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Executive Summary 1. Background The urban cooperative banking sector has witnessed phenomenal growth during the last one and a half decades. Certain infirmities have, however, manifested in the sector resulting in erosion of public confidence and causing concern to the regulators as also to the well functioning units in the sector. One of the factors significantly affecting the financial health of the Urban Cooperative Banks (UCBs) is their inability to attract equity / quasi equity investments. At present, UCBs have limited avenues for raising such funds and even their share capital can be withdrawn. Against this backdrop, an announcement was made in the Annual Policy Statement for the year 2006-07 to constitute a Working Group to examine the issue of share capital of UCBs and identify alternate instruments / avenues for augmenting the capital funds of UCBs. Accordingly, a Working Group was constituted under the Chairmanship of Shri N. S. Vishwanathan, Chief General Manager-in-Charge, Urban Banks Department, Reserve Bank of India. 2. Methodology The Group deliberated on the various issues relating to its terms of reference on the basis of presentations made by its members. It also met Chairmen/ CEOs of a few medium/ large UCBs. The areas deliberated included international practices and structures for issue of bonds by cooperatives, adaptability of the provisions of Indian Companies Act, 1956 for issue of preference shares, State Government perspective on the issues involved and provisions of select State Cooperative Societies Acts and Multi State Cooperative Societies Act, 2002 pertaining to issuance of shares and debentures including their transferability, SEBI Act, 1992 and Securities Contract Regulation Act, 1956 (SCRA).

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3. Findings The Group observed that a large number of UCBs are short of the prescribed regulatory capital. Out of 217 UCBs with deposits of over Rs.100 crore, 30 banks, i.e. 15% of the banks in the sample were undercapitalized. Therefore, the need for analyzing the issues involved in and identification of alternate sources of capital cannot be overemphasized. There were legal and structural issues affecting enhancement of capital of UCBs. They are governed by the respective Cooperative Societies Act of the State under which they are registered; besides there are 33 UCBs registered under the Multi State Cooperative Societies Act (Multi State Act). While the Acts are in essence similar, they differ in details in respect of several matters including those relating to freedom to raise and price various financial instruments. The financial instruments issued by UCBs cannot be listed on a stock exchange. In certain countries the financial intermediaries in the cooperative sector are strong and socially effective. The federated structure in countries such as Netherlands (Rabobank Group), France (Credit Agricole Group) and Finland (OKO Group) lent financial strength to all the cooperative entities forming part of the structure. While the federal arrangement differed in details, it revolved around a strong apex level entity, which had even supervisory powers and responsibility. Bringing such a system in India would require an enabling legislative framework. Further, in some countries including Netherlands, Trust Preferred Securities (TPS) are used to raise long term stable funds. Trust preferred securities are undated cumulative preferred securities issued out of a special purpose vehicle (SPV), usually a trust formed by a bank holding company (BHC). The SPV would issue preferred securities to the prospective investors. There is no legal bar on Multi State UCBs raising funds through this process excepting the limit placed on the extent to which funds can be raised by way of debentures. To enable other banks to raise funds through TPS, the states concerned may be required to bring suitable amendments in the Acts to facilitate formation of trust by UCBs.

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Brief History of Urban Cooperative Banks in India The term Urban Co-operative Banks (UCBs), though not formally defined, refers to primary cooperative banks located in urban and semi-urban areas. These banks, till 1996, were allowed to lend money only for non-agricultural purposes. This distinction does not hold today. These banks were traditionally centred around communities, localities work place groups. They essentially lent to small borrowers and businesses. Today, their scope of operations has widened considerably. The origins of the urban cooperative banking movement in India can be traced to the close of nineteenth century when, inspired by the success of the experiments related to the cooperative movement in Britain and the cooperative credit movement in Germany such societies were set up in India. Cooperative societies are based on the principles of cooperation, - mutual help, democratic decision making and open membership. Cooperatives represented a new and alternative approach to organisaton as against proprietary firms, partnership firms and joint stock companies which represent the dominant form of commercial organisation. Urban Banking Sector - A Bird's eye-view The High Power Committee on Urban Co-operative Banks constituted by RBI in 1999, has aptly commented that the co-operative credit endeavour was the first ever attempt at micro credit dispensation in India. UCBs were essentially designed to tap the resources of lower and middle income groups and extend credit support to their economic activities. Over a century old urban, co-operative credit movement today has a network of 2,084 urban co-operative banks with 7,368 branch outlets spread over the country. Their total deposit sources aggregated Rs.71,701 crore and outstanding loans accounted for Rs45,856 crore as at the end of June 2000. The deposits of UCBs are equivalent to 9% of commercial banks' deposits. Few states such as Maharashtra, Gujarat, Karnataka, Andhra Pradesh and Tamil Nadu account for over 80% of urban co-operative banks presence and 75% of their total deposits. Predominant concentration of Urban Co-operative Banks in these 5 states is mainly on account of emergence of strong co-operative leadership. UCBs normally confine their area of operation to localised geographical

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regions. But over a period of time, their area have crossed the frontiers of districts and in some cases the states of their registration. The client profile of UCBs predominantly comprises priority sector segments viz. Small business establishments, SSIs, retail traders, professional, self-employed persons and SRTOs, etc. who would not normally find it easy to have access to large commercial banks. There are weak banks in the total population of UCBs. But most of the banks may be rated as satisfactory to very good. Many of them are highly computerized. We should, therefore, judge each entity on its performance. Wrong doings by a few should not make us berate the entire lot as it would hurt the honest managements who should in fact get encouragement. As regards their regulation, which has become a subject of intense debate in the recent past, UCBs essentially being co-operative societies are governed by their respective state governments out of the powers derived from respective State Co-operative Societies Acts. Being banking institutions, they are also governed by the Reserve Bank of India by virtue of powers conferred on it under the Banking Regulations Act. As UCBs are member driven institutions, every member has to have stake in the capital and irrespective of a member's shareholding, each member has only one vote.

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Draft Vision Document for Urban Co-operative Banks Urban Co-operative Banks (UCBs) are an important part of the financial system in India. It is, therefore, necessary that the UCBs emerge as a sound and healthy network of jointly owned, democratically controlled, and ethically managed banking institutions providing need based quality banking services, essentially to the middle and lower middle classes and marginalized sections of the society. This document sets out the broad approach and strategies that need to be adopted to actualize this vision.

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Objective In the light of above, the broad objectives of the document can be set out as under: i. To rationalize the existing regulatory and supervisory approach keeping in view the heterogeneous character of entities in the sector. ii. To facilitate a focused and continuous system of supervision through enhanced use of technology. iii. To enhance professionalism and improve the quality of governance in UCBs by providing training for skill up-gradation as also by including large depositors in the decision making process / management of banks. iv. To put in place a mechanism that addresses the problems of dual control, given the present legal framework, and the time consuming process in bringing requisite legislative changes. v. To put in place a consultative arrangement for identifying weak but potentially viable entities in the sector and provide a framework for their being nurtured back to health including, if necessary, through a process of consolidation. vi. To identify the unviable entities in the sector and provide an exit path for such entities.

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The Operating Environment Urban cooperative banks form a heterogeneous group in terms of geographical spread, area of operation, size or even in terms of individual performance. As such, development of the urban cooperative banking institutions into safe and vibrant entities requires the small banks in the group to be insulated from systemic shocks by emphasizing their cooperative character. Further, the weak banks may have to be strengthened as a group, through a process of consolidation that may entail mergers/ amalgamations of viable entities and exit of the unviable ones, if there are no other options available. It is also felt that it is necessary to set up a supervisory system that is based on an in-depth analysis of the heterogeneous character of the urban cooperative banks and one that is in tandem with the policy of strengthening the sector.

Regulatory Environment The urban co-operative banks are regulated and supervised by State Registrars of Co-operative Societies, Central Registrar of Co-operative Societies in case of Multi-state co-operative banks and by Reserve Bank. The Registrars of Co-operative Societies of the States exercise powers under the respective Co-operative Societies Act of the States in regard to incorporation, registration, management, amalgamation, reconstruction or liquidation. In case of the urban co-operative banks having multi-state presence, the Central Registrar of Co-operative Societies, New Delhi, exercises such powers. The banking related functions, such as issue of license to start new banks / branches, matters relating to interest rates, loan policies, investments, prudential exposure norms etc. are regulated and supervised by the Reserve Bank of India under the provisions of the Banking Regulation Act, 1949(AACS). Various Committees in the past, which went into working of the UCBs, have found that the multiplicity of command centers and the absence of clear-cut demarcation between the functions of State Governments and the Reserve Bank have been the most vexatious problems of urban cooperative banking movement. This duality of command is largely responsible for most of the difficulties in implementing regulatory measures with the required speed and urgency and impedes effective supervision.

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Proposed Operating Framework The entities in the sector display a high degree of heterogeneity in terms of their deposit/ asset base, area of operations and nature of business. A system of differentiated regulatory and supervisory regime as opposed to a one size fits all approach may be more appropriate, keeping in view the vastly differentiated entities comprising the sector. The broad principles governing RBI regulation over UCBs could largely follow the principles as under: A. Unit Banks (Simplified regulatory regime) Unit banks, in particular, the smaller among them, essentially capture the basic concept and spirit of cooperative banking since they function from a single office/ branch and cater to the clientele in and around their place of business. As such, they have a natural ability to relate to the customer, have the local feel and flavour and consequently modulate their business strategy to meet the local aspirations. Since small unit banks with deposits below, say, Rs.50 crore epitomise the basic tenets of cooperative banking, less stringent regulations could be considered for such banks. For example, CRAR could be replaced by the simpler form of minimum capital requirement viz. Net Owned Funds to NDTL ratio which is easier to compute for the small banks while serving the purpose adequately. At the same time, keeping in view their ability to assess and absorb risks, appropriate limitations like a lower level of single and group exposure limit could be prescribed for these banks to contain their concentration risk. Similarly, the exposure by such banks to sensitive sector should be checked, as these banks lack the wherewithal, in terms of expertise, technology and financial strength to sustain exposure to capital market / real estate etc. As such, keeping in view the nature and size of their operations, appropriate relaxations like a lower prescribed minimum investment in G-Sec (in view of their inability to access market) and restrictions necessary to insulate them from systemic shocks may be introduced for such banks. Ideally the unit banks should work within a small geographical area and accordingly the Unit banks to be eligible for the simplified regulatory regime shall conform to this requirement by rolling back their business in far off locations. The suggested simplified regulatory prescriptions are given in Annexure - vi.

