Private Banks: The Irony of Creaky Vaults

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Private banks must be held accountable for them to serve the public interest

BANKS ARE IN the business of inspiration, as a grandee of finance once said, and their fundamental job is to inspire trust. In India, they inspire everything from awe to expletives, but their basic survival depends on the faith placed in them by the faceless millions who lend them money: if depositors were to suddenly withdraw their deposits in fear of losing them, they’d suffer a ‘bank run’ and fall apart. Not only must people feel assured that banks aren’t playing loose and reckless with their money, they need to trust one another not to panic on rumours of any such thing.

The rarity of bank runs is among the marvels of this age, surely, one that even the rational rigour of Game Theory can’t entirely explain. As an analogy, consider a game that illustrates the woes and wonders of social cooperation. It’s called the Stag Hunt. Imagine a group of hunters lying in wait with their bows stretched behind the bushes along a deer trail in a forest. If they all choose to cooperate, stay perfectly still and let not a leaf rustle, they’ll get to have a hearty feast. But as time wears on, everyone begins to lose patience. And then, instead of the long- awaited stag, a hare comes hopping into sight. Now what? Each archer can opt for this easy prey and save himself starvation, but the shake-up is bound to scare their original target off, leaving the rest hungry (and himself underfed). What should a rational player do? Gauge the intent of others, of course, while settling for either a ‘Nash equilibrium’ of greater gains for all in pursuit of a unified goal, or a ‘gnash standoff’ with everyone’s selfish aims implying less for each. How the scenario resolves itself, nobody can foretell.

Banks, in contrast, are lucky. They can count on most of their creditors to stay put and not flee. For the industry, this is optimal. Even those on the verge of bankruptcy are kept stable by aam customers. But here’s the thing. Is this plain and simple inertia? Or an unspoken expectation that a higher authority will ensure they don’t lose their savings? And what if the stability of banks is sub-optimal for the rest of the economy?

The Government’s domination of India’s banking sector since 1969 appears to have lulled large numbers into seeing any bank as a bank, a place where their money is safe. This is assumed to be so even if a Public Sector Bank (PSB) gets robbed every now and then; the country’s exchequer, after all, is big enough to refill its vaults. A private bank, however, is just another business—as vulnerable to failure as any other. Indeed, many have had to down their shutters: Global Trust Bank, Lord Krishna Bank and Bank of Madura, to name some. If account holders didn’t lose anything, it was only because their operations got taken over by other banks. But fail, they did. And now that a scandal has erupted at ICICI Bank, with dodgy loans extended to a business group suspected to have enriched its CEO Chanda Kochhar’s family, the popular notion that privately- owned banks operate on a superior plane of integrity has all but come apart.

If state control of money corrupts, any control of money could corrupt. Absolute control, absolutely so.

As a regulator, the RBI insists that all banks operate under a strict set of rules designed for safety. Their primary job, after all, is to funnel cash where it’s best used. For this, they borrow cheaply from the masses and lend at higher rates of interest to a few, and if they squeeze their overheads within this ‘spread’, they turn a profit for shareholders. In line with global norms, however, they must have some money of their own too: as a capital cushion, their equity base needs to have about a tenth of the value of their risk-laden loans, deemed sufficient to cover defaults. If unpaid loans exceed this cushion, it needs to be restuffed with cash from shareholders; else, it goes bust. The RBI is also supposed to define and monitor internal processes so that nobody dupes or bullies a bank for credit. At PSBs, these systems bear cracks that crooks can exploit, as the Nirav Modi scam appears to have revealed. At private banks, fraud isn’t so easy. But while they might adhere to RBI norms a whole lot better, they often prove just as bad on what’s beyond regulatory oversight: case by case lending.

Every ambitious business chases size in a country of such vast potential. For a bank, size is a measure of its ‘assets’, the sum of its loans, regardless of what they’re really worth over their lifespan

All credit entails risk, a ‘price’ for which is extracted by way of a higher rate of interest charged. The lender’s job is to assess myriad factors—say, of a startup’s prospects—and price that risk accurately. The discretion this calls for could spell genuine errors of judgement; an economy, for instance, could suffer an unforeseen slump and doom a worthy project. On the flipside, in a market where the quality of information is poor, error avoidance results in credit inefficiency: either too few loans are disbursed or good borrowers get slapped with higher rates for the sins of the shady. Even so, bad loans tend to average out over time, and so long as they remain a tiny fraction of good loans, private banks thrive.

THE MOMENT mala fide intent enters the story, however, all bets are off. Since corporate loans are so large, just a few risk reports fudged and advances approved in return for secret favours could cause losses; and if the books get smudged with red ink far too frequently, the entire enterprise could be thrown into jeopardy. This problem afflicts all kinds of banks, and if badly managed, private banks in rapid-expansion mode perhaps even more so. Every ambitious business chases size in a country of such vast potential; for a bank, size is a measure of its ‘assets’, the sum of its loans, regardless of what they’re really worth over their lifespan. Since most loans have long payback periods, it’s an industry that almost lends itself to business myopia.

