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I. INTRODUCTION

Indian Capital Markets are regulated and monitored by the Ministry of

Finance, The Securities and Exchange Board of India and The Reserve Bank
of India.
The Ministry of Finance regulates through the Department of Economic
Affairs - Capital Markets Division. The division is responsible for formulating
the policies related to the orderly growth and development of the securities
markets (i.e. share, debt and derivatives) as well as protecting the interest
of the investors. In particular, it is responsible for

institutional reforms in the securities markets,

building regulatory and market institutions,
strengthening investor protection mechanism, and
providing efficient legislative framework for securities markets

The four important elements of securities markets are the investors,

the issuers, the intermediaries and regulators.

REGULATORY FRAMEWORK
At present, the main Acts governing the securities markets are:
The Reserve Bank of India;
the SEBI Act, 1992;
the Companies Act, 1956,(which sets the code of conduct for the
corporate sector in relation to issuance, allotment and transfer of
securities, and disclosures to be made in public issues);
the Securities Contracts (Regulation) Act, 1956, (which provides for
regulation of transactions in securities through control over stock
exchanges)

1. RESERVE BANK OF INDIA

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Whereas it is expedient to constitute a Reserve Bank for India to regulate the issue of bank
notes and the keeping of reserves with a view to securing monetary stability in India and
generally to operate the currency and the credit system of the country to its advantage.1
The Reserve Bank of India (RBI) is governed by the Reserve Bank of India
Act, 1934. The RBI is responsible for implementing monetary and credit
policies, issuing currency notes, being banker to the government, regulator
of the banking system, manager of foreign exchange, and regulator of
payment & settlement systems while continuously working towards the
development of Indian financial markets. The RBI regulates financial markets
and systems through different legislations. It regulates the foreign exchange
markets through the Foreign Exchange Management Act, 1999.
The control and supervisory roles of the Reserve Bank of India is done
through the following:

Issue Of Licence: Under the Banking Regulation Act 1949, the RBI
has been given powers to grant licenses to commence new banking
operations. The RBI also grants licenses to open new branches for
existing banks. Under the licensing policy, the RBI provides banking
services in areas that do not have this facility.

Prudential Norms: The RBI issues guidelines for credit control and
management. The RBI is a member of the Banking Committee on
Banking Supervision (BCBS). As such, they are responsible for
implementation of international standards of capital adequacy norms
and asset classification.

Corporate

Governance: The

RBI

has

power

to

control

the

appointment of the chairman and directors of banks in India. The RBI

has powers to appoint additional directors in banks as well.

1 See Preamble to the Reserve Bank of India Act, 1934.

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KYC Norms: To curb money laundering and prevent the use of the
banking system for financial crimes, The RBI has Know Your Customer
guidelines. Every bank has to ensure KYC norms are applied before
allowing someone to open an account.

Transparency Norms: This means that every bank has to disclose

their charges for providing services and customers have the right to
know these charges.

Risk Management: The RBI provides guidelines to banks for taking

the steps that are necessary to mitigate risk. They do this through risk
management in basel norms.

Audit and Inspection: The procedure of audit and inspection is

controlled by the RBI through off-site and on-site monitoring system.
On-site inspection is done by the RBI on the basis of CAMELS. Capital
adequacy; Asset quality; Management; Earning; Liquidity; System and
control.

Foreign Exchange Control: The RBI plays a crucial role in foreign

exchange

transactions.

It

does

due

diligence

on

every

foreign

transaction, including the inflow and outflow of foreign exchange. It

takes steps to stop the fall in value of the Indian Rupee. The RBI also
takes necessary steps to control the current account deficit. They also
give support to promote export and the RBI provides a variety of
options for NRIs.

Development: Being the banker of the Government of India, the RBI

is responsible for implementation of the governments policies related
to agriculture and rural development. The RBI also ensures the flow of
credit to other priority sectors as well. Section 54 2of the RBI gives

2 1[54. Rural Credit and Development.The Bank may maintain expert staff to study various
aspects of rural credit and development and in particular it may:(a) tender expert
guidance and assistance to the National Bank;
(b) conduct special studies in such areas as it may consider necessary to do so for
promoting integrated rural development.]

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stress on giving specialized support for rural development. Priority

sector lending is also in key focus area of the RBI.

Fig. 1 Role of Rbi in Securities Market

Role of the Reserve bank of India (RBI):
The Reserve Bank of India (RBI) started functioning from April 1, 1935 under
the Reserve Bank of India Act, 1934. It was a private shareholders
institution until January, 1949, after which it became a state-owned
institution under the Reserve Bank (Transfer to Public Ownership) of India
Act, 1948, and started central banking functions.3
The objective of the RBI is to promote the development of financial
infrastructure of markets and also to maintain stable payments system and
monetary stability so that financial transactions can be safely and efficiently
executed.

