LEGAL ASPECTS OF CORPORATE GOVERNANCE IN THE BANKING SECTOR

This article is written by Rutvij Vyas of 2^nd Year of Faculty of Law, GLS University, an intern under Legal Vidhiya

Abstract

This article delves into an interesting topic of ‘Legal Aspects of Corporate Governance in the Banking Sector’, this article begins exploring the practices of promoting accountability, integrity, and transparency in the operations of the banking sector. In the past several years, the financial sector has witnessed several crucial developments with a structural framework of corporate governance practices.  This article explores key elements of corporate governance practices in the banking sector with its legal-regulatory framework, the structure of the board of directors, risk management framework and compliance requirements. This article also analyses the RBI Act and Ranking Regulation Act and their role in the protection of the rights of several stakeholders, directors and authorities. This article also focuses on landmark judicial precedents concerning corporate governance in the banking sector with recent emerging developments in the field. This article also provides a valuable analysis of challenges and opportunities to overcome the challenges in the banking sector. Overall, this article underscores the significance of robust legal machinery & framework to foster a sound & sustainable banking system. 

Keywords

Banking Sector, Corporate Governance, Compliance, Risk Management, Transparency,  Reserve Bank of India Act of 1934, Banking Regulation Act of 1949.

Introduction

In the 21st Century, the Global economy which is based on the ideals of globalization and facilitation of wealth, the banking sector serves a pivotal role in global financial transactions^[1], facilitator of wealth, distributor of monetary resources and provider of credit to governments, corporate houses, individuals and businesses. It becomes essential for economic stability, growth and development to ensure the smooth functioning of the banking sector. Thus, the role of corporate governance in the banking sector is crucial for the overall welfare of the State and its citizens. Corporate governance in the banking sector includes the regulatory framework of systems, legal practices and regulatory procedures to govern Banks. All institutes providing services/ business operations of banks are called a Bank. The first ever modern bank was started in the year 1407 in Geneva, Switzerland. The word “bank” is believed to be derived from the Italian word “Banco”.

The most accurate definition of a bank, as provided by the Reserve Bank of India is:-

“A bank is an institute which collects deposits from the public, to lend them with condition to return it at the end of fixed term or whenever it is demanded”. The functions of the bank can be categorized into two heads:-

1. Main functions:- To accept deposits; To lend money; to invest money; to do inter-banking transactions.
2. Subsidiary functions:- to issue the letter of credit; to establish a mechanism looking after the finances of customers; to do international transactions; provide RTGS/NEFT services .etc.

In India, the Reserve Bank of India is the apex authority concerning Corporate Governance in the banking sector^[2] . The legal aspects of corporate governance in the banking sector include:-

1. Recognition of paramount importance to the banking sector and associated activities due to the deep significance of the sector.
2. Ensuring the protection of public funds for depositors, shareholders, borrowers, the government and overall credit machinery.
3. Developing a well-structured legal framework including special legislations, regulatory authorities, checks and balances and a bank trusteeship policy.
4. Promote accountability, transparency, and integrity within banks as well as among banks and risk management.
5. The composition of a corporate board with independent directors, women directors and other mandated directors to establish strategic objectives of the bank, Corporate laws also prescribe the established qualifications, fiduciary duties and independence criteria for the board. 

Thus, ensuring the corporate governance practices in the banking sector is essential to protect the interests of key stakeholders with the creation of a responsible and accountable bank^[3].  Corporate governance also includes compliance with the established principles and maintenance of the legal soundness, standards and stability in banking operations.

To ensure legal compliance the laws also provide for civil & criminal actions to the breacher, powers to regulatory authority, and regulatory actions. The compliance not only helps in the continuance of the well-fare measures but also deters the wrongdoers, from maintaining public trust and confidence of the public in the banking sector.

