Fault Lines in the Indian Banking Industry

Both the PNB fraud and the Rotomac case underline how fund diversions were overlooked, but what’s distressing is how no alarm bells were sounded, no red flags were raised

Two things occur with metronomic regularity in the Indian banking sector: scams and committee reports. One, perhaps, follows from the other.

The Indian banking story, whether pre- or post-nationalization, has been an unfortunate hostage to a long catalogue of scams and frauds. The discovery of each scam is usually followed up with a flurry of committees and reports, rule reversals and a systems overhaul. A few years lapse in all this frenetic activity, a sharp light is focused on the scam area and just about when everybody starts getting complacent, another scam hits the industry. The entire round-robin league is replayed all over again.

The modus vivendi is common: exploit the system’s weakest link. There is another common thread in all the scams: diversion of funds. Both the Punjab National Bank (PNB) and Bank of Baroda (BoB) scams—the Nirav Modi and Rotomac cases, respectively—underline how fund diversions were overlooked; what’s distressing is how no alarm bells were sounded, nor red flags raised, despite an obvious piling up of operational, human and market risks that have debilitated two of India’s stronger public sector banks. Unfortunately, this seems to have become the default template for Indian banking scams, underscoring wide gaps in the regulatory framework. A cursory glance at scams since 1990 show how each episode methodically leveraged regulatory and supervision gaps.

The Harshad Mehta scam coincided with the dawn of India’s economic reforms. Mehta exploited the manual and antiquated settlement systems in trading of government securities. Taking advantage of a few pliant bank officers, Mehta conducted gilts trade between different banks using forged documents and diverted proceeds to prop up untenable equities positions. The scam-tainted large public sector banks (State Bank of India), foreign banks (Standard Chartered), small private banks (Bank of Karad, now extinct), corporate behemoths and sundry securities markets intermediaries.

A decade later, Ketan Parekh—ironically Harshad Mehta’s protégé—replicated almost the same methods: divert funds from the banking system through fraudulent methods to sustain equity market positions. KP would obtain pay-orders from Ahmedabad-based Madhavpura Mercantile Cooperative Bank without providing sufficient collateral. He would discount these pay-orders with Bank of India in Mumbai and use the proceeds to ramp up shares. The house of cards eventually collapsed when bear traders hammered KP’s favourite stocks and Madhavpura’s outstanding pay-orders exceeded its ability to repay Bank of India.

Here’s another familiar story: Sanjay Agarwal, former CEO of Lloyds Brokerage, created portal Home Trade in 2000 but was forced to go on the run a year later. Agarwal had inserted himself into the world of cooperative banks, promising to invest in gilts on their behalf and delivering lucrative trading returns. Instead, he diverted the money without delivering the securities or providing the promised returns. The charade continued till one of the cooperative banks complained about not receiving the promised securities.

In recent times, Winsome Diamonds and Jewellery Ltd allegedly used standby letters of credit to divert Rs7,000 crore. Winsome Group promoter Jatin Mehta shares another common strain with Nirav Modi: both have ostensibly become citizens of Saint Kitts and Nevis islands in the Caribbean, which does not have an extradition treaty with India.

Many more similar banking scams have occurred and gone undetected for long periods till the final moment of denouement. One trend is unmistakeable: money is diverted out of the banking system with the active connivance of either the bank’s senior management or a couple of rogue officers. This is what makes both the PNB and BoB cases incredulous: with Reserve Bank of India (RBI) putting so much emphasis on anti-money laundering mechanisms, and with an increasing number of prosecutions against either money laundering or diversion of bank funds, it is indeed curious how both the banks persisted with lax risk mitigation and supervision frameworks.

This also then begs the question: how is it that so many similar scams occur with such frequency, especially when RBI is such a hands-on regulator and supervisor? Every small action needs RBI approval, be it a CEO’s annual bonus, bank management’s decision to nominate a senior executive to the board or to open a branch in a city. Yet, copycat scams continue with ineluctable monotony.

Each time a scam occurs, committees are set up and numerous studies take place. Even now, post the PNB scandal, RBI has set up a committee under chartered accountant Yezdi H. Malegam to examine the increasing number of frauds in the banking system, the measures that will be needed to prevent them (including technological solutions), the role and efficacy of various audits currently conducted in banks to mitigate such frauds and the growing divergence between RBI and bank assessments on asset quality.