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B. All Banks (other than unit banks with deposits less than Rs. 50 crore) Regulatory prescriptions, as applicable to commercial banks should be applicable in all respects to banks falling in this category. However, for these banks the extant relaxations for UCBs could remain in force for the period already prescribed. Further, it is suggested that as a matter of principle, there should not be any unscheduled Multi State Bank. This could be operationalised through the Central Registrar of Cooperative Societies, which could ensure that a bank is scheduled before it is granted registration under the Multi State Co-operative Societies Act. In order to ensure that all scheduled banks are also, as far as possible, strong enough to support themselves and a few smaller UCBs around them, the RBI could prescribe appropriate norms for scheduling of cooperative banks. Further, banks in this category which comply with the prescribed regulatory requirements can be extended facilities and privileges as are presently available to the commercial banks of comparable size. The existing scheduled banks, both under Multi State and State Cooperative Societies Act, which do not meet the prescribed criteria and do not comply with the prudential and regulatory regimen akin to that of commercial banks, could be excluded from the second schedule to the RBI Act through a time bound corrective action framework As a corollary, the existing non-scheduled Multi State Banks could also be required to close their branches/withdraw from any business outside the principal State of their activity.

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Supervision The number of unit banks with deposits under Rs. 50 crore constitute 33 percent of UCBs and account for less than 6 percent of deposits of the sector. These banks, limited by their size / type of operations, pose lower systemic risks and could be supervised by a combination of simplified off-site surveillance system of the RBI and on-site audit by the state governments. Based on these reports, Reserve Bank of India, at its discretion, could conduct inspection of such banks, which, however would not be normally covered under its regular schedule of inspection. The increased dependence on off-site surveillance of RBI and on-site supervision by RCS in respect of the small unit banks would provide increased flexibility to the RBI to deploy its supervisory resources to the larger and more risky banks.

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.Agenda of Reforms The urban co-operative banking sector being an integral part of financial system, RBI has brought in a series of reforms in it. The recent Mdhava Rao Committee which is also called High Power Committee (HPC) on UCBs, has dwelt extensively on certain regulatory issues related to UCBs' licensing policy, future set up of weak and unlicensed banks, application of capital adequacy norms, resolution of conflicts arising of dual control over UCBs, etc. RBI has accepted these recommendations and implemented them. However, issues related to dual control necessitate legislative changes to State and Central Acts and there is hardly any progress in this area. In the backdrop of the present scenario, future agenda for reforms in urban co-operative banking sector, as I perceive is four fold: (a) Aligning urban co-operative banking sector with the rest of the financial system (b) Deciding the future of weak entities (c)Improving governance (d) Resolving the issues emanating from dual control (a) Aligning UCB sector with rest of financial system Unlike the other segments of co-operative credit sector, UCBs today undertake multifarious banking activities. Some of them have also been permitted to undertake forex and merchant banking activities. There is a view emerging in the recent past that UCBs being members of payment system, beneficiaries of deposit insurance scheme and enjoying unlimited access to public deposits, it is an imperative necessity to apply exactly the same regulatory rigours to UCBs as applicable to commercial banks. While broadly agreeing with this argument. I feel that their institutional frame work, size of operations and balance sheet, nature of business, product mix and above all the skill levels, may have necessarily to be kept in view while deciding on the supervisory and regulatory rigours. Therefore, without undermining the regulatory efficacy, there is a need to fine-tune the prudential prescription. The view expressed by my distinguished

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colleague, Deputy Governor Dr. Y.V. Reddy, in the context of implementation of Financial Standards and Codes in India is equally applicable in UCBs' adoption of prudential standards. He said "although the notion of a code of good practices is intuitively appealing, the temptation to prescribe universally valid model codes which do not allow for differences in institutional development, legislative frame work and more broadly, different stages of development must be avoided". Notwithstanding cultural differences between UCBs and commercial banks, RBI has been gradually attempting at regulatory convergence for both. To begin with, in 1993, RBI introduced Income Recognition and Asset Classification Norms to UCBs. In 1995, the prudential exposure norms to single/group borrowers were also made applicable to them. However, introduction of capital adequacy norms was delayed due to statutory limitations on UCBs' right to raise unlimited capital but these are also now going to be implemented from 31 March 2002, in a phased time-frame. The future agenda for reforms as. I visualise should focus on these following issues: (i) Today, main risk exposure of UCBs is not the credit risk but interest rates risk. Most of the UCBs interest rates particularly on deposits are out of sync with the rest of the banking sector. In this backdrop, observance of Risk and Asset Liability Management guidelines assumes importance. RBI has recently constituted a Working Group to evolve guidelines keeping in view the specifics of UCB sector. The Group is expected to submit its recommendations very soon. (ii) As market discipline is an important supervisory tool in approach to new Capital adequacy framework, prescription of disclosure standards for UCBs, perhaps is of imminent necessity. UCBs, therefore, should be able to disclose their level of owned funds, unimpaired networth, CRAR. Gross/Net NPAs, operating results, ROA. compliance with reserve requirements, per employee productivity, etc. with balance sheet figures. This issue is engaging the attention of RBI. (iii) Strengthening the audit systems is of paramount concern for RBI as it is an important tool in its supervisory kit. It had taken a lead in appointing an expert panel in 1995 for reforming the audit systems in vogue in UCBs. The panel suggested professionalisation of audit, mandatory concurrent audit for larger banks, redesigning audit format, etc. RBI had accepted these recommendations and advised States to initiate measures. Unfortunately, many state governments have yet to respond positively despite Five years of persistent persuasion by RBI.

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(iv) Yet another important issue which is engaging the attention of the observers of co-operative banking movement is defining the frontiers of UCBs. Whether they should have unlimited access to inter-bank markets ? Whether their reach should be nation-wide ? Whether they can have access to capital market ? In view of special role assigned to UCBs, in the recent Monetary and Credit Policy Statement made by the Governor, it was decisively stated that they should not have unrestricted access to inter-bank markets as resorting to this avenue is essentially to meet their temporary liquidity mismatches rather than raising short term resources to fund their long term assets. By their sheer volatile nature, neither capital market nor its instruments can be investment avenues for UCBs who are representatives of small depositors. As regards their area of operation, we have very recently taken a decision to allow only such UCBs with Rs. 50 crores owned funds to go beyond their state of jurisdiction. (v) Whether UCBs membership of Payment System should be unconditional ? This issue has come into focus in the wake of Madhavpura Mercantile Co-operative Bank crisis. In case of commercial banks, in the event of payment crisis, CRR balances would be available besides SLR securities, whereas in respect of UCBs, their SLR investments need not entirely be in Government Securities and in case of non-scheduled banks maintenance of CRR balances with RBI is not mandatory. Whether a system can be evolved whereby fire-walls can be erected to avert payment crisis of co-operative banks by way of lodging certain ..Government Securities, mandatory cash deposits with clearing houses for meeting payment obligations in the event of liquidity crisis ? Whether such an act would further pre-empt" the resources of UCBs? Or these deposits would constitute part of SLR funds? This issue needs extensive enquiry. Well these are issues which require informed deliberations for crystalising into policy inputs. (b) Future set-up of weak Banks The sheer number of weak banks which is well over 200 is a cause of concern. In a large number of eases licenses have already been cancelled and the banks have closed down. This process is taken up

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very cautiously so as not to create panic in the society. 'Closure is decided only after all other options are exhausted. Level of capital, history of losses and size of NPAs are some of the factors which weigh with us in taking a decision on closure. Possibilities of rehabilitation are invariably explored before such a decision is arrived at. Rehabilitation may involve the following strategies : (a) Registrars should direct the co-operative courts for speedy recovery process and execution of decrees b) Unviable branches should either be relocated or closed down c) Avenues should be explored for the bank getting additional capital d) Merger with a well-managed bank. However, a forcible merger should be strictly avoided. (c) Improving Governance It is extremely important-that there .is a mechanism to ensure that an effective system of internal governance is in place. Chief Executive should be a person of clean image and display a professional attitude. Board should consist of knowledgeable persons who are aware of their responsibilities as board members. There should be a board level committee which should focus attention on the Findings of audit and inspection teams and ensure compliance thereof. The Committee should also ensure compliance with various regulatory instructions issued by RBI as also state governments. It is ultimately the board's responsibility that all prudential norms of governance are observed by the bank. (d) Dual control dilemma Duality of command over UCBs perhaps has become an intense issue of debate in co-operative circles Academics, co-operators and bankers made vociferous representations to the Madhava Rao Committee that dual control over UCBs must end as that was instrumental in stifling their growth. Narsimham Committee II had also unequivocally recommended for ending dual control regime over UCBs. Is dual command the causative factor for the ills of UCBs? Is it an impediment in effective supervision over them ? Having been closely associated with the regulation of the cooperative banking structure for quite some time. I am indeed inclined to agree with the Madhava Rao Committee recommendation on this issue. The Committee aptly observed "... that dual control regime, per se, need not cause any hindrance to the

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growth of urban banking movement. It is the absence of clear cut demarcation between functions of RBI and that of State Govt. that adversely affects the smooth functioning of UCBs.'' Most of the issues emanating out of dual control regime is due to overlapping jurisdiction of RBI and state governments. It, therefore, recommended demarcation of banking related functions and such of those which warrant only state governments' action, RBI has concurred with its recommendations and is impressing upon the state governments for bringing in legislative 'amendments. Duality in command does come in the way of effective supervision. In the case of commercial banks RBI has all the wherewithal under Banking Regulation Act for dealing with crucial aspects of functioning of commercial banks. In the case of cooperative banks, however, many areas which directly relate to supervision over them have been kept beyond RBI's authority. Situation gets somewhat messy as may be indicated by a few illustrations as follows: (i) RBI has no authority to deal with delinquent management in a cooperative bank. This requires intervention of the Registrar of Cooperative Societies. (ii) Making investments out of surplus resources being clearly a banking function should be entirely within the decision making powers of cooperative banks subject to RBI guidelines but this needs approval of the Registrar. (iii) Similarly, writing off an unrealisable debt also requires permission of the Registrar. (iv) There was an instance where on request made by RBI, the Registrar superseded the board of a cooperative bank. But subsequently the State Government in its wisdom annulled Registrar's orders and restored the Board. It is strange but true. (v) It is open for a bank whose licence has been cancelled to appeal to the government. RBI is required to appear before the Appellate Authority. Often RBI is advised to review its decision. It is a matter of satisfaction, however, that RBI's decisions have been supported by government and in no case RBI's decision has been struck down. Nevertheless the exercise has to be gone through.

