Banking frauds and eroding public trust

Banks are a crucial intermediary in India’s financial system. Growth needs finance, and that can come from savers. But savers are in hundreds of millions, dispersed all over, whereas borrowers who need finance are much fewer. It is impossible for savers to personally meet and negotiate finance terms with borrowers. Besides, in case of a default, where will the lenders go? Enforcing millions of individual contracts will be impossible; hence the need for intermediation. Small firms and ventures can probably make do with their own savings, or borrowing from friends and relatives. But for the bulk of finance needs of economic growth, we need an efficient system of intermediation. This giant channeling of finance from savers to investors is the economy’s lender-to-borrower pipeline. Finance can also be by direct equity against the issue of shares, or against the issue of bonds. But most of financing is through the banking system. 

In India, banking contributes to more than three-fourths of the funding needs of the economy. Indeed, most of the personal financial savings of the people are also parked in banks. And more than 70 per cent of banking is in the public sector that is majority-owned by the government of India.  Hence the health and profitability of banking is of great importance. Banks create profits by the margin between the saving and lending rate. This margin is quite slim. Hence one bad loan can wipe out the entire year’s profit. So loans are supposed to be made with great prudence. Banks must be judicious in their assessment of repayment risk. Almost all of bank lending is against collateral. Yet an assessment of the borrower, and his creditworthiness is essential, no matter what the collateral. As famous banker J. P. Morgan said more than a century ago, “the first thing is character”, and that means trust. If trust in the borrower is not there, then no amount of collateral can compensate for it. Thus the very basis of banking is trust.

Savers trust that their savings are safe in banks, especially public sector banks. Bankers trust that borrowers will try their utmost to repay loans on time and in full. In case of genuine adverse business conditions, it is only because of trust that bankers are willing to renegotiate the terms, and give fresh deadlines for repayment. Of course, lending is not done only on basis of subjective assessment and relationship. There are rules, procedures, regulations, audit requirements and other bureaucratic controls. But at the foundation is trust between various stakeholders.

If this intangible “trust capital” starts eroding, then the entire banking industry edifice can collapse.  Banking frauds of the kind being reported from Punjab National Bank in la Nirav Modi affaire, contribute to public scepticism and breakdown of trust. How is it possible that for seven years, thousands of crores of financing was done without proper audit and paper trails, cross checks and re-verification, acknowledgement from overseas correspondent banks? This points to systemic failure or worse, collusion. Either way the public’s trust in banking takes a hit.  If the savers decide to pull out their deposits from the banking system, it can have a domino effect causing panic withdrawals and emergency bank shutdown. Banks never have adequate funds to redeem all deposits all at once, since much of their funds are out as loans.

Most loans don’t turn bad, and indeed generate handsome profits for the bank. Some loans become distressed due to adverse business conditions and can be nursed back to health with help and cooperation from the bank. Some loans become bad, and NPAs but adequate advance provisioning and collateral liquidation can take care of NPAs in normal times. These are all well laid out risk management practices, which is part of normal banking business. But when there is malfeasance, fraud and stealing, then the risk management rules are useless. Additionally, even strictly within rules, there is much flexibility of action, some of which borders on the unethical. That too when it comes to light will degrade trust in the banking system. The huge increase in official NPAs in banks is no doubt because of stricter enforcement of recognition rules.

But there is also an increasing suspicion that some of this is because of crony lending. There is a perception of an unholy nexus between political, business and bureaucratic elite which leads to crony capitalism, as has been pointed out by many observers and commentators. On top of disgust with outright fraud, is also the feeling of injustice and unfairness. Small borrowers and farmers are hounded for repayment while the big fish get away. So the need to restore trust is not only for reasons of efficiency but also to remove the perception that the system is unfairly tilted to favour the rich and mighty. 

In a recent piece, Dr. B. Yerram Raju outlined ten concrete steps to restore faith in the banking system. This involves swift penal action against the guilty, a thorough review of the procedures regarding discretionary powers, transfers and rotation of bank staff and audit processes. He also advocates stopping sale and incentives for selling non-banking products like mutual funds and insurance (this can be debated separately), and boosting the morale of customers and staff.  Please note that this does not necessarily involve large scale and mindless privatisation of the public sector banks. No doubt that the dominance of the public sector in deposits and lending can be reduced. Preferential business to public sector banks from the government can also be removed (and this is consistent with the Competition Commission guidelines, too).

But in the Indian context, in its current stage of economic development, the coexistence of public and private sector banking is an imperative. We as depositors, borrowers, taxpayers and voters can demand better governance, transparency and efficiency in the functioning of public sector banks. But just complete privatisation will be like throwing the baby with the bathwater. Banking is ultimately all about protecting and nurturing a precious asset called people’s trust.  Economic growth and all round development requires this “trust capital” be safe and to grow.

(The writer is an economist and Senior Fellow, Takshashila Institution)