RBI and Cooperative Banks: A Regulatory Dilemma

Syllabus: GS3/Indian Economy

Context

• Recently, the Reserve Bank of India (RBI) released a discussion paper seeking public comments on issuing new licences for cooperative banks.
• It revived a long-standing debate on whether cooperative banks can be effectively regulated within India’s modern banking framework.

About Cooperative Banks

• Cooperative banks are member-owned, democratically governed financial institutions based on the principles of:
  • Open membership (anyone can join by contributing share capital at par);
  • Democratic control (one member, one vote);
  • Mutuality and self-help.
• Historically, cooperatives have played a critical developmental role, especially in rural and semi-urban India, by:
  • Providing affordable credit and savings facilities;
  • Serving people excluded from mainstream banking;
  • Operating with lower costs and local trust;
• The All-India Rural Credit Survey Committee (1954) famously observed that ‘if co-operatives fail, there fails the last hope of rural India’.

Current Status of Cooperative Banks

• As of March 31, 2025, India had 838 cooperative banks with deposits below ₹100 crore each.
• No new cooperative bank licences have been issued since 2001, but the idea resurfaces roughly every five years.
• Cooperative banks remain largely small, fragmented, and locally concentrated, making regulation complex.
• In contrast, large commercial banks like SBI can be regulated through system-based supervision and sample inspections, despite having thousands of branches.

Future Projection of Cooperative Banks

• If new licences are issued, the RBI may face a surge of small, unitary institutions requiring individual supervision, significantly increasing regulatory burden without necessarily improving financial stability or inclusion.

Related Issues & Concerns

• Structural Mismatch: Cooperative share capital is withdrawable and linked to membership, behaving more like a checking account than stable capital.
  • This structure is not compatible with capital-centric prudential banking regulations.
• Scale vs. Mutuality: True cooperatives are meant to be small, neighbourhood-based patronage institutions.
  • Banking, however, requires scale to provide services like remittances, credit cards, export credit, and corporate finance.
  • A ‘cooperative bank” thus becomes an oxymoron, too small to be efficient, too large to remain truly cooperative.
• Governance Challenges: Democratic control allows borrower-members to sit on boards, often weakening professional governance.
  • Many large cooperative banks no longer meet cooperative principles like membership is effectively closed, and non-member business dominates member business.
• Regulatory Burden and Backdoor Licensing: Issuing cooperative bank licences can become a backdoor route to banking licences for promoters who do not qualify for universal banks. RBI faces a paradox like ‘too small to regulate effectively’ and ‘too large to remain a genuine cooperative’.

Related Efforts & Initiatives

• Committee Reviews & Recommendations:
  • Malegam Committee (2011): It primarily focused on financial sector reforms and institutional structures, recommended permitting the issue of new licences to Urban Cooperative Banks (UCBs), subject to strict eligibility and prudential conditions.
    • It argued that well-governed, professionally managed cooperatives should not be denied banking licences merely because of their cooperative form.
    • New licences could promote competition and financial inclusion, especially in urban and semi-urban areas.
    • Licensing should be selective, with emphasis on sound governance, capital adequacy, and viability, to avoid weak and politically captured entities.
  • R Gandhi Committee (2015) on UCBs: It strongly recommended resuming the issuance of new licences to cooperative banks, but within a well-defined and differentiated regulatory framework. It recommended that:
    • New UCB licences may be issued, particularly to professionally managed and financially sound entities, to strengthen financial inclusion.
    • The sector should move to a four-tier structure, with regulation calibrated to size and risk.
    • Large UCBs should be treated almost on par with commercial banks in terms of prudential norms, governance, and supervision.
    • Consolidation through mergers and voluntary transition of strong UCBs into small finance banks should be encouraged.
    • Governance reforms, including fit-and-proper criteria for boards and CEOs, were essential before expansion.
  • Vishwanathan Committee (2021): It took a cautious and conservative view on cooperative bank licensing, shaped by recent failures such as PMC Bank. It recommended that:
    • No aggressive issuance of new cooperative bank licences should be undertaken.
    • The RBI’s priority should be strengthening existing cooperative banks rather than expanding their numbers.
    • Emphasis should be placed on better governance, tighter supervision, and early supervisory intervention.
    • Consolidation, mergers, and exit mechanisms should be encouraged for weak and unviable cooperative banks.
    • Regulatory standards should be risk-based and proportionate, but with enhanced powers for the RBI (enabled by amendments to the Banking Regulation Act).
  • In brief, committees such as Malegam (2011) and Gandhi (2015) supported new licences, while Vishwanathan (2021) urged caution.
• Umbrella Organisation (UO): Established to provide shared services to cooperative banks, offering a foundation for a federated structure.
• Legislative Amendments: Changes to the Banking Regulation Act to strengthen RBI’s supervisory powers over cooperatives.
  • Banking Regulation Act amendments have reduced the problem of dual regulation (Centre vs States).
• Internationally, especially in Western economies:
  • Primary cooperatives handle customer relationships;
  • Federated institutions manage sophisticated banking functions;
  • Regulation aligns federations with universal banks, easing supervisory challenges.

Way Forward

• Adopt a Federated Cooperative Model: Encourage the creation of two or more national-level federal cooperative institutions.
  • Sophisticated banking and capital should sit at the federated level, where capital is stable and regulation is feasible.
• Affiliate, Don’t Multiply: Allow Tier-IV cooperative banks (deposits above ₹10,000 crore) to affiliate smaller cooperatives.
  • Convert single-branch cooperative banks into cooperative societies and cancel their banking licences.
• Banks of Cooperatives, Not Cooperative Banks: National entities may carry the word ‘cooperative’, but function as banks for cooperatives, not as cooperatives themselves.
  • Provide shared branding, technology, compliance, and value-added services.
• Ease RBI’s Regulatory Burden: Fewer, well-capitalised federal institutions mean better supervision and lower systemic risk.
  • Grassroots financial inclusion can continue through newly formed cooperative societies affiliated to these federations.

Conclusion

• Cooperatives remain indispensable for financial inclusion, but cooperative banks in their current form strain both governance and regulation.
  The RBI now stands at a crossroads: continue with piecemeal licensing or reimagine cooperative banking through a federated, future-ready model. Whether it chooses to think boldly remains the central question.

Source: BS