By Invitation. Fix the broken system of banking first

It must be one of the ironies of our times that it takes a bank scam to get people worried about the safety of their deposits, when all along banks were nurturing a ₹9 lakh crore bad debt portfolio. The PNB scam is the latest in a long list of sordid episodes and could be missed for what it really is — another inglorious NPA added to an overflowing pile.

But until such time it qualifies to be one it will probably remain a fraud, an unauthorised availment of credit facilities through transgressing due processes of evaluation and collateral. If non-repayment of a bank loan can attract criminal charges ranging from cheating, fraud and conspiracy, one wonders how many of the bad loans in the NPA stockpile got the same treatment.

A former Deputy Governor of the RBI revealed last year that in almost all cases of reported fraud, the loans were ‘seasoned’ NPAs for three to four years before the fraud was declared. This is worrying, because all along the official explanations on NPAs hardly went beyond economic distress and excess corporate leverage as primary causes, while the details of wilful defaults (RBI’s euphemism for fraud) were never disclosed.

The massive restructuring of loans by banks, especially since 2012, seemed to corroborate this reasoning. But in hindsight now, it look like banks only managed to postpone the inevitable. This is clear from the failure of restructuring and the massive slippages to NPAs year after year. Thankfully, the RBI has put an end to this charade. With the benefit of hindsight again, we now blame the public sector and call for its privatisation. But there is enough case against the public sector even without scams.

If loss of credibility is an outcome of scams, so is the fact that neither the Government nor the regulator were seen to be acting decisively. All action has been explicitly focused on recovery and repair of banks’ balance sheets, but the underlying problem of errant bankers and broken systems remains a festering wound. The loss of credibility of institutions and systems goes beyond diminished market values and financial losses.

It may not be apparent, but deposits are the liquidity lifeline of our banks, not profits or borrowings. In what must be an inexplicable inversion of the risk-return relationship, our public sector banks, despite miniscule return on assets and massive NPAs, were not only able to grow their deposits at an average 14 per cent or more in the last 10 years, but raised them at costs which only AAA rated corporates can aspire to. Clearly, people were placing their trust and deposits on the implicit but ubiquitous backing of Government, but with credibility now fast eroding, the shift away from bank deposits, which low interest rates triggered, could accelerate in future. This could spell trouble for banks.

Role of regulator

The RBI’s role also comes into question. With the Ministry now forced to pull up the regulator, the RBI’s initial response in setting up a committee to review frauds has been predictable. As a supervisor of banks, the RBI carries out routine Annual Financial Inspection (AFI) that focusses on “statutorily mandated areas of solvency, liquidity and operational health of the bank.”

There were also the famous AQRs initiated in early 2015, but largely purposed for unearthing under-reporting of NPAs. One does not know if the RBI carries out operational or systems audits specifically. If it did, the fact of a standalone SWIFT messaging system separated from the core banking system should have been a flashing red flag. Notwithstanding the business rationale, such a separation poses clear operational risks that warrant a higher level of checks and balances. In hindsight, one can only surmise that such controls did not exist or were not strong enough to deter frauds.

The RBI also has its nominee directors on most PSU bank boards but that does not seem to have helped either.

The fact that a fraud could slip past so many layers of supervision for so long opens up two possibilities — of connivance, despite having strong systems or sheer inefficiencies.

Investigating agencies tend to pursue the former line of thought but we must continue to believe that improving governance and competencies will redeem the system. The lessons for RBI should be to re-purpose its supervisory function and review its inspection tool kit to make them fit for purpose.

To be fair, operational risk has always been a challenge for regulators. The BIS views the problem in terms of capital requirement and to this end it experimented with several approaches. The challenge is one of measuring and controlling something that cannot be clearly defined. The Indian scenario is unique, with banking dominated by State owned players, who have tended to be reckless or inefficient. Privatisation may sound an easier option than reforming the public sector, given that private players have been more efficient with better governance standards.

But on the flip side, they have a greater proclivity to risk avoidance and are largely guided by profits and markets, not necessarily the best prescription for an economy seeking to grow itself out of an investment inertia.

The writer is an independent consultant

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