Why Banking Frauds Are So Frequent At PSU Banks

The terrain that is Indian banking turns tricky when government’s shareholder action in PSU banks starts impinging on RBI’s regulatory regime

It’s difficult not to detect a sense of déjà vu in the Nirav Modi scam, especially in all the hand-wringing and ex post facto zeal in setting up committees and investigations. Scams are a recurring motif in Indian banking, and the Punjab National Bank (PNB) case fits into the broad template of all previous stings.

In the search for solutions, a steady crescendo of drum-beats has been advocating whole-scale privatization of public sector (PSU) banks as a cure-all panacea. Implicit in the suggestion is the assumption that scams are the exclusive preserve of PSU banks. While it is true that the extent of scams and corruption is highest in PSU banks, data shows Indian private banks are not entirely immune.

The history of Indian banking over the past 50 years is littered with examples of failed private banks that were forcibly merged with stronger public sector banks (and with even stronger private banks recently—such as Bank of Rajasthan with ICICI Bank Ltd). This was done to safeguard depositors’ monies and to avoid systemic disruption. Here are a few random examples: Bank of Bihar was merged with State Bank of India in 1969; Hindustan Commercial Bank with PNB in 1986; Bari Doab Bank Ltd with Oriental Bank of Commerce in 1997; Kolkata-based United Industrial Bank merged with Allahabad Bank in 1989-90; Bank of Karad with Bank of India in 1994. The word merger has a volitional ring to it, but truth be told, there was nothing voluntary about these mergers.

Private banks have no special genes making them immune to scams and frauds. Global Trust Bank had to be merged with Oriental Bank of Commerce after its net worth was wiped out due to systemic fraud perpetrated by insiders. Even voluntary mergers in the post-reforms era are designed to escape distress and seek shelter with a stronger bank.

On balance, though, the larger proportion of scams in PSU banks does beg the question: why do they recur? One immediate reason could be the blurred lines of control and command. The government is the owner of PSU banks and exercises its shareholder rights capriciously: random appointments and transfers of chief executives, influencing appointment of board members, rationing out capital allocation in the name of fostering efficiency are some of the arbitrary control levers. The terrain turns tricky when government’s shareholder action starts impinging on Reserve Bank of India’s (RBI’s) regulatory regime. Bank senior executives, politically seasoned in picking up conflicting signals, reflexively align with the government even if it means contravening RBI’s regulatory framework.

For example, in the PNB fraud case, the bank’s core banking system (CBS) was not linked to its SWIFT system, thereby allowing officers to clandestinely issue letters of undertaking to Modi’s companies and confirming them with counter-party banks overseas through the SWIFT system.

This is despite RBI exhorting banks to link CBS with SWIFT; yet, PNB chose to violate these orders. It is, therefore, odd that none of the members of PNB’s governance troika—board, RBI or its all-powerful shareholder—pulled up the management or even sought an action taken report.

Former RBI governor Raghuram Rajan writes in his book, I Do What I Do: “Today, a variety of authorities…monitor the performance of public sector banks… It is important that we streamline and reduce the overlaps between the jurisdictions of the authorities, and specify clear triggers or situations where one authority’s oversight is invoked.”

RBI is tasked with detecting infirmities, but has no authority to enforce its own orders, administer remedial measures or even deliver swift punitive action. The central investigative agencies are tasked with following up on investigations and pursuing legal recourse. The political pulls and pressures on these agencies, as well as the Indian legal system’s long-drawn processes, provides swindlers with enough escape routes (pun intended), and is never a deterrent.

There is a likelihood that diminished incentives to regulate and supervise could be leading to weakened supervision and vigilance: most of it has become detection (after the event investigation) rather than prevention, which is to create systems and processes that raise alarms before the event or while transactions are taking place.

Flawed risk-mitigation design, which puts excessive focus on credit or market risks, has taken away attention from operation risk, leaving it susceptible to breaches. In addition, there is excessive dependence on manual supervision, at both external and internal levels. The sheer volume of transactions makes it impossible to manually control and supervise.

In the end, no matter what the design, somebody will always attempt to finesse the system. Blame corrupt politicians and bureaucrats, or the steadily disintegrating moral fibre of Indian businessmen, bankers and other white-collar professionals (as pointed out in this article), but scams are here to stay. The trick will be to construct a process design that prohibits anybody taking advantage of the system for sustained periods. And that will require dismantling some of the entitlement rights of the majority shareholder.

