is for non-priority purposes and funds can also be diverted to other firms, owned or controlled by the same group, friends or relatives.
• 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.
• 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.

What are the current regulations?

• 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.

Issues with regulations

• 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.
• The second issue is that the circular forecloses such operational flexibility.
• 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.
• 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.
• 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.
• Lack of flexibility: Rules are not flexible, do not provide for unforeseen circumstances, and can be easily circumvented.
• Use more generic terms: Regulation needs to use more generic terms. Terms such as Working Capital Term Loan might mean different things in different banks.
• Diversion of fund is risk better dealt by banks: Is it not better to leave management of exceptional risks such as diversion of funds to the banks?
• The cost of regulation: the costs of regulation be justified by the benefits.

Conclusion

When regulation ignores market practices, it lacks legitimacy, a construct from neo-institutionalist literature. When legitimacy is wanting, compliance suffers.

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