Thus, we can observe that the Legal aspects of corporate governance in the banking sector play a pivotal role in ensuring the integrity, transparency, accountability and stability of banks. By dealing with the topic of corporate governance practices in the banking sector, we can foster our learnings on operations of the banking sector, operating in the best interests of its stakeholders and the economy of the nation. Overall, for the safe-secure and sound banking systems, it becomes crucial to address the legal aspects of corporate governance in the banking sector.

Research Objective

The objective of this research article is:-

1. To highlight the scope and significance of corporate governance in the Banking sector.
2. To present a thorough analysis of the Reserve Bank of India Act of 1934
3. To present a thorough analysis of the Banking Regulation Act, of 1949
4. To sum up the legal aspect of corporate governance in the Banking sector

What is Corporate Governance?

Corporate governance is a set of mechanisms, processes & procedures made to govern the corporate institutions. Shailer, Greg defines the term ‘corporate governance’ in their book ‘Encyclopaedia of Business and Professional Ethics’ as a description of processes, structures and mechanisms that influence the control and direction of the company^[4]. Simply it means all forms of system including rules and regulations by which a corporate entity is directed and controlled. Corporate governance plays a vital role in balancing the interests of all company parties, including many stakeholders, such as management, shareholders, government, customers, financiers, suppliers, distributors and society. It also helps in mitigating and resolving the conflict of interests among parties^[5]. Corporate governance establishes and ensures the well-defined structure of a company, through which the objectives of the company are set and in furtherance monitored for the welfare of the company and society. It also aims to secure the long-term success of the company. The corporate government holds a key position in ensuring that the company is transparent,  accountable and responsible.

The concept of Corporate governance revolves around certain key principles which are:-

1. Recognising and ensuring the rights of Shareholders:- the corporate governance practices recognise the rights of shareholders and ensure the continuance of rights by compliance mechanism.
2. Maintaining transparency in the corporate world:- corporate governance practices promote and ensure effective transparency in the company.
3. Holding directors and executives accountable for fraudulent & mischievous actions:- corporate governance ensures the lifting up of the corporate veil to hold accountable and punish the directors/ office holders in case of fraudulent activities.
4. Promoting ethical behaviour within the company:- The corporate governance practices ensure ethical behaviour within the company.
5. Establishing a process of identifying, assessing and managing the risks faced by the company:- corporate governance plays a key role in the risk management framework, corporate governance includes establishing a framework to assess, recognise, analyse, control and mitigate the risks involved in the business.
6. Ensuring compliance with the relevant legislation applicable to the company:- It becomes important for corporate governance, to check for whether the companies are complying with the relevant legislation. Corporate governance also includes the compliance mechanism and in furtherance, it punishes those companies who fail to comply.

Corporate governance is often supported by the 4 P’s i.e. “People”, “Purpose”, “Processes” & “Practices”. The Ministry of Corporate Affairs, in the year 2003 established the National Foundation for Corporate Governance (NFCG) as a not-for-profit trust. The NFCG provides for a framework to deliberate on issues related to good governance in Companies. The corporate governance practices vary across all jurisdictions, for example, the People’s Republic of China has different practices vis-a-vis that of India or the USA. For instance, the Indian court’s perspective of corporate governance in the case of “G Vasudevan V. Union of India^[6]” may defer from the observations of the Delaware Supreme Court’s verdict in the leading matter of Smith v. Van Gorkom (1985)^[7]. Corporate governance practices worldwide include diverse legal instruments such as legislation, executive rules and regulations and judicial precedents.

Significance of Corporate Governance in the Banking Sector

Corporate governance in the banking sector secures the stability, sustainability, integrity and accountability of every important financial institution. The objective of corporate governance is to maintain the best interests of stakeholders, which includes diverse members of the society, such as customers, creditors, institutional investors and employees. Some key significance of corporate governance in the banking sector are:-

1. Financial stability:– effective corporate governance practices are essential for the financial stability of banks, the government to establish financial stability implements robust risk management frameworks, control mechanisms and compliance frameworks. The banking sector is inherently exposed to several potential risks, such as operational risks, market risks and regulatory compliance risks. Sound governance practices avoid potential risks and ensure high productivity and long-term sustainability of banking operations. 