The onus of adding on assets that don’t end up as non-performers is squarely on a bank’s management. In ensuring this, its CEO, the one in charge, is accountable to shareholders, who in turn are represented by a board of directors. Headed by a chairperson, this board’s role goes beyond setting business targets—and awarding the CEO a multi-crore pay package—to include such matters of governance as staying alert to any violation of principles.

Alas, that’s only on paper. In reality, shareholders are largely aloof and boards rarely vigilant. The wider the dispersal of ownership, it seems, the worse this negligence can get. If nobody owns more than a thin sliver of a bank’s shares, no ‘owner’ has much to lose by way of reputation or investment if things go awry. In a business that’s Greek to most outsiders, this can prove perilous. Unlike, say, Kotak Mahindra Bank, whose promoters have both their names affixed and also direct control, ICICI Bank is owned mostly by a scatter of institutional investors with no ‘principal’ to speak of.

So long as they’re satisfied with its stock price—a function of quarterly earnings, popular perceptions, market sentiments and other factors of dubious relevance—they are unlikely to pay close attention. Like retail investors, if they aren’t too pleased by what they see on the ticker tape, they can simply sell and move on.

Under those sort of circumstances, why would anyone bother to question the CEO of a profitable private bank?

Ah, but there’s also a chairperson, is there not? If there’s anyone with a mandate to look after a bank’s long-term interests, it’s the person who chairs board meetings. But a mandate is one thing, actual empowerment another. At some banks, the chairperson and CEO are the same. This appals gurus of corporate governance; but even at banks where they’re separate, the CEO’s aura of authority is often enough to deter challengers of his or her wisdom. In any case, it’s just the big numbers that get onto the big table. Clues of any graft within are not easy to spot.

As for ICICI Bank, it was only after its dud loan to a business partner of Kochhar’s husband came under the CBI scanner for an alleged conflict-of-interest that its board began to stir, and that too with unseemly lethargy, having defended its CEO at first (nothing was amiss, it argued). With profits being logged and bad loans still under a tenth of its total, perhaps few directors saw any cause for alarm. Investors at large appear calm too. After scaling a peak in January, ICICI Bank’s scrip slid on allegations against Kochhar in March, but then staged a recovery in early April once the board expressed confidence in her leadership.

The tacit assumption that India’s Government would save private lenders from their follies poses the same moral hazard as in America. If bad assets cause no grief, why worry about quality?

Meanwhile, as the spotlight turns on private banks overall, the RBI has begun to nudge boards to get tough with CEOs. Axis Bank’s denial of a fourth term as CEO to Shikha Sharma is a direct upshot of this. But given the flaws of the operative model, such specific interventions usually make more news than a difference.

The details of a private bank’s internal affairs may escape oversight from above, but what about peer surveillance? Every decision involves multiple points of clearance, and credit committees presumably have more than one member. Yes, say bankers privy to such things, but it’s a complex process riddled with grey zones, so the earnest have little incentive to go against higher- ups—or the general drift—if it means putting a career at stake right now for the sake of being proven right later. Plus, while the typical corporate hierarchy brooks no defiance anywhere, a culture of deference to bosses is especially acute in India. All in all, confide these bankers, it’s a mug’s game to take on a bank’s big shots. And if anyone catches a whiff of something rotten, it’s often pointless to cry foul. What’s done is done, and in a business of trust, keeping smelly stuff suitably sanitised may well be a sane option.

WHAT HAPPENS when a bank does go bankrupt? If it’s a PSB, the Centre usually bails it out. If it’s a private bank, the Government is under no obligation to save it. Since banks owe one another vast sums of money at any given point, however, the crash of a single lender could set off chaos across the entire economy, a ‘systemic risk’ that has led many to assume that no bank ‘too big to fail’ will be allowed to. A recent precedent for this was set by the US after the Great Recession of 2008-09 when the Obama administration plugged private losses with public funds. It was a one-off, but it effectively meant that banks on a roulette roll got to make big profits on high-risk bets while the going was good but had the whole country pick up the tab for their excesses once their fragile assets crumbled. Expedience overcame ethics.

Systemic risks in India are low, given the RBI’s restrictions on banks, but they do exist. Yet, the tacit assumption that India’s Government would save private lenders from their follies also poses the same moral hazard as in America. If bad assets cause no grief, why worry about quality? And if one’s survival isn’t ever at stake, why crib about corruption? Badly managed banks could simply whistle along like they always have, enriching a few at the cost of the rest.

For half a century or more, no Indian bank has vanished with people’s money, nor is one likely to now. Deposit insurance of up to Rs 1 lakh also acts as a safeguard of sorts. No depositor needs to break into a sweat. Yet, each bank scandal is a reminder of the cost the country bears for the pelf that tends to accompany power. Bad banks, let’s face it, retard no less than aid the economy. The irony is that for this to change, India might finally need to break the spell cast on them by public concern for their safety. Else, teeth agrit, even a gnash equilibrium might begin to look like a best-case scenario.