3 For more detailed reading of the RBIs early functions, see RBI: Functions and
Working, Bombay, 1983.

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The role of the RBI is to regulate and supervise the functioning of banks,
promote development of financial infrastructure of markets, and, maintain a
stable payments system and monetary stability so that financial transactions
can be safely and efficiently executed.
The supervisory powers of the Reserve Bank of India are located in Section
35-A (1)4 of the Banking Regulation Act, 1949.
A. RBI as Regulator and Supervisor of Payment and Settlement
Systems :
The Payment and Settlement Systems Act of 2007 (PSS Act)
gives the Reserve Bank oversight authority, including regulation
and supervision, for the payment and settlement systems in the
country.
In this role, RBI focus on the development and functioning of
safe, secure and efficient payment and settlement mechanisms.
The Reserve Bank has a two-tiered structure. The first tier
provides the basic framework for our payment systems. The
second tier focuses on supervision of this framework.
B. RBI as a Regulator of Credit:

4 [ 35A Power of the Reserve Bank to give directions. (1) Where the Reserve Bank is
satisfied that
(a) in the 178 [public interest]; or
179
[(aa) in the interest of banking policy; or]
(b) to prevent the affairs of any banking company being conducted in a manner detrimental
to the interests of the depositors or in a manner prejudicial to the interests of the banking
company; or
(c) to secure the proper management of any banking company generally,
it is necessary to issue directions to banking companies generally or to any banking
company in particular, it may, from time to time, issue such directions as it deems fit, and
the banking companies or the banking company, as the case may be, shall be bound to
comply with such directions.
(2) The Reserve Bank may, on representation made to it or on its own motion, modify or
cancel any direction issued under sub-section (1), and in so modifying or cancelling any
direction may impose such conditions as it thinks fit, subject to which the modification or
cancellation shall have effect.]

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The Reserve Bank of India is the controller of credit i.e. it has

the power to influence the volume of credit created by banks in
India.
It holds the cash reserves of all the scheduled banks and
controls the credit operations of banks through quantitative and
qualitative controls.
It controls the banking system through the system of licensing,
inspection and calling for information.
It acts as the lender of the last resort by providing rediscount
facilities to scheduled banks. It can do so through changing the
Bank rate or through open market operations
C. Regulator and Supervisor of the Financial System:
The institution is also the regulator and supervisor of the
financial system and prescribes broad parameters of banking
operations within which the country's banking and financial
system functions.
Its objectives are to maintain public confidence in the system,
protect depositors' interest and provide cost-effective banking
services to the public.
The Banking Ombudsman Scheme has been formulated by the
Reserve Bank of India (RBI) for effective redress of complaints
by bank customers.
The RBI controls the monetary supply, monitors economic
indicators like the gross domestic product and has to decide the
design of the rupee banknotes as well as coins.

2. SECURITIES EXCHANGE BOARD OF INDIA

The Securities and Exchange Board of India (SEBI) is the regulatory
authority established under the SEBI Act 1992 and is the principal regulator

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for Stock Exchanges in India. SEBIs primary functions include protecting

investor interests, promoting and regulating the Indian securities markets.
All financial intermediaries permitted by their respective regulators to
participate

in

the

Indian

securities

markets

are

governed

by

SEBI

regulations, whether domestic or foreign. Foreign Institutional Investors are

required to register with SEBI in order to participate in the Indian securities
markets.
OBJECTIVE OF SEBI
Securities & Exchange Board of India (SEBI) formed under the SEBI Act,
1992 with the prime objective of:

Protecting the interests of investors in securities,

Promoting the development of, and

Regulating, the securities market and for matters connected therewith

or incidental thereto. Focus being the greater investor protection, SEBI
has become a vigilant watchdog.

II. OBJECTIVE OF THE STUDY

The aim of this research is to acquaint the reader with:

The measures taken by RBI as a regulatory and supervisory body to

avert financial panic by governing the financial market.
The measures taken by RBI for Investor protection and their interest.

III. CORPORATE SCANDALS: INDIAN SCENARIO

1. HARSHAD MEHTA SCAM

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Harshad Mehta (1992), The first stock market scam was one
which involved both the government of India bond and equity

markets in India.
The manipulation was based on inefficiencies in the settlement

system in GOI bond market transactions.