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I feel there are 3 ways of resolving dual control issues : (a) One approach is by bringing in the subject of cooperation under concurrent list so as to enable the Union Government to legislate in matters pertaining to cooperative banking. But such a move involves amendments to the Constitution. (b) Another way of approaching this issue is the states enacting progressive legislations thereby making Registrars confine their acts only to register and accept byelaws. As a result, dual command over UCBs will be ceased automatically Though a lead has been taken by the Governments of Andhra Pradesh and Karnataka in this direction, most of the slates are yet to follow. Even in Andhra Pradesh and Karnataka, it does not make any change in the status of existing banks unless they are registered under the new legislation. Unless a uniform initiative is taken by all the states, perhaps it would be difficult to remove irritants of dual control regime. (c) Yet another approach is to demarcate the regulatory roles of state governments and RBI in the State Acts, as suggested by the Madhava Rao Committee. I rather tend to agree with this approach since it is best way to resolve dual control "dilemma. There have also been suggestions that the Banking Regulation Act, which is a central statute may be amended in a manner that it enables RBI to assume certain powers which are at present available to state governments under the respective State Cooperative Societies Act, However, the legal advice given to RBI does not support such a move. Here I would like to make it clear that while RBI is in favour of ending the dual control, as far as Madhavpura episode is concerned, the immediate cause of its problems did not arise out of the present regime of dual control. What happened in the case of Madhavpura was ostensibly due to lack of observance of prudential banking practices.

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Licensing Policy of New Urban Cooperative Banks Present Licensing Policy 3.1 The existing licensing policy of RBI is broadly based on the recommendations of the Marathe Committee.11 At present, organisation of a new UCB is allowed on the basis of the need and future potential for mobilisation of deposits and purveying of credit, so that the new institution becomes a viable proposition and satisfies the felt banking needs of local people. To determine the need and potential for UCBs, presence only of urban cooperative banks functioning at a given centre is taken into account and presence of all other banking network is excluded. This is done as the clientele of UCBs are supposed to be distinct from those of commercial banks. Another criterion for determining the adequacy of banking network is to take into account the average population served by the existing UCBs. The present policy also prohibits organisation of UCBs in the rural centres on account of distinct credit delivery system already in place for rural centres. Approach of the Committee 3.2 The Committee observes that there are no quantifiable, objective criteria for determining the need for an UCB in a given area. The Committee has also noted the recommendations of the Marathe Committee, which felt that "the Reserve Bank may address itself to the task of prescribing quantitative definitions for the key indicators like `need', `potential' and `adequacy' or otherwise of the `banking cover'. The Marathe Committee was of the view that while "need" for the organisation of a new UCB refers to concepts such as population coverage, spatial and geographical spread of existing banks etc., the "potential" criterion relates to an assessment whether, in the area of operation proposed, the new entity would be able to achieve the norms of viability within a reasonable period of time. Marathe Committee also felt that the determining basis for such an assessment should be the `credit gap' in the functional area and suggested the following guidelines for assessing the same.

i) Industrial activity present and proposed; setting up of new industrial estates etc; ii) Level of trading activity; emerging markets and market yards; iii) Sub-urban areas - existing and proposed; iv) Existing banking network, deposits, advances, credit-deposit ratio; v) Average population served by existing bank offices.

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3.3 The Committee has examined these factors in the context of a substantially deregulated regime and policy posture of RBI with reference to organisation of new Private Sector Banks and Local Area Banks (LABs). The Committee is of the view that in a market driven regime, focus of the regulator should be on strong start-up capital, compliance to prudential norms, adherence to CRAR ab initio and professional character and integrity of management. If these factors are given due weightage before granting licence for a banking entity, there may not be any need to prescribe other parameters. 3.4 While responding to the questionnaire on this issue, a section of urban cooperative banks, their federations, and state cooperative banks have suggested that credit gap' criterion should be a determining factor to establish the need for a bank, in a given locale specific. The Committee has examined this aspect and in its view, credit gap' in a given area cannot be determined on unidentifiable parameters. The concept has to be well defined, structured and universally acceptable. Hence, in the absence of precise, measurable and scientific tools to determine exact quantum of credit gap, prescription of credit gap' criterion for assessing the need, will only result in a laborious exercise without any tangible results. The suggestion that the credit gap may be determined on the basis of Potential Linked Credit Plan (PLP) of NABARD has also been examined by the Committee. The objective behind the preparation of Potential Linked Credit Plan is to bring to the notice of the planners, government, developmental agencies, bankers, farmers, private sector agencies etc, the need for infusion of specific infrastructure and non credit inputs to facilitate planned development of the district. The focus of PLP is essentially on rural development with the thrust on district as a whole. Since UCBs initially start at an urban centre, it is difficult to arrive at credit gap of an exclusive urban locale from PLP. Given the weak conceptual relevance of credit gap', the Committee is not inclined to agree with this criterion for determining the need for a new urban cooperative bank at a given centre. 3.5 Yet another suggestion put forth by respondents to the questionnaire circulated by the Committee is, that the adequacy or otherwise of banking network at a given centre can be determined by the conventional arithmetical formula viz., Average Population Per Bank Office (APPBO). The APPBO is arrived at by application of following formula : Population of a given centre No. of banks offices (branches)

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3.6 At present, RBI is following this norm and if the Average Population Per Bank Office (excluding commercial and other banking network) at a given centre is less than 10000, the centre is deemed to be adequately banked. The Committee has tried to assess the merits of this norm. In the opinion of the Committee, adequacy of banking network, at a given centre, cannot be gauged purely by statistical or arithmetical formula like APPBO. To a great extent, it depends on the level of economic activity, infrastructure, degree of urbanisation, buoyancy of service sector and the credit absorption capacity of the centre as a whole. These factors are not static and keep changing with reference to govt. policy, entrepreneurial capabilities and emergence of new economic activities. A cursory glance at urban banking network in 5 districts of Maharashtra viz. Pune, Nasik, Sangli, Satara and Kolhapur reveals presence of a large network of UCBs. By application of APPBO norm most of the towns in these districts at present appear to be over banked. Still the cooperative initiative has not diminished. It is understood that RBI continues to receive applications from promoters for organisation of new banks and for opening branches in these districts. On the other hand, in the states like Orissa and Bihar, there are as few as 14 and 6 UCBs respectively notwithstanding the liberal policy stance of RBI. Given the thin presence of urban banking sector in these states, it appears that there is scope for the growth of urban cooperative banking movement. But, disparity in the presence of urban banking movement point to the fact that adequacy of banking network cannot be gauged exclusively by mechanical application of APPBO. Rightly, no such norm is applied by RBI while giving approval for organisation of new Commercial Banks or Local Area Banks. Moreover, excluding the non-urban banking sector in an area for gauging adequacy of banking network may not be an objective criterion. Selective prescription of population criterion only for UCBs leads to imposing artificial barriers on their growth besides going against the principle of equity. 3.7 The Committee feels that the licensing policy should not only be transparent but also precise and objective. The procedures have to be simple and minimal. In this context, the Committee agrees with the core principles enunciated by the Basle Committee on Banking Supervision that "the licensing authority must have the right to set criteria and reject applications for establishments that do not meet the standards set. The licensing process at a minimum should consist of an assessment of the banking organisations, ownership, structure, directors and senior management, its operative plan and internal controls, and its projected financial condition, including its capital base".12 Thus, licensing process should be minimal but rigorous. Further, in a market driven system, the

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regulator is neither expected to carry out such an exercise to assess the viability of a bank nor it has the wherewithal to go into micro level assessment of an individual entity. Moreover, if the viability norms to be achieved within a specified period are stipulated, once a bank is licensed and starts operating, there is no practical way in which compliance with such norms can be enforced. The Committee is, therefore, of the view that the regulator has only to lay down appropriate entry point norms and leave the issue of need, potential and viability of a bank to the promoters' judgement.

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Chapter I Introduction and Approach 1. Introduction 1.1 The urban cooperative banking system has witnessed phenomenal growth during the last one and a half decades. From 1307 urban cooperative banks (UCBs) in 1991, the number of UCBs rose to 2105 in the year 2004. Deposits increased from Rs.8,600 crore to over Rs.1,00,000 crore, while advances had risen from Rs.7,800 crore to over Rs.65,000 crore during the same period. Along with this spectacular growth certain infirmities have, however, manifested in the sector resulting in erosion of public confidence and causing concern to the regulators as also to the well functioning units in the sector. A significant step in the recent past for addressing the problems of UCBs was the formulation of the draft Vision Document, which was placed in the public domain in March 2005. 1.2 One of the factors significantly affecting the financial health of the UCBs is their inability to attract equity / quasi equity investments. At present, UCBs have limited avenues for raising such funds and even their share capital can be withdrawn. In the context of the competition that the UCBs are facing from other financial intermediaries, including the commercial banks, both on the asset and the liability sides, strengthening the ability of the banks to raise capital funds in order to expand their business has become all the more critical for the sector. Therefore, the various steps initiated in pursuance of the proposals of the draft Vision Document for UCBs would need to be supplemented with measures that enable them to strengthen their capital base so as to achieve the objectives set out therein. 1.3 Against this backdrop, the constitution of a Working Group to examine the issue of share capital of UCBs and identify alternate instruments / avenues for augmenting the capital funds of UCBs was announced in the Annual Policy Statement for the year 2006-07.

