The Local Area Bank Scheme was introduced in August 1996 pursuant to the announcement of the then Finance Minister. In his budget speech, the Finance Minister referred to the setting up of new private local banks with jurisdiction over two or three contiguous districts. He observed that this would enable the mobilization of rural savings by local institutions and make them available for investments in the local areas. The Local Area Banks (LABs) were expected to bridge the gap in credit availability and strengthen the institutional credit framework in the rural and semi-urban areas.

Following this, guidelines for setting up of LABs in the private sector were announced by the Reserve Bank of India (RBI) on 24th August 1996. Over a period of about five and a half years, as many as 227 applications for establishment of LABs in the private sector had been received by the RBI of which 214 applications were rejected while 'in-principle' approvals for establishment of 10 LABs were issued and 3 applications are under examination. However, due to the inability of the promoters to fulfill the conditions stipulated in the 'in-principle' approvals, 4 such approvals were withdrawn. 5 banks were licensed under Section 22 of the Banking Regulation Act 1949. Of these, only 4 LABs are functioning at present. 1 application is pending.
[Source: Report of The Review Group on The Working of The Local Area Bank Scheme
published on Sep 01, 2002 ]

Agriculture continues to be an important sector in our national economy even now despite the diversification, which the economy has undergone under the stimulus of five decades of planned economic development. Though the contribution of agriculture and allied activities to GDP may have declined from over 50% in the 1950's to only about 23% now, it has to be stressed that about 70% of our population still continues to be dependent on agriculture for gainful employment. Our economy is also still predominantly rural and there is imperative need for creating job opportunities outside agriculture. An expert who met us drew our attention to the fact that a special feature of China's economic policies in recent years has been the stress it has laid on generation of employment in non farm occupations in rural areas.

Rural development in general and agricultural development in particular calls for creation of outlets for provision of institutional credit for productive purposes. A conscious policy of augmenting the flow of institutional credit for agriculture has been pursued with vigour in post independent India. Recognising that cooperatives with their local knowledge and local leadership would seem to be the best agency for providing credit with mechanisms for monitoring end use of credit, Government and RBI have promoted cooperative movement on a big scale with access to special credit arrangements, some of them on concessional terms. However, while cooperatives have made tremendous progress, they have failed to come up to the high expectations entertained of them. They are plagued by a variety of problems, - poor mobilization of local resources, ineffective leadership, poor monitoring of end use of credit and mounting overdues. The relatively dismal performance of cooperatives led the policy makers to look to commercial banks particularly the Public Sector Banks to step into the breach through their rural branches, which proliferated in the three decades following nationalisation. Commercial banks did bring a new approach to bear on the provision of credit for agriculture with their superior material and human resources. Commercial banks, however, soon encountered problems of overdues and it was felt that their high cost structure could make them inappropriate agencies for purveying of rural credit on a dispersed basis. It was this realization which led to the setting up of Regional Rural Banks (RRBs) in 1976. These banks, in the share capital of which the Central and State Governments participated, were linked to a sponsor bank which also contributed to the extent of 35% of their share capital. These banks, which at the outset adopted lower scales of compensation for their staff than their sponsor banks, were specially mandated to lend to weaker sections at rates of interest with a concessional element. They could initially manage to lend at concessional rates because of their access to subsidised refinance from their sponsor banks and NABARD. But the RRBs were crippled soon enough by several factors among which was a new compensation policy in pursuance of which they had to pay their employees on par with those of their sponsor banks. Their character as low cost institutions specially designed to serve rural areas was thus lost irretrievably. They were also adversely affected by the problems of mounting overdues and uneasy industrial relations.

It was presumably due to the set backs encountered in the channelisation of credit through cooperatives, rural branches of commercial banks and RRBs that the new concept of a Local Area Bank emerged. The concept was attractive in that it sought to involve local leadership in mobilization of local resources for profitable lending in a compact area. It sought to combine the kind of local knowledge presumed to be the special feature of cooperatives with the professional ethos of a commercial bank.

Objective:
In 1996 it was decided to allow the establishment of local banks in the private sector with the objective to bridge the gaps in credit availability and enhance the institutional credit framework in the rural and semi-urban areas and provide efficient and competitive financial intermediation services in their area of operation.

Capital:
The minimum start-up capital of a LAB was fixed at Rs.5 crore. The promoters of these banks were required to bring in the entire minimum share capital up-front. It was also decided that a family among the promoter group could hold equity not exceeding 40% of the capital. The NRI contributions to the equity of the bank were not to exceed 40% of the paid-up capital. The entire initial capital subscribed by the promoters (including their friends and relatives/associates) would carry a lock in period of three years from the date of licensing of the bank. Further, the promoters' equity to the extent of 40% of the initial paid- up capital was to be locked in at least for two years beyond the aforesaid period of three years subject to review before expiry of five years from the date of licensing of the bank.

Promoters:
The promoters of a LAB could be individuals, corporate entities and societies. The number of NRI promoters was not to exceed 20% of the total number of promoters.

Voting Rights:
Individual shareholder voting rights were to be restricted to a ceiling of 10% of the total voting rights in terms of Section 12(2) of the Banking Regulation Act, 1949.