Pricing bubble came about in the equity markets, where the
market index went up by 14.3 % between September 1991 and
April 1992. The amount involved in this crisis was approximately

Rs.54 crore.
The scam can be categorized as Capital Market scam in which it
is done by manipulating the facts in order to attain enormous
profits.
Two major instruments used in this scam is:
1. READY FORWARD (RF) MODUS OPERANDI
The Ready Forward Deal (RF) is in essence a secured short term
(typically 15 day) loan from one bank to another bank. The lending
is

done

against

Government

Securities

exactly

the

way

pawnbroker lends against jewelry. In fact the borrowing bank

actually sells the securities to the lending bank and buys them back
at the end of the period of the loan at (typically) a slightly higher
price.

The RF in India serves two main purposes:

Like repo markets around the world they provide much

needed liquidity to the government securities markets. They
are an important tool in the hands of the banks to manage
their Statutory Liquidity Ratio (SLR) requirements.

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Banks in India were required to maintain 38.5% (now being

reduced to 30%) of their demand and time liabilities (DTL) in
government securities and certain approved securities which
are

collectively

known

as

SLR

securities.

RF

helps

in

managing this requirement in two ways:

A bank which has a temporary surge in DTL may not want to
buy SLR securities outright and then sell them when the DTL
comes back to normal. Instead it can do a RF deal whereby it
effectively borrows the securities from a bank which has
surplus SLR securities. An RF in SLR securities can thus be

seen either as lending of money or as borrowing of securities.

An RF deal is not legally a loan. A bank which borrows under
RF does not have to treat it as a part of its liabilities at all.
Since it is not a part of its DTL, it does not need to maintain
an SLR in respect of this borrowing. If the bank makes an
outright borrowing, it would have to maintain 38.5% of it in
SLR securities.
In India, the RBI allowed banks to do RFs only in government

securities and not in PSU bonds or units. As far as companies and individuals
were concerned, the RBI's prohibitions did not apply. However, some
provisions of the Securities Contract Regulation Act (1956) particularly

P a g e | 10

sections 135, 166 and 207, prohibited forward contracts and options other
than the settlement trading allowed in the stock exchanges. Legal opinion
has been that this ban does not apply to securities which are not listed in the
stock exchanges. Since units and most PSU bonds are not listed.

Fig.2.Modus Operandi

5 Contracts in notified areas illegal in certain circumstances. 13. If the Central Government
is satisfied, having regard to the nature or the volume of transactions in securities in any
[State or States or area] that it is necessary so to do, it may, by notification in the Official
Gazette, declared this section to apply to such [State or States or area], and thereupon
every contract in such 44 [State or States or area] which is entered into after the date of the
notification otherwise than 45 [between the members of a recognised stock exchange or
recognised stock exchanges] in such 46[State or States or area] or through or with such
member shall be illegal:
[Provided that any contract entered into between members of two or more recognised stock
exchanges in such State or States or area, shall
(i)
be subject to such terms and conditions as may be stipulated by the respective stock
exchanges with prior approval of Securities and Exchange Board of India;
(ii)
require prior permission from the respective stock exchanges if so stipulated by the
stock exchanges with prior approval of Securities and Exchange Board of India.]

6 16. (1) If the Central Government is of opinion that it is necessary to prevent undesirable
speculation in specified securities in any State or area, it may, by notification in the Official
Gazette, declare that no person in the State or area specified in the notification shall, save
with the permission of the Central Government, enter into any contract for the sale or
purchase of any security specified in the notification except to the extent and in the manner,
if any, specified therein. (2) All contracts in contravention of the provisions of sub-section (1)
entered into after the date of notification issued thereunder shall be illegal.

7 Omitted by Securities Laws (Amendment) Act, 1995, S.22 (w.e.f. 25-01-1995).

8 http://www.authorstream.com/Presentation/urru-2258830-harshad-mehta-scamcfii/

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MECHANISM OF THIS SCAM:

As explained above, a ready forward deal is, in substance, a secured
loan from one bank to another. To make the scam possible, the RF had
to undergo a complete change. In other words it practically had to
become an unsecured loan to a his was wonderfully engineered by the
Brokers. There were three crucial steps in this transformation:
1. The settlement process in the government securities markets had to
become broker intermediated: delivery and payments had to be
routed through the broker instead of being made directly between
the transacting banks.
2. The broker through whom the payment passes on its way from one
bank to another had to find a way of crediting this money into his
account though the account payee cheque was drawn in favour of a
bank.
3. While the above two steps would transform the RF from a loan to a
bank into a loan to a broker, it would still be a secured loan. The
broker had to find a way of persuading the lending bank to dispense
with security or to accept worthless security.
1.1

