Cover Story: Perishing Asset Quality

First Mallya, now Nirav Modi episode showcases transparency and information systems of the RBI needs overhauling and it has to start from the top which means central bank’s board

By Asit Manohar

The Rs 11,400-crore bank fraud in Punjab National Bank, which was perpetrated by billionaire Nirav Modi in collusion with a few bank employees, has once again brought governance practices in Public Sector Banks (PSBs) back to public debate. There are questions raised on the way these entities function. A political blame game is on. But the problems in this sector are far beyond one instance of fraud. After five decades of bank nationalization, India’s public sector banks face deeper structural problems ranging from poor management practices, ineffective risk-management systems, vulnerability to a political-corporate nexus, and large chunk of bad loans and lack of sufficient autonomy. So, let’s examines the serious structural problems that have engulfed India’s state-run banks and the likely course of this industry, which constitutes 70 percent of India’s banking sector assets.

It’s impossible for a visitor to miss the British Raj ambience of Punjab National Bank’s (PNB) Brady House branch in Mumbai. The imposing structure is a stone’s throw away from the Bombay Stock Exchange and Reserve Bank of India (RBI). As symbol of its legacy and a pride of the bank for several decades, the Brady House branch today is in the eye of a storm — aRs 11,400-crore fraud in which PNB finds itself embroiled. The bank, India’s second largest by assets, is fighting to save its image and win back investor confidence since it reported the fraud — since Valentine’s Day (14 February), to be precise — when it disclosed to stock exchanges that a fraud had been underway for several years (since 2011).

The fraud, it divulged, had been orchestrated by a few PNB employees at Brady House and billionaire jewellerNirav Modi’s companies. A CBI investigation has already led to the arrests of two PNB employees. Policymakers, regulator and investors have been taken by surprise seeing the extent and nature of the fraud that was perpetrated issuing  fake Letters of Understandings (LoUs) to Nirav, who used them to borrow from overseas branches of certain Indian banks for several years. PNB has taken a hit, both in terms of its image and investor-confidence. PNB’s stock price has eroded 31 percent since the day of the announcement of the fraud. We will have to wait and watch before the full extent of damage can be ascertained.


The PNB fraud can’t be seen in isolation. It represents a larger systemic problem. The fact is that India’s state-run banks often operate as feudal institutions. These banks eagerly wait for cues from their higher-ups in the bureaucratic hierarchy. Most bank chairmen function like feudal kings in PSU banks and officers down the hierarchy often get unfair treatment. The working culture is far different from that of a typical private sector bank.

The chairman and others in the top brass, in turn, look for cues from their bosses (read bureaucrats in the government and ministers) and aim to please them by taking orders rather than taking independent decisions that are in accordance with spirit of competition and longterm efficiency of the institutions. There is no sense of ownership and accountability. This was one major reason behind the buildup of the NPA pile in state-run banks. During the period of the economic boom, most PSBs competed to get a larger share of the corporate loan pile often forgetting the rules of prudence and credit assessment.

When banks focus blindly on loan volumes and less on quality of loans, the problems begin. This later manifested itself as NPAs when the economic cycle took a downturn. At one point, it was quite common to see advertisements in national newspapers by state-run banks flashing their ‘Total Business’, which was basically done to impress the bosses in government and didn’t give any indication of the quality of the balance sheet. “Whether it was UPA or NDA, this feudal culture hasn’t changed much,” said one retired banker who spoke on condition of anonymity. Every outgoing bank chairman merrily passed on the bad loan burden to the successor and showed a healthy balance sheet.


It will be a cardinal mistake to imagine that PNB is a one-off problem for the banking sector. This is only the outcome of loose checks and balances, and governance practices that have crippled state-run banks for a long time. PNB, in fact, only represents the real situation of public sector banks in India long-affected by weak risk-management systems, poor management and no significant autonomy in big business decisions. The fraud signals the deeper problems faced by sarkari banks and raises questions on the logic of recapitalising these lenders using taxpayers’ money before fundamental reforms are executed to change the way these banks function.

In a recent interview with Firstpost, KC Chakrabarty, former RBI deputy governor, and former chairman and managing director of PNB said the fraud should not be seen in isolation. This is the result of long-followed poor risk-management systems and inefficient auditing practices, Chakrabarty said, adding there needs to be proper risk-based audit and supervision in place to prevent such frauds. Banks do various types of audits of their accounts, the banking regulator, the RBI, too does periodic monitoring of bank transactions, the government (majority owner of these banks) frequently reviews the PSU bank performance. Yet, none of these could sniff out a fraud that has been going on since 2011.


