A way of diluting credit discipline (On RBI’s current account circular)

Relevance: Credit Discipline, Regulations by RBI

Synopsis: Recent RBI circular on opening current accounts will have the counter-intuitive effect of diluting credit discipline rather than strengthening it.

Context

Recently, some bank borrowers have gone to court demanding that it quash the Reserve Bank of India (RBI) circular on opening current accounts. However, now the RBI has extended the date for compliance.

Why such move by RBI?

Current accounts with non-lending banks are an important channel for diversion. Internal diversion is for non-priority purposes and funds are diverted to other firms, owned or controlled by the same group, friends or relatives.

What are the regulations?

1. If borrowing is through a cash credit or overdraft account, no bank can open a current account.
2. If a borrower has no cash credit or overdraft account, a current account can be opened subject to restrictions.
3. If the bank’s exposure is less than 10% of total borrowings, debits to the account can only be for transfers to accounts with a designated bank.
4. If total borrowing is ₹50 crore or more, there should be an escrow mechanism managed by one bank which alone can open a current account.

Issues with the regulations:

1. First, if a borrower has an overdraft, how can there not be a current account? An overdraft is the right to overdraw in a current account up to a limit.
2. Second, the circular forecloses operational flexibility.
3. Third, why should a bank with low exposure transfer funds to another bank when it can use it to adjust other dues with it?
4. Fourth, there is a mismatch between what a borrower needs and the regulations allow. Support of non-lending banks through current accounts in other banks is required for large accounts. The circular rules out this possibility.
5. Fifth, transactions in an active current account enables a bank to monitor a borrower’s account. The lack of such control will increase NPAs.
6. Sixth, the regulation mandates splitting working capital into loan and cash credit components across all banks. Such a one-size-fits-all regulation does not factor in the purpose of the different facilities.

Other regulatory issues

• First, it is more effective to base regulation on principles that focus on outcomes rather mere compliance.
• Second, regulation needs to use more generic terms. Terms such as Working Capital Term Loan might mean different things in different banks.
• Third, it is questionable to design regulation to target exceptional events such as diversion of funds as it is better to leave it to management.
• Fourth, the costs of regulation should be justified by the benefits.
• Lastly, when regulation ignores market practices, it lacks legitimacy and when legitimacy is wanting, compliance suffers.

Conclusion

Forced compliance is leading to a new banking practice of overdraft in fixed deposits. A bank could also merely rename current accounts as overdraft, as there is no bar in having a credit balance in an overdraft account.