SETTLEMENT PROCESS

The normal settlement process in government securities is that the

transacting banks make payments and deliver the securities directly to each
other. The brokers only function is to bring the buyer and seller together and
help them negotiate the terms. He does not handle cash or securities. In this
respect, the broker functions like the broker in the interbank foreign
exchange market. Closer to ordinary life, this is how the real estate broker
also operates: he does not handle the money or the title deeds which are
exchanged directly between buyer and seller.
During the scam, however, the banks or at
least some banks adopted the alternative settlement process of making
delivery and payment through the broker. That is to say, the seller hands

P a g e | 12

over the securities to the broker who passes them on to the buyer. Similarly,
the buyer gives the cheque to the broker who then hands it over to the
seller. This settlement process is similar to what obtains in the stock market
where in fact the buyer and the seller may not even know whom they have
traded with: both know only the broker. There were two important reasons
why the broker intermediated settlement began to be used in the
government securities markets:
a. The brokers instead of merely bringing buyers and sellers together
started taking positions in the market. In other words, they started
trading on their own account, and in a sense became market makers in
some securities. Brokers taking positions has its advantages: it adds
liquidity to the market. But the fact that brokers were doing so was not
openly recognized, and brokers adopted the subterfuge of pretending
to act on behalf of a bank. Some banks allowed their name to be used
in this manner where a transaction 7 which is actually on the broker's
personal account is routed through the bank.
b. When a bank wanted to conceal the fact that it is doing an RF, the
broker came in handy. The second leg of the RF would be made out to
be with a different bank so that at first glance it does not appear as if
a RF has been done. On paper, it appears as if an independent
purchase and an independent sale transaction have been dome with
two different parties. The broker provided contract notes for this
purpose with fictitious counterparties, but arranged for the actual
settlement to take place with the correct counterparty.
1.2 PAYMENT CHEQUES:
1. A broker intermediated settlement allowed the broker to lay his hands
on the cheque as it went from one bank to another through him. The
hurdle now was to find a way of crediting the cheque to his account
though it was drawn in favor of a bank and was crossed account
payee.

P a g e | 13

2. As it happens, it is purely a matter of banking custom that an account

payee cheque is paid only to the payee mentioned on the cheque. In
fact, exceptions were being made to this norm, well before the scam
came to light.
3. Privileged (corporate) customers were routinely allowed to credit
account payee cheques in favour of a bank into their own accounts to
avoid clearing delays, thereby reducing the interest lost on the
amount.
4. Normally, if a customer obtains a cheque in his own favour and
deposits it into his own account, it may take a day or two for the
cheque to be cleared and for the funds to become available to the
customer. At 15% interest, the interest loss on a clearing delay of two
days for a Rs. 100 crores cheque is about Rs. 8 lakhs.
5. On the other hand, when banks make payments to each other by
writing cheques on their account with the RBI, these cheques are
cleared on the same day.
6. The practice which thus emerged was that a customer would obtain a
cheque drawn on the RBI favoring not himself but his bank. The bank
would get the money and credit his account the same day.
7. This was the practice which the brokers in the money market exploited
to their benefit.

1.3 DISPENSING THE SECURITIES

The brokers thus found a way of getting hold of the cheques as they
went from one bank to another and crediting the amounts to their
accounts. This effectively transformed an RF into a loan to a broker

rather than to a bank.

But this, by itself, would not have led to the scam because the RF after
all is a secured loan, and a secured loan to a broker is still secured.
What was necessary now was to find a way of eliminating the security

itself!
There are three routes adopted for this purpose

P a g e | 14

1. Some banks (or rather their officials) were persuaded to part with
cheques without actually receiving securities in return. A simple
explanation of this is that the officials concerned were bribed and/or
negligent. A more intriguing possibility is that the banks senior/top
management were aware of this and turned a Nelsons eye to it to
benefit from higher returns the brokers could offer by diverting the
funds to the stock market. One must recognize that as long as the
scam lasted, the banks benefited from such an arrangement. The
management of banks might have been sorely tempted to adopt this
route to higher profitability.
2. The second route was to replace the actual securities by a worthless
piece of paper a fake Bank Receipt (BR). This is discussed in greater
detail in the next section.
3. The third method was simply to forge the securities themselves. In
many cases, PSU bonds were represented only by allotment letters
rather than certificates on security paper. And it is easier to forge an
allotment letter for Rs. 100 crores worth of securities than it is to forge
a 100 rupee note! Outright forgery of this kind however accounted for
only a very small part of the total funds misappropriated.
Normally in this system, the issuing bank
writes a covering letter to the payee bank instructing the latter to
credit the account of the customer. In the case of the brokers during
the scam, this precaution was also dispensed with. Since everybody
knew that 8 brokers were taking positions on their own account, it was
but natural that they would receive payments on their own account,
and the banks asked no questions about the enormous sums that were
credited and debited into the brokers' personal accounts.