2. Board independence:– The key significance of corporate governance in the banking sector is board oversight and its independence, which regulates the roles, responsibilities and competency of the board. It ensures secure oversight of management, effective decision making and a strategic risk management framework. The independent board members ensure inclusivity with diverse expertise and effective guidance which is in the best interests of the bank.

3. Confidence of investors:- Effective corporate governance practices instil immense confidence in investors. As per research, when a financial institution adheres to accountable and integrated corporate governance practices, investors are more likely to trust the banking operations. This trust develops a fiduciary relationship between the bank and investors, which helps in the long term. The investor’s confidence also attracts investments and enhances overall growth and stability.

4. Ethical conduct and compliance to the established protocols:– the corporate governance practices ensure ethical conduct & compliance in the banking sector. Ethical conduct includes an institutionalized behaviour of following ethical guidelines, a code of conduct and compliance with State policies by managerial and non-managerial staff. Compliance with the norms and rules also ensures in prevention of fraud, misconduct and unethical practices.

5. Protection of interests of stakeholders:– Corporate governance practices are important for the protection of the rights and interests of shareholders, employees, creditors and other sections of society. Corporate governance practices promote the ideas of transparency, accountability and integrity for the long-term sustainability of the banking sector.

Overall, in the banking sector corporate governance plays a paramount significance. These significances include financial stability, protection of the interests of stakeholders, ethical conduct and compliance, confidence of investors and independence of board members. These robust practices often enhance the bank’s resilience, public trust and overall stability^[8].

Role of the Reserve Bank of India (RBI) Act, 1934

The Reserve Bank of India is an apex banking regulatory body, it was established in the year 1934 by the Reserve Bank of India Act of 1934. RBI being an apex banking body, holds a key position in the regulation and supervision of the banking sector. The Reserve Bank of India’s corporate governance mechanism includes the responsibility of overusing banking operations, ensuring stability in the banking sector, holding directors accountable for fraudulent activities and supervising the overall functioning of registered banks in India. RBI is a promoter, supervisor, guide and regulator of sound banking practices. The Reserve Bank of India Act of 1934, empowers the RBI to establish a well-structured framework for corporate governance standards and to maintain the same.

The preamble of the Reserve Bank of India Act of 1934 reads, “to regulate the issue of bank notes……securing monetary stability……credit system of the country to its advantage; to have a modern monetary policy framework”. To maintain banking stability in India, RBI uses several banking tools like

The RBI Act of 1934 under section 3 provides for the establishment & constitution of RBI which is responsible for currency issuance and regulation of financial machinery. Section 20 puts an obligation of the RBI, to transact government businesses. The RBI Act empowers the Reserve Bank of India to govern and control the banking machinery, and to issue licenses to the scheduled banks. Section 35A, empowers the RBI, to regulate the cooperative banks. Section 45(M)(A)(A) empowers the RBI to take regulatory action against auditors in case where any auditor fails to comply with any direction issued by the bank by an order.

Section 45(N) provides the RBI with inspection powers to periodically inspect banking and non-banking institutions. Section 45NB regulates and provides for all disclosure of information of information related to a non-banking financial company, to ensure accountability and transparency. In the case of Reserve Bank of India v. Peerless General Finance and Investment Co. Ltd^[9]. the apex court highlighted that the RBI has a crucial role as a regulatory body to ensure the protection of the interests of depositors and various investors, and to issue directions to the financial institutions.

-In the leading case of Reserve Bank of India v. Jayantilal N. Mistry (2015)^[10] the Hon’ble Supreme Court held the RBI’s inherited power to issue regulatory guidelines and directions functioning with the banking sector.