The above article was originally published in Mint newspaper and can also be read here

Bank Recapitalisation: Slow-Mo Replay

Scepticism over bank recapitalisation plan is fuelled by the government’s predilection for grandiose policy announcements without adequate preparation or execution

Like all things Indian, there are multiple ways of viewing Union finance minister Arun Jaitley’s comprehensive presentation on the Indian economy and the package of measures formulated to provide some momentum to a decelerating economy.

One is to view government as profligate: throwing caution to the winds, raiding the exchequer and reaping subsequent political dividends. With state assembly elections due in Gujarat and Himachal Pradesh, this package seems custom-built to address concerns over slowing growth, rising unemployment and the severe economic dislocation which followed demonetisation and implementation of the goods and services tax.

Some may even view this development as a snub to the reconstituted Prime Minister’s Economic Advisory Council (EAC). Convened to suggest measures to revive the economy, the council rebuffed calls for a fiscal stimulus programme during its maiden 11 October meeting. EAC chairman Bibek Debroy ostensibly acknowledged, during his post-meeting press briefing, that there was indeed an economic slowdown but, puzzlingly, declined to publicly list the reasons. The new package can thus be seen as realpolitik trumping good economic sense.

Viewed through a different lens, the package can be seen as an attempt to generate temporary feel-good with all the right ingredients thrown in—large numbers, a dizzying number of projects, heady growth estimates. This scepticism is fuelled by the government’s predilection for grandiose policy announcements without adequate preparation or execution. What further bolsters the cynicism is the inordinate rush to announce schemes without fleshing out details: for example, the Rs2.1 trillion bank recapitalisation plan lacks all the relevant details. There is another reinforcing factor: the government has front-ended announcements of funds injection, but all mentions of painful restructuring, if any, have been kept for later.

There is another nuanced view. Keeping the political compulsion as a constant, since the impact of the economic distress on impending elections cannot be ruled out, Jaitley’s package tries to walk a fine line by providing an economic stimulus while also heeding fiscal concerns. While this assessment does seem closer to reality, implementing it is unlikely to be easy. For example, it will be difficult for the government to undertake all the listed infrastructure projects without any budgetary support, given the private sector’s current inability to pitch in with capital.

Many observers and analysts have inveighed against the recapitalisation programme even though the final design is yet to be revealed. They see it as rewarding banks with a free get-out-of-jail card without any corrective measures to avoid repeating past mistakes. There’s also the moral hazard question: recapitalisation studies conducted globally have shown that banks receiving fresh government capital tend to exhibit increased risk-taking activity compared with banks deprived of capital infusion. There are other studies which show that recapitalisation stimulates the credit cycle for only larger banks and existing borrowers. This then contradicts the government’s assertion that recapitalisation will lead to increased credit availability for the micro-, small- and medium-enterprise segment.

While these are legitimate concerns, the recapitalisation programme seemed like a fait accompli, especially since banks were caught in a vicious cycle, leading to a credit impasse which exacerbated the economic distress. As the largest shareholder, it was incumbent on the government to recapitalize banks to kick-start the credit cycle and growth process. Banks could have raised fresh capital from the market by diluting the government’s stake, but their contaminated books made that impossible.

Ideally, recapitalisation and restructuring should go together. The government’s current plan incorporates one without the other or, at best, inserts a time lag between the two actions. Many commentators have been clamouring for an accompanying restructuring programme. One suggestion is to reduce the government’s stake in public sector banks, which, then, one naïvely assumes will provide banks with operational autonomy. Will, say, a 30% or 40% stake prevent ministers and government officials from calling up a bank’s chief executive and influencing credit decisions? Government intervenes in a bank’s credit operations in many other ways.

The Banking Regulation Act mandates that a bank’s board, apart from the executive directors and the regular government nominee (usually a conscientious bureaucrat), should also include professionals with knowledge of accountancy, agriculture and rural economy, cooperatives, small-scale industry, among others. Governments often exploit this section to appoint party loyalists and sympathizers under one category or another since the eligibility criteria is not rigid. These nominees then enjoy unofficial government imprimatur to intermediate between the bank and Big Business. This gap must be plugged.

The other demand is for complete privatization but, realistically speaking, the political economy will not allow that. And, even if that goes through, it is not fool-proof because some of the largest private banks are also struggling with mountains of bad loans featuring the usual suspects: large corporations. A sustainable, long-term solution must therefore include punitive measures for all wilful defaulters, especially majority shareholders, and not just politically convenient soft targets.

The above article was originally published in Mint newspaper and can also be read here