Many similar committees were set up earlier and voluminous reports submitted; yet, sadly, they are never enough to prevent future scams.

Next episode: what could be the probable reasons for the recurrence of such scams.

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

NPAs: The New Wedge in Centre-State Relations

NPAs are expected to acquire a two-tier, federal character with enormous implications for Centre-state relations

There was jubilation in stock markets recently after finance minister Arun Jaitley hinted at a scheme to sort out the messy tangle of bad loans in the banking sector. The equity market’s optimism beggars belief because NPAs—or non-performing assets, as bad loans are called technically—have remained impervious to an alphabet soup of previously attempted schemes. And now, NPAs are expected to acquire a two-tier, federal character with enormous implications for Centre-state relations.

In the post-1991 era, multiple schemes have been conceived and launched to tackle the menace of NPAs: DRTs (debt recovery tribunals, as suggested by Narasimham Committee-I and then subsequently amended in 2012), CDR (corporate debt restructuring), SARFAESI Act (Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest), CRILC and JLF (Central Repository of Information on Large Credits and Joint Lenders’ Forum), 5/25 scheme, ARC restructuring (asset reconstruction companies, formed as a consequence of DRTs), SDR (strategic debt restructuring), AQR (asset quality review), S4A (scheme for sustainable structuring of stressed assets) and finally the IBC (Insolvency and Bankruptcy Code).

There are multiple reasons for many of these schemes failing, which includes an inadequate legal framework for pursuing resolution; however, the one reason that remains unchanged from pre-reforms period is final policy design always providing corporate borrowers enough protection so that they can reprise the same act all over again. And while public attention has focused on Vijay Mallya—deservedly of course—there are other larger industrial groups which are habitual offenders but manage the system adroitly. Former Reserve Bank of India (RBI) governor Raghuram Rajan was compelled to state: “…it is extremely important that banks do not use the new flexible schemes for promoters who habitually misuse the system (everyone knows who these are) or for fraudsters.”

This raises issues of “moral hazard”; in the Indian context, moral hazard has taken the form of corporates or public sector banks undertaking increasingly riskier behaviour because they know the government is underwriting that risk or bearing the cost of that risk. Post the 2008 financial crisis, moral hazard has acquired some flexibility globally: it has become acceptable to bail out institutions if government feels such failure can lead to widespread systemic risk.

This may have inspired finance ministry’s chief economic advisor Arvind Subramanian to blithely suggest that government should perhaps bail out large corporate borrowers because that is how “capitalism works”. He feels only write-offs can sort out the “mountain of debt” sitting on bank books, or settle the twin-balance sheet problem (over-leveraged companies and NPA burdened banks). 

Interestingly, Subramanian has also contributed to the NPA soup cauldron: the annual economic survey recommends the creation of PARA, or Public Sector Asset Rehabilitation Agency. Not to be left behind, even RBI’s recently appointed deputy governor Viral Acharya has gamely added his two-bit: PAMC (Private Asset Management Company) and NAMC (National Asset Management Company).

So, while attempts are being made to untangle the knotted skein of corporate bad loans, albeit through an ever-growing thicket of acronyms, Jaitley has at the same time flatly turned down requests for farm loan waivers. He has received wide support. State Bank of India chairman Arundhati Bhattacharya has warned that fulfilling such pre-election promises might lead to dilution of credit discipline: borrowers might tend to defer repayment till the next elections in the hope of loan waivers. This newspaper also recently pointed out that the Indian agricultural sector needs long-term structural investments, not short-term exchequer-funded loan waivers. There is merit in each of these arguments.

But, here’s a catch: the ruling Bharatiya Janata Party also promised farm loan waivers in its Uttar Pradesh assembly election manifesto. Having won the elections and faced with the prospect of fulfilling that promise now, Jaitley has used an escape hatch to wriggle out of the commitments. Answering the debate on Finance Bill in Rajya Sabha, he has asked individual states to foot the bill for farm loan waivers. He has effectively created a two-tier, federal, moral hazard framework: Centre’s responsibility to bail out large corporates and states get to write off farm loans.