2. BANK RECEIPT

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In an RF deal, as we have discussed it so far, the borrowing bank delivers

the actual securities to the lender and takes them back on repayment of the
loan. In practice, however, this is not usually done. Instead, the borrower
gives a Bank Receipt (BR) which serves three functions:
a. The BR confirms the sale of securities.
b. It acts as a receipt for the money received by the selling bank.
Hence the name bank receipt.
c. It promises to deliver the securities to the buyer. It also states that
in the meantime the seller holds the securities in trust for the buyer.
In short, a BR is something like an IOU
(I owe you securities!), and the use of the BR de facto converts an RF
deal into an unsecured loan. The lending bank no longer has the
securities; it has only the borrowers assurance that the borrower has
the securities which can/will be delivered if/when the need arises.
Bank Receipts issued without Backing of Securities
As stated earlier, a BR is supposed to imply that the issuer actually has
the securities and holds them in trust for the buyer. But in reality the
issuer may not have the securities at all. There are two reasons why a
bank may issue a BR, which is not backed by actual securities:
A bank may short sell securities, that is, it sells securities it does
not have. This would be done if the bank thinks that the prices of
these securities would decrease. Since this would be an outright
sale (not an RF!), the bank issues a BR. When the securities do
fall in value, the bank buys them at lower prices and discharges
the BR by delivering the securities sold. Short selling in some
form is an integral part of most bond markets in the world. It
can be argued that some amount of short selling subject to some
degree of regulation is a desirable feature of a bond market. In
our opinion, an outright sale using a BR, which is not backed by

P a g e | 16

securities, is not harmful per se though it violates the RBI

guidelines.
The second reason is that the bank may simply want an
unsecured loan. It may then do an RF deal issuing a fake BR
which is a BR without any securities to back them. The lending
bank would be under a mistaken impression that it is making a
secured loan when it is actually advancing an unsecured loan.
Obviously, lenders should have taken measures to protect
themselves from such a possibility (This aspect will be examined
later when we discuss the banks control system in general and

counterparty limits in particular.)

During the scam, the brokers perfected the art of using fake BRs to
obtain unsecured loans from the banking system. They persuaded
some small and little known banks the Bank of Karad (BOK) and the
Metropolitan Cooperative Bank (MCB) to issue BRs as and when
required. These BRs could then be used to do RF deals with other
banks. The cheques in favour of BOK were, of course, credited into the
brokers accounts. In effect, several large banks made huge unsecured
loans to the BOK/MCB which in turn made the money available to the
brokers.
3. BREAKDOWN OF CONTROL SYSTEM
The scam was made possible by a complete breakdown of the
control system both within the commercial banks as well as the
control system of the RBI itself. The internal control system of the
commercial banks involves the following features:
Separation of Functions: The different aspects

of

securities

transactions of a bank, namely dealing, custody and accounting are

carried out by different persons.
Counter-party Limits: The moment an RF deal is done on the basis
of a BR rather than actual securities, the lending bank has to

P a g e | 17

contend with the possibility that the BR received may not be backed
by any/adequate securities. In effect, therefore, it may be making
an unsecured loan, and it must do the RF only if it is prepared to
make

an

unsecured

loan.

This

requires

assessing

the

creditworthiness of the borrower and assigning him a credit limit

up to which the bank is prepared to lend. Technically, this is known
as a counter-party limit.
Lapses in RBI Supervision:
The principal reasons for the incidence of large-value
frauds within the domestic banking system in India through the 1990s can
be broadly classified under regulatory lapses arising from criminal conduct
and reckless mismanagement which occur due to the critical absence of or
failure to enforce:
(1) Internal control systems;
(2) Internal audits of those mechanisms;
(3) Corrective actions to mitigate or prevent opportunities for fraud, reckless
mismanagement, or conflicts of interest raising the potential for such
behavior.

Impact of the Scam

STOCK MARKET

The immediate impact of the scam was a sharp fall in the share prices.
The index fell from 4500 to 2500 representing a loss of Rs. 100,000
crores in market capitalization.