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Accordingly, a Working Group was constituted under the Chairmanship of Shri N. S. Vishwanathan, Chief General Manager-in- Charge, Urban Banks Department, Reserve Bank of India. The members of the group were: (i) Shri Anil Diggikar, Commissioner for Cooperation & Registrar of Cooperative Societies, Government of Maharashatra (ii) Shri J.C. Sharma, Commissioner for Cooperation & Registrar of Cooperative Societies, Government of Andhra Pradesh (iii) Shri D. Krishna, Chief Executive, National Federation of Urban Cooperative Banks and Credit Societies Ltd (NAFCUB) (iv) Prof. Mukund Ghaisas, Chairman, Maharashtra State Urban Cooperative Banks Federation (v) Shri K. D. Zacharias, Legal Adviser, Reserve Bank of India In place of Dr. S. K. Sharma, who was initially the member of the Working Group in his capacity as Commissioner for Cooperation & Registrar of Cooperative Societies, Government of Maharashtra. 1.4 The terms of reference of the Working Group were as under: (i) To consider whether the paid up share capital can be treated as core capital for capital adequacy purposes in the light of International Accounting Standards Boards standard IAS 32 and if not to suggest a time frame to implement the proposed standard. (ii) To suggest alternative avenues for raising capital particularly in the light of recent guidelines on newer instruments issued to commercial banks by the Reserve Bank. (iii) To look into international experiences of cooperative banks/ credit unions in raising capital and to suggest measures that can be implemented in the context of primary (urban) cooperative banks in India. (iv) To make such other recommendations as the Group may deem relevant to the subject.

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A copy each of the notification on the constitution of the Working Group and the nomination of Shri Anil Diggikar in place of Dr. Sharma are given as Annex I & II respectively. 1.5. Approach adopted by the Group 1.5.1 Initially, specific responsibilities were assigned to each member for undertaking in-depth study of relevant issues and making presentations before the Group. Accordingly, the members made presentations on the following topics: a) International practices and structure for issue of bonds by cooperatives. b) Provisions of the Indian Companies Act, 1956 in regard to issue of preference shares and the feasibility of their adoption for UCBs. c) State Government perspective on issues relating to shoring up of capital base of UCBs. d) Cooperative Societies Acts of significant states and Multi State Cooperative Societies Act and analysis of provisions of the Indian Companies Act, 1956, securities Contract Regulation Act (SCRA), 1956 and the SEBI Act, 1992 in so far as they relate to issue of various financial instruments. In addition, views of Chairmen/ Chief executive Officers of a few large and medium sized UCBs were ascertained. 1.5.2 The Working Group had five meetings in which the presentations were made and the issues raised in the presentations were discussed in detail. The major findings and the recommendations of the Group are given in the ensuing chapters.

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CHAPTER II Important Findings 2.1 The Group observed that a large number of UCBs are short of the prescribed regulatory capital. Out of 217 UCBs with deposits of over Rs.100 crore, 30 banks had reported CRAR below 9 %, 20 of which reported CRAR of less than 5%. Thus, 15% of the banks in the sample were under-capitalized. The extent of under-capitalization could be higher in the smaller banks. Therefore, the need for analyzing the issues involved in and identification of alternate sources of capital cannot be over-emphasized. 2.2 There are both legal and structural issues that affect the enhancement of capital of UCBs. Therefore the Group studied the legal issues as also a few successful international models to examine the possibility of their being adopted in the context of the legislative framework obtaining in India. The Group also examined a suggestion made by NAFCUB for setting up a private screen based platform for trading of financial instruments, counting for capital, issued by UCBs. The International Accounting Standards Board's (IASB) recommendations regarding non eligibility of share capital of cooperative societies to be treated as equity on account of it being eligible for withdrawal was also studied with reference to the provisions of the Cooperative Societies Acts. These issues are discussed in the ensuing paragraphs. 2.3 Legal Framework 2.3.1 UCBs are not operating under any one single legislation, i.e., they are governed by the respective Cooperative Societies Act of the State under which they are registered; besides there are 33 UCBs registered under the Multi State Cooperative Societies Act (Multi State Act). While the Acts are in essence similar, they differ in details in respect of several matters including those relating to freedom to raise and price various financial instruments. Extracts of relevant provisions of a few State Acts and the Multi State Act are given in Annex III. It may be observed therefrom that while the Maharashtra State Cooperative Societies Act, 1960, (Maharashtra Act) has no specific provisions as to the nature of instruments through which funds can be raised, which is left to the rules and bye-laws, the Multi State Act has specific provisions in this regard prescribing a limit of 25% of the

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share capital for raising funds by way of non-convertible debentures etc. The pricing of share capital is another important issue where the provisions of the law are not uniform. The Maharashtra Act does not specify either the value at which the share capital has to be issued or the value at which it should be redeemed. These are provided for in the rules. However, the Multi State Act is specific that the share capital can be issued only at face value. There are also differences between Acts on the limits up to which one can subscribe to the share capital of UCBs. In the Maharashtra Act, for example, apart from a prohibition on holding more than onefifth of share capital of the society, a monetary ceiling of Rs.5 lakh per individual shareholder is prescribed, while in the Multi State Act there is no such monetary ceiling. It was, therefore, evident that it may be extremely difficult to identify instruments that are legally permissible across all Cooperative Societies Acts. However, because of concentration of UCBs in five states viz. Maharashtra, Gujarat, Karnataka, Tamil Nadu and Andhra Pradesh, making requisite amendments in the Acts of these States and the Multi State Act would cover 85% of the banks by number and asset size. 2.3.2 Market for a financial instrument is enhanced by its transferability. The Cooperative Societies Acts, in general, require that a share be transferred only to an existing member or to a person whose application for membership has been accepted. This restriction on transfers comes in the way of marketability and therefore, adversely affects the liquidity of shares of UCBs. 2.3.3 Another legal aspect relates to listing of financial instruments issued by UCBs. As per SEBI Act, 1992 and Securities Contract Regulation Act, 1956 SCRA), for a financial instrument to be eligible to be listed in the Stock exchange, it should have been issued by a body corporate as defined under theCompanies Act, 1956. A cooperative society is a body corporate as per the Cooperative Societies Acts. However, as per the Companies Act it is not a body corporate. As such the financial instruments issued by UCBs cannot be listed in a stock exchange. 2.4 International Systems The Group analyzed the systems / structures obtaining in countries where the financial intermediaries in the cooperative sector are strong and socially effective. In particular, the federated structures of

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Rabobank Group (Netherlands), Credit Agricole Group (France) and OKO Group (Finland) were examined based on literature available and information provided by the institutions in their web sites. The features of Trust Preferred Securities, an instrument popular in countries like USA / Netherlands, were also looked into for examining their feasibility in India. The findings of the Group in these matters are briefly outlined in the following paragraphs. 2.5 Federated Structure 2.5.1 Rabobank Group (i) Rabobank Group is the largest financial services provider in Netherlands and has an extensive network worldwide. Rabobank Group is a cooperative banking organization comprising Rabobank Netherland, Rabobank Netherlands' local member credit institutions (Local Banks) and numerous other subsidiaries like Rabobank International. While Rabobank Netherlands is a legal entity, the Rabobank Group is not a legal entity. The cooperative structure and local involvement have been the cornerstones of the Group for more than a century. (ii) The local Rabobanks, which are cooperatives, are members of Rabobank Netherlands. Membership is subject to the Articles of Association having been approved in advance by Rabobank Netherlands. As of December 31, 2005, there were 248 Local Rabobanks as members and shareholders of Rabobank Netherlands. Further, while Rabobank Netherlands is a subsidiary of the local Rabobanks, it is in fact at the head of an inverted pyramid. The Local Banks serve their customers with the support of Rabobank Netherlands and not vice versa. The latter provides managerial, operational and advisory services, which include credit approvals, cost sharing and other centralized functions such as IT, human resource management, liquidity, capital and risk management, etc. Further, in accordance with the Credit System Supervision Act, 1992, it is responsible for supervising the financial health and professionalism of the Local Rabobanks. It also acts as treasurer to the Group and a holding company of a large number of subsidiaries. Rabobank Group is treated as a consolidated entity for regulatory and supervisory purposes.

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(iii) Local Rabobanks do not have any shareholders and as such do not pay dividends. Hence they retain all profits after net payments on trustpreferred securities and membership certificates (Please refer paragraph 2.6.1 and note to paragraph 3.4.2). (iv) In accordance with the Credit System Supervision Act, 1992 an internal Cross-Guarantee System is in place whereby certain entities within the Rabobank Group are liable for the other participants' financial obligations in case of a shortfall of funds. Participating entities within the Rabobank Group include Rabobank Netherlands and the Local Rabobanks. This cross guarantee system, in a way, provides, to any bank within the structure, access to the resources of the entire Group, facilitating support in times of need. In effect they all have joint and several liability for each others commitment. 2.5.2 Credit Agricole Group (i) Originally, the Credit Agricole Group was the banker of the French agricultural sector and farming communities. However, it has evolved and broadened its activities to service all sectors of the economy and all types of clients. (ii) The organization has a three-tier structure. There are more than 2,500 Local Banks grouped into 48 Regional Banks, which in turn hold a majority of the capital of Credit Agricole S.A., the central bank of the Group. The Federation Nationale du Credit Agricole is the representative body of the Group. The Federation also offers support and services to the Regional Banks, such as occupational training and human resources management. Credit Agricole S.A. is the largest bank of France having a unified, yet decentralized, organization. (iii) The Local Banks own most of the capital of Regional Banks, and form the base of the group. The Regional Banks are co-operative entities and undertake all banking activities. Some of the Regional Banks have obtained funds from capital markets by issuing non-voting shares (certificats cooperatifs dinvestissement). Regional Banks, via SAS Rue La Boetie, hold a majority stake in Credit Agricole S.A. Credit Agricole S.A. in turn, holds 25% of the share capital of each Regional Bank. (iv) As a result of Credit Agricoles desire to embrace the market while strengthening its mutual identity, Credit Agricole S.A. was floated on

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the stock market in December 2001. Credit Agricole S.A. is a universal bank, present across the entire spectrum of banking and insurance activities. Credit Agricole S.A. represents all Group business lines and entities, and has three main roles within the Group, i.e. lead institution, central banker and the entity responsible for ensuring consistent development. It manages the treasury operations of Credit Agricole and raises and lends funds on the international capital markets. It also provides many of the international services offered by the Group as well as a number of technical and financial services through its specialized subsidiaries. Credit Agricole S.A. designs the products marketed by the Regional Banks and is responsible for its subsidiaries and for international growth. (v) Credit Agricole S.A. owns 25% of the Regional Banks' capital and all Group interests in foreign banks and operating subsidiaries specializing in particular business lines. In view of Credit Agricole S.A.s stake in the Regional Banks, 25% of the Regional Banks results are accounted for in the results of Credit Agricole S.A. using the equity method. Credit Agricole S.A. coordinates the implementation of commercial strategy, in particular by defining broad marketing and communications policy. As the Groups lead body, it also is in charge of managing centralized savings and advances for the Regional Banks apart from audit and risk management. 2.5.3 OKO Bank Group (Finland) (i) OKO Bank Group comprises 239 independent member cooperative banks and the Groups statutory central institution, OP Bank Group Central Cooperative. OKO Bank is the largest subsidiary of the Central Cooperative. OKO Bank is a commercial bank, which also acts as the OKO Bank Groups central bank. The OKO Bank Group Central Cooperative and its 239 member cooperatives own 41.3% of shares and have 55.8% of votes. (ii) OP Bank Group Central Cooperative is the groups know-how and service centre. It is a cooperative owned by the member banks and its function is to produce services for the member cooperative banks. The most notable subsidiary of the Central Cooperative is OKO Bank.

