THE LEGAL PROCESS FOR BANK INSOLVENCY UNDER BANKING LAW

This Article is written by Edleen T. Makiwa of Marwadi University, an intern under Legal Vidhiya.

ABSTRACT

Bank insolvency is more than just a financial crisis; it is an issue that concerns public welfare and the stability of the nation’s economy. Unlike corporate insolvency, which mainly impacts shareholders and creditors, the failure of a bank creates far-reaching consequences, affecting depositors, disrupting financial markets, and undermining public confidence in the banking system. This paper delves into the legal process governing bank insolvency under banking law, with a focus on the Indian regulatory framework. It explores key legislations such as the Banking Regulation Act of 1949 and the limited role of the Insolvency and Bankruptcy Code of 2016 in bank insolvency. It analyses mechanisms adopted by the Reserve Bank of India, including the Prompt Corrective Action (PCA) framework, imposition of moratoriums, bank mergers, and reconstruction schemes.  This paper argues that while the current legal framework is oriented toward a resolution and prevention of panic, reforms are needed to improve transparency, enhance regulatory accountability, and ensure better depositor protection. Ultimately, the paper emphasizes the necessity for a robust and adaptable legal system that balances the interests of depositors, creditors, regulators, and the broader financial system.

KEYWORDS

Bank Insolvency, Banking Law, Financial Distress, Financial Sector, Depositor Protection, Reserve Bank of India, Prompt Corrective Action, Reconstruction Schemes, Non-Performing Assets.

INTRODUCTION

Banks are the backbone of any modern economy, acting as intermediaries between savers and borrowers, promoting investments, and facilitating day-to-day economic transactions. A well-functioning banking sector is essential for monetary stability, employment generation, and capital formation. However, banks are also vulnerable to a wide range of risks, including credit risk, market risk, operational risk, and systemic shocks, which, if not managed effectively, can lead to insolvency. Bank insolvency refers to a situation when the bank is unable to meet its financial commitments, such as paying depositors or fulfilling loan repayments, due to inadequate funds or a shortfall in capital. This situation usually emerges when the bank’s capital drops below the mandated regulatory threshold, rendering it incapable of fulfilling the legal claims of its creditors.

Unlike other commercial entities, banks deal with public funds on a massive scale. Therefore, the failure of even a single bank can trigger widespread panic, affect thousands of depositors, disrupt market confidence, and impact the economy at large. This unique nature of banks necessitates a distinct and carefully structured legal approach to insolvency. In India, the legal framework governing insolvency is multi-layered, combining regulatory supervision, statutory intervention, and crisis management mechanisms. While the Insolvency and Bankruptcy Code of 2016 revolutionized corporate insolvency, it is largely inapplicable to banks due to their systemic importance. Instead, the Reserve Bank of India (RBI) assumes a pivotal role in overseeing bank health and intervening when signs of distress emerge. This paper seeks to explore the process of banking insolvency under Banking Law in India.

