Reforming Regulations to curtail Banking Crises

Prutha Pandharkame

The extant rating system is one of an incentive based mechanism, however, non-compliance of it does not invite sufficient adverse consequences. Thus, a formal punitive system is the need of the hour.

The Global Financial Crisis of 2008 was mainly a result of the excessive risk-taking practices of big banks, inability to have control over them, and to add to the whammy, the lenient government practices that acted as a catalyst for everything to go wrong.

From a regulatory perspective, therefore, the Global Financial Crisis can be viewed as a watershed moment to determine the vital need to have sound “corporate governance” mechanisms in place. Not only are corporate governance mechanisms a way to maintain regulatory control over the actions of the bank, but they are also a tool to maintain the trust and faith of all stakeholders in the financial system of the state – to assure confidence to the depositors to park their money in a healthy financial system. When banking crises like these occur, people lose faith in the financial system, thereby reducing the credit availability with the banks, which further adversely affects the economy of the country as a whole. Thus, sound and fool proof corporate governance tools and their effective implementation is the only way to maintain stability in the financial system of any country.

Speaking of India’s corporate governance structure and mechanisms that are mainly managed by Reserve Bank of India (RBI) – which is the chief regulatory body of the banking sector – the recent banking crises have questioned the efficiency and quality of corporate governance in India. With the Punjab National Bank (PNB) fraud, which essentially came about because two employees in the bank continued to provide Letters of Undertaking (LoU) to Nirav Modi and Mehul Choksi without taking any securities in exchange, thus leading the bank into massive liabilities. A total of ₹11,400 crore of unauthorised transactions had already taken place before the fraud was detected. The employees who were complicit in helping Nirav Modi acquire LoUs against zilch securities had updated the transaction on SWIFT. However, the details of these transactions were not updated on the Core Banking System. What is really surprising is that out of the three lines of defences that constitute corporate governance, none of them were able to detect these lapses through SWIFT as well.

While PNB is a public sector bank, the private banks are not immune to such crises. A recent major banking crisis among the private-owned banks, was that of YES bank, which was until very recently the fifth largest credit provider in India. YES bank faced its doom as a result of its excessive risk-taking practices and credit lending to the troubled borrowers such as Anil Ambani’s Reliance Group, the Dewan Housing Finance Limited (DHFL) and Infrastructure Leasing & Financial Services (IL&FS). The unravelling of India’s shadow banking sector which included IL&FS and DHFL further worsened the condition as YES bank had lent a large chunk of credit to these institutions. YES bank also came into trouble due to under-reporting of bad loans, which only came to light after the RBI introduced the Asset Quality Review (AQR) for banks, which highlighted the stark disparities and the dwindling nature of credit with YES Bank. The deteriorating nature of credit with YES bank also significantly reduced the confidence of depositors in YES Bank further leading to its collapse.

The tipping point for YES bank came when one of its directors, Mr. Uttam Prakash Aggarwal resigned from the board stating major corporate governance lapses in the bank. The unethical practice of using up of mutual funds, to fund his own company also went undetected for the longest time, thus leading to the bank’s downfall. By changing its management structure to regain the confidence of investors, the RBI has now come to the rescue of YES Bank. The RBI had also placed a 30-day moratorium on the bank and introduced a Reconstruction Plan wherein the State Bank of India would be prompted to acquire 49% stake in YES bank to regain financial stability.

However, what needs sharper attention is the delayed response by the regulator. The dwindling nature of credit was known to RBI very well from the year 2017-18 onwards…

Sluggish response?

There’s no denying the fact that the measures taken by the RBI were vital and necessary. However, what needs sharper attention is the delayed response by the regulator. The dwindling nature of credit was known to RBI very well from the year 2017-18 onwards, yet it failed to take timely action to identify these loans as bad loans and thereby take essential recourse to it. Had this been done in a timely manner, the total collapse of YES Bank could have been averted and confidence in the bank been restored.

Taking a look at all of these lapses one thing is pretty clear that there are lapses in corporate governance facilitated by the RBI which needs fixing. In the case of PNB, it was the internal controls that were compromised. The rationale behind the three lines of defensive in the structure of the banking system, is essentially to build a multilevel structure to identify corporate governance lapses. If the first line of command fails to detect it, the second will and so on. However, there is no explanation as to why these transactions went unnoticed by the other two lines of defence as well. The employees could have been complicit because they might have received kickbacks from Nirav Modi’s company. The problem of kickbacks can be reduced, if not avoided, by building a stronger compensation structure for employees solely based on the principles of ‘pay for performance’ and on the basis of the compliance levels of the bank with corporate governance norms.

While the RBI has recently introduced the ‘claw-back’ mechanism which allows the bank to take back the variable component of compensation paid to employees in a case where there has been under-reporting or mis-reporting of Non-Performing Assets (NPAs), it’s focus has been on tightening compensation structures of ‘top-executives’. While this move is justified, given that top management has the most power, the PNB crisis tells us how mis-management can seep through to the lower-levels as well. Therefore, a compensation structure that is designed as per the level of every employee’s role and responsibility in the bank should help correct this problem and also incentivise employees to avoid under-reporting. Such a compensation structure will also help avoid lapses as seen in the YES Bank where there was a constant under-reporting of the NPAs.

The RBI needs to specifically focus on the issue of keeping in check related-party transactions as it can often (and it very well did in the case of YES Bank) lead to unethical dealings by the promoter of the bank. A suggestion given by Mr. Srinivasan, who was the Chief General Manager of RBI, was that there be a separate committee solely of independent directors in order to investigate and monitor related-party transactions. This will bring in more transparency and accountability on the part of top management dealings.

Instability in one bank destabilises the entire system. Soon after the YES Bank scam, the Government of Maharashtra floated a circular advising all its departments to avoid parking money in private sector banks. A circular issued by the government is considered as a legitimate source and thus is instrumental in influencing depositing habits amongst people

Delayed action is also something that RBI needs to look into. In a speech by Mr. Vishwanathan, who was the Deputy Governