Post-PNB, Privatisation Seems Like A Panacea, But It’s No Guarantee Against Fraud

Closing the stable door after the horse has bolted is a favourite Indian pastime. Now that the Punjab National Bank (PNB) fraud involving two diamantaires – Nirav Modi and Mehul Choksi – has brought the mismanagement of public sector banks into sharp focus, the Reserve Bank of India (RBI) has set up a committee under the chairmanship of Y H Malegam to suggest measures to prevent frauds in banks, and the Finance Minister has begun talking like a Dutch uncle to public sector bank managements for sleeping on the job.

And, unsurprisingly, there are calls for privatising banks, as if this is the answer to fraud.

The RBI website put out a bland statement saying it has asked banks to “implement, within the stipulated deadlines, the prescribed measures for strengthening the Swift operating environment in banks.” (Swift is a secure international messaging system for enabling speedy money transfers between banks and their customers. The PNB scam went undetected because the information fed into the Swift system were not routed through the bank’s core banking solution system, which would have flagged this increase in PNB’s contingent liabilities immediately to the higher-ups).

Further, the RBI has set up the Malegam committee to “look into the reasons for high divergence observed in asset classification and provisioning by banks vis-a-vis the RBI’s supervisory assessment, and the steps needed to prevent it; factors leading to an increasing incidence of frauds in banks and the measures (including IT interventions) needed to curb and prevent it; and the role and effectiveness of various types of audits conducted in banks in mitigating the incidence of such divergence and frauds”.

Arun Jaitley, for his part, has not only asked the RBI to come clean on whether there were supervision and regulatory lapses in the PNB case, but also excoriated the bank’s management for messing things up despite being given the authority to run it efficiently without political interference. Mint quotes him as saying: “(We have told you) we want you to be autonomous, none of us are going to call you up, and therefore take your own decisions. When authority is given to the managements you are expected to utilise that authority effectively and in a right manner. Therefore, the question for the management itself is, were they found lacking? And on the face of it the answer seems yes, they were. You are found lacking when you are unable to check who amongst them (the staff) were delinquent.”

Meanwhile, calls have grown from industry bodies for using this scandal to start privatising banks, an idea that has not yet found favour with the government, or the opposition, for that matter. The Congress party has unequivocally opposed the idea, calling it “preposterous” and “irresponsible”. Since most of the bad loans and scams originated in the UPA era, one wonders what was more “preposterous”, the creation of bad loans or the attempts to resolve them.

The PNB scam has allowed the opposition to take the high moral ground on corruption, and one cannot expect it to allow the government to solve the problem by taking bolder steps, including privatisation. However, the bulk of the Congress criticism is bunkum. Manish Tiwari is quoted by Business Standard as accusing the government of being unable to fix the bad loans problem and fraud. “You are unable to deal with NPAs (non-performing assets) and banking fraud and you say the entire banking system be privatised.”

Nobody, of course, has asked for the privatisation of the entire banking system, not even the big boys of industry.

On the other hand, the problem of NPAs is actually being fixed through the insolvency and bankruptcy code, and by the recapitalisation of banks.

However, privatisation is another thing. As things stand, given the beaten down values of public sector bank shares, this may not be the best time to think about it. And while privatisation may be a good thing in itself, since it reduces the amount of taxpayer resources that keep getting soaked up in recapitalising banks, linking current incidents of fraud to public ownership of banks is problematic.

For two reasons: one, frauds are not unique to public sector banking and the private sector is as prone to it as anyone else; and two, while one can have an ideological (or even pragmatic) position for or against public ownership of any asset, whether banks or telecom companies, the larger issue is accountability and the ability to manage risks of all kinds. If the public sector is going from bad to worse, it is because the issue of who the managers are accountable to, or what they are accountable for, is not being answered squarely. Given crossed lines of accountability, some managers believe that politicians and bureaucrats are their bosses, not shareholders or taxpayers. Others, protected by unions, may believe they are not accountable to anybody.

So, it is fine for Jaitley to criticise banks for not doing their jobs, but he also needs to ask himself one question: as the owner of banks, why isn’t the Finance Ministry not able to get bank managements to act independently and transparently? Clearly, till the structure of direct reporting of top management to the Finance Ministry is ended, few chief executive officers will believe that they can tell the ministry to buzz off.

The assumption that private sector banks are somehow fraud-free flies in the face of facts. If that was the case, we would not have had the global financial crisis in 2008, a catastrophe almost entirely precipitated by private commercial and investment banks in the US.

In India too, the list of private sector bank failures and/or frauds is a long one: remember the Harshad Mehta securities scam? Among the banks involved either as victims or prime players were Standard Chartered and Citibank, apart from public sector banks. Remember Global Trust Bank? It was involved in risky lending and finally had to be merged with Oriental Bank of Commerce. Remember the IPO scam, where private banks were seen to be aiding multiple applications by the same person in public issues? Remember the sting operation against public and private sector banks, where bank managers were seen to be aiding those seeking to launder money? HDFC Bank, Axis Bank and ICICI Bank were among those stung, and later fined by the RBI.

If it can be argued that in the public sector accountability is low because no one can be sacked and that there is political meddling, we can easily argue that in the private sector, the pursuit of profits by taking high risks can be a moral hazard and an invitation to fraud. Reason: when bets pay off, the rewards to managers and staff can be huge. At best, one can argue that risk mitigation measures may be – just may be – stronger in listed public sector banks with professionals at the top.

As long as there is human avarice, and a willingness and incentive to use corrupt or dubious means to make money, there will be bank frauds. The remedy is to fix accountability and put in place risk mitigation measures to minimise frauds, and to ensure that when fraud happens, it can be managed without busting the institution or bringing down the whole system. In theory, this should be possible even in public sector banks, who are subject to multiple levels of supervision – by the regulator, the RBI, by the Central Vigilance Commission, and vetting of their books by the Comptroller and Auditor General.

In the PNB fraud, the issue of letters of undertaking (LoUs) to Nirav Modi for the import of precious stone roughs was facilitated by the fact that one bank manager was handing this case for almost seven years – something unusual in public sector banking where transfers are almost routine every two or three years. The manager offered the LoUs without any margin money or credit limit being sanctioned for the diamantaire. The scam was detected only when the manager retired.

Clearly, the system – any system – can be manipulated to ensure that some powerful people can take advantage of it. And this too is not about public sector banking alone. Remember Nick Leeson, the derivatives trader at Barings Bank, who evaded all internal checks and balances and took on huge exposures till he was undone by unexpected market movements? The losses he made were hidden for more than three years, between 1992 and 1995. One man brought Barings Bank down crashing, just as one man (though, higher-ups could have connived or known about it) brought huge losses to PNB.

No system is risk-free, and no matter what the checks and balances, some crooks will find a way. Banking is about risk-taking, and the trick is to limit the amount of risk any one person, or a connected group of persons, can take. The right thing to do is to put rules in place that will reduce the damage any rogue official can inflict on an organisation. Global Trust Bank failed because its dynamic CEO took too many risks on the road to faster growth, and he came crashing.

The reverse is also true: public sector banks have huge amounts of bad loans on their books as they are risk-averse: they are unwilling to take the risk of resolving some of these bad debts for fear of corruption allegations and vigilance enquiries. So, they face a double-hazard, or taking too high a risk at the promptings of politicians, and then not taking enough risk to settle bad loans resulting from bona fide business failures.

The moral of the story is this: frauds can be minimised by ensuring accountability among officials and managers, but they cannot be eliminated. Privatisation by itself is no insurance against fraud.