This further complicates attempts at creating a long-term, sustainable set of solutions for controlling and resolving the financial system’s NPAs. It also adds new headaches to the already vexed Centre-state relations. Competitive waiver promises have already weakened the fragile balance sheets of Andhra Pradesh and Telangana. 

It also raises issues of discrimination. If the Centre wants to bail out some 30-40 large corporate borrowers on the pretext that their debt misery was the outcome of external shocks, does not the same logic or argument apply to farm loans, especially since many states have been victims of droughts, inadequate monsoons and crop failures? There is no doubt the NPA mess needs to be resolved urgently to kick-start investments and the growth process. But then, that solutions framework cannot be built on the foundation of discrimination and selective relief.

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

The SBI merger: is bigger always better?

The process increasingly looks like a shotgun wedding, with not enough opportunity to pause and ponder

The anticipated merger of the State Bank of India (SBI) with its five associate banks and Bharatiya Mahila Bank (BMB) finally got off the ground with the government sending a letter to all seven banks on 20 June. From thereon, the time taken for obtaining individual board approvals, appointing legal and accounting firms as well as investment banks, getting them to conduct due diligence and arriving at a fair share swap ratio, was under two months.

That should be some kind of a record. Deals involving smaller companies or banks have taken far longer. And this is the country’s largest bank, SBI, merging with six other pretty large banks. There are many imponderables involved in such negotiations: for example, the overlap in the combined physical network, the people question, or integrating disparate back-end systems and processes. Clearly, the government is in a hurry to complete this merger.

The merger is being pursued in the belief that larger automatically means better. Vanity is also a motivating factor—creating an institution that will make it to the list of the world’s largest banks confers bragging rights.

There are perceived gains as well: the government, as shareholder, feels it will have six less capital-hungry banks to worry about. There are also expectations that a larger institution will be better equipped to deal with sticky loans, thereby enabling fresh credit outflows to productive sectors. Productivity and efficiency gains are among other expected benefits. But these could turn out to be illusory given the SBI’s legacy and ownership structure. A former SBI chairman had once remarked that reforming SBI was like trying to make an elephant dance. Even after discounting for exaggeration, there are grounds for circumspection; a large and unmanageable bank is getting even larger.

What’s even more worrying is how the process increasingly looks like a shotgun wedding, with not enough opportunity to pause and ponder. Three issues merit wider debate.

One, the merger patently lacks shareholder democracy. Individual shareholders have been discouraged from objecting. Anybody wishing to oppose must own at least 1% of either bank’s share capital (for example, that amounts to 77.6 million SBI shares) or must marshal 100 shareholders irrespective of their shareholding. According to SBI’s annual report for 2015-16, only five shareholders owned more than 1% in the bank on 31 March 2016: the President of India (60.18%), Life Insurance Corp. of India (11.27%), HDFC Trustee Co. Ltd (on behalf of HDFC Mutual Fund, 2.08%), Bank of New York Mellon (as depository for SBI’s outstanding global depository receipts, 1.86%) and Reliance Capital Trustee (on behalf of Reliance Mutual Fund, 1.09%).

Similarly, chances are that mostly institutions own shareholding of over 1% in the three associate banks with public shareholding—the State Bank of Bikaner and Jaipur, State Bank of Travancore and State Bank of Mysore.

While it is safe to assume that the President won’t be objecting, it is also unlikely that any institutional investor will really challenge the process. The SBI owns 100% in the State Bank of Patiala and State Bank of Hyderabad, while the government owns 100% in BMB. Two other associate banks were merged with the SBI earlier: the State Bank of Saurashtra in 2008 and State Bank of Indore in 2010.

In the face of such power asymmetry, in which one set of shareholders has greater rights than another group, the predictable has happened. Left trade unions in Kerala have taken the deal to court; there it might languish for a time.

Two, the merger seems to overlook a critical, post-crisis concern—the too-big-to-fail (TBTF) question. Tremors of the 2008 trans-Atlantic financial crisis were felt all over the interconnected world. The TBTF theory posits that some institutions are so large and intricately interconnected with different parts of the economy that failure can create a systemic shock. This forced many governments to bail out large financial institutions with taxpayer money. It might also be instructive to note that many countries have been formulating preventive TBTF regulations. Australia, for example, has prohibited any merger between the country’s four largest banks. Switzerland, on the other hand, has the world’s most stringent capital norms.

