Bank losses, frauds and economic risks

The non-performing assets (NPAs) in the banking sector in India are humongous. “…by 2014…in all, roughly 15 per cent of state bank loans had gone bad” (Sharma 2016). In fact, regulators, banks, Government of India (GOI), courts, and firm managements are currently grappling with this issue. GOI has recapitalised public sector banks (PSBs) to the extent of Rs. 2.11 trillion. It has taken several steps in recent years to avoid or keep NPAs to the minimum in future.

However, these corrective measures are primarily in the nature of improving the audit process so that frauds are caught or prevented. Even if it is assumed that frauds are prevented, there is another and even bigger issue of assessing the economic risk in giving loans in a dynamic economy.

Policy measures in the last few years
Let us consider the various corrective measures by the public authorities. The RBI carried out Asset Quality Review (AQR) in 2015. This was to basically examine if NPAs had been under-reported in the balance sheets of banks. This indeed turned out to be true. This review brought to the forefront the huge NPA problem in India.

The Insolvency and Bankruptcy Code (IBC), 2016 is the new bankruptcy law of India. The IBC is a one-stop solution for resolving insolvencies, which was earlier a long, costly, and ineffective process.
GOI set up National Company Law Tribunal (NCLT) in 2016. The NCLT is basically a quasi-judicial body, which adjudicates issues relating to companies in India. This is useful as the usual courts take very long.

GOI set up the Banks Board Bureau (BBB) in 2016. This is (supposedly) an autonomous body of GOI to improve the governance of public sector banks (PSBs), recommend selection of chiefs of such banks and financial institutions, and to help banks in developing strategies and capital-raising plans.

The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests Act (SARFAESI Act), 2002 was amended in 2016. The amendment added new definitions to SARFAESI, widened the scope of debts and secured creditors, and bestowed new powers upon RBI.

Observe that all these measures are in addition to laws like the Indian Penal Code, The Prevention of Corruption Act, and so on.

Reaction to more recent PNB story
More recently, an alleged scam has come to the surface in Punjab National Bank (PNB). The PNB story has further convinced the public authorities to strengthen the audit process in banks. Subsequently, the Fugitive Economic Offenders Bill is under active consideration by GOI; it aims to stop economic offenders who leave the country to avoid the due process of law. On 1 March 2018, the Union Cabinet approved a proposal to establish a National Financial Reporting Authority (NFRA) as an independent regulator for the auditing profession.

The alleged fraud in the PNB case involves a maximum loss of Rs. 113.94 billion; this is a gross figure which does not consider recovery of assets by the Enforcement Directorate (ED) to the extent of Rs 63.93 billion. The maximum possible losses in the PNB story are not even 1% of the total bad loans. In a broader perspective, very few frauds have happened in banks in India and yet NPAs are humongous. Why?

Understanding the huge NPAs in India
Joseph Schumpeter taught us about the role of entrepreneurs, and the role of competition, and creative destruction in a capitalist economy. Many of these ideas apply even to mixed but dynamic and fast-growing economies like India; at least they do now even if they did not earlier during the heydays of economic planning, given the liberalisation and opening-up of the economy in one way or another since the early 1990s.

It is not surprising then that many stock analysts, rating agencies, and professional investors are at work making updated assessments of listed firms; this is indeed what can possibly make a financial market efficient (Grossman and Stiglitz 1980). The assessments need to be carried out on an ongoing basis because technology, businesses, economy, and economic policies keep changing all the time. How does all this matter for banks?

The work of evaluating a firm is required not just in the stock market but also in banks. There are three reasons for this. First, banks cannot always rely on the analysis of others even if they have access to such analysis, which is anyway often not the case. Second, their needs can be different from those of the usual stock analysts as they are evaluating loans and not stocks of firms; it is the latter which interests stock analysts.

Third, banks are dealing with not just listed firms but also unlisted firms; in fact, the latter can be more important clients given that listed firms may choose to issue bonds (and use external commercial borrowing) instead of taking loans from banks in India. Unlisted firms are typically not covered by the usual analysts. So, the banks need to do their own homework in assessment of economic risks and they need to go well beyond the reputations of businesses, which can change very quickly in a country like India these days. It is only then they can give loans somewhat safely.

Richard Koo, among others, has shown how, in a boom, equity prices go up, the debt of firms tends to rise, and firms tend to over-invest. If asset prices fall, then there is discomfort with what becomes a high debt-equity ratio. This then leads to a long-drawn-out process of deleveraging (Koo 2009). During this period, NPAs can rise. These can be prevented only by keeping in mind that the seeds of a downturn can lie in the boom itself (Shin 2010). This requires considerable restraint and discipline during the boom…

Let us provide a perspective at this stage. Economic risks matter. They can lead to large bank losses if the risk assessment is not carried out seriously. Economic risk assessment requires personnel who are meaningfully educated, experienced, competent, insightful and visionary. Unfortunately, these qualities are often missing among many bankers. This needs to change. Economic risks are present even if frauds are kept under check. It appears that this rather simple economic point is getting missed in policymaking that is directed at the issue of large NPAs in India. The focus of the public authorities is instead on keeping a further check primarily on frauds; this does not help very much.

Last but not the least, there is an issue of appropriate incentives for bank managers to make a proper assessment of risks, avoid NPAs, and avoid a delay in recognition of NPAs, if these do arise (Banerjee and Duflo 2014). In this context, a further tightening of the audit process can discourage and demoralise honest bank officials; this may aggravate and not resolve the problem of large NPAs…

There is a lesson in all this for India: there is a need to pay attention to financial economics and not just to issues of accountancy, procedures, audits, and legality.

By: Gurbachan Singh
(Author works at Delhi Centre of Ashoka University; Reprinted with permission from Ideas for India-www.ideasforindia.in)