The PNB fraud will certainly make ripples across the Indian banking sector. But it isn’t the only dark spot in the public sector banking industry. There are a plethora of problems these lenders have been tackling for a long time, including the issues arising out of poor governance practices, shortage of capital, lack of reforms and vulnerability to the corporate-political nexus on account of their sheer public sector character. The biggest problem PSU banks have been facing is the mounting NPAs. Over 90 percent of the total gross NPAs of the banking sector is with state-run banks, also because of their sheer asset size in relation to private and foreign banks.

Around 70 percent of the Indian banking system is controlled by state-run banks, in other words, the government. But, government control has not done any good to these institutions after five decades of nationalization, even though it has helped to spread the banking services to India’s far-flung villages and direct credit to farm sector. Today, the total gross NPAs of state-run banks is nearing around Rs eight lakh crore. But, if one looks at the total chunk of stressed assets including the parts of loans that are being restructured, the figure will be far higher. If one looks at the overall industry NPA picture, again PSBs come out on top.

PNB has a GNPA figure of 12.11 percent, Bank of Baroda is at 11.31 percent, SBI at 10.35 percent and Canara Bank has 10.38 percent. The figures look even bad among the relatively smaller peers of SBI in the public sector banking industry. IDBI Bank tops the list with GNPAs of 24.72 percent, followed by Indian Overseas Bank which has 21.95 percent of its loans gone bad, UCO Bank had 20.64 percent gross NPAs, United Bank 20.1 percent and Dena Bank 19.56 percent. Total slippages of SBI rose to Rs 25,836 crore, compared with Rs 9,026 crore in the previous quarter.


There have been promises on bold reforms in state-run banks for a long time in order to change these institutions for better. But, except certain cosmetic incremental reform steps, nothing much has happened. One of the major reforms that ruling governments promise repeatedly is that of consolidation of government-owned banks, but except for mergers in the state bank group, which are largely technical in nature, there has been no major progress on this front. In 2014, an expert panel under PJ Nayak had recommended bringing down government holding in these banks below controlling stake and let private parties run these banks. But nothing much has happened so far except the continuation of long-practiced policies and cosmetic reforms such as splitting chairman and CEO posts and bringing private sector CEOs.

In the light of the PNB episode, it’s time the government looked at privatisation of PSU banks more seriously and, in the meantime, commences the process of overhauling the risk-management framework that has proven to be completely ineffective so far. The PNB episode conclusively tells the regulator and policymakers that cosmetic steps won’t work anymore.


On 24 November, 2010, at around noon, the Central Bureau of Investigation (CBI) called a press conference in Mumbai to make an important announcement. As the media waited eagerly for the finer details, the central agency announced the arrest of eight bank officials including the then CEO of LIC Housing Finance Ltd in Mumbai, a top officer of LIC and officials of Bank of India (BoI), Central Bank of India and Punjab National Bank (PNB). During the course of the presser, the CBI claimed to have broken the back of a corporate loan racket, wherein bank officials allegedly took bribe from middlemen on behalf of companies to arrange loans to them that wouldn’t be given under normal course of credit operations.

As the details of the ‘corporate loan scam’ or ‘bribe-for-loan scam’ (as media the called it) unveiled, the then Union finance minister Pranab Mukherjee warned banks then to take action against the bankers involved in the scam and put proper checks and balances to avoid the recurrence of such frauds. It is another thing entirely that the CBI could never follow up with a strong case in the court of law. But the big takeaway is that bankers never learned their lesson.

The instances of fraudulent transactions and loan scams involving bank officials continued. This included both and big and small frauds — Citibank fraud, Bank of Baroda forex scam, Syndicate Bank fraud and several other lesser-known scams. In most instances, the victims were public sector banks and culprits their own officials. Most cash-for-loan scams happened through middlemen. “There are many advisory firms that arrange loans for companies from banks, offering bank officials kickbacks. Big firms don’t need them but mid-sized and small companies go after these middlemen to approach bankers,” said a senior banker with experience of over 30 years, who didn’t wish to be named.

Looking at PNB-like frauds, if someone thinks that there are no checks in place in the system, they are wrong. “There are checks but no one really cares,” said another banker who too requested anonymity. He takes the example of the LoU (Letters of Undertakings) fraud in PNB. If a branch-level official does a transaction of this manner for a period of seven years, it can get caught at different levels if any of the checks in place triggered this illegal activity.


It’s not just about fraud, but also about wrong credit decisions and the art of acting too late. Banks continued to support Kingfisher despite fully knowing that things were not looking good financially. Lenders offered to restructure Vijay Mallya’s loan after realising that they had already thrown good money after bad. In March 2012, Kingfisher halted its international operations to Europe and Asian countries and cut down local flights to 110 to 125 a day with a fleet of 20 planes (down from from 340 flights earlier) to save money. By October 2012, the bird flapped its wings for the last time. Since then, it hasn’t seen the skies.

