Introduction
Banking law is a broad term for laws that looks after working of the banks and other financial institutions. The banks must adhere to a myriad of federal, state, district and even local regulations. Lawyers perform numerous tasks that relate to creating, following and enforcing regulations. The Banking Regulation Act of 1949 is a law which controls all the banking firms in India. On 16th March when it came into force it was passed as the Banking Companies Act, 1949 and later on it changed to Banking Regulation Act on 1st March 1966. The Act lays out a foundation under which commercial banking in India is administered and controlled. The Act also gives the Reserve Bank of India (RBI) the ability to authorize banks, have to dictate over shareholding and voting rights over shareholders, superintend the appointment of the boards and management, manage the functions of banks, provide instructions for audits, influence suspension, amalgamation and liquidation etc. In Jammu and Kashmir, it came to force from 1956, and later it became applicable for only banking companies. But again in 1965, it was amended to make it applicable to regulate cooperative banks and to make new changes. When the American economy enlarged in the 20th century, lawmakers became anxious about the impact that banks have on the economy. When banks face struggles, the consumers and the public are the ones who get widely affected. Lawmakers initiate banking regulations to make sure that banks perform regulations in a lawful and translucent way. Banking regulations vary habitually, and they remain tendentious.
The enactment of banking law is diversified and expansive. There are hundreds and thousands of regulations. Banks must start to determine how regulations appeal to them. Whether you want to initiate regulations, accomplish them or bring an accusation of transgressions. There is a wide range of possibility accessible for individuals given this area of practice.
Banking law is an area where the attorneys who have a large amplitude to retain and keep track of information exercises. If an individual enjoys reading technical information then that individual might enjoy banking law. In this task, my topic is – Nature of Securities and Risks involved. The above-mentioned topic has made me curious and longing to dive deeper into all the information available. Hoping my task will help you gain a better understanding of Banking Laws in India and the topic mentioned above.
Nature of Securities
There have been many debates regarding the nature of securities. There are two schools of thought: One school of thought has classified them as property and the other school of thought has classified them as obligations. There is a difference in the interest because certain rules of law applicable to the assets that are classified as property but they do not apply to obligations. In the article “The Legal Nature of Securities – Inspirations from Comparative Law” written by Eva Michele, he argues that securities are neither property nor obligations. According to the 18th and 19th century, German and English scholarship the securities are assets of their kind and they are referred to as circulating rights. The securities are assets invented by market participants and they have been created to circulate in liquid markets. Securities make it easier for the issuers to raise money from the public.
The rules which govern the securities of banking laws are developed in a way which focuses to facilitate the purpose and also makes the circulation of them cost-efficient. This has resulted in rules that allocate the legal risk involved within the transfer far away from the purchaser of such securities. In this article, the writer Eva Micheler has made an argument that by categorizing securities as assets of their types but which are different from tangibles and intangibles helps us to explain the rule more properly. The writer has put forward the case of Hunter v Moss (1944), this is an English trusts law case from the Court of Appeal concerning the certainty of subjects matter necessary to form a trust. Similarly in Commissioner of Income Tax, Kolkata v. Smifs Securities Limited: In this case, the assessee had claimed Rs 54, 85,430 as depreciation on goodwill. The origin of such goodwill was given as – By the scheme of amalgamation of YSN Shares and Securities (P) Ltd. that is the amalgamating company, with Smifs Securities Ltd. – which was sanctioned by the High Courts of Bombay and Calcutta – effect from 1-4-1998, assets and liabilities of YSN Shares and Securities (P) Ltd. were transferred to the company.
