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Insights into Editorial: Can banking recover?

Insights into Editorial: Can banking recover?



State-owned Punjab National Bank (PNB) disclosed that it has discovered around Rs 11,400 crore worth of fraudulent transactions. The lender named firms and people associated with billionaire jeweller to conspire with some of its officials to defraud the bank using bank guarantees. 

This bank fraud is another cause of worry as the Indian banking system is already reeling under the pressure of growing NPAs, or non-performing assets.

What is the fraud about?

The failure has occurred at many levels. From handful employees at the level of the bank; senior management and auditors who did not track these problematic transactions for years; even RBI for creating opacity with new financial instruments and The Finance Ministry for failing in its oversight and regulation are the major reasons for the current fraud.

The main issue of the scam is with the new financial instrument, the letter of undertaking (LoU).

The PNB scam relied on the existence of an unusual financial instrument, the letter of undertaking (LoU).

This is a bank guarantee that enables a bank’s customer to raise short-term credit from another Indian bank’s foreign branch. It has to be another Indian bank.

 It was created by the RBI as an additional incentive to importers who could then avail of cheaper credit abroad.

What is irregular about this?

In the normal course, when an importer goes to a bank to ask for such a guarantee, one of two things happens. One, the bank asks him for collateral before it gives a guarantee. Second, the bank sanctions a credit limit.

That means it will evaluate the importer and says he is good to be given a loan for a certain amount.

In the PNB fraud case, the bank employees had sent these guarantees (unauthorised letters of undertakings (LoUs)) in the absence of credit limits and collateral security.

These LoUs which are equivalent to providing credit and should be recorded as contingent liabilities were not so recorded.  In some cases, corresponding entries were made in the core banking system, but for lower amounts.

When loans are not repaid — in this case vast amounts borrowed from other banks based on these LoUs were apparently siphoned off to shell companies.

What was intended to be trade credit was misused, with no record and monitoring of the spending from those loans.

Why is crony capitalism also a major reason for fraud?

Crony capitalism is an economy in which businesses thrive not as a result of risks they take, but through a nexus between a business class and the political class. Crony capitalism has its many forms.

Some favoured companies are not declared wilful defaulters even when the government’s own investigating agencies find that they are diverting funds.

Those declared as wilful defaulters are neither punished nor prevented from leaving the country. In fact their names are not even made public, so they can continue to access loans from other banks.

Some insolvent companies are made to sell their assets which are then purchased at throwaway prices by relatives or associates of the defaulting owners.

Moreover, shell companies held by influential people continue to enable the siphoning of assets and money laundering in various forms.

Is Privatisation answer to the prevailing Banking issues in India?

The current mess has become an excuse to demand the privatisation of state-held banks. However, privatisation unlikely would make things better for Indian banking.

The key issue is one of poor regulation, and not ownership. Indeed, despite current trust in the public banking system is still visible because of sovereign guarantee.

Poorly regulated private banks are even more prone to scams and failure as the financial sector is rife with information asymmetries and market imperfections.

Private profit orientation generates incentives for managements to exploit loopholes in the rules and engage in risky behaviour.  For instance, the subprime mortgage crisis of 2008-’10 was manufactured by major private banks in USA.

The bailouts they then require tend to be even more expensive for the public exchequer because bank runs have to be prevented. Many private banks in Europe and USA had to be bailed out by governments.

Private Banks are not safe from NPA issue. For instance, private banks such as Axis and ICICI also face large NPAs, often with the same companies that are defaulting on public banks.

Cases of governance breakdowns are not a monopoly of PSB in India, many privately-owned banks also have been regularly identified with such errors. 

In fact, because of the opacity of banking practices, public banks are actually easier to regulate.

Way forward

Banking failures have large social consequences given the deep financial linkages banks have with each other as well as with other parts of the economy.

Privatisation is surely not the answer. It shows the acceptance of procedural weakness of the fiscal system and might mean much higher costs for the common man.

The government may ask banks to go for more “hair cut” or write offs for NPAs.

The Banking Regulation Act may be amended to give RBI more powers to monitor bank accounts of big defaulters.

RBI wants stricter rules for joint lenders’ forum (JLF) and oversight committee (OC) to curb NPAs.

The NPA problem has to be tackled before the time a company starts defaulting. This needs an early risk assessment by the lenders.

Strategic debt restructuring (SDR) scheme and sustainable structuring of stressed assets (S4A) has to be implemented in timely manner.

Recovering from current Banking problems will require stricter adherence to sound banking rules and more transparency and accountability from both public and private players.