RBI recently issued an alert list of entities not authorised to deal in forex.
On September 7, the Reserve Bank of India (RBI) issued an alert list of entities not authorised to deal in forex, and to operate electronic trading platforms for forex transactions. Two days later, Finance Minister Nirmala Sitharaman chaired a meeting on ‘illegal loan apps and outlined multiple steps to prevent operations of such illegal loan apps’.
Both these back-to-back announcements highlight a problem facing governments and financial regulators worldwide. The technology has made it so easy, and relatively costless, to first develop these apps and then offer financial services to the public (via these apps). It is a huge problem for the public to understand the legality of these apps, before they avail these financial services. The authorities on realising that some of these apps are illegal, issue customer alerts and ban lists. But by then it is late for some people who have already availed these financial services.
These events take one back to the history of Indian banking where we see a similar sequence of events. India was always home to many banking organisations before the banking regulation was set up. WE Preston, member of the Royal Commission on Indian Currency and Finance in 1926, that went on to establish the RBI, remarked: “….it may be accepted that a system of banking that was eminently suited to India’s then requirements was in force in that country many centuries before the science of banking became an accomplished fact in England.”
Before Britain, India had moneylenders and indigenous banks which were unevenly spread across the country. After the victory in the Battle of Plassey, British-style banks started developing in India. The three presidency banks were the first to be organised as joint stock companies.
Despite the presence of both indigenous banks, and British-style banks, banking regulation was missing in India. The ideas on regulating banks started to shape in England with the Bank of England gradually working as both a central bank and a banking regulator. But India neither had a central bank nor laws to shape banking.
In 1850, the Indian Companies Act was enacted, but it did not recognise banks as separate companies. The Act allowed unlimited liability for banking and insurance companies until 1860, when limited liability was introduced in banking and insurance. The banks were recognised first by the companies Act much later in 1913, and even that was at best a cursory inclusion. With the lack of regulation, many entities that registered as banks were not providing any banking services. There was no database on banks, and no clarity on what it takes to establish and run banks.
In 1913, the government started collecting data on the number of banks, and business activity of the banks. The data from 1913 onwards shows there were large scale bank failures and bank frauds throughout the period.
The first step towards bank regulation started in 1935 with the establishment of the RBI. The RBI defined banks for the first time, but it did not have enough powers to regulate banks yet. The enactment of the Bank Regulation Act in 1949 gave the central bank the powers to licence and regulate banks. The RBI classified all licenced banks as ‘A’ category. All the existing banks had to qualify for the RBI licence based on prudential requirements, else they would be asked to close down or merge with stronger banks.
This weeding out process of weak banks took a long time and led to closures of many banks. In 1960, there was a major failure of the Palai Central Bank which led to closure of several small banks in Kerala. The government and regulator learnt hard lessons in this failure, which led to the establishment of deposit insurance in India.
It’s often said that ‘history does not repeat itself, but it rhymes’. The history of banking regulation in India rhymes well with the current times. Just like it happened in the past, we are back to times when we are seeing the mushrooming of entities and apps offering lending (and forex facilities). The Indian Banking Enquiry Committee Report of 1931 pointed that the Bengal region saw mushrooming of several small banks called as loan offices, similar to modern day digital lending apps.
The government and the regulator are not sure how to regulate these activities. The technology has evolved and manifested in such a way that it is easy to establish these lending operations. In an earlier era, there were some costs, as wannabe banks had to inculcate some costs in terms of physical space and hard currency. All these are hardly a concern today.
What are the options for the government, and the regulator? We need a new digital banking regulation Act, which clearly defines the various entities that can provide financial services, and only those entities must be allowed to run operations. The RBI has started to define digital banking and lending via guidelines, but they are in silos. The guidelines include current banks, but exclude fintechs which is not correct as some of the fintechs may be providing useful services. The Act should encourage competition from new entrants, provided they follow the rule book. The government needs to work quickly towards a digital banking regulation else the pace of technology will constantly beat the customers.