A master circular is a compilation of all the instructions/guidelines on a particular subject by RBI till a specific date. They serve as a single point of reference for the regulated entities.
The draft was brought in to protect banks from increasing instances of fraud by imposing penalties for non-compliance with ‘material’ terms and conditions of the governing contract.
Limits on Loans and Advances to Directors
Section 20 of the Banking Regulation Act of 1949 prohibits banks from granting loans to directors or to any firm in which they have substantial interest as a partner, manager, employee, guarantor, or owner. However, there are certain exceptions to this rule which allow banks to grant credit facilities to such individuals/firms.
One of these exceptions is for facilities that are based on the issuance of guarantees. This is because the issuance of guarantees does not constitute a loan or advance within the meaning of the Act and is therefore exempt from the restrictions under Section 20. Nevertheless, bankers need to be careful when granting guarantees to directors because such guarantees can lead to a situation where directors become creditors of banks. This could defeat the very purpose of Section 20, which is to ensure that the liabilities of directors do not devolve onto the banks.
As a result, banks need to have systems in place that ensure that the directors do not exceed their discretionary powers when it comes to sanctioning advances. This can be done by having a formal procedure in which the details of such loans and advances are documented. Banks should also make sure that such information is sent to the Head Office and that it is meticulously followed up. In addition, banks should have an in-house system to report any breaches of these rules.
It is also crucial that a proper credit appraisal process is in place to determine the extent of a director’s involvement in a firm or entity before lending them any money. This way, the risk associated with extending credit to such persons can be reduced by ensuring that the company is capable of repaying the debt and is not prone to financial difficulties.
Furthermore, NBFCS must have a board-approved policy on the grant of loans to directors, senior officers, and their relatives, as well as entities in which such persons have a significant shareholding. The proposals for such loans should be sanctioned by the appropriate authority in the financing bank under the powers vested with them, but they should be reported to the Board.
Limits on Loans and Advances to Specific Classes of Persons
There are several classes of individuals to whom credit facilities may be extended. These include persons engaged in the manufacturing or construction business. The loan amount to such persons should not exceed 25% of the value of the securities held by them or Rs 10 lakhs, whichever is higher. The loan should be secured by deposit of security in the form of cash or guarantee. The term of the loan should be up to a maximum period of 8 years. The interest payable on the loan is to be computed on the basis of the equated monthly installments (EMIs) agreed upon by the borrower and the lender.
The loans given to individual borrowers are much smaller in amount and are used for purposes like purchasing consumer durables, education, and purchase of immovable property like houses. These loans are also usually repaid in much shorter terms than those for corporates, with the repayment usually being made through EMIs over a few years.
With the motive of preventing the speculative holding of sensitive commodities such as food grains, major oilseeds, sugar, and raw cotton with the help of bank credit, RBI has been issuing several directives from time to time stipulating restrictions on the loans and advances against such commodities. However, these directives have been largely unsuccessful in curbing the same. The latest master circular by RBI, stipulating the penal charges against non-compliance with the material terms and conditions of the governing contract, has been aimed at curbing this malpractice to some extent.
Despite this, there are many REs who continue to charge penalty interest on the outstanding balance of such loans and advances. This practice should be discouraged as the levying of such interest would adversely affect the economy and lead to lower availability of funds for other productive purposes. Therefore, the modalities for imposing penalties must be clearly stipulated and well-defined. In addition, the penal charges should not be ‘capitalized’ in the loan contracts to avoid attracting any additional component to the rate of interest. This should be in line with the ‘principal-and-agent’ principle in the banking sector and prevent any discriminatory treatment amongst the REs towards the individual borrowers.
Limits on Loans and Advances to Specific Classes of Companies
For the borrowers who are engaged in supplying goods/services to the Government or those providing goods/services directly to Government departments/agencies, banks can consider rescheduling their debt by increasing the tenor or decreasing the interest rate on the basis of the overall repaying capacity of the borrower taking into account repayment commitments under old term loans, compensation available from insurance schemes and other sources. In addition, for such borrowers, the credit limits should be reviewed on a regular basis to ensure that they continue to remain within the need-based requirements and according to the bank’s prescribed lending norms.
The financing bank’s board should approve the proposal for finance to these borrowers of directors. It is also necessary for banks to evolve suitable arrangements to monitor the end use of the credit limit and ensure that the cash credit/overdraft accounts are used only for the purpose for which the bank sanctioned them. The financing bank should delegate appropriate powers in this regard to its officers so as to minimize any misuse and ensure that all transactions are reported to the head office on a daily basis.
Besides this, the companies to whom finance is extended must have a satisfactory net worth. It is also necessary to ensure that the promoters/directors of the company have a substantial stake in the company being financed. In addition, the company funded should not have any history of default to banks/FIs.
In addition, the statutory and other restrictions on loans and advances issued by RBI should be complied with. Further, the terms and conditions of the loan agreement should clearly stipulate the amount, tenor, and purpose for which it is being provided and the security taken by the financing bank with respect to the same. In the case of loans/advances to a significant shareholder, a declaration by the person to be the major shareholder (preferably in writing) should be obtained from the borrower and verified by the bank before sanctioning the loan/advance.
Limits on Loans and Advances to Specific Classes of Individuals
In order to prevent speculative holding of sensitive commodities like food grains, major oilseeds, and raw cotton with bank credit, RBI has issued directives stipulating restrictions on loans and advances by banks against such commodities time and again. This Master Circular seeks to strengthen the vigilance and monitoring of compliance with these norms further by introducing specific limits on loans and advances against specified sensitive commodities.
As per the terms of the Draft Circular, the levy of penal charges should be confined to cases where there is default or non-compliance with the material terms and conditions contained in the governing contract, but the REs may have leeway to determine such threshold as long as it is not discriminatory. It is also sought to be ensured that the details of the material’s terms and conditions, which warrant the imposition of penal charges, are clearly spelled out in the governing contract and displayed on the REs’ websites.
It is proposed that the material’s terms and conditions, relating to the loan and advance against shares, debentures, or bonds, should be as stipulated in the Master Circular on Bank Finance Against Shares, Debentures, and Bonds dated 28 August 1998 and Master Circular on Financing of Acquisition of Equity in Overseas Companies dated 7 June 2005. It is further proposed that banks should evolve, among other things, procedures for ascertaining the interest of a director of a financing bank or his relatives in credit proposals/award of contracts placed before them.
Similarly, banks should not extend funds-based and non-fund-based facilities, such as the opening of LCs, providing guarantees and acceptances, etc., to a director of another banking institution or related entities unless RBI expressly permits it.
The ‘personal loans’ would include consumer credit, education loans, and loans given for the creation/enhancement of immovable assets such as housing. It is further clarified that the term ‘directors’ shall be understood to mean persons who have control or management rights exercisable by virtue of their holding or voting power, directly or indirectly, in a company (including its subsidiaries). The ‘interested parties’ include those who have been granted loans under the ‘Betterment Scheme’ and those who are supplying inputs to the beneficiary under the ‘Credit Linked Subsidy Scheme’.