A Punjab National Bank branch in Kolkata. Photo: Reuters

The Indian public might be baffled by the sudden spike in news articles on the rise in non-performing assets (NPAs) in the banking system, especially in the Public Sector Undertaking (PSU) banks, that is, those owned by the federal government.

Notwithstanding the heavy provisioning (about 2.2 trillion rupees in the 2017-18 financial year), gross NPAs stand at 8.4 trillion rupees (US$129 billion), which is 10.2% of total loans. It is presumed the NPA level will peak by September at 11.2%. Does that mean the health of the banks suddenly deteriorated, or that borrowers ran away overnight with huge sums?

This uncomfortable feeling is because of the recent revelations of loans issued by Punjab National Bank (PNB) to firms connected to Nirav Modi and Mehul Choksi as well as the defaults by Kingfisher Airlines.

Do we need to be despondent? Fortunately, the picture is not all that gloomy.

For some years Indian banks knew that a sizable portion of their financial assets were not performing, but they were reluctant to recognize it. The past sins of glossing over bad accounts and the current stricter asset quality review regime of the Reserve Bank of India (RBI) is leaving a black hole in current profitability. The silver lining, however, is that operating-profit pre-provisioning has been improving.

Only about 14% of the NPAs (1.1 trillion out of 8.4 trillion rupees) are willful defaults. That means 86% of NPAs could have been avoided. The reasons could be many, such as global factors, or being on the wrong side of the economic cycle, which are not factors fully controlled by the banks. But they still could have been anticipated.

However, there are reasons that can be directly attributed to the banks, such as poor credit appraisal, slack monitoring, herd mentality and excess lending leading to overcapacity.

Recent regulatory actions by the RBI and legislative action by the government in the form of an Insolvency and Bankruptcy Code (IBC) along with the institutional framework of the National Company Law Tribunal are commendable, path-breaking and far-reaching reforms. The change of ownership of stressed assets will revive productive capacity of the idling assets. Balance-sheet cleanup coupled with additional capital infusion will contribute to a revival of the capital lending cycle.

Unfortunately, high-decibel television debates to assign the political responsibility for the Nirav Modi saga are undercutting the sincere efforts and the recent successes in NPA resolution.

But an NPA resolution, however efficient it may be, is a reactionary response. It consumes enormous time and resources. NPAs have a huge opportunity cost.

Fundamental issues

Accumulated experience, hindsight knowledge and thorough analyses of high-value NPAs tells us that fundamental issues such as corporate governance, professional independence at various levels, and effective structural and operational measures are capable of reducing and preventing recurrence of NPAs.

Unlike conventional companies, banking firms run their business on the deposits of moneys taken from the public, not on their own funds. Stated differently, banks run on liability and not on their own capital.

The capital fund is merely a safety cushion. With small capital, the bank management gets to deal with disproportionately large sums of money taken as deposits. This fiduciary responsibility is one of the main reasons the Banking Regulation Act of 1949 held the managing director, directors, auditors and managers of a bank as public servants.

In a landmark judgment in February 2016 on an appeal filed by the Central Bureau of Investigation, the Supreme Court of India held the chief managing director and executive director of erstwhile private-sector bank Global Trust Bank (GTB) as public servants and allowed their prosecution under the Prevention of Corruption Act of 1988. This was not to scare away the bankers. It was only to remind the fiduciary responsibility and to urge banks to strengthen their internal vigilance.

The owner-management-regulator relationship is very crucial for the health of a bank. It should not leave any scope for conflict of interest. Overlooking obvious signs of NPAs, and disguising a bad account as good, are some of the unethical practices owing to owner-management conflicts of interest.

The normal corollary is fudging of balance sheets to project a rosy picture. The same outcome emerges when top managers are keen to project their tenure as a success story.

This nexus was deep and brazen in GTB. When the bank was forced to bring in additional capital to meet the minimum capital requirement because of accumulated NPAs, its management sanctioned a huge loan to certain infamous persons and then returned the same in the next entry as additional capital against allotment of shares on preferential basis.

The efficiency of an internal audit and accounting system that reconciles every transaction is an area begging urgent attention. It is accepted that the letters of understanding issued by the Brady Street Branch of PNB in Mumbai were off the system. But the fee income booked on those LoUs must have been substantial, and how was it accounted and tallied?

Lack of centralized data

Consortium lending for high-ticket loans, which is based on a common appraisal and documentation, is a theoretical construct. In practice it has contributed to many high-value NPAs. Instead of risk reduction, it dilutes the accountability of individual banks. This arrangement has degenerated into cursory loan appraisal and slack monitoring of utilization of funds.

To what extent individual boards assume accountability in this bandwagon of consortium lending is another conundrum. Often a subsidiary of the lead banker is the merchant banker for project appraisal and loan syndication in many failed consortium lending arrangements. There is a serious conflict of interest there.

There is no apex repository of data on loans in multiple banking arrangements, capable of raising a red flag when combined exposure crosses a threshold. The experience has been that only after an account with one lender is reported as fraud do similar skeletons tumble out of the closets of other banks.

Bad credit appraisal, the main reason for NPAs in PSU banks, needs not be a reflection of poor competency of officers inasmuch as it is a result of organizational culture. In fact, in many big-ticket NPAs, credit appraisals are tailor-made, often on the oral instructions from the top management. Excessive reliance on third-party inputs for appraisals are also contributing factors.

Customer due diligence (CDD) has to be a dynamic process, like a periodic comprehensive health checkup. In practice, it has declined into a formality of documentary compliance rather than a periodic business due diligence. CDD information on the suppliers and buyers of the borrower is weak. Often the frauds emanate from there.

The last resort to deal with willful default is criminal action. Not all defaults are necessarily fraud. A trust-based contractual obligation is suddenly viewed as a fraud. The common man would be surprised to know that the Indian Penal Code (IPC) does not have a definition for fraud.

Ingredients of fraud as defined under the Indian Contract Act and of the criminal offense of cheating as defined under the IPC are similar, thus giving a legal foothold to investigating agencies. The legal hurdles to investigation are many. The biggest stumbling block in international criminal assets recovery is that what may be a crime in the eyes of India’s legal system may not be viewed as a crime in foreign jurisdictions.

Thus the responsibility of preventing NPA has to rest squarely on the bank management. Independent and competent boards representing the interests of all stakeholders, and above all the interests of the institution of the bank, have to be adequately empowered. When the management fails, the regulator has to be swift and unsparing.

S Jaganathan is an officer of the Indian Police Service. He has extensive experience covering financial crimes. Views expressed in the article are strictly his own.