Since the accused were active brokers in the stock markets, the
number of shares which had passed through their hands in the last

P a g e | 18

one year was colossal. All these shares became tainted shares, and
overnight they became worthless pieces of paper as they could not be
delivered in the market. Genuine investors who had bought these
shares well before the scam came to light and even got them
registered in their names found themselves being robbed by the
government. This resulted in a chaotic situation in the market since no
one was certain as to which shares were tainted and which were not.
LIBERALIZATION

The governments liberalization policies came under severe criticism

after the scam, with Harshad Mehta and others being described as the
products of these policies.

Bowing to the political pressures and the bad press it received during
the scam, the liberalization policies were put on hold for a while by the
government. The Securities Exchange Board of India (SEBI) postponed
sanctioning of private sector mutual funds.

Implementation of some aspects of the Narasimham Committee were

also

probably

delayed.

Some

question

marks

arose

regarding

privatization as the chairman of the committee looking into this ended

up in jail on charges of involvement in the scam.
The much talked about entry of foreign pension funds and mutual
funds became more remote than ever. The Euro-issues planned by
several Indian companies were delayed since the ability of Indian
companies to raise equity capital in world markets was severely
compromised. The ability of Indian companies to raise equity capital in
world markets was also severely compromised.
Following the Harshad Mehta fraud, the Narasimhan
Committee set up in 1991, recommended the separation of supervisory
functions from banking functions. The Committee recommended that the

P a g e | 19

duality of control over the banking system between the Reserve Bank of
India and the Banking Division of the Ministry of Finance should end and
that the Reserve Bank of India should be the primary agency for the
regulation of the banking system 9. This was implemented by the creation
of a separate Department of Supervision (DOS) in November 22, 1993.
Prior to 1993, the supervision and regulation of
commercial banks was handled by the Department of Banking Operations
& Development (DBOD). The DOS took over inspection of commercial
banks from the DBOD and from April, 1995 it has taken steps to extend
its area of supervision over the All-India financial institutions. 10 The DOS
was split into the Department of Banking Supervision (DBS) and
Department of Non-Banking Supervision (DNBS) on July 29, 1997, with
the latter being entrusted with the task of focussed regulatory and
supervisory attention towards the NBFC segment.11 The DBS deals with
financial sector frauds related to banks and serves as a secretariat for the
Board for Financial Supervision (BFS). The BFS was constituted on
November 16, 1994, with the RBI Governor as the Chairman and
functions under the RBI (BFS) Regulations, 1994 exclusively framed for
the purpose in consultation with the Government of India 12. The Board is
chaired by the RBI Governor and is constituted by co-opting four nonofficial Directors from the Central Board as members for a term of two
years and the Deputy Governors of the Bank act as ex-officio members.
9 See Narasimha Committee, Report of the Committee on the Financial System, Reserve
Bank of India,Mumbai, 1991, pp 130.

10 See RBI Annual Report 1995-96, Bombay

11 See Paper titled "Supervision of Indian Financial System, 1995-2000", Reserve
Bank of India, Department of Banking Supervision, Mumbai, December, 2000.
12 Ibid.

P a g e | 20

2. THE FALL OF GLOBAL TRUST BANK (2005)

The audited balance sheet of the bank for the year ending March 31, 2002
showed a profit of Rs 400 Million, but the Annual Inspection Report of the
Reserve Bank of India , which as the Central Bank of the country monitors
banking and non banking financial operations in the country, showed a
negative net worth. Global Trust Bank came out with its financial results for
the year ending March 31, 2003 on September 30, 2003, and a Reserve
Bank of India press note dated the same day started that the companys
management had made special efforts for the recovery of non- performing
assets relating to the previous years and had made necessary provisions in
accordance with RBI guidelines. The RBI welcomed the decision of the
companys management to clean up the balance sheet.
Within a few months of this, the RBI put Global Trust Bank under
moratorium. The story began in 1994 when the Global Trust Bank started its
operations.

An

indigenous

scheme

was

devised

thereupon

to

allow

promoters to gain from keeping the share prices of the bank at a high level.
They were running basically an assured return scheme. In its pursuit of
higher margins, the bank became an aggressive lender by sometimes
stretching the source of funds.

GTB was a private bank promoted by Ramesh Gelli, a leading banking

professional, in the early 90s under the government's new policy of
liberalization and privatization in the financial sector. Since its inception
GTB was aggressive in its banking style. It lent large sums to stock
market players. In principle there is nothing wrong in doing so. But
banks that do this type of lending generally have excellent risk control
systems in place. On July 24th 2004, the central government, on the
request of the banker's bank the Reserved Bank of India, issued three

P a g e | 21

months moratorium on Global Trust Bank (GTB), which will last till
October 23rd 2004 in the interest of public and depositors. The RBI also
set a withdrawal limit of Rs. 10,000 for the depositors. It created
chaos in the public because failure of each financial institution brings
doubt in the mind of common depositors who generally centralize all

their earnings in single bank.