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(iii) OKO Bank acts as an independent commercial bank and financial institution for the member cooperative banks. It has three subsidiaries. The OKO Bank is the central financing institution of the cooperative banks and as a commercial bank it engages in the business operations set forth in the Credit Institution Act. The special purpose of the Bank is to promote and support, as a central financing institution, the activities of the cooperative banks and other institutions belonging to the Cooperative Banks Group. The bank can offer investment services as well as custodial and asset management services. The bank is responsible for the debts and commitments of the central institution and its member banks and other Cooperative Credit Institutions. The central institution and its other member banks are in turn responsible in the same way for this bank's debts and commitments. The central institution has the right to issue instructions to OKO Bank on its operations in order to ensure the Bank's liquidity, capital adequacy and risk management as well as the right to supervise the bank's operations. (iv) OKO Bank issues two categories of shares. Series A are intended for the public and are listed on the Helsinki Exchanges. Each Series A share entitles its holder to one vote at the general meeting of shareholders. Series K shares can only be owned by a Finnish cooperative bank and the central institution, OKO Bank Group Central Cooperative. Each Series K share gives its holder five votes. The Series K share can be converted into Series A share upon a demand of the shareholder or, in respect of nominee-registered shares, subject to certain conditions and the Articles of Association. The majority of Supervisory Board members are elected from among the members of the Supervisory Board of the OKO Bank Group Central Cooperative. One of their duties is to appoint the Chairman of the Executive Board and the President. (v) OKO Bank, through its issuance of two categories of shares, presents a hybrid model that blends the benefits of a listed entity and those of a cooperative. While the Series A shares enable raising capital on stock exchange, the Series K share ensures cooperative control over the institution.

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2.5.4 Observations of the Group on the above models The similarity in the above three models is the presence of an Apex level entity to which the cooperatives are federated. In the Indian context, such an apex level entity could be either at the State level, the national level or at any other level. However, as per the provisions of the Banking Regulation Act 1949, Reserve Bank can grant license to a primary cooperative bank as defined in Section 5(ccv) of the Act and the Central / State Cooperative Banks as defined in the NABARD Act, 1981. As the apex level entity required for the adoption of the above models would not fall in any of these categories that RBI can license, the creation of such an entity would require that an enabling legislative framework be created. 2.6 Trust Preferred Securities (TPS) 2.6.1 Trust preferred securities are undated cumulative preferred securities issued out of a special purpose vehicle (SPV), usually a trust formed by a bank holding company (BHC). The SPV would issue preferred securities to the prospective investors. The SPV shall pass on the proceeds of the preferred security issuance and loan them to the BHC. The BHC would issue debentures/subordinated note to the SPV to reflect its indebtedness to the latter. The trust preferred securities generally allow for at least twenty consecutive quarters of dividend deferral, after which the investors have the right to take hold of the sole asset in the trust, viz. a deeply subordinated note issued by the BHC. The note, which is subordinated to all obligations of the BHC other than its common and preferred stock, has terms that generally mirror those of the trust preferred securities, except that the subordinated debt has a fixed maturity of at least 30 years. The SPV, in the form of a Trust, is preferred to the principal issuing the securities directly, possibly, because of the accompanying tax benefits for the investor. In the U.S.A., because trust preferred securities are cumulative, the Federal Reserve Board limits them, together with directly issued cumulative perpetual preferred stock, to no more than 25% of a BHC's core capital elements. 2.6.2 Observations of the Group The feasibility of allowing issue of Trust Preferred Securities was examined and it was found that it would require UCBs to float an SPV in the form of a trust. Except for the Multi State Act, most of the other

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Cooperative Societies Acts do not specifically provide for a cooperative society forming an organization registered under any other Act. As such, in order to enable the co-operative banks registered, other than under Multi State Act, to raise funds through TPS, the states concerned may be required to bring suitable amendments in the Acts. There is no legal bar on Multi State UCBs raising funds through this process excepting the limit placed on the extent to which funds can be raised by way of debentures. The Group observed that through trust preferred pool arrangements, the small BHCs have been successful in raising capital in U.S.A. It would be ideal to have such a system in the Indian context because it would help small UCBs to raise resources from the market through this route. However, this would require an enabling legislative framework. 2.7 Suggestion of NAFCUB for Separate Trading Platform 2.7.1 As mentioned in paragraph 2.3.3, the financial instruments issued by the cooperative banks are not eligible to be listed in the Stock Exchanges. There was a view that since the equity or equity like financial instruments would normally have a long maturity period, absence of liquidity might come in the way of such instruments being subscribed to. As such a proposal was made by NAFCUB to create a separate screen based platform under its aegis for trading of securities issued by UCBs. Through this platform NAFCUB sought to facilitate issue of certain long maturity redeemable instruments. (For detailed proposal please see Annex IV). 2.7.2 The Group found that the following issues, both legal and structural, need to be addressed first if the arrangement is to be put in place. (i) The platform was akin to a stock exchange. It would require a regulator on the lines of SEBI, since it would not fall within the purview of SEBI Act. (ii) It will require such regulator to have control on all the participants of the "exchange". The Group found that there was no existing authority with such powers. (iii) It requires a mechanism by which the transactions put through in the exchange will be reflected in the books of the various participating banks.

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2.8 Accounting of Share Capital 2.8.1 The exposure draft issued by International Accounting Standard Board (IASB) on International Accounting Standard (IAS) 32, proposes that membership shares be presented as liabilities and not equity. The rationale for the proposed treatment is that an equity instrument is a contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities, a requirement not met by share capital contribution of members of cooperative societies, as they can be withdrawn. 2.8.2 The Cooperative Societies Acts provide for the share capital to be withdrawn after a lock in period of three years subject to such withdrawals in a year not exceeding 10% of the share capital at the beginning of that year. The withdrawal of capital under this provision would result in the violation of the normal principle of the equity holders being entitled to residual value of an entity. To this extent, the share capital contribution in the Indian context fails the test of definition of equity referred to in IAS 32. 2.8.3 The Working Group found that share capital of UCBs has generally been stable. In respect of 217 UCBs with deposits of more than Rs.100 crore, it was observed that over a three-year period between 2003-2006, the share capital remained the same or had increased in respect of 200 banks. Moreover, at the time of liquidation, the share capital held by the members of a bank ranks junior to all other creditors. Whenever a bank with negative net worth is merged with a sound bank, the acquirer bank does not give any compensation to the shareholders of the target bank in preference to the depositors and other creditors of that bank (target bank) 2.8.4 It is evident from the foregoing that while the share capital contributed by members has some features which are not in consonance with those associated with equity, in practice, it has been fairly stable and there are checks and balances to prevent it being withdrawn freely.

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CHAPTER III Recommendations 3.1. At present, the sources of owned funds for UCBs are share capital subscribed by the shareholders and retained earnings. At the same time, as observed in paragraph 2.1, given the presence of a number of under-capitalized banks, there was a felt need for alternate sources for long term capital/ quasi-capital funds. Therefore, the various options for raising capital funds for UCBs were examined in the context of the legal and structural issues referred to in the preceding chapters. The recommendations of the Group on the issues referred to it as also a few other incidental matters are elaborated in the ensuing paragraphs. Recommendations of the Group 3.2 To remove the monetary ceiling prescribed on subscription to share capital 3.2.1 As a prudential measure, Reserve Bank has prescribed certain minimum share to borrowings ratio. Normally, share capital of UCBs is subscribed to by the borrowers to meet this requirement. In fact, shares of UCBs are generally not purchased as an investment option. Where these are attractive as an investment, the UCBs concerned are reluctant to issue shares as they are a costly source of funds in view of the high dividend payout by the profit making UCBs, coupled with the statutory requirement of having to issue share only at face value, i.e. without any premium. In such cases there is a scope for arbitrage by borrowing from the bank for investment in its shares. 3.2.2 There are certain UCBs with low capital or negative net worth. Such banks do not pay dividend. Shares of such banks are not likely to be an attractive source of investment. However, several institutions having close allegiance to the prominent shareholders of a UCB might be willing to invest in the share capital of the bank as a part of their support to strengthen it even if it amounts to an investment without any return in the immediate future. The Group observed that where such UCBs are able to identify potential investors, the monetary ceiling prescribed in the Acts on individual share holding comes in the way of shoring up the share capital through this route. The Group therefore recommends that:

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The State Governments be requested to exempt the Urban Cooperative banks from the existing monetary ceiling on individual shareholding either through a notification or through amendment to the Act, where necessary. 3.3 To Permit issue of Tier II bonds 3.3.1 As discussed in Chapter I, the sources for raising stable and long term funds having equity or quasi equity characteristics are virtually absent for UCBs. At the same time, in the current deregulated environment and inter sector and intra sector competition, the UCBs need access to such funds. In this context, the Group recommends that: UCBs may be permitted to issue unsecured, subordinated, non-convertible, redeemable debentures / bonds, which can be subscribed to by those within their area of operations and outside. 3.3.2 These bonds could have the following features. (i) The minimum maturity of the bonds should be 10 years. There need be no upper limit on maturity (ii) The liability of the bank to the bond holders would be subordinated to the claims of depositors and other creditors but would rank senior to shareholders, including holders of special shares (please see paragraph 3.4 below), if any. (iii) The bonds can have a fixed or floating interest rate. The interest rate can also be a combination of fixed and floating rates with the latter part being linked to factors like rate of dividend declared for ordinary shareholders etc. (iv) The Bonds will not have any put option but can have a call option exercisable by the bank, not before five years, with prior permission of the Reserve Bank, which may be granted if it does not result in the regulatory capital falling below the prescribed level. (v) The bonds will be ordinarily redeemed upon maturity. However, in the case of banks whose CRAR is below the prescribed minimum at the time of redemption, since the depositors have preferential claim over