STAGES IN THE LEGAL PROCESS OF BANK INSOLVENCY

1. Identification of Financial Distress: Before a bank formally enters insolvency, regulatory authorities like the Reserve Bank of India monitor its financial health through regular supervision and audits. Financial distress is triggered when a bank fails to maintain the minimum Capital Adequacy Ratio (CAR), liquidity, Non-Performing Assets (NPAs), or shows signs of default. If early warning signs such as capital shortfall or excessive NPAs are detected, the bank may be placed under enhanced surveillance.
2. Activation of the Prompt Corrective Action (PCA) Framework: When financial indicators fall below prescribed thresholds, the RBI places the bank under the PCA framework under which lending to risky sectors may be restricted, management or board-level changes may be recommended.[1] The goal is to initiate timely corrective steps to prevent further financial deterioration.
3. Imposition of Moratorium: If the bank’s condition worsens despite the PCA, the RBI may, with the approval of the Central Government, impose a moratorium under section 45 of the Banking Regulation Act, 1949, for a fixed period, but the total time period of the moratorium shall not exceed six months.[2] This is a temporary freeze on withdrawals beyond a certain limit, granting new loans or advances, and the disposal of assets. It prevents a run on the bank while a resolution plan is prepared.
4. Drafting and Implementation of a Reconstruction or Amalgamation Scheme: During the moratorium period, the RBI prepares a scheme of reconstruction or amalgamation for the financially distressed bank. The scheme, once approved by the Central Government, is legally binding on all the stakeholders and overrides existing contracts.
5. Depositor Protection and Payouts: If the situation cannot be resolved through restructuring, depositors are protected under the Deposit Insurance and Credit Guarantee Corporation.
6. Post-Resolution Oversight and Monitoring: After resolution, whether through amalgamation or reconstruction, the RBI continues to monitor the health of the newly structured entity. This ensures that government reforms are implemented, risk management is strengthened, and financial stability is maintained. This stage is crucial to prevent a relapse into financial distress.

CAUSES OF BANK INSOLVENCY

Bank Insolvency comes as a result of a majority of factors, including financial factors, management factors, and regulatory factors:

Financial factors

1. High Non-Performing Assets (NPAs): When a bank lends money and the borrower fails to repay the loan within the prescribed amount of time, it is a Non-Performing Asset.[3] A high NPA level means the bank is not earning interest on a large portion of its loans, reducing its profitability and eroding its capital base.
2. Poor Capital Adequacy: The Capital Adequacy Ratio (CAR) represents the proportion of a bank’s capital in relation to its risk-weighted assets, serving as an indicator of the bank’s financial strength and ability to absorb potential losses.[4] If this ratio falls below the prescribed regulatory minimum, the bank lacks sufficient buffer to absorb losses, making it vulnerable to insolvency.
3. Asset-Liability Mismatch: This occurs when a bank borrows money for a short term, e.g., from depositors, but invests it in long-term assets like infrastructure loans. If many depositors withdraw their money at once, the bank may not have enough liquid assets to pay them, creating a liquidity crisis.
4. Overleveraging: This refers to a situation where a bank takes on too much debt compared to its equity or core capital. This increases the risk of insolvency as the bank may struggle to meet interest and repayment obligations during financial stress.
5. Credit Concentration: This risk arises when a bank lends a large portion of its funds to a single borrower, group, or sector. If that borrower or sector defaults in repayment, the bank faces massive losses, endangering its solvency.

Management Factors

1. Inefficient Management: When a bank’s leadership fails to make informed, strategic decisions or lacks the expertise to adapt to market changes, it results in misallocation of funds, poor asset quality, and financial mismanagement, which erodes trust and financial health.
2. Fraud and Misappropriation: Internal fraud by employees or collusion with borrowers leads to direct financial losses. The Punjab and Maharashtra Co-operative Bank (PMC Bank) case is a classic example of how concealed bad loans lead to insolvency.[5]
3. Neglect of Due Diligence: Due diligence involves thoroughly assessing the creditworthiness of borrowers and verifying documentation before approving loans. When banks rush through the lending process without properly evaluating the borrower’s repayment capacity, it leads to poor loan quality and a higher risk of repayment defaults, contributing to insolvency.
4. Aggressive Lending: Sometimes, bank executives overestimate the institution’s financial strength and approve high-risk loans without sufficient evaluation. This aggressive lending strategy, driven by the desire for rapid growth, can backfire, especially during economic downturns, leading to a rise in repayment defaults and losses, which contribute to insolvency.

Regulatory Factors

1. Non-Compliance with RBI Guidelines: Banks in India are governed by regulations laid down by the Reserve Bank of India (RBI). These include rules related to capital adequacy, asset classification, provisioning norms, and exposure limits, etc. Failure to comply with these norms, such as lending beyond permissible limits or misclassifying bad loans, can lead to regulatory penalties and financial deterioration, increasing the risk of insolvency.
2. Legal Disputes: Banks can become entangled in costly legal battles such as disputes with depositors, borrowers, regulatory agencies, or other financial institutions. Prolonged litigation can drain financial resources, divert management attention, and damage reputation. In some cases, banks may also face heavy fines for violating applicable laws or regulatory guidelines or other compliance regulations, which weakens their financial standing.