Banking Regulation Act, 1949

The Banking Regulation Act of 1949 was enacted on the date of 10th March 1949. This act strengthened the foundations of banking in India. The BRA gave the title of India’s central bank to the Reserve Bank of India and subsequently empowered RBI with powers such as licensing, shareholder-voting rights regulation, supervising board appointments and control over the bank administration^[11].

Well-structured framework for the governance of corporate banking in India. The key objectives and scope of The Banking Regulation Act of 1949 are:-

1. Control over management of Banking companies:- The BRA provides for the regulation, control and supervision of banking companies by the regulatory authority, to ensure the sound operations of financial institutions and the protection of the interests of depositors and creditors. Moreover under section 35, inspection and inquiry in banks by RBI to ensure their compliance with the act.
2. Licensing of banks:- The BRA empowers the Reserve Bank of India (the apex banking authority) under section 22 to issue licenses to banks, that comply with the legal procedure and to nullify the license of banks that fail to comply.
3. Regulation of all banking institutions:- the Banking Regulation Act of 1949, governs the composition, establishment, operations, functioning and compliance of banking institutions. furthermore, the act also provides corporate governance practices such as the appointment of directors(section 10A), independent board members, the conduct of general meetings and compliance with legal provisions.
4. The Banking Regulation Act of 1949 also regulated the branch expansions of banking under section 23, It is mandated that banks must obtain the approval of RBI to open new branches.

Important sections:-

1. Section 10A:- Section 10A empowers the RBI to appoint additional directors to the board of directors to ensure effective management.
2. Section 10B provides for the composition of the board of directors with detailed specifications of their qualifications and disqualifications. 
3. Section 16 lays down provisions related to general meetings of baking institutions. With their quorum provisions and voting rights of shareholders.
4. Section 30 serves as a crucial provision dealing with the Audit and inspection of financial institution’s accounts, balances and records.
5. Section 46 highlights the penalties for noncompliance and contravention of the Banking Regulation Act and other laws. The penalties include a monetary fine

Risk Management Framework

The Reserve Bank of India (RBI) plays a pivotal role in governing the banking & financial sector. To mitigate the risks in the banking sector, the RBI guidelines of 2010 on “Risk Management and Inter-Bank Dealings” which is also known as “The Master Circular on Risk Management^[12]” serve as a key consolidated document for the banking risk management framework. The Master circular is objective to provide a single reference document for the risk management, the master circular provides for 4 key risk management mechanisms, they are:-.

1. Credit risk management by the banks;
2. Market risk management by banks and institutional investors;
3. Operational risk management;
4. Liquidity risk management;

The RBI guidelines mandate all financial and banking institutions to develop a robust framework to assess, identify, recognise, analyse, control and mitigate all the risks in the sector. All banks registered under the Banking Regulation Act of 1949 are required to comply with the mentioned guidelines by the Reserve Bank of India and to monitor the risk management framework to be in concurrence with other legal requirements. The RBI guidelines also include the management of credit risk with a special emphasis on its management^[13].

The bank may face legal consequences by lawful authority in the form of penalties, in case of failure to comply with the guidelines

Other legislations regulating the banking sector in India are:-

• The Recovery of Debts Due to Banks and Financial Institutions Act of 1993^[14]; otherwise called as- the RDDB Act.
• The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act of 2002^[15] ; otherwise called as the SARFAESI Act.
• The Insolvency and Bankruptcy Code, of 2016; otherwise called as- the IBC of 2016^[16].
• The Payment and Settlement Systems Act of 2007^[17]; otherwise called as the PSS Act^[18].