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the bondholders, the redemption of the bonds would not be permitted, except against fresh issue of such bonds. (vi) The bonds will be subjected to a progressive discount for capital adequacy purposes as under: Remaining Maturity Rate of discount a) Less than one year 100% b) More than one year and Less than two years 80% c) More than two years and less than three years 60% d) More than three years and less than four years 40% e) More than four years and less than five years 20% (vii) The bank cannot give loan against its own bonds. (viii) The bank would normally be required to maintain CRR and SLR against the liabilities covered by the bonds. However, Reserve Bank may consider granting exemption from the reserve requirements. (ix) The bonds may be transferable by endorsement and delivery. (x) The bonds will be treated as Tier II capital, subject to the total Tier-II capital not exceeding Tier I capital. However, Where banks with negative net worth raise funds by way of such bonds through conversion of existing deposits, Reserve Bank may make an exception to this rule and treat these as part of regulatory capital even though Tier I capital is negative. 3.4 To permit UCBs to issue special shares 3.4.1 Subscription to the ordinary shares of UCBs entitle the subscriber to the membership of the society and voting right on one member one vote basis. The membership is restricted to the area of operations of the bank. Very often, as already mentioned in paragraph 3.2.1, the shares of UCBs are not subscribed to as investment but to meet the share-linking norms. The financially strong banks are reluctant to issue ordinary shares both because it inflates its

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membership size and also is costly. In view of the above constraints in issuing ordinary shares, the group recommends that: UCBs may be allowed to issue special shares on specific terms and conditions. banks can also be allowed to issue these shares at a premium, which could be approved by the respective RCS, in consultation with RBI. 3.4.2 The broad features of the special shares could be as under: (i) Subscription to these shares will be on a non-voting basis. (ii) They may be issued either at par or at a premium. (iii) These shares may be issued in predetermined quantities over a specified period of time. They can as such be either wholly or partly underwritten. (iv) They may be subscribed to by members, non-members including those outside the area of operations of the UCB concerned. (v) They will be perpetual with a call option that can be exercised only after ten years, with prior permission of RBI, which may be granted in the event of the redemption not resulting in the CRAR falling below the prescribed minimum. (vi) They will carry return by way of dividend, which shall not be less than the rate of dividend paid on ordinary shares, in terms of return on face value. However they shall be subject to a lock-in clause in terms of which the issuing bank shall not be liable to pay dividend, if a) the banks CRAR is below the minimum regulatory requirement prescribed by Reserve Bank ; or b) the impact of such payment results in CRAR falling below or remaining below the minimum regulatory requirement prescribed by Reserve Bank of India. However, banks may pay dividend with the prior approval of Reserve Bank when the impact of such payment may result in net loss or increase the net loss, provided the CRAR remains above the regulatory norm.

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(vii) The amounts raised by way of special shares would be treated as Tier-I capital. (viii) The bank cannot give loan against the shares issued by itself. (ix) These shares may be transferred by endorsement and delivery. Note: The Rabobank raises fund through Membership Certificates (MCs) with infinite maturity period issued through an SPV, which is an investment institution. These are tradable through the bank once in a month. The returns are linked to 25 interest rates of specified gilts. The Rabobank Netherlands has raised a sum of Euro 5.8 billion through this instrument, which is considered as Tier-I capital. The detailed features of MCs are given in Annex V. It may be observed that the features of the special shares proposed above are fairly akin to those of MCs. Since the return is linked to performance and not to any external benchmark, the special shares have a greater proximity to equity than the MCs, which also justifies the recommendation to allow the issue of the special shares at a premium. 3.5 To permit UCBs to issue preference shares 3.5.1The Group observed that the better managed medium sized UCBs may be provided an instrument, which is neither a debt instrument like a bond nor a perpetual security like special shares referred to above. The Group, therefore, recommends that: UCBs may be allowed to issue redeemable cumulative preference shares on specific terms and conditions with the prior permission of the respective RCS granted in consultation with RBI. The funds raised through such shares may be treated as Tier II capital. 3.5.2 The broad features of the preference shares are as under: (i) Subscription to these shares will be on a non-voting basis. (i) The minimum maturity of the preference shares should be 10 years. There need be no upper limit for maturity.

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(ii) The dividend shall be fixed and can be cumulative. (iii) The liability of the bank to the preference shareholders both for dividend and principal would rank senior only to the ordinary shareholders and holders of special share, if any. (iv) The preference shares will not have any put option but can have a call option exercisable by the bank not before five years from the date of issue, with prior permission of the Reserve Bank which may be granted if, inter alia, it, does not result in the regulatory capital falling below the prescribed level. (v) The preference shares will be ordinarily redeemed upon maturity. However, in the case of banks whose CRAR is below the prescribed CRAR at the time of redemption, since the depositors have preferential claim over the preference shareholders, the redemption would not be permitted, except against fresh issue of such shares. (vi) The preference shares will be subjected to a progressive discount for capital adequacy purposes as under: Remaining Maturity Rate of discount a) Less than one year 100% b) More than one year and Less than two years 80% c) More than two years and less than three years 60% d) More than three years and less than four years 40% e) More than four years and less than five years 20% (vii) The bank cannot give loan against its own shares. (viii) The bank should create a sinking fund @ 20% of the principal in the last five years to maturity. (ix) The bank would be required to maintain CRR and SLR against the liabilities covered by the preference shares. However, Reserve Bank may consider granting exemption from the reserve requirements.

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(x) The preference shares will be treated as Tier-II capital, subject to the total Tier-II capital not exceeding Tier-I capital. However, Where banks with negative net worth raise funds by way of such shares through conversion of existing deposits, Reserve Bank may make an exception to this rule and treat these as part of regulatory capital even though Tier I capital is negative. 3.6 Issues involved in raising funds through special shares and the Group's opinion/ recommendations thereon There are certain issues involved in accessing funds through special shares, some of which would have relevance to tier II bonds as well. The Groups recommendations and opinion thereon are as under: 3.6.1 Cooperative Societies Acts / Rules (a) There is a need to amend the Multi State Act to remove the limit prescribed on raising of funds by way of non convertible debentures / bonds. Wherever such limits are prescribed in other State Acts, necessary amendments may be made. In some of the states like in Maharashtra, the limits are prescribed in the rules, in which cases the government may have to exempt the UCBs from the provision or amend the rules, as required. (b) The Group is of the opinion that issue of special shares at a premium and the rate at which dividend can be declared thereon would not be violative of the existing provisions of the Acts / Rules in this regard as these are applicable only to ordinary shares. However, if in any Act there is a specific bar on issue of securities other than ordinary shares, necessary amendments would be called for. 3.6.2 Public Issue and Private Placement In terms of SEBI Regulations, a public issue requires issue of a prospectus, appointment of Merchant Banker, etc., besides obtaining acknowledgment from SEBI. This provision would not be applicable for funds raised through private placement. However, a private placement cannot have more than 50 investors. Since SEBI Regulations would not cover the securities issued by UCBs, the Group opines that the limitation on the number of investors would not be applicable to instruments issued by UCBs. In other words they may raise funds

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through these instruments on a private placement basis without being subject to restrictions prescribed by SEBI. 3.6.3 Listing and Transferability As the SEBI Act and the Securities Contracts and Regulation Act do not cover the instruments issued by the UCBs, they cannot be listed in a stock exchange and to that extent free tradability would not be possible. After due deliberations, the group came to the conclusion that listing is not sine qua non for transferability. A financial instrument can be transferred by endorsement and delivery. Therefore, the Group has suggested that the bonds and special shares be transferable by endorsement and delivery. 3.6.4 Investment by UCBs UCBs may be permitted to invest in Tier II bonds of other UCBs. Reserve Bank may prescribe an appropriate limit linked to the investing banks and recipientbanks Net Owned Funds. 3.6.5 Rating Rating of an instrument may be left to the discretion of the issuer. Incidentally, commercial banks are allowed to invest in unlisted bonds to the extent of 10% of their non-SLR investments. In this context, the Group recommends that the Reserve Bank may make an exception in this regard to enable the commercial banks to invest in the special shares, preference shares and Tier II bonds issued by UCBs within the ceiling prescribed for investment in unlisted securities. 3.7 To permit UCBs to issue long maturity deposits 3.7.1 At present banks are not permitted to raise deposits for periods over 10 years. As an alternate to Tier-II bonds and to provide a simpler method for raising long-term funds, it is recommended that UCBs may be permitted to raise deposits of over 10 year maturity and such deposits can be considered as Tier II capital subject to their meeting certain conditions.