The Reserve Bank of India (RBI)—in keeping with various multilateral agreements at the Financial Stability Board, G20 and the Bank for International Settlements—has designed a risk mitigation framework for dealing with “domestic systemically important banks” or D-SIBs. The framework recognizes SBI and ICICI Bank as D-SIBs, both of which must maintain higher common equity tier I (CET I) than their peers. It allows national authorities greater discretion in the selection and risk mitigation processes than what’s prescribed for global systemically important banks, G-SIBs.

But here’s the thing. Once the merger is completed, SBI could become part of the G-SIB club, ending RBI’s discretionary approach. What happens then? Will the current capital shield be adequate? If no, what impact will additional CET I have on expected efficiencies? Even if it doesn’t get clubbed with G-SIBs, RBI will perforce have to review its D-SIB framework.

Finally, a speculative thought. Rumours are China now wants in on plurilateral trade in services agreement (TiSA) and India has also expressed a similar desire. Leaked TiSA documents show nil barriers to financial services imports, including total freedom to overseas financial companies for acquiring local outfits. Is the SBI merger a pre-emptive move then?

Some of these conversations need to happen now, not post-merger. Especially whether bigger is always better.

This appeared in Mint newspaper on September 21, 2016, and can also be read here

Taxing Half-Truths

This is election season. So, in keeping with the mood of the day, we’ll deal with the familiar area where economics and politics interact and blend into each other. Every now and then, some politician will stand up and berate the centre for not providing enough funds for Mumbai city. The logical course for this now-so-familiar harangue is as follows: highlight the city’s enormous contribution to the centre via direct taxes paid and then blame the centre for usurping these funds without spending a dime on the Mumbai’s development. This gets repeated often and – like any other fragment of gossip -- acquires some modicum of legitimacy.

The truth is often far removed. Let’s tackle the issues one by one. First, the tax contribution. It is entirely true that Mumbai city collects and provides huge amounts of income tax to the centre. Figures and percentages keep varying, depending on which report you are reading or which politician you heard last. It is also true that only a fraction of that money gets back to the city for its further development. But, here begins the smokescreen.

The income tax collected by the city is indeed huge. But, is all of that generated by Mumbai city alone? Not really. Take the case of some of the highest corporate tax payers. For example, the country’s largest bank, State Bank of India, is among the top tax payers from Mumbai city. But, are its profits derived from this megapolis alone? Hardly. The bank has thousands of branches spread across the country, conducting banking business, making profits, which all show up in Mumbai because the bank’s headquarters are based in the city.

Take the case of another large private sector company, Hindustan Unilever Ltd. The company makes soaps, detergents, toothpastes and other such products across the country and sells them widely throughout into every corner of this vast landmass. But, when it comes to paying taxes on its total profits (which includes contributions from each and every sale that occurs in some village or tehsil), the lump-sum amount seems to emanate from Mumbai only because the MNC’s India headquarters are located in the city.

But, have you ever wondered why does everybody harp about direct taxes only? Why does nobody actually talk about Mumbai contribution to, say, the total excise duty kitty? The reason is: excise is collected at point of manufacture and most factories are spread out across the country, instead of being concentrated in one city or state or region.

The second part of the half-truth: does the government spend very little on the city’s development? Absolutely, no doubt about that. But, again there’s more too it than meets the eye -- under the federal structure of the country, the centre pools all the central taxes received from the different states and then allocates resources from this pool to different states, based on a formula devised by a finance commission (which is changed every five years). In addition, the centre also launched a scheme called Jawaharlal Nehru National Urban Renewal Management to improve the civic infrastructure of all major metro in the country. Resources are allocated based on certain criteria. People should ask: have the state government, or the city authorities, met all the conditions?

People should not get sold on half-truths about the city. Or get swayed by emotion-tweaking statements about the city’s contribution. In all of this, the city’s actual problems get dwarfed and its real contributions obfuscated.