The excess consideration paid by the assessee over the value of net assets acquired of YSN Shares and Securities (P) Ltd. should be considered as goodwill arising on amalgamation. It was claimed that the extra consideration was paid towards the reputation which the YSN Shares and Securities (P) Ltd. was amusing to retain its existing clientele. The assessing officer held that goodwill wasn't an asset falling under Explanation 3 to Section 32(1) of the tax Act, 1961. The expression ‘asset’ shall mean – a) tangible assets as in buildings, machinery, plant or furniture whereas b) intangible assets means patents, copyrights, trademarks, licenses, franchises or any other business or commercial rights of similar nature. Under these circumstances, they are of the view that goodwill is an asset under Explanation 3 to Section 32(1) of the act. The assessing officer concluded that no amount was paid on account of goodwill. This case dealt with intangible rather than tangible property. The concurrent findings of facts recorded by the authorities that the assessee was entitled to claim a deduction in the course of business under Section 36(1) Act. The civil appeal filed by the Department stands dismissed with no order on costs.
Risks Involved
Risk is a quantifiable plausibility of loss or less than expected returns. Banks have been working endlessly to modify the framework of technology and there are a rapid change and development in the banking environment. The banking industry has endorsed the importance of Operational risk in moulding the risk profiles of financial institutions. Developments as in using more highly automated technology, growth of e-commerce, larger-scale mergers and assets that test the viability of newly desegregated systems, there is an emergence of banks as large volume service providers, the increased pervasiveness of outscoring and greater use of financing technique that reduces market and credit risk but that creates increased Operational Risk.
In the article – “Operational Risks involved in Banking Industries” written by M Rajendran, he mentions about many risks such as – financial risk, financial risk in banking sectors, operational risk, methods of measuring operational risk and alleviation of operating risking banking sectors.
This study directs to extend on the different characteristics of online banking risks and also the risk management methods employed in mitigating these risks. The rapid improvement in online banking also holds threats as well as opportunities and robustness. The study of risks involved emphasizes more on various aspects of online banking risks. Those risks are – strategic risks, transaction risk, reputation risk, compliance risk, information security risks, credit risk, internet rate risk, liquidity risk, price risk, and foreign exchange risk. As there is a vast hi-tech improvement and also the ongoing rivalry between available banking organizations and latest participants have sanctioned for an immeasurable range of banking products and services so that they are available and they can be distributed to retail and wholesale clients via an electronic allotment channel which is referred to as online banking. The risks involved in online banking should not only be recognized but also be attended to and controlled by banking establishments. the banking establishments should vigilantly handle the risks according to the elementary attributes and also challenges of online banking services. The risk management principles that stay applicable for online banking activities ought to be personalized modified and in some exceptional cases, they are enlarged to deal with explicit risk management challenges. The attributes of online banking activities are fashioned by these challenges. Applying the comprehensive risk management prerequisites in the region of online banking may be counter-productive. The only reason being that these would immediately be old-fashioned because of the rapid change and developments related to hi-tech. The “Risk Management Principles” adjacent as total prerequisites.
However, some examine that the organizations of outsourcing relationships, security control and legal and reputational risk management require comprehensive values.
We’ve often heard people say that “profit is a reward for risk-bearing” and this is nowhere truer than in the case of the banking industry. The banking industry is exposed to various types of risks and a successful banker is the one that can tranquillize these risks and generate remarkable returns
for the shareholders consistently. A successful banker can mitigate risk by correctly identifying the risks first. The reason as to why these risks arise and what kind of damage the risk can cause. The major types of risks faced by every bank are as follows –
a) Credit Risks
Credit Risk is defined as the risk that arises from the non-payment of the loans by borrowers. Credit risks are also defined as risks of not receiving payments from borrowers and banks also include the risk of delayed payments under credit risks.
Often these risks are caused when the borrower gets bankrupt. However, these risks can be avoided only if the bank conducts a thorough check and sanctions loans only to those individuals and businesses that are not likely to get bankrupted. Since the banks would be unaware when an individual or a business would become insolvent; hence the credit rating agencies provide adequate information to the banks to make informed decisions in this regard.
Credit Risks completely depends on the profitability of the banks and therefore are extremely sensitive to it. There would be a great impact on the profitability of the bank if the credit risk rises by a small amount. Since the profitability of the banks gets widely affected even with a small amount of rising in the credit risk, the banks have come up with a broad variety of measures. For instance, banks always hold a certain amount of funds in reserves to lessen such risks.