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3.7.2 The features to be fulfilled by the long term deposits to be eligible for being treated as Tier II capital could be as under: (i) Minimum maturity will be 15 years. (ii) It will be subordinated to the claims of depositors and other creditors but would rank senior to shareholders, including holders of non-voting shares, if any and will be subject to RBI approval for repayment which will be given as long as banks assessed CRAR exceeds 9 per cent. (iii) It should have floating rate of interest. Premature withdrawal will not be permitted. However, banks would have the option to repay anytime after 10 years with prior permission of RBI. (iv) The deposits will not be eligible for DICGC cover (v) The bank cannot give loan against these deposits. (vi) The bank would be required to maintain CRR and SLR against the liabilities covered by the deposits. However, Reserve Bank may consider granting exemption maintaining the reserve requirements. (vii) These deposits will be subjected to a progressive discount for capital adequacy purposes as proposed in paragraph 3.3.2 (vi). (viii) These deposits will be treated as Tier-II capital, subject to the total Tier-II capital not exceeding Tier-I capital. However, the Group recommends that : Where banks with negative net worth raise such long term deposits through conversion of existing deposits, Reserve Bank may make an exception to this rule and treat these as part of regulatory capital even though Tier I capital is negative. 3.8 To grant exemption from Income Tax There are several constraints in the way of UCBs being able to raise stable long-term equity / quasi equity funds. The suggestions for issue of Tier-II bonds and special and preference shares would require amendments to Acts / Rules which may be time consuming. In the

41

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Urban Banking

circumstances, the only source of own funds for the UCBs is retained earnings. The Group therefore recommends that: Reserve Bank could suggest to the Government of India to defer the application of income tax on UCBs for a period of three years by which time, the alternate instruments may also take concrete shape. The waiver of Income Tax can be subject to appropriate restriction on declaration of divided to ensure that the consequent savings are used to shore up the capital base. 3.9 To dispense with the share linking norms The regulatory provision requiring a certain percentage of borrowings to be contributed to share capital is intended to ensure a minimum capital for theUCBs. This requirement was prescribed to ensure that capital was earmarked whenever a loan is disbursed so that the UCBs did not create risk assets disproportionate to their capital. However, now that UCBs are brought under the regime of linking capital adequacy in terms of a ratio to risk assets, prescribing a share to loan ratio on a borrower-to-borrower basis may not be necessary. The Group therefore recommends that: The extant instructions on share linking to loans may be dispensed with. 3.10.1 Accounting of Share Capital 3.10.1 The various features of the share capital contribution have been discussed at length in paragraph 2.8. As observed therein, while the share capital does not have all the characteristics of equity, it has been by and large stable. In respect of treatment of member contribution as share capital, World Council for Cooperative Credit Unions (WOCCU) has, in a letter addressed to International Accounting Standards Board, suggested that the member's shares should be deemed as equity if (i) An entity has the unconditional right to refuse redemption of members shares, or

42

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Urban Banking

(ii) An entity may be prohibited by law or its governing charter from redeeming members shares if doing so would cause the number of a members shares or amount of paid-in capital from members shares to fall below a specified level. 3.10.2 The Group opined that the above stand taken by WOCCU is logical. In the Indian context, the Cooperative Societies' Acts provide for limiting withdrawal of share capital in a year to 10% of total share capital at the beginning of the year. It could be argued that this limit of 10% of share capital or the minimum lock-in period can be circumvented by non payment of residual amount of loan to the extent of share capital held. However, it needs to be understood that this does not tantamount to withdrawal of capital. If the share capital cannot be adjusted on account of non-compliance with either of the two conditions stipulated by law, the residual loan would be a liability of the borrower and would continue to accrue interest. The borrower would not be eligible for non-application of interest on the residual loan amount on the grounds of having share capital of like amount. As a corollary, the said borrower would also be eligible to get dividend on his share capital. 3.10.3 In view of the above as also the empirical evidence of share capital of UCBs being by and large stable, the Group recommends that: Share capital contribution may continue to be treated as equity and reckoned as Tier I capital for regulatory purposes. 3.11 Federated Structure A reference is invited to the observations in paragraph 2.5.4 relating to the international systems. The Group opines that creating a federated structure on the lines of the one obtaining in Netherlands or in Finland may be faced with legal hurdles as also in bringing the UCBs under the fold of an umbrella of one organisation in view of the different cultural and social settings they are now working in. However, creating a legal framework for facilitating the emergence of such umbrella organisation(s) appears to be the only long term solution to enhance the public and depositors' confidence in the sector. As this would not only require amendments to the Cooperative Societies Acts but also entails changes to the supervisory and regulatory practices, the Group recommends that:

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Urban Banking

The entire issue of creating an appropriate legislative and supervisory framework be separately examined taking into consideration the international experiences and systems. 3.12 Trading Platform The Group considered the suggestion of NAFCUB for having a separate trading platform for securities issued by UCBs. The Group noted that the suggestion was made by NAFCUB for providing a mechanism for transfer of instruments and liquidity to the investors. However, the Group has suggested a few instruments, which could be transferred through endorsement and delivery. As such, the legal and structural issues referred to at paragraph 2.7.2 apart, it was of the view that the efficacy of having a separate trading platform for these securities could be examined, if and when, on the basis of experience gained from issue of such instruments by UCBs, a need is felt.

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Urban Banking

Recent Developments Over the years, primary (urban) cooperative banks have registered a significant growth in number, size and volume of business handled. As on 31st March, 2003 there were 2,104 UCBs of which 56 were scheduled banks. About 79 percent of these are located in five states, - Andhra Pradesh, Gujarat, Karnataka, Maharashtra and Tamil Nadu. Recently the problems faced by a few large UCBs have highlighted some of the difficulties these banks face and policy endeavours are geared to consolidating and strengthening this sector and improving governance. Source: Adapted from a paper by O.P. Sharma, formerly of the History Cell.

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Urban Banking

3.13. Concluding Remarks 3.13.1 As discussed in Chapter I, the spectacular growth of the UCB sector has affected the performance of the banks, which has led to large number of banks turning weak and sick. As on March 31, 2006 almost 30 % of the banks were still in Grade III and Grade IV signifying weakness and sickness (Reserve Bank Annual Report 200506). The Group noted that over the last couple of years the UCBs sector has been witnessing a gradual decline in terms of rate of growth of business. However, as growth of business is linked to capital, the additional instruments suggested by the group seek to reverse this trend and improve the growth potential of the UCBs without adversely affecting depositor interest. This would also facilitate the realization of the goal for strengthening the sector as set out in the draft Vision Document for UCBs. 3.13.2 The instruments proposed by the Working Group are universally applicable for all UCBs. However, it could be argued that these do not address the problems of weak banks which may find it difficult to raise resources through these instruments. This may not be true in all cases. The High Networth Individuals, for example, who may be willing to invest in UCBs for turning them around, may find, in the special shares and other instruments proposed, a feasible and attractive avenue. Moreover, consolidation in the sector is an effective instrument for resolving the issues of non-viable banks. At present there are not many UCBs with the financial strength required to take over other weak banks. The alternate instruments suggested would facilitate the emergence of a larger number of financially strong UCBs that would have the ability to absorb the losses occurring in the process of take over of weak banks. The Group opined that this would enable the regulators to play a proactive role in resolving, through mergers, the problems posed by the non-viable entities.

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Structures and Spread of UCBs In terms of geographical spread, UCBs are unevenly distributed across the states. Five states viz., Maharashtra, Gujarat, Karnataka, Andhra Pradesh and Tamil Nadu account for 1523 out of 1924 banks that presently comprise the sector. Further, the UCBs in these states account for approximately 82% of the deposits and advances of the sector as may be seen from the table below:

Name of the State

No of banks in operation

% to total no. of banks 26.68 15.24 14.25 6.27 6.22 2,106

Deposits (Rupees in lakhs) 60,72,498 16,27,946 8,35,274 3,10,521 2,11,324 90,57,563

% of deposits to total deposits 55.08 14.77 7.58 2.82 1.92 82.15

Advances (Rupees in lakhs) 37,42,401.2 9,70,287.03 5,37,186.7 2,12,113.28 1,37,888.23 55,99,876.5

% of advances to total advances 55.09 14.28 7.91 3.12 2.03 82.44

Maharashtra Gujarat Karnataka Tamil Nadu Andhra Pradesh Total

639 321 300 132 131 1,523

For all UCBs in the country, the total Deposits are Rs. 1,10,25,642 lakhs and total Advances are Rs. 67,93,017 lakhs

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Urban Banking ANNEX I

NOTIFICATION

Working Group to Examine Issues Concerning raising of capital by Primary(urban) Co-operative Banks As announced in the Annual Policy Statement for the Year 2006-07, it has been decide constitute a Working Group, as under, to examine the issues relating to treatment of paid share capital as core capital and identifying alternate avenues for raising capital by primary (urban) cooperative banks: Shri N.S. Vishwanathan Shri S.K. Sharma, I.A.S Shri J.C. Sharma, I.A.S. Shri D. Krishna Shri Mukand R. Ghaisas CGM-in-Charge, UBD, RBI Commissioner for Cooperation & RCS Maharashtra Commissioner for Cooperation & RCS Andhra Pradesh Chief Executive, NAFCUB Chairman Co- Member Co- Member Member

Shri K. D. Zacharias

Chairman, Member Maharashtra Urban Co-operative Banks' Federation Legal Adviser, RBI Member

The terms of reference of the Working Group are as under:

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(i) To consider whether the paid up share capital can be treated as core capital for capital adequacy purposes in the light of IASB 32 standards and if not to suggest a time frame to implement the proposed standard. (ii) To suggest alternative avenues for raising capital particularly in the light of recent guidelines on newer instruments issued to commercial banks by RBI. (iii) To look into international experiences of co-operative banks/credit unions in raising capital and to suggest measures that can be implemented in the context of primary (urban) cooperative banks in India. (iv) To make such other recommendations as the Group may deem relevant to the subject. The Working Group will commence its work immediately and submit its report by July 15, 2006 Urban Banks Department of Reserve Bank of India will provide secretarial assistance Working Group.

(V.S.Das) Executive Director Reserve Bank of India April 21, 2006

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Urban Banking ANNEX II

Chief General Manager-in-Charge DO.UBD.CO.13441/09.18.200/05-06 Dear Shri Working Group to Examine Issues Concerning raising of capital by Primary(urban) Co-operative Banks As announced in the Annual Policy Statement for the year 2006-07 by RBI, a Working Group had been constituted to examine the issues relating to treatment of paid up share capital as core capital including avenues for raising fresh capital by primary (urban) co-operative banks with Commissioner for Co-operation & RCS, Maharashtra as one of its members. The 1st meeting of the Working Group was held on May 24, 2006 and was attended among others, by your predecessor Shri S.K.Sharma, IAS. 2. It gives me pleasure to invite you to join the Working Group. The date and venue of the next meeting will be conveyed to you shortly. Yours sincerely (N.S.Vishwanathan) June 28, 2006

Shri Anil Diggikar, IAS. Commissioner for Co-operation & RCS, Government of Maharashtra Central Building Annexure Pune- 411001.