MECHANISMS TO REDUCE THE EFFECTS OF BANK INSOLVENCY

• Prompt Corrective Action (PCA) Framework

The Prompt Corrective Action framework is a regulatory tool used by the Reserve Bank of India (RBI) to monitor banks showing signs of financial weakness.[6] It serves as an early warning system designed to alert the regulator as well as investors and depositors when a bank’s financial health begins to deteriorate. The primary goal is to address potential issues before they escalate into a full-blown crisis. Under the PCA framework, the RBI may impose limitations on banks’ lending to high-risk or unrated borrowers, though it does not entirely prohibit them from extending credit.[7] Banks placed under PCA can be taken off the list by reducing their Non-Performing Assets (NPA), strengthening their capital adequacy, and boosting overall profitability.[8]

• Imposition of Moratoriums

In the context of bank insolvency, a moratorium can be said to be a legally enforced temporary suspension of certain banking operations, typically imposed by the Reserve Bank of India (RBI) to prevent further deterioration of a troubled bank’s financial position. During this period, restrictions are placed on activities such as withdrawals, lending, and other transactions to maintain stability and avoid panic among depositors. The moratorium allows time for the regulator to assess the situation and implement a resolution plan, such as reconstruction, merger, or acquisition, ensuring minimal disruption to the financial system. For example, the moratoriums imposed on Ganesh Bank of Kurundwad (2006), Sikkim Bank Ltd (1999), Lakshmi Vilas Bank, among others, were followed by prompt restructuring actions to restore their operations, depositor confidence, and to protect the interest of depositors.[9]

• Bank Mergers

A bank merger is one of the key resolution mechanisms used during bank insolvency to restore financial stability and protect depositors’ interests. When a bank is facing insolvency due to factors such as poor asset quality, inadequate capital, or mismanagement, the Reserve Bank of India (RBI), in consultation with the Central Government, may opt for merging the distressed bank with a financially stronger institution. This process helps in ensuring the continuity of banking services, preventing panic withdrawals, and avoiding systemic crisis in the financial sector. Bank mergers are typically carried out under section 45 of the Banking Regulation Act of 1949, which empowers the RBI to draft a scheme of amalgamation.[10] The process often includes the transfer of assets, liabilities, and employees from the financially weaker banking company to the transferee bank. These strategic mergers aim to stabilize the failing bank, treasure depositors, and maintain confidence in the banking system while minimizing the need for liquidation.

• Bank Reconstruction Schemes

Reconstruction schemes are strategic plans initiated to revive a financially distressed bank without resorting to liquidation. These schemes are formulated under the powers granted to the Reserve Bank of India (RBI) by section 45 of the Bank Regulation Act, 1949. When a bank is unable to meet its obligations due to high Non-Performing Assets (NPAs), capital erosion, or mismanagement, the RBI, with the approval of the Central Government, may impose a moratorium and subsequently propose a scheme of reconstruction to ensure the bank’s survival and protect depositor interests. A reconstruction scheme may include a wide range of measures, such as capital infusion by financially stronger banks or investors, a change in management, or board composition, reorganization of the bank’s liabilities and assets, sale of non-performing assets, restrictions on certain operations during the recovery period, etc.

Therefore, the aforementioned are mechanisms aimed at reducing the effects of or stop bank insolvency.