Conclusion

Overall, the article concludes on an affirmative note, that corporate governance practices play a pivotal role in the welfare, stability and sustainability of the banking sector and allied stakeholders. The legal framework related to the banking sector includes several legislations like the Reserve Bank of India Act, of 1934 and the Banking Regulation Act of 1949, guidelines for example the Master Circular on Risk Management, judicial precedent and internal codes of conduct. It also encompasses several practices like the establishment of a lucid division of roles and responsibilities, enhancing transparency, promoting accountability, encouraging the use of ethical practices and maintaining stability through integrity within banks. We have witnessed that over past years, there has been a rise in the significance of corporate governance practices in the banking sector, as these practices are essential for mitigating risks, ensuring the trust of the public and protecting the interests of stakeholders. Moreover, this article highlights a crucial point, the role of disclosure requirements in maintaining transparency and accountability. The risk management framework also plays a crucial role in banking governance, especially after the Lehman brothers’- subprime crisis, the RBI guidelines of 2010 on “Risk Management and Inter-Bank Dealings” which is also known as “The Master Circular on Risk Management^[19]” serve as a key consolidated document for the banking risk management framework. As in the past several years, corporate governance practices have strengthened the Indian Banking sector, there are several prevalent. Challenges that persist.

Overall, the legislative aspect of the corporate governance practice in the banking sector if adhered to, complied and followed continuously can-do wonders as an imperative for all stakeholders, banks, regulators, creditors and society at large.

 References

1. Hall, M. (2021). What is the banking sector? [online] Investopedia. Available at: https://www.investopedia.com/ask/answers/032315/what-banking-sector.asp.
2. KHAN, K. (2017). All About Corporate Governance In The Banking Sector. [online] iPleaders. Available at: https://blog.ipleaders.in/corporate-governance-in-the-banking-sector/#:~:text=RBI%20in%20India%20plays%20leading [Accessed 27 Apr. 2024].
3. Hopt, K.J. (2021). Corporate Governance of Banks and Financial Institutions: Economic Theory, Supervisory Practice, Evidence and Policy. European Business Organization Law Review, 22(1), pp.13–37. doi: https://doi.org/10.1007/s40804-020-00201-z.
4. Shailer, G. (2018). Corporate governance. Encyclopedia of Business and Professional Ethics, pp.1–6. doi https://doi.org/10.1007/978-3-319-23514-1_155-1.
5. Tricker, B. (2012). Corporate governance: Principles, Policies and Practices. Oxford University Press
6. AIROnline, 2019 Mad 1363
7. 488 A.2d 858 (Del. 1985)
8. Kulkarni, S. (2023). CORPORATE GOVERNANCE IN THE INDIAN BANKING SECTOR A BRIEF STUDY ON SELECTED INDIAN BANKS. IJCRT, [online] 11, pp.2320–2882. Available at: https://ijcrt.org/papers/IJCRT2303905.pdf [Accessed 10 Aug. 2023].
9. 1987 AIR 1023, 1987 SCR (2) 1,
10. AIR 2016 SUPREME COURT 1, 2016 (1) ADR 614, 2016,
11. Gautam C (n.d.). 70 Policies — Banking Regulation Act, 1949. [online] orfonline.org. Available at: https://www.orfonline.org/expert-speak/42925-70-policies-banking-regulation-act-1949 [Accessed 5 May 2024].
12. Reserve Bank of India (n.d.). Reserve Bank of India. [online] www.rbi.org.in. Available at: https://www.rbi.org.in/commonman/English/Scripts/Notification.aspx?Id=546 [Accessed 20 Apr. 2024].
13. Garg, A. (2018). RBI Requirements relating to Risk Management in Banks – leaders. [online] iPleaders. Available at: https://blog.ipleaders.in/rbi-risk-management/ [Accessed 20 Apr. 2024].
14. https://legislative.gov.in/sites/default/files/A1993-51_0.pdf
15. https://legislative.gov.in/sites/default/files/A2002-54.pdf
16. https://ibbi.gov.in/uploads/legalframwork/e9cca2f4d2cf3508f3c823f070429be8.pdf
17. https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/86706.pdf
18. Amarchand S Mangaldas & Co., Rai, C.-M., Bhatia, M., Biswas, S. and Sivaramakrishnan, V. (2022). In brief: banking regulatory framework in India. [online] Lexology. Available at: https://www.lexology.com/library/detail.aspx?g=1aeefc29-41f7-4da7-aa78-e272fe8d427e.
19. Reserve Bank of India (n.d.). Reserve Bank of India. [online] www.rbi.org.in. Available at: https://www.rbi.org.in/commonman/English/Scripts/Notification.aspx?Id=546 [Accessed 20 Apr. 2024].