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Urban Banking ANNEX IV

RAISING CAPITAL THROUGH ISSUE OF NON-VOTING SHARES BY URBAN CO-OPERATIVE BANKS-CONCEPT OF PRIVATE EXCHANGE D. Krishna, Chief Executive, NAFCUB In order for urban co-operative banks to access larger number of investors without going to the capital market, a system that would bring together all the members of a group of urban co-operative banks to invest in any of, or in more than one urban bank has been drawn up in this presentation. This class of investors called non-voting shareholders will be different from existing regular and nominal members. While like nominal members, the non-voting shareholders will also not have the voting rights, the essential difference will be: (a) they can be from outside the area of operation of banks; and (b) each investor can own non-voting shares of more than one urban bank. The salient feature of the scheme would that a bank in a small center with limited scope of making members from its area of operation can sell non-voting shares to a large number of investors that are members of other banks across the Country. The Model We want to create a private screen based exchange of their own wherein shares of Non Voting types can be issued and traded amongst all members of participating cooperative banks.

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To start with, we want to restrict the number of issuing banks. So, in the beginning only those banks having a deposit base of more than 100crore and falling in Grade I or Grade II bracket in Tier II category will be allowed to issue the instrument. Later the other banks can also join by issuing this instrument. All the members of the issuing banks will be allowed to participate in subscribing and trading. So, at an initial stage we can look at an approx. number of 500 Banks issuing shares. These 500 Banks have an approx. 5 million members. If we consider that even if 2% of the members subscribe to the shares issued then we would have an investor base of approx. 1 lakh. Instrument The instrument that we have proposed is a Non Voting Preference Share. This is with reference to the minutes of the last meeting, wherein we had found out that Maharashtra State Cooperative Act does not bar the issuance of Preference Shares by cooperative banks. The features of the same are as follows: _ Non Voting The instrument holders would not get voting rights like equity shareholders _ Fixed Dividend The instrument holders would be entitled to get a fixed dividend on the face value _ Cumulative - The dividend would be cumulative _ Tradable/Transferable The instrument can be traded in the secondary market created for it Rules and Regulations How much to issue? The banks would be allowed to issue a minimum of 20% of the Net Own Funds or Rs. 1 Crore, whichever is less.

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The maximum limit upto which banks can issue Non Voting Shares will be 100% of their Net Owned Funds. How much dividend should the cooperative bank pay? The dividend would be decided by the banks on an individual basis and the bank has an option to reset the dividend after every 3 years with cap and floor of the change being 200 basis points. What are the Exit Options available to the investor? _ Secondary Market the investor can sell his/her shares on the exchange created and get out of the market _ At the end of the 5th year of issue the investor will have a PUT Option, i.e. the investor will have an option to sell 20% of his holding to the issuing bank at the Market Price or the Face Value, whichever is lower _ At the end of the 8th year of issue the bank will have a CALL Option, i.e. the bank will have an option to buy 20% of the Preference Shares issued at the Market Price or the Face Value, whichever is higher _ Starting from the 8th year, every 3rd year there would be an alternate CALL/PUT Option having the above conditions Why would the members subscribe to Non Voting Preference Shares? _ The members would have a chance to invest in the shares of other cooperative banks _ The members holding these Non Voting Preference Shares would get a fixed dividend every year _ There would be Capital Appreciation of the Non Voting Preference Share Value

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To established such model a sound networking structure should also be in place. We have proposed a networking structure also for this modelISSUER

Subsidiary of NAFCUB

Exchange

DP

COOP. BANK

INVESTOR

In the model we have tried to keep the shareholder at par with the equity shareholder and the depositor in term of advantage and disadvantage.

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Urban Banking ANNEX V

Features of Rabobank Membership Certificates What are Membership Certificates? Rabobank Memership Certificates enables one to invest in certificates of shares in Rabobank Ledencertificaten N.V. This institution invests the majority of its capital in subordinated loans extended to Rabobank Nederland. It invests the remainder of its capital in loans to creditworthy borrowers, such as the State of the Netherlands. The certificates are offered exclusively to Rabobank members. What are subordinated loans? A subordinated loan means that if Rabobank Nederland is unable to meet its payment obligat9ions, all creditors' claims will be paid first. Membership certificate holders will consequently only receive their investment including any accumulated dividend back after the creditors have been paid. Returns Rabobank Ledencertificaten N.V. is expected to pay a dividend four times a year. The dividend payment is linked to the average effective return on the most recent ten-year Dutch state loan. over a specified period. Should the effective return rise, the dividend payment will rise in tandem. As such there is no market risk .No or less dividend will be paid if Rabobank fails to make a profit or make insufficient profit or if the Rabobank Group's capital position is insufficient. Monthly buying and selling Rabobank Membership Certificates not listed on a stock exchange and are tradable once a month via an internal market. The price is not set and depends on supply and demand. The actual trading price will be updated each month on our site.

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(TIMSR) Costs

Urban Banking

One can buy or sell Rabobank Membership Certificates each month. There are no buying costs and custody fee is not charged. The selling costs depend on the channel used to place order or orders: Period to maturity Rabobank Membership Certificates have, in principle , an infinite period to maturity. Rabobank, is, however, entitled to decide to redeem the certificates on certain specified period and every year thereafter

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Urban Banking Annexure-VI

Proposed 2 - Tiered Regulatory Regime UCBs may be classified into the following two tiers of regulatory regime: Tier I: Unit Banks with deposits upto Rs. 50 crore Tier II All other Banks

To determine the deposit base, the fortnightly average of the NDTL reported in the statutory returns in the preceding accounting year may be reckoned so that a stable and reliable basis is adopted. The prudential norms recommended for banks falling under different Tiers are as under: (I) Tier I Banks i.e. Unit Banks with deposits less than Rs.50 crore (i) Asset classification norms: To identify NPAs on the basis of 180 day delinquency norm for three more years commencing March 31 2005 but build up adequate provisions in the BDDR over the next three years such that they would be able to transit to 90 day NPA norm by March 31 2008. Since the 90 day norm for asset classification came into force effective March 31 2004, revised asset classification norm should not result in any write back of provisions and the new norm would be applicable for identification of NPAs in 2005 and onwards. Note: Extant instructions would apply for agricultural loans.

(ii) Provisioning norms: 57

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The provisioning norms will be as under for another three years: Sub standard : 10% : 100% of unsecured portion plus 20% of

Doubtful (up to one year) secured portion

Doubtful (one to three years) : 100% of unsecured portion plus 30% of secured portion Doubtful for more than 3 years: 100% of unsecured portion plus 50% of secured portion Loss : 100%.

Note: i) A Sub standard account will be classified as 18 months.

doubtful after

ii) All the above provisioning norms will apply for another 3 years. Consequently implementation of the instructions requiring classification of substandard account into doubtful category after 12 months instead of 18 months and 100 % provisioning for doubtful assets of over 3 years would be deferred by another three years. As such the banks should build up adequate provisions over this period to facilitate smooth transition. (iii) Norms for Investment: (iii.i) SLR: The minimum SLR holding in Government and other approved securities as a percentage of NDTL for non scheduled UCBs is presently 15 % for banks with NDTL of over Rs. 25 crores and 10% for the remaining non scheduled UCBs. It is observed that the smaller banks, particularly those operating in rural, semi-urban centers, find it difficult to make investments in G-Sec due to lack of access to the markets. In order to meet SLR requirements, these banks often have to purchase G-Sec at a price that is higher than prevailing market rates, as they do not have the wherewithal to obtain information on current market price of these securities, like access to PDO-NDS platform etc.

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While efforts will be made to enable access to securities market through Primary Dealers, in the interregnum, these banks could be exempted from compulsory investment in G-Sec to the extent of the deposits kept by them in SBI, Associates and Nationalised banks. (iii.ii) Non-SLR: continue. Present limit of 10% of total investments would

(iv) Borrowings: Not to exceed 2% of deposits (v) Capital Adequacy: At present all UCBs are required to comply with 9% CRAR akin to commercial banks. For easier understanding and simplification, it is suggested that CRAR in respect of Tier I banks may be replaced with a Net Owned funds to NDTL ratio. It is proposed that a NDTL to NOF ratio of 15 could be prescribed. (vi) Exposure Norms: 10% of capital funds or Rs.40 lakhs, which ever is lower for individual borrower and 20% or Rs.80 lakhs, which ever is lower, for group, would be applicable in order to contain concentration risk for the Tier I banks. Off-Balance sheet exposure not to exceed 2 percent of NDTL. (vii) Sensitive Sector Exposure: Tier I banks should not be allowed to take any direct exposure to real estate, builders or to the capital market. However, loan for individual housing may still be extended by these banks upto the present limit of Rs.15 lakh per individual borrower. (viii) Audit: Concurrent audit should be compulsory for all banks. Statutory audit should be done using Long Form Audit Report. Statutory audit of banks with deposit base of over Rs 25 crore should be entrusted to chartered accountants.

59

(TIMSR) TIER - II ( All other banks):

Urban Banking

For all banks, other than unit banks with deposits upto Rs.50 crore, all regulations as applicable to commercial banks should be applied, However, for these banks the extant relaxations for UCBs could remain in force for the period already prescribed. Further, facilities and opportunities available to commercial banks should, as far as possible, be also made available to such banks to enable them to grow and compete with commercial banks. Banks that do not comply with the regulations should either reduce their operations to qualify for the relaxed regulations applicable for unit banks with deposits less than Rs.50 crore or may be required to convert into cooperative societies.

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Index
Sr. No. 1 Content Executing Summary a) Background b) Methodology c) Finding Brief Histroy Bird's Eye View Vision Objective Operating and Regulatory Environment Proposed operating Framework a) Unit Bank b) All bank Supervision Agenda of Reform a) Aligning Urban Banking b) Future set up of Weak Bank c) Improving Governance d) Dual Control Dilemma Licensing Policy of New Urban Banking Introduction and Approach Page No. 1

2 3 4 5 6 7

3 4 5 6 7 8

8 9

10 11

10 11

17 21

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(TIMSR) 12 Important Finding a) Legal Framework b) International System c) Federated Structure d) Trust preferred Securities e) Suggestion of NAFCUB f) Accounting of Share Capital

Urban Banking 24

13

Recommendation a) Recommendation of Group b) Permit issue of Tier II Bond c) Permit issue of Special Share d) Permit issue of preference share e) Issue Involved in rasing Fund i) Cooperative Act/ Rules ii) Public Issue and Private Placement iii) Listing and Tranferablity iv) Investment by UCB v) Rating vi) Permit issue long maturity deposit vii) Examination From Income Tax viii) To dispense with the share linking norms Concluding Remarks Structures and Spread Annex I to VI Recent Development

33

15 16 17 18

46 47 48 61

62