What is to be done about bank failures?

The freezing of accounts, and stoppage of lending and deposit taking activity of Punjab and Maharashtra Co-operative Bank (PMC) has once again brought to the fore the issue of riskiness of banks, especially co-operative banks. Unlike scheduled commercial banks, the PMC has dual regulation by the Reserve Bank of India and the Registrar of Cooperative Societies of the State government. That can create problems if the two regulators are not aligned. The RBI slapped a freeze suddenly causing great anguish and shock among depositors. It has now allowed depositors to withdraw up to Rs 10,000 per account to meet their expenses. This still leaves nearly forty percent depositors who cannot access their full savings. There are cases of depositors who have their entire life savings in PMC, and they are likely to face a lot of hardships. It may be that all depositors will eventually get all their money back, but this may take some time, and it also depends on determining the true health of the bank.

This is not the first co-op bank to face RBI action this year. The sudden freeze on withdrawals and fresh loans is necessitated to prevent a bigger disaster down the road. Of the 1542 urban coop banks under dual regulation, 46 have negative net worth as per the RBI. But it’s not only co-op banks which can fail. Even scheduled commercial banks can be in danger of failing and bankruptcy. In the last year eleven public sector banks were put under prompt corrective action (PCA), which too was a freeze on making out new loans, i.e. not undertaking any new business. their bad loan ratio i.e. Non-Performing Assets (NPA) ratio had become too high. The RBI presently has also put restrictions on yet another bank, Laxmi Vilas Bank’s operations.

Let’s step back and ask some basic questions. When depositors put their hard-earned income in banks, are they actually taking a risk? If yes, are there truly risk-free options for savers to park their savings? And are these risk-free alternatives as liquid as a bank account? That is, can savers withdraw any amount on demand, the way they can from a bank? Why is there a difference in risk, perception or real, between co-operative banks and scheduled commercial banks?  Between public sector and private banks? Between Indian and foreign banks? Should depositors pay for the sins of bad loans, or worse, for frauds committed by top management? Who is responsible if a fraud goes undetected for a long time? What is the responsibility of auditors, who knowingly do not highlight risks in their report on the bank’s status? What is the responsibility of the inspectors and supervisors? Can deposit insurance protect all depositors, even if the bank fails due to a business downturn or fraud or both? Is the Financial Resolution and Deposit Insurance bill, which has been temporarily withdrawn from Parliament, the solution to these problems? To what extent is the crisis imputable to lapses of governance, where large loans are given to cronies of directors?

Answering all the above questions is beyond the scope of this column, and requires extensive research and supporting data. The fact is that a two third of India’s banking is in the public sector, and largely under government ownership. That creates an impression that deposits will always be safe, no matter what the rules are regarding deposit insurance. Indeed, the FRDI bill of 2017 had to be withdrawn because of a public furore about one clause, which implied that public deposits above the insured amount, could be used to “bail in” the bank in case of failure. This implied that depositors can also implicitly become shareholders in the bank without their explicit consent. This is not yet acceptable to the “fixed income” mindset of depositors in public sector banks.

Indeed, in the wake of the 2008 global financial crisis, there was a massive flight of deposits from private and foreign banks into public sector banks in India. Even prominent companies like Infosys announced that they were moving cash deposits into banks like State Bank of India. It was as if to signal that money is safe in PSBs rather than private banks. If large companies exhibit this mindset, you can’t blame the small depositor who feels that her money is safe in a PSB or a co-op bank regulated by the RBI. There is an implicit absolute demonstration of trust by the depositor community.

Was this created by bank nationalisation. whose fiftieth anniversary was observed this year?  Whatever you may think of that historic decision, the fact is that bank nationalisation led to a huge expansion of the branch network, and largescale mobilisation of national savings as deposits into the banking system. Nationalisation was basically a political decision. But even to this day, talk of privatisation or denationalisation does not get any traction among all political parties. Indeed, even the record-breaking pace of opening of Jan Dhan Yojana, zero balance bank no frill bank accounts was possible thanks to the effort of mainly public sector banks.

And yet the inescapable fact is that public sector banks are reeling under record NPA’s. In the past four years nearly three lakh crore of equity capital has been poured into them by the government. But their combined market value is barely 5 lakh crore. It seems like stock market investors are neither impressed nor optimistic about PSBs. The government has also undertaken mergers and consolidation, mainly to reduce the number of PSBs, exploit synergies and improve performance.

Banking reform is a long but necessary journey. The economy also requires much deepening of the financial sector and more formalisation. The savers must be made aware that putting their money in banks, public or private is fraught with risk. Banks can and will fail, although there will be deposit insurance protection. Ownership whether public or private does not matter, but managerial autonomy and governance standards are important. So is the integrity of auditors, rating agencies. And of course, the regulator has a big responsibility. Indian finance will remain bank dominated, but its healthy growth needs all-round strengthening of capital base, FRDI type of reforms, stronger governance and autonomy, and more vigilant and proactive watchdogs.

( Dr. Ajit Ranade is an economist and Senior Fellow, Takshashila Institution)