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PNB scam: What it entails for the banking system

  Given the already precarious position of the Indian banking system, the Punjab National Bank scam has come at a bad time. What other can of worms will the scam throw up, and what measures need to be taken, especially in the current scenario, still remains to be seen.  

Dr Suresh Srinivasan

The Indian banking industry has been reeling for a while, with several major issues to deal with. Stressed assets have become a recent phenomenon, and have proven to be a major challenge to the banking industry. As if that was not enough, the sector has now been hit hard by the Punjab National bank (PNB) fraud. This might well turn out to be the biggest corporate scam the country has ever faced, of course until the next ones surface!
PNB, the country’s second largest public sector bank, announced in February 2018 that it has been defrauded to the tune of more than `11,000 crore by jeweller and diamond merchant Nirav Modi and his group operating through a series of companies.

India’s banking sector: Current status
The Indian banking system is already weak and fraught with above acceptable levels of Non-performing assets, or NPAs. This is already a major problem for the economy. Stressed assets are pegged at close to `10 lakh crore. These are an aggregation of NPAs and restructured loans. In effect, what this means is that the quantum of monies that the banks can collect from such outstanding loans will fall significantly short of face value, as the quality of the borrower is quite bad and the probability of repayment is low.
This translates to more than 15% of the total loans and advances; for private banks, it is pegged at around 5%. A large part of these stressed assets are not provided for. More importantly, it is now being estimated that the quantum of stressed assets has surpassed the net worth of the banks, which is a major concern.
There have been a number of recent initiatives to resolve the NPA issue and strengthen the banking system. Strategic debt restructuring (SDR) and a Scheme for Sustainable Structuring of Stressed Assets, also called S4A, have been initiated. However, success in terms of material reduction in NPA levels is yet to be observed.

How Nirav Modi created the damage
PNB has blamed two of its employees for the scam. The bank indicated that the employees bypassed the “core banking system”, an enterprise resource planning system of the portal that aggregates company-wide information and provides the same to various branches for running their day to day operations.
By bypassing this system, the two employees are said to have created fraudulent “payment notes”, which are documents that create a liability to the bank in favour of other banks; these were not recorded in the bank’s books.
On the back of these payment notes, other banks seem to have advanced amounts to beneficiaries who are related to the alleged fraudsters Nirav Modi and Group. This means that no one — either within PNB or in the Reserve Bank of India — came to know that PNB was liable to other banks to the cumulative tune of the fraud.
It is also widely believed that Nirav Modi’s influence has not been merely with PNB, but also with other bank’s officials, who have colluded on suppressing such a fraud. Given the magnitude of the swindle and the time periods over which this seems to have been covered up, this could just be the tip of the iceberg and more instances could crop up as investigations proceed.

Privatising public sector banks
The fact that on the one hand, such scams and frauds continue to exist, even as the government pours public monies into the weak banking system on the other, is extremely discouraging. The government recently announced a `88,000 crore package to capitalise the banks in the country. The government has stated that the need for such capitalisation is the poor performance of banks driven by the lack of governance as well as the lack of an independent professional board that provides management depth and execution oversight. Interference from the government in commercial decisions is a major concern.
The biggest problem for public sector banks is the weak credit assessment and the extending of funds to borrowers who have gone beyond the capacity to repay. This is pretty much sinking good money behind bad money! Given the fact that the government and its headhunting agencies have been influencing the appointment of the banks’ senior management, the ability and independence of these managers to go after such defaulters has always been under question. And of course, we should not forget that for any commercial bank, assessing credit adequacy and the ability to collect outstanding payments are critical!

The problems are not new
The poor governance and control within the public sector banks is quite well known. The P.J. Nayak committee in 2014 flagged precisely these problems three years ago, and recommended creating an intermediary structure, where the Banks Board Bureau (BBB) can professionally run the public sector banks (PSB), taking the burden away from the government and also eliminating its interference. Although the BBB was created two years ago, it has not gone beyond headhunting for senior PSB positions.
With such levels of interference and lack of independence, it seems the PSBs will continue to underperform. The `88,000 crore package thus definitely appears to be a short term fix, as the long term solution — to strengthen the PSB management and moving the government away from managing the banks — clearly seem more difficult to execute.
In effect, the government should privatise the public sector banks and move away from managing commercial banks. The key message is that if the government does not get out of managing banks, it will need to pump more valuable public money into uncompetitive PSBs. And here, the message being received across the board from the PNB fraud is that the internal control systems of these banks are extremely weak and vulnerable, and a more accurate and realistic  assessment of NPAs and stressed assets might peg the values at substantially higher!

Way forward
Once the scam has surfaced, many voices were raised. What were the auditors doing? We should strengthen the regulations. We need to enhance the internal control systems, and so on. But the reality is that as long as human beings exist, greed cannot be destroyed. To satisfy its needs, the human mind is ingenious enough to overcome any tight regulation!
More critically, the current accountability is quite low. Privatisation could substantially enhance this when independent professional managers are given actual charge, where they are fully accountable to the shareholders. Such responsibility and vigil could minimise such problems, as in large private sector companies.
The government is currently contemplating initiatives like merging weak PSBs with strong banks; this, however, is by no means an answer. The government needs to seriously consider privatising such weak PSBs, leave the ownership and management to capable private players; actually, there seems to be no better option. However, since India is a democracy, it is extremely difficult from a political and employee union perspective to hand over public assets like banks to private players. All said and done, this needs serious considerations. 

Dr Suresh Srinivasan is a Chartered Accountant, has an MBA (Bradford UK) and a Doctorate in Strategy. He is the Director of the 2-year PGDM at Great Lakes Institute of Management, as well as a Sr. Associate Professor. He is also a management consultant.