Kingfisher, once the second-largest airline in India, had little chances of resuming its operations since the necessary regulatory approvals were not in sight and its balance sheet was bleeding. The company’s losses had expanded to Rs 2,142 crore in the fourth fiscal quarter ending in March 2013, compared with a net loss of Rs 1,150 crore a year earlier. The accumulated losses as of March 2013 stood at a whopping Rs 16,023 crore.

In early 2011, the bank consortium including SBI had converted debt amounting to Rs 1,400 crore into equity at a 60 percent premium to the prevailing market price. Going by the stock exchange data, on 31 March that year, there was preferential allotment to SBI and ICICI Bank due for conversion of compulsorily convertible preference shares into equity shares at a price of Rs 64.48 each. Remember, on that day, KFA shares closed at Rs 39.90 on the BSE. Within a few months, the share value had eroded so much that banks were put in a difficult position. Kingfisher last traded at Rs 1.36 on the BSE on 22 June, 2015. Banks are still fighting in courts to get the money back from Mallya, who is now in London and has waged a legal war on Indian banks. It is unlikely that banks will get their money back.

Mallya is only one case. There are several other cases of large loan defaults (at least two dozen of such cases are now with NCLT for bankruptcy proceedings), where banks have been caught off-guard. The latest is the Rotomac loan default case, where the size of the loan default is now estimated about Rs 3,700 crore. Here too banks acted too late. For instance, one of the lenders to Rotomac’sVikram Kothari, Bank of Baroda classified this account as an NPA way back in October 2015 and tagged this as a case of fraud in December 2017. But the bank moved to investigators only after the Nirav Modi scam broke out.

What is surprising is that the Indian banking system has no fewer checks and balances than any other country, whether regulatory monitoring, auditing or internal checks, but all of these has failed when it comes to preventing fraud. That calls for a major overhaul.

Various process failures of public sector banks in India are not new. What is new in the PNB fraud is that, for the first time, questions are being raised about the supervisory capacity and systems in Reserve Bank of India (RBI). The government has written to the RBI asking for why the scam was not detected in its systems. Concerned citizens have asked for similar information in the past and disclosures by RBI have not been adequate.

In 2011, the RBI refused to release information in response to a Right to Information query about some inspections carried out on cooperative banks. Its decision was overruled by the Central Information Commission (CIC). The CIC’s decision throws light on the functioning of RBI. One request (in the same query) to which the RBI did reply, indicates lack of documentation about the supervision process. The appellant had asked RBI to provide him with procedure, rules and regulations of inspection being carried out on co-operative banks. In contrast, the Federal Deposit Insurance Corporate of the US (which plays a similar role in bank inspection) releases detailed manuals on the process of inspections.

There are, no doubt, legitimate concerns about releasing inspection reports of banks and the RBI has, in the past, refused to release such information. Inspection reports contain commercially sensitive information not only of banks but of borrowers as well. Releasing that would harm businesses. Imagine you are trying to sell your house and negotiating to with a potential buyer. Through inspection reports, the potential buyer finds out that you have a large loan due for repayment in three months. The potential buyer will draw out the negotiation process to turn on the heat on you. You do not want that.

However, this does not apply to the process of inspections. How much do we really know about RBI’s audit process? Why is there no transparency about the process followed? We do not know how much time is spent per day, how many auditors per branch of a bank, what template is followed, what aspects of banking are audited, etc. Without public information on how RBI conducts banks’ audit, there is no accountability of the process. Since the CAG (Comptroller and Auditor General of India) does not audit RBI, even the normal accountability of other wings of government is missing for RBI.

We do not know if RBI updates its supervision systems when it comes across these types of frauds. In September 2016, a Deputy Governor of RBI highlighted the risks associated with SWIFT systems. Union Banks SWIFT system had been hacked in July 2016. The strategy on Union Bank was similar to the one used on the Bangladesh central bank.

While this may be true of PNB, it may also be true of RBI. Did RBI change its supervision process after 2016? Was SWIFT messaging auditing a part of the RBI inspections? We do not know.

Transparency and information systems of the RBI need to be overhauled. This has to start at the top: the RBI board. Laws which govern the functioning of RBI need to be changed to bring about transparency and accountability. This has to then be supported by scrutiny into the functioning of the institution. A tragedy is a terrible thing to waste. The legislature should take a relook at the legislative framework of transparency, accountability and governance of RBI. The Draft Indian Financial Code addresses many of these concerns and there is need to incorporate its principles in primary legislation.