Pot Versus Kettle: RBI And Finance Ministry Have No Business Blaming Each Other In PNB Fraud

The Reserve Bank of India (RBI) Governor, Urjit Patel, has not done his reputation any good by indirectly suggesting that the Punjab National Bank (PNB) fraud was partly the result of a lack of legislative backing that would enable the central bank to take direct action against erring public sector banks (PSBs). In a speech posted on the RBI website, he said that the “RBI’s regulatory powers over PSBs are weaker than those over the private sector banks”. If every time some fraud surfaces, the only answer is more power to the regulator, we might as well run a financial police state.

This is not to suggest that the RBI is more at fault than the owner of PSBs, the government. The Finance Ministry did not do its own reputation any good when it pointed fingers at the RBI for possible regulatory failures. This is like the owner of a house, who may have failed to lock his door, claiming that his valuables were lost because the police failed to prevent theft.

Given that the Nirav Modi-PNB fraud is a political hot potato, clearly both government and the central bank are into a mutual blame game. Ties between the Finance Ministry and the RBI have been frosty ever since the fraud broke surface in February. Let us be clear: when it comes to the PNB or other bank frauds, neither the RBI nor the Finance Ministry can escape blame. The government is the owner of PSBs, while the RBI is the regulator. Both have to act in tandem, or even alone, to fix problems. Blaming one another for something that has gone wrong is not going to help matters. This is the time for them to stick together, not point fingers are each other.

That said, Urjit Patel is being less than honest if he thinks the problem is about the lack of adequate legal powers rather than lax supervision. In his speech, he quoted from the International Monetary Fund/World Bank’s Financial Sector Assessment Programme to note: “The RBI’s legal powers to supervise and regulate PSBs are also constrained – it cannot remove PSB directors or management, who are appointed by the government of India (GoI), nor can it force a merger or trigger the liquidation of a PSB; it (RBI) has also limited legal authority to hold PSB boards accountable regarding strategic direction, risk profiles, assessment of management, and compensation. Legal reforms are thus highly desirable to empower the RBI to fully exercise the same responsibilities for PSBs as now apply to private banks, and to ensure a level playing field in supervisory enforcement.”

In one line, Patel says the RBI’s “regulatory powers are not ownership-neutral”; it has less control over PSBs as compared to private banks.

This is certainly true, but it is foolish to suggest that lack of statutory powers somehow constrains its hand. This should be obvious from the fact that it has not been able to stop frauds even in private sector banks. From the Harshad Mehta scam of the 1990s to the Ketan Parekh one in the last decade, the RBI has not distinguished itself in the matter of fraud prevention. Its greater powers over private banks have not translated into better supervision of this part of the banking system. Whether it is the IPO scam, or the money laundering scam in private and public sector banks, the RBI acted only after these things came to light in the media. Even assuming it cannot sack PSB directors or bank boards or force mergers, nothing stops the central bank from informing the government on what needs to be done, and, if nothing is done, flagging this concern in public.

In a 2013 sting operation by CobraPost, an investigative website, many bank managers were shown to be eager to help potential customers with money laundering. Among the banks fined by the RBI after an investigation, there were as many public sector banks as private. So, the charge that it has less powers vis-a-vis private banks does not make sense. Nearly Rs 50 crore of fines were levied on both public and private banks by the RBI.

In the IPO scam, where banks were involved in the financing of benami retail investors and in opening multiple demat accounts, it was not the RBI which discovered the scam; that came (rightly) from the Securities and Exchange Board of India (SEBI) side, since it is the regulator for primary and secondary markets. But it is surprising that when banks are financing thousands of retail investors in IPOs, the RBI didn’t have a clue about what was going on. And the bulk of the financing was often done by private sector banks, over which the RBI always had more leeway to regulate.

As for public sector banks, currently 11 of them are under the RBI’s preventive correct action (PCA) category, due to high non-performing assets. The RBI also has powers to force PSBs to send default cases to the bankruptcy courts, powers that were given through changes in the law last year.

The short point is this: there are many ways for the RBI to discipline PSBs, and if it wants to, it can. In the worst case scenario, where the government does not listen to its advice, it can always take other actions (like imposing higher prudential norms for some PSBs) that will force the government to act, whether it is to change boards or sack directors. In any event, even assuming the RBI could do this on its own, one wonders where it would have found the people to replace the ones it wants to sack, when good quality bankers often refuse to join public sector banks for the kind of pay they get.

There is obviously a case for improving governance in PSBs, including by privatising some of them, but Urjit Patel is wrong to believe that more power to the RBI is the only solution. The recent scams were not due to the absence of legal power to do something about them. The RBI needs sharper antennae to detect frauds before they happen, and not just more power to discipline banks when these are discovered. Its record in discovering fraud is poor.

The PNB fraud could have happened even if the RBI had more powers just as bank bad loans piled up despite the central bank having all the power to force higher provisioning at an earlier point in the crisis.

(An earlier version of this story was published in DB Post)