Indian Banking Industry: Governance Reforms Imperative to Regain Confidence of Stakeholder

Yes Bank is among the latest to be added to the list of Indian banks that have been in trouble recently. The string of bank failures has raised questions about the industry’s otherwise strong regulatory framework. Is there a way to prevent more such episodes?

Yes Bank, India’s fifth largest bank, is currently in crisis due to corporate governance issues. Problems at Yes Bank surfaced a few years earlier, when it was forced by the RBI to disclose its nonperforming loans (NPLs) on grounds of discrepancy in reporting—totaled approximately $630 million vis-à-vis $113 million reported for the financial year ended March 2016. The gap widened to almost $1 billion by 2017. NPLs included loans disbursed to some of its biggest customers such as Anil Ambani’s now bankrupt Reliance Communications. The bank also gave huge loans against intangible collateral that was tough to value or seize, such as virtually unenforceable “personal guarantees” by well-known businessmen. Finally, it came to light that for the quarter ended December 2019, Yes Bank had reported a loss of INR18,564 crores with a gross NPL of 18.87%. It reported a capital adequacy ratio of 4.2% at the end of the September quarter.

The RBI imposed a freeze on withdrawals, triggering panic among the bank’s customers and affecting business entities with corporate accounts. The uncertainty and speculation surrounding Yes Bank’s fate for the last few months eased to an extent after India’s largest bank, the government-owned State Bank of India (SBI), stepped in to rescue it; SBI will bail the bank out on certain conditions. As efforts are being made to revive the bank, asset prices have fallen, affecting equity investors, while AT1 bonds have taken a severe a hit (INR8,415 crores wiped off), which has impacted debt investors significantly. The arrest of its founder Rana Kapoor by the Enforcement Directorate (ED) under the Prevention of Money Laundering Act (PMLA) in March 2020 was a low point in the bank’s history.

Indian Banking Sector Disasters
Yes Bank is not the only example. More Indian banks have landed in trouble lately, leading to losses for their depositors, some of whom had trusted the banks with their life savings. Bad loans, NPAs and fraudulent activities are some of the reasons cited for the largescale disasters.

In October 2019, Punjab and Maharashtra Co-operative (PMC) Bank was forced to down its shutters. The reason behind it was that two-thirds of loans were allegedly given to a real estate company, HDIL, that went bankrupt. The bank had transferred 70% of the total credit facilities to HDIL and its associated companies. Besides, about 21,049 bank accounts had been opened under bogus names to conceal 44 loan accounts. The bank catered to a large population but was not actively supervised by the RBI. The issues came to light when a whistleblower from the bank alerted the regulator of fraudulent activities. The RBI will now take a call on whether to liquidate the bank, revive it or merge it with another bank.

Before this, it was the Punjab National Bank fraud case. This INR10,000-crore scam revolved around fake Letters of Undertakings (LoUs). With the help of some PNB officials, certain tycoons in the jewelry industry used these instruments to source funds illegally and then went absconding.

Apart from these prominent examples, there are many cases involving smaller banks. One of these is Mapusa Urban Cooperative Bank (MUCB), the oldest cooperative bank in Goa, whose license has been cancelled by the RBI. Sanctions were imposed on MUCB in 2015 after its capital adequacy ratio fell below the RBI-designated 9% threshold, and accumulated losses exceeded INR100 crores. The irony of the situation is that when MUCB hit rough weather in sustaining operations, it sought to merge with none other than PMC Bank, whose survival itself is at stake now.

Why do banks fail?
There are multiple reasons, such as:

1. Absence of or poor corporate governance standards – It is essential for banks to adhere to corporate governance standards and maintain complete transparency in dealings. Being the custodians of savings of citizens, banks must follow proper protocols for governance.
2. Concentration of risk – For PMC Bank, the main reason for downfall was disproportionate concentration of assets in one or few companies or sectors. Even in case of scheduled commercial banks, while technically lending is diversified, there have been cases of evergreening loans by lending to entities associated with company promoters, thus leading to circulation of funds without the asset actually earning money through normal operations.
3. Weak regulatory control over cooperative banks – Disclosure requirements for cooperative banks are lower compared to those for scheduled commercial banks, while regulations are also comparatively less stringent. As a result, it is easy for discrepancies to creep in. Politicians usually seek board positions on these banks, looking to secure easy funding for personal gains.
4. Inaccurate evaluation of risks in lending – A bank should be able to accurately evaluate projects from the perspective of feasibility and profitability, and accordingly lend money. Incorrect estimation of risk to return ratio can prove a costly mistake.
5. Withholding disclosure of NPAs – Hiding or withholding disclosure of important items such as NPAs is like a ticking time bomb. Early disclosure of suspicious accounts can help banks to take corrective measures on time. However, in their bid to aggressively grow credit, banks at times ignore disclosure norms due to which risks increase.

On their part, Indian banks have resisted political interference in lending and lobbied with the government to obtain more power to seize and liquidate assets of willful defaulters. Such borrowers used to take cover under India’s legal system and prolong the process of recovery, rendering it ineffective. The Insolvency and Bankruptcy Code gave banks the much-needed enforcement power and specific timelines for resolution of such cases. However, relaxation of certain terms and conditions under pressure from the industry and exemptions provided due to the current COVID-19 crisis are a huge setback to effective implementation of reforms.

How to protect banks from failing
Given the myriad reasons and mechanisms of failure, a one-stop solution is not possible. However, addressing the main causes of recent failures may soften the blow to an extent.

1. Improving lending standards – Lending to commercially unviable projects must be discouraged. Political interference is a perennial obstacle to justified lending even in non-banking corporations. Hence, unless politicians stop interfering, it would be difficult to make lending foolproof.
2. Strengthening audit committee – Both internal and external audit committees must have the authority to take strict actions to ensure banks operate in line with regulations.
3. Effectively handling whistleblowing – Alarms raised by whistleblowers must be looked into by an independent audit committee to restrict interference and coercion by senior members who may be guilty.
4. Conducting forensic audits periodically – Periodic forensic audits are important to check wrongdoings by a bank and its personnel. All financial transactions and decisions involving finance are analyzed to detect scope of fraud.
5. Increasing regulatory control over cooperative banks – There is need for higher regulatory supervision of cooperative banks by the RBI, considering their rapidly increasing assets as well as depositor base. Currently, they are regulated and supervised by the Registrar of Cooperative Societies (RCS) at the state level or central level. The government has also proposed modification of the Banking Regulation Act in February 2020 to give RBI greater powers for supervision over cooperative banks. Hopefully, the bill will be passed by the Parliament soon.
6. Improving composition of board of directors – The board is a part of all critical decisions and determines the overall direction for the bank. Having more independent directors and ensuring greater diversity at the board level can help in improving governance standards and, thereby, preventing frauds.
7. Separating ownership and management – To establish accountability, ownership and control should be separated through mandates. After the Yes Bank fiasco, the RBI is actively asking banks to cap promoter shareholdings, but much more needs to be done in this regard.

In a country like India, banking has not penetrated as much as it has in developed markets; moreover, several sections of the society (rural, lower strata in urban areas) remain unbanked. In such a scenario, banking crises further dent the confidence of the general population and slow the process of expansion of banking coverage. This has implications for general governance reforms such as Direct Benefit Transfer (DBT) or direct payment of subsidies and scholarships to beneficiary accounts.

Amid decreasing confidence, people either hoard cash or look for alternative options. The main objective of banks is to ensure safety of personal wealth of individuals. If trust has waned, the banking industry, in coordination with the government and regulatory authority, must work toward regaining the confidence of citizens.