The bank's net loss for the year stood at Rs 812.38 crore as compared
to Rs 272.70 crore for the financial year ending March 31, 2003. The
accumulated loss for the financial year exceeded the capital, reserves
and surplus by Rs 810.10 crore.
UTI Bank-Global Trust merger: Confirmed uncertainty

The merger of UTI Bank and Global Trust Bank appears set to be
mired in more uncertainty. The swap ratio announced earlier
appears set for revision if the merger goes through. There is big

question mark on this aspect too.

UTI Bank has asked for a second valuation to be carried out in
the light of new information regarding Global Trust Bank. In the
wake of this development, the Global Trust Bank stock may

continue to exhibit price weakness. -BL Research Bureau.

The boards agree to recommend to shareholders a swap ratio of
nine shares of UTI Bank to four shares of Global Trust Bank i.e.,
2.25:1. Analysts felt that the swap ratio was in line with their

expectations.
However, the proposed merger soon ran into problems. Before
the merger was officially announced, the counters of UTI Bank
and GTB at the Bombay Stock Exchange (BSE) witnessed huge
volumes and a sizeable rise in prices.

PROBLEMS

P a g e | 22

Problems of the bank stem mainly from its very large quantum of Non
Performing Assets (NPA, the assets which do not generate revenues)
accumulated over a period of time.
Consequently, higher provisioning for the same took atoll on its net
worth, thus adversely impacting the capital adequacy of the bank. The
bank had a large net loss in the financial year 2003 mainly due to
large provisioning for its NPAs.

FAILURE
The failure of GTB was result of unavailability of such system and the

ultimate effect was a huge pile up of bad debts.

There was a change at the top -the promoter was side lined and
professionals were brought in. This has not worked and the bank went

down.
Two years back, Gelli was seen manipulating the stock markets in
league with rogue broker, Ketan Parekh. Ketan Parekh in 2001
lured the bank into the share market. That's when the bank lent
aggressively to brokers, diamond traders disregarding prudential

norms laid down by the RBI, to which every bank has to abide.

ROLE

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Role of RBI: Reserve Bank of India announced the merger of GTB with
Oriental Bank of Commerce as a damage control measure and to

reduce the panic level of the common depositor.

The role of SEBI was also shoddy as it put off the

proposed

merger of GTB and UTI and froze the GTB shares hold by UTI and
Ketan Parekh. In mid March 2001, it became clear that the proposed
merger of UTI Bank with GTB might not come through, as the SEBI
preliminary investigation report found manipulation and rigging in the
share price of GTB prior to the merger announcement.
Another SEBI official hinted that the
investigation revealed that the manipulation in the GTB scrip was
motivated and done with the help of the bank's senior management
team. SEBI's findings had not only questioned the merger proposal but
also opened a Pandora's box that may put the management in a major
jam. Sources added that the final investigation was also looking at the
shareholding pattern of GTB and the major beneficiaries from the swap
ratio.
PROPOSAL TO MERGE GTB WITH OBC

The RBI which has a mandate to protect depositors of

commercial banks had to rush through with the merger proposal
in the last one month. Almost all nationalized banks including
Canara Bank, Andhra Bank and J&K Bank were approached.

Even Corporation Bank was also sounded out.

The RBI finally zeroed in on Oriental Bank of Commerce (OBC)
as the banks NPA level had come down drastically. Once the
regulator selected the bank, it thrashed out all the merger
modalities such as safeguarding the depositors money and
retention

of

employees.

At

the

announcement

of

the

P a g e | 24

amalgamation of OBC, RBI officials said that any swap ratio

would be unlikely.
As a part of the scheme, the entire amount of the paid up capital
and reserves of GTB would be treated as provision for bad and
doubtful debts and depreciation in other assets. Estimates
showed that GTB had a negative net worth of around INR 9,000
million. The capital of the bank as on 31 March 2003 was at INR
1213.5 million while reserves and surplus were at INR 1461.6

million.
The RBIs decision followed hectic activity in the corridors of the
Ministry of Finance to save the bank following negative reserves.
The RBI and SEBI were to oversee the merger so that it was

completed quickly.
OBC was to take over GTB, with all its assets, loans and NPAs.
The bank was to take over GTBs INR 15,000 million bad loans in
exchange for which it would get 104 branches of GTB and 8 lakh

customers.
The RBI sop of no swap ratio was the icing in the cake for OBC.
If any surplus remained after accommodating all appropriations,
only then would shareholders get the amount on a prorata basis.

