Prof. V.P. Gupta, Director, Rau’s IAS Study Circle, New Delhi – Jaipur – Bengaluru
The recent news pertaining to bank fraud by Nirav Modi in Punjab National Bank and the loan default by Rotomac has shaken India’s financial sector, leading to a government and central bank crackdown on lenders’ systems and practices. Alleged fraud cases have been unearthed in other banks as well such as Oriental Bank of Commerce, Bank of Baroda, Andhra Bank etc. In light of these events, it is clear that internal control mechanisms and supervisory mechanisms in banks are not satisfactory.
This article talks about how bank rules were flouted, the supervisory failure of banks in the country, its impact on the financial sector and measures that should be adopted to improve banking sector regulation.
HOW BANK RULES WERE FLOUTED?
Bank rules were flouted by the issue of unauthorised Letters of Undertaking (LoUs) and misuse of the SWIFT framework. LoU is a bank guarantee that enables a bank’s customer to raise short term credit/buyers’ credit from another Indian bank’s foreign branch. It has to be another Indian bank because LoU is not recognised by foreign banks. This instrument was created by the Reserve Bank of India to help importers obtain credit on easy terms. However, these LoUs were misused by not recording them as contingent liabilities in bank’s books thus leading to excessive issue of LoUs and misuse of funds by transferring them to shell companies. Shell companies are companies that include multiple layers of firms which are created for the purpose of money laundering. Most shell companies do not deal in any product or render any service. These companies hold assets only on paper and not in reality.
The SWIFT (Society for Worldwide Interbank Financial Telecommunications) system, akin to a closed group using an instant messaging platform, is used by banks worldwide to securely transmit coded information and instructions on financial transactions. In its complaints, PNB alleged that the SWIFT system that was used to authorise the illicit transactions bypassed its internal systems (core banking solution). Thus misuse of SWIFT system resulted in the frauds.
These incidents reflect limited capability of banks to undertake risk management. There are various types of risks faced by banks such as credit risk and operational risk among others. Credit risk is the potential of a counterparty to fail to meet its loan obligations. It is the most significant risk in Indian scenario as the level of non-performing assets (NPAs) is very high. Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems. It is due to these risks that such events have happened.
IMPACT ON THE FINANCIAL SECTOR
Negative impact on buyers’ credit
The bank frauds have created negative implications on other sectors of banking. One of them is buyers’ credit used for trade financing. In the aftermath of such frauds, banks have become reluctant to issue guarantees through LOUs. This has resulted in increasing the interest rates on buyers’ credit and has adversely affected trade financing. It is mainly impacting small traders.
Buyers’ credit is short term credit available to an importer (buyer) from overseas lenders such as banks for goods that they are importing. It helps local importers obtain access to cheaper foreign funds that may be closer to London Interbank Offered Rate (LIBOR) as against local sources of funding which are costly. LIBOR is a benchmark rate which some of the world’s leading banks charge each other for short-term loans. It serves as the first step to calculating interest rates on various loans throughout the world. LIBOR is administered by the ICE Benchmark Administration (IBA), and is based on five currencies: US dollar (USD), Euro (EUR), pound sterling (GBP), Japanese yen (JPY), and Swiss franc (CHF). It is the world’s most widely used benchmarks for short-term interest rates. Buyers’ credit interest rates are amongst the lowest in credit products. It allows importers to manage their cash flows. This credit facility is available for 90 days, 180 days and 1 year.
The process of obtaining buyers’ credit is simple. For example: Person A whose bank is PNB, is an importer. He asks PNB to issue an LOU on his behalf so that he can obtain overseas credit to buy imports. Hence, PNB issues an LOU to another Indian bank located overseas with a guarantee to pay back on the due date. Hence the overseas bank deposits this amount in the NOSTRO account of PNB. Nostro account refers to an account that a bank holds in a foreign currency in another bank. For example, Bank X has an account with Bank Y, in Bank Y’s home currency. To Bank X, that is a Nostro account, meaning “our account on your books”.
Since, buyers’ credit is also a short term source of credit, its interest rate depends on LIBOR and it is usually 20-25 bps above LIBOR. However, in the aftermath of PNB scam, the interest rate on LOUs/buyers’ credit has increased to around 50-60 bps above LIBOR. This will negatively impact trade financing and affect forward contracts between the importers and suppliers. It has also affected the banking dealings between Indian and foreign banks.
Issue of LOUs to be discontinued
RBI has decided to discontinue the practice of providing guarantees by issuing LOUs and letters of comfort for trade credits for imports to India. The decision will be applicable to authorised dealer category-I banks. It is expected to have a negative impact on the trade financing activities of the country as importers heavily relied on LOUs as it is a cheap source of credit. LOUs for trade credit to importers can still be issued but only subject to compliance to certain provisions.
MEASURES TO IMPROVE BANKING REGULATION
1. Role of banks: Repeatedly the government and RBI have said that banks should operate autonomously with greater professionalism, transparency and accountability. For this banks should assess the credit-worthiness of borrower before sanctioning loan; applying a regular evaluation and rating system of investment opportunities; fix prudential limits; enforce maximum limit exposure to a single borrower; alertness on the part of staff at all stages of credit dispensation. Also, large exposure to a single borrower should be avoided by banks.
2. Role of government : Since the biggest fraud has occurred in PNB which is a Public Sector Bank (PSB), it puts a question on the sovereign guarantee and trust in the public banking system. Since government is the major shareholder in all public sector banks, it should take serious steps to improve risk management and corporate governance by banks. It should empower the bank’s managements, secure their independence and reduce political interference in bank’s managements.
3. Role of RBI : RBI already has a mechanism for corporate governance in banks. It undertakes disclosure and transparency measures for free flow of information, off-site surveillance mechanism to monitor the movement of assets, its impact on capital adequacy and overall efficiency. It is also implementing the Prompt Corrective Action by specifying benchmark ratios for Capital Adequacy Ratio, Non-Performing Assets and Return on Assets. Any breach on these ratios is considered as a warning. However, the occurrence of these frauds necessitates that RBI should focus on banking regulation by ensuring effective stressed asset management and ensure that the banking system recognises financial distress early and takes prompt steps to resolve it. RBI has also mandated banks to implement prescribed measures to strengthen SWIFT operating environment.
4. Constitution of Y.H. Malegam Committee : Further, looking at the rising frauds in banking system, RBI has decided to constitute an expert committee under the chairmanship of Y.H. Malegam to look into the matters of asset classification by banks and frauds and their prevention.
5. Is privatisation the answer to banking sector problems? Not really. This is because the problem lies in regulation and not ownership. Poorly regulated private banks are more prone to scams. Also, private sector banks may exploit banking rules to earn higher profits. For example: global financial crisis of 2008. Hence, the need of the hour is strengthening the regulation of banks.
6. Use of blockchain technology : Use of blockchain technology which maintains a chronologically ordered record of all actions and files (“blocks”) linked together (“chain”) in a distributed and decentralised database can help bring efficiency and transparency in banking transactions. It is based on an electronic decentralised ledger that gives all the participating entities, including banks, the ability to access a single source of information. It also enables them to track documentation and authenticate ownership of assets digitally, as an unalterable ledger in real time. This technology allows easy tracking and verification of entries.