When a loan is being sanctioned, a certain amount of money is appropriated to the provision account. Banks have started using tools like structured finance to lessen such risks. The process which helps the banks to remove the concentrated risks from the banks' books and diffuse it amongst the various investors in the capital market is known as Securitization.
The unpaid loans will always be a by-product of conducting the banking business. So, the modern banks after realizing this are prepared to handle the situation without becoming insolvent until a catastrophic loss occurs.
b) Market Risks
Banks not only make loans but they also hold an important portion of securities. Banks encounter various forms of market risks. For instance, suppose the banks are holding a large amount of equity then they are exposed to equity risk. Banks also hold foreign exchange so they are exposed to foreign risks. In the same way, banks lend against commodities like gold, silver, and real estate which exposes them to commodity risks as well. As mentioned above banks hold a portion of securities and some of these securities are held because of the treasury operations of the banks, that is, as a means to park money for the short
term. Nevertheless, banks also hold many securities as collateral based on which banks give loans to their customers. The business of banking is therefore coiled with the business of capital markets. The financial derivatives used by the banks are freely accessible for sale in any financial market. Banks simply use hedging contracts to be able to mitigate market risks. Banks use contracts like forwards, options and swaps. Banks are capable of eliminating market risks from their balance sheet.
c) Operational Risk
Operational risk takes place because of failed business processes in the banks' daily activities. Banks often conducts massive operations to be profitable. Hence, to maintain consistent internal processes on such a large scale is an extremely difficult task. Examples of operational risk would come with payments credited to the incorrect account or executing an incorrect order while dealing within the markets. None of the departments in a bank are immune to operational risks. One of the main reasons for operational risk to arise is mainly because of hiring the wrong people. The other reason for operational risk to occur is if there is a breakdown of the information technology systems. Some of the reasons leading to catastrophic errors might be a lapse in the internal processes. For instance, Barings Bank ended up bankrupt because it failed to implement appropriate internal controls. One trader was ready to bet such a lot within the derivatives market that the equity of Barings Bank was exhausted and therefore the bank simply ceased to exist.
d) Liquidity Risk
Liquidity Risk is another quite risk that's inherent within the banking business. Liquidity risk is that risk that the bank will not be able to meet its obligations if the depositors come in to withdraw their money. In this system, only half of the deposits received are held back as reserves and the rest is used to create loans. Hence, if all the depositors would come together to withdraw their money, the bank would not have enough money. So this situation is called “Bank Run”. This incident of banks running out of money has happened countless times over the history of modern banking. Banks, these days does are not very concerned about liquidity risk because they have the backing of the central bank as in Reserve Bank of India. If the situation of ‘bank run’ arises in on a particular ban, the central bank transfers all its resources to the affected bank. Therefore, depositors can be paid back when they demand their deposits. This gives the depositors confidence in the banks' finances. The modern banks have gone through the situation of the bank run. Nevertheless, none of them has become bankrupt due to a bank run because of the established of central banks.
e) Business Risk
The banking industry is advanced and diversified. Banks today have a wide variety of programmes from which they have to choose. One such programme is that banks need to focus their resources
on obtaining their strategic goal in the long run. However, there is a risk that a particular bank may choose a wrong strategy and because of this wrong choice, the banks may suffer losses and may end up being collapsed. For instance, the case of banks such as Washington Mutual and Lehman Brothers. These banks chose the subprime route to growth. Their strategy was to be the preferred lender to people who have less than perfect credit scores. However, the entire area of subprime lending went bust and since these banks had heavy exposures to such loans, they suffered dire consequences too. Banks have no possible way to reduce the risks that are created by following inappropriate business
objectives.
Conclusion
This assignment has helped me widen my views and broaden my understanding of the mentioned topic. It has also helped me discover the nature of securities and the various types of risks that are involuntarily included and how it can be avoided. The risks involved in banking are not only for the banks but also for those investing in the bank and borrowing from it. To summarize, I would like to restate that banking law is a broad term for laws that looks after the working of the banks and other financial institutions.
Anugraha Sundas
Jogesh Chandra Chaudhuri Law College, Calcutta University
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