RESERVE BANK OF INDIA'S SCHEME OF AMALGAMATION OF GLOBAL

TRUST BANK WITH ORIENTAL BANK OF COMMERCE

Global Trust Bank Ltd., (GTB) was placed under an Order of

Moratorium on July 24, 2004.

P a g e | 25

The option available with the Reserve Bank was to compulsory

merger under section 4513 of the Banking Regulation Act, 1949

Oriental Bank of Commerce (OBC) interest was examined by the
Reserve Bank of India keeping in view its financial parameters,
its retail network and its synergies as well as strategic

advantages
Taking into account the interests of the millions of depositors of
GTB, as well as the bank strengths and weaknesses, the Reserve
Bank prepared following draft scheme of amalgamation of GTB

with OBC.
The Government of India has sanctioned the scheme for
amalgamation of the Global Trust Bank Ltd. With the Oriental
Bank of Commerce. The amalgamation came into force on
August 14, 2004.

13 45. Power of Reserve Bank to apply to Central Government for suspension of business by
a banking company and to prepare scheme of reconstitution of amalgamation.(1)
Notwithstanding anything contained in the foregoing provisions of this Part or in any other
law or 2[any agreement or other instrument], for the time being in force, where it appears to
the Reserve Bank that there is good reason so to do, the Reserve Bank may apply to the
Central Government for an order of moratorium in respect of 3[a banking company].
(2) The Central Government, after considering the application made by the Reserve Bank
under sub-section (1), may make an order of moratorium staying the commencement or
continuance of all actions and proceedings against the company for a fixed period of time on
such terms and conditions as it thinks fit and proper and may from time to time extend the
period so however that the total period of moratorium shall not exceed six months.
(3) Except as otherwise provided by any directions given by the Central Government in the
order made by it under sub-section (2) or at any time thereafter the banking company shall
not during the period of moratorium make any payment to any depositors or discharge any
liabilities or obligations to any other creditors. 4[(4) During the period of moratorium, if the
Reserve Bank is satisfied that
(a) in the public interest; or
(b) in the interests of the depositors; or
(c) in order to secure the proper management of the banking company; or
(d) in the interests of the banking system of the country as a whole, it is necessary so to do,
the Reserve Bank may prepare a scheme
(i) for the reconstruction of the banking company, or
(ii) for the amalgamation of the banking company with any other banking institution (in this
section referred to as the transferee bank).

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IV.

CONCLUSION

Central bank plays important role in achieving economic growth of a

developing country. It promotes economic growth with stability. It helps in
attaining full employment balance of payment disequilibrium and in
stabilizing exchange rate.RBI is an autonomous body promoted by the
government of India and is headquartered at Mumbai. RBI is an autonomous
body promoted by the government of India and is headquartered at Mumbai
treasury foreign exchange movements and is also the primary regulator for
banking and non- banking financial institutions The RBI operates a number
of government mints that produce currency and coins.RBI regulates the
borrowings whereas trading is regulated by SEBI. Both the regulatory bodies
should work towards the investor protection as it is one of the major issue
with the financial panic. It must ensure that credit is available to the
productive sectors of the economy and establish institutions designed to
build the countrys financial infrastructure and Expand access to affordable
financial services and promoting financial education and literacy.

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V. BIBLIOGRAPHY

Websites
https://www.quora.com/What-was-the-Harshad-Mehta-scam accessed on
30th September 2015
http://indianeconomyataglance.blogspot.in/2009/03/harshad-mehtasscam.html accessed on 30th september 2015.
https://www.academia.edu/10925909/The_Ketan_Parekh_Fraud_and_Super
visory_Lapses_of_the_Reserve_Bank_of_India_RBI_A_Case-Study accessed
on 1st October 2015.
http://www.iimahd.ernet.in/~jrvarma/papers/vik18-1.pdf accessed on 1st
October 2015.
http://indiankanoon.org/doc/1829498/ accessed on 1st October 2015.

Books

Bhandari, M.C., Guide to Company Law Procedures, 22ndedWadhwa

and Co., New Delhi (2010).
Gupta, S.N., The Banking Law in Theory and Practice, Universal, New
Delhi (1999)
Ramaiya, A., Guide to the Companies Act, 17th ed. Wadhwa and Co.,
New Delhi (2010)

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Statutes
1. Reserve Bank of India, 1934.
2. Banking Regulation Act, 1949.
3. Payment and Settlement Systems Act of 2007.
4. Securities Contract Regulation Act, 1956.