CONCLUSION

Bank insolvency is a multifaceted issue with social, legal, and economic implications. Given the critical role that banks play in ensuring financial stability, any legal process governing their insolvency must be designed not merely to settle liabilities but to prevent collapse, safeguard the interests of depositors, and rebuild trust in the banking sector. The Indian legal framework offers a distinct approach to bank insolvency, emphasizing resolution and reconstruction over outright liquidation. Through tools like the Prompt Corrective Action (PCA) framework, imposition of moratoriums, and strategic mergers, regulators aim to ensure continuity of operations while mitigating systemic risk. However, the limited application of the Insolvency and Bankruptcy Code leaves a gap in the standardized insolvency proceedings, which could be filled through future legislative reform. In conclusion, while India’s current legal process for bank insolvency is functional and primarily geared toward preserving financial stability, it must evolve in tandem with global standards and domestic financial complexities. A more transparent, accountable, and depositor-friendly framework is necessary to prepare the Indian banking system for future uncertainties. Timely reforms, enhanced supervision, and cross-border cooperation will be key to ensuring that banks remain resilient pillars of the economy rather than points of systemic vulnerability.

REFERENCES

1. Airtel, https://www.airtel.in/blog/personal-loan/explaining-the-prompt-corrective-action-framework-pca-by-rbi/ (last visited July 21, 2025).
2.  Banking Regulation Act, 1949, No. 10, Acts of Parliament, 1949 (India).
3. Testbook, https://testbook.com/banking-awareness/npa-non-performing-assets-and-the-recovery (last visited July 21, 2025).
4.  Adam Hayes, What Is the Capital Adequacy Ratio (CAR)? Investopedia (July 21, 2025, 09:03 PM), https://www.investopedia.com/terms/c/capitaladequacyratio.asp#:.
5. Hermant Singh, PMC Bank Fraud Case: Full Details of the Bank Fraud, Jagran Joshi (July 21, 2025, 10:50 PM), https://www.jagranjosh.com/general-knowledge/pmc-bank-fraud-case-1570456027-1.
6. Drishti IAS, https://www.drishtiias.com/to-the-points/paper3/prompt-corrective-action-pca (last visited July 22, 2025)
7. Forum IAS, https://forumias.com/blog/prompt-corrective-action-pca/ (last visited July 23, 2025).
8. PMF IAS, https://www.pmfias.com/prompt-corrective-action/ (last visited July 23, 2025).
9.  Mohammed Kudrati, Since 1999, RBI Has Put At Least 12 Banks Under Moratorium, Boom (July 25, 2025, 08:12 PM), https://www.boomlive.in/fact-file/since-1999-rbi-has-put-at-least-12-banks-under-moratorium-10733.

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[1] Airtel, https://www.airtel.in/blog/personal-loan/explaining-the-prompt-corrective-action-framework-pca-by-rbi/ (last visited July 21, 2025).

[2] Banking Regulation Act, 1949, §45, No. 10, Acts of Parliament, 1949 (India).

[3] Testbook, https://testbook.com/banking-awareness/npa-non-performing-assets-and-the-recovery (last visited July 21, 2025).

[4] Adam Hayes, What Is the Capital Adequacy Ratio (CAR)? Investopedia (July 21, 2025, 09:03 PM), https://www.investopedia.com/terms/c/capitaladequacyratio.asp#:

[5] Hermant Singh, PMC Bank Fraud Case: Full Details of the Bank Fraud, Jagran Joshi (July 21, 2025, 10:50 PM), https://www.jagranjosh.com/general-knowledge/pmc-bank-fraud-case-1570456027-1.

[6] Drishti IAS, https://www.drishtiias.com/to-the-points/paper3/prompt-corrective-action-pca (last visited July 22, 2025)

[7] Forum IAS, https://forumias.com/blog/prompt-corrective-action-pca/ (last visited July 23, 2025).

[8] PMF IAS, https://www.pmfias.com/prompt-corrective-action/ (last visited July 23, 2025).

[9] Mohammed Kudrati, Since 1999, RBI Has Put At Least 12 Banks Under Moratorium, Boom (July 25, 2025, 08:12 PM), https://www.boomlive.in/fact-file/since-1999-rbi-has-put-at-least-12-banks-under-moratorium-10733.

[10] Bank Regulation Act, 1949, supra note 2, at 3.

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