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^[1] Hall, M. (2021). What is the banking sector? [online] Investopedia. Available at: https://www.investopedia.com/ask/answers/032315/what-banking-sector.asp.

^[2] KHAN, K. (2017). All About Corporate Governance In The Banking Sector. [online] iPleaders. Available at: https://blog.ipleaders.in/corporate-governance-in-the-banking-sector/#:~:text=RBI%20in%20India%20plays%20leading [Accessed 27 Apr. 2024].

^[3] Hopt, K.J. (2021). Corporate Governance of Banks and Financial Institutions: Economic Theory, Supervisory Practice, Evidence and Policy. European Business Organization Law Review, 22(1), pp.13–37. doi: https://doi.org/10.1007/s40804-020-00201-z.

^[4] Shailer, G. (2018). Corporate governance. Encyclopedia of Business and Professional Ethics, pp.1–6. doi: https://doi.org/10.1007/978-3-319-23514-1_155-1.

^[5]Tricker, B. (2012). Corporate governance: Principles, Policies and Practices. Oxford University Press

^[6] AIROnline, 2019 Mad 1363

^[7] 488 A.2d 858 (Del. 1985)

^[8] Kulkarni, S. (2023). CORPORATE GOVERNANCE IN INDIAN BANKING SECTOR A BRIEF STUDY ON SELECTED INDIAN BANKS. IJCRT, [online] 11, pp.2320–2882. Available at: https://ijcrt.org/papers/IJCRT2303905.pdf [Accessed 10 Aug. 2023].

^[9] 1987 AIR 1023, 1987 SCR (2) 1,

^[10] AIR 2016 SUPREME COURT 1, 2016 (1) ADR 614, 2016,

^[11] Gautam C (n.d.). 70 Policies — Banking Regulation Act, 1949. [online] orfonline.org. Available at: https://www.orfonline.org/expert-speak/42925-70-policies-banking-regulation-act-1949 [Accessed 5 May 2024].

^[12] Reserve Bank of India (n.d.). Reserve Bank of India. [online] www.rbi.org.in. Available at: https://www.rbi.org.in/commonman/English/Scripts/Notification.aspx?Id=546 [Accessed 20 Apr. 2024].

^[13] Garg, A. (2018). RBI Requirements relating to Risk Management in Banks – iPleaders. [online] iPleaders. Available at: https://blog.ipleaders.in/rbi-risk-management/ [Accessed 20 Apr. 2024].

^[14] https://legislative.gov.in/sites/default/files/A1993-51_0.pdf

^[15] https://legislative.gov.in/sites/default/files/A2002-54.pdf

^[16] https://ibbi.gov.in/uploads/legalframwork/e9cca2f4d2cf3508f3c823f070429be8.pdf

^[17] https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/86706.pdf

^[18] Amarchand S Mangaldas & Co., Rai, C.-M., Bhatia, M., Biswas, S. and Sivaramakrishnan, V. (2022). In brief: banking regulatory framework in India. [online] Lexology. Available at: https://www.lexology.com/library/detail.aspx?g=1aeefc29-41f7-4da7-aa78-e272fe8d427e.

^[19] Reserve Bank of India (n.d.). Reserve Bank of India. [online] www.rbi.org.in. Available at: https://www.rbi.org.in/commonman/English/Scripts/Notification.aspx?Id=546 [Accessed 20 Apr. 2024].

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