In 1995, Barings, a British investment bank that had been around for over 200 years, was brought down by a rogue trader in Singapore, Nick Leeson. The bank had suffered a loss of $1.3 billion in unauthorised trades. In 2008, Societe Generale, a leading French bank, lost over $5 billion in unauthorised positions taken by a trader. In 2011, a rogue trader caused losses of over $2 billion at UBS, the Swiss bank.
What was common to these banks? Well, private ownership. The amount of $1.77 billion involved in the fraud at the government-owned Punjab National Bank (PNB) is a large one and a cause for concern. However, in exposing itself to the fraud, PNB is in the exalted company of some of the most sophisticated private banks worldwide. Like road accidents or plane crashes, frauds at banks are unavoidable. They are a cost of doing business, so to speak. The key is to ensure that losses inflicted by fraud stay within reasonable bounds.
In a banking fraud, some employees of a bank or outsiders – or the two colluding with each other–cause losses to a bank. Often – but not always – the fraud relates to the sanction of a loan or credit risk. This results in a non-performing asset (NPA). Since public sector banks (PSBs) account for the majority of the NPAs in the Indian banking system today, there is a widespread perception that this is proof of colossal fraud at PSBs.
Not all NPAs, however, can be ascribed to fraud or mala fide intent. Indeed, we have it on the authority of the Economic Survey of 2016-17, no less, that NPAs in the Indian banking system have arisen primarily for reasons beyond the control of bank management. Since PSBs are at the receiving end of an enormous amount of flak on account of NPAs, it’s worth quoting the Survey on the subject:
Without doubt, there are cases where debt repayment problems have been caused by diversion of funds. But the vast bulk of the problem has been caused by unexpected changes in the economic environment: timetables, exchange rates, and growth rate assumptions going wrong.
So much for the notion that it is a combination of political interference and managerial incompetence which has left PSBs with a mountain of NPAs. Just one comparison should drive home the point even further. Gross NPAs as a proportion of total loans at State Bank of India (SBI), the largest bank in India, stood at 10.35 per cent in the quarter ended December 31, 2017. This was after the merger of the parent SBI with all its associate banks, some of which were in a weak state. At the second largest bank, the private sector, ICICI Bank, NPAs on the same date stood at 7.82 per cent, just two percentage points lower. Yet, nobody has alleged political interference or managerial incompetence at ICICI Bank.
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Frauds in banking don’t just relate to loans. They may also relate to what is called ‘operational risk’ which involves subversion of systems or processes by employees or outsiders. If, for instance, somebody were to hack into a bank’s IT system and transfer out funds from customer accounts, the bank would have to make good the loss.
The instances of fraud we cited at the beginning of this piece all relate to operational risk. Going by what has been reported so far, the fraud at PNB also relates to operational risk. It appears that an employee at PNB used the SWIFT (Society for Worldwide Interbank Financial Telecommunications) messaging system at the bank to issue unauthorised letters of undertaking (LoUs), which are a form of guarantee, to various firms in the Nirav Modi group.
LoUs are typically issued against cash put up by a firm locally. The overseas branches or affiliates of the firm then used the LoUs to obtain short-term credit from banks abroad. LoUs are typically issued for 90 days or so. At PNB, the employee reportedly issued LoUs for 365 days. According to media reports, the fraud was uncovered after the employee retired and his replacement refused to renew an LoU without a cash margin being provided.
Since the LOUs had been issued and used for a period of around seven years, it would appear that the Modi firms were making repayments when due. Otherwise, the LoUs would not have been renewed. Mr Modi has said in his letter to PNB, now made public, that he was in a position to honour all his dues to the bank and that the confiscation of his assets and suspension of his operations had rendered this impossible.
Was any effort made to recover as much of the dues of Rs 11,700 crore as possible? Or did the uncovering of the fraud leave the PNB management with no choice but to alert the law enforcement authorities? These are among the questions that need answering. We also need a handle on outstanding dues from the Nirav Modi group to all banks and the value of the assets seized from the group, so that we have an idea of the losses to which banks are exposed. The Reserve Bank of India (RBI) must disseminate information of losses in bank frauds annually, using an appropriate metric, say, losses in frauds as a proportion of net interest income or total value of transactions. This will help ensure that hysteria or panic does not erupt every time there is a fraud in the system.
A fraud alerts a bank to shortcomings in systems and processes. In the case of PNB, the delay in linking the SWIFT system with the core banking system has been highlighted. But this is by no means the only lapse. The large number of LoUs issued to the Modi group would have resulted in a surge in fee income at particular branches. The PNB management should have examined how this came about. This applies equally to internal auditors and statutory auditors. Any dramatic improvement in performance must prompt questions. The failure to do so in the case of Nick Leeson was seen to be a key factor in the fall of Barings. The lapses on the part of management and auditors at PNB are only too evident.
The government has been quick to point an accusing finger at the RBI for alleged supervisory lapses. Those familiar with RBI inspection reports will testify to the high quality of these reports–they often pick up issues that have eluded both the management and the board. It is not clear that it is the supervisor’s job to pick up frauds. The practice is for banks to report frauds to the supervisor after which the RBI swings into action. The government must resist the temptation to deflect the heat it is facing on to the RBI.
Frauds are only one form of violation of laws and regulations. These are violations involving some employees without the knowledge of top management. There are other instances where banks themselves violate laws and regulations at the expense of customers, shareholders and, sometimes, the taxpayer, with top management in the know.
There is a long and depressing list of such violations in private banks abroad–Libor-rigging (London Interbank Offered Rate which serves as a benchmark to calculating interest rates on various loans throughout the world), manipulation of exchange rates, money laundering, non-compliance with sanctions, to name a few.
In recent years, banks have ended up paying over $200 billion – that’s right, $200 billion– in fines for these violations. One of the most hallowed names in banking, Wells Fargo, was charged with creating millions of accounts in the names of customers without their consent and has been told that it cannot grow its assets for some time.
The PNB affair has predictably set up an enormous clamour for privatisation of PSBs. Although commercial interests in India, international agencies and the media have been pushing this agenda for a while now, successive governments have not yielded to it. However, given the demands made on it for recapitalisation of PSBs, there is every prospect that the present government will seek to privatise at least some of the weaker PSBs. This is most likely if the government is returned to power in 2019. The Chief Economic Advisor has said time and again that the government intends to shrink the role of PSBs. Episodes such as the one involving PNB, no doubt, come in handy for the purpose.
The argument is made that managers at PSBs lack the incentives to perform. Frauds and NPAs will continue to happen and PSBs as a category are fated to be under-performers. This ignores the fact that in the period 2000-10, PSBs raised their performance and we saw PSB performance converging towards that of private banks. It also ignores the fact that, in private banks, incentives to perform can have the perverse effect of producing exactly the same outcomes – by getting managers to take excessive risks and breaching laws and regulations.
If the gambles pay off, managers make huge bonuses for themselves and enrich shareholders. If the gambles fail, the taxpayer is left holding the can. That is precisely what happened in the global financial crisis of 2007-08. It explains the enormous fines banks have had to pay up in recent years. To flog the incentives argument in light of these experiences and to contend that privatisation will usher in an era of clean, problem-free banking is the height of ignorance.
T.T. Ram Mohan is a professor at IIM Ahmedabad. He can be contacted at email@example.com