Area of operation:
The area of operation of an LAB was restricted to a maximum of three geographically contiguous districts. The activities of an LAB were to be focussed on local customers predominantly in rural and semi-urban areas so as to bridge the credit gap in these areas.

Scope of activities:
LABs were required to finance agriculture and allied activities, SSI, agro-industrial activities, trading activities and non-farm sector. Their lending to priority sector was to be at least 40% of the net bank credit and lending to weaker section was to be at least 25% of their priority sector lending (10% of net bank credit).

Registration, licensing, scheduling:
The bank would be registered as a public limited company under the Companies Act, 1956. It would be licensed under the Banking Regulation Act, 1949 and would be eligible for inclusion in the Second Schedule of the Reserve Bank of India Act, 1934.

Applicability of Statutes:
The bank would be governed by the provisions of the Reserve Bank of India Act, 1934, the Banking Regulation Act, 1949 and other relevant statutes. However, in regard to liquidity requirements and interest rates, such banks would be governed by the provisions applicable to the Regional Rural Banks (RRBs) established under the Regional Rural Banks Act, 1976.

Prudential norms:
LABs would be subject to prudential norms, accounting policies and other policies as laid down by RBI. The bank would have to maintain capital adequacy at 8% of risk weighted assets and comply with the norms of income recognition, asset classification and provisioning since inception.

Licensing Procedure:
As per the procedure followed in such cases the RBI granted an 'in- principle' approval for setting up a LAB which laid down the terms and conditions needed to be fulfilled by the promoters before a licence could be granted for commencement of banking business.

The RBI could, at its discretion, call for any additional information required by it or withdraw/cancel the 'in-principle' approval in the event of non compliance with the conditions laid down in the 'in -principle' approval

Only four LABs are functioning at present. These are,

1. Coastal Local Area Bank Ltd. established on 27th December 1999 with an area of operation comprising three contiguous districts viz. Krishna, Guntur and West Godavari with its head office at Vijayawada (Andhra Pradesh),

2. Capital Local Area Bank Ltd. established on 14th January 2000 with its area of operation comprising three districts viz. Jalandhar, Kapurthala and Hoshiarpur with its head office at Phagwara (Punjab),

3. South Gujarat Local Area Bank Ltd., established on 3rd October 2000 with an area of operation comprising three contiguous districts viz. Navsari, Surat and Bharuch with its head office at Navsari (Gujarat),

4. Krishna Bhima Samruddhi Local Area Bank Ltd.established on 28th February 2001 with an area of operation comprising three contiguous districts of Mahbubnagar in Andhra Pradesh and Raichur and Gulbarga in the state of Karnataka with its head office at Mahbubnagar(Andhra Pradesh).

The licence of Vinayak Local Area Bank Ltd., Sikar (Rajastan) established on 21st October 2000 was cancelled by Reserve Bank on 16th January 2002 as major irregularities were noted in its functioning.

The LABs were allowed to open branches in only one urban centre per District and rest of the branches were allowed to be opened in the rural and semi urban centers subject to requisite clearance in respect of rural branches from the District Consultative Committee for the concerned districts.

The LABs could be included in the Second Schedule of the Reserve Bank of India Act, 1934 subject to the fulfillment of the eligibility criteria laid down in Section 42(6) of the said Act ibid.

The regulatory responsibility over the LABs vests with Rural Planning and Credit Department (RPCD) of the RBI. The RPCD issues licence for these banks as per provisions of Section 22 of the Banking Regulation Act, 1949 and grants permission for opening of branches at new places of business as per the provisions of Section 23 of the Act ibid. The financial health of the LABs is monitored through off-site returns and other statements required to be submitted by these banks. The appointment of the CEO and the Chairman of the LAB requires clearance of the RBI as per the provisions of Section 10B of the Banking Regulation Act, 1949 read with Section 35B of the Act ibid. The remuneration of the CEO also requires prior approval of the RBI. The composition of the Board of these banks is to be in accord with the provisions of Section 10A of the Banking Regulation Act, 1949. As LABs are commercial banks in the private sector, banking policies as applicable to commercial banks are made applicable to them except where these pertain to areas of business which LABs are not permitted to undertake.

Supervision over LABs lies with the Department of Banking Supervision (DBS). During the first year of its operation, the LAB is subjected to quarterly on-site supervisory monitoring visits. The quarterly visits cover areas such as examination of loans and investments, treasury functions, internal checks and controls so as to ensure that the affairs of the bank are not being conducted in a manner detrimental to the interests of the depositors.

Thereafter, the LAB is covered under Annual Financial Inspection (AFI) Programme of DBS. This covers areas such as management functions, functioning of Board of the bank and constitution of various committees of the Board, internal control system, internal audit and inspection, information system, deposit, advance and investment portfolio, NPAs, profitability, capital adequacy and maintenance of statutory norms as CRR and SLR.

An analysis about the functioning of LABs and about the report of the Review Group appointed by RBI in 2002 to study and make recommendations on the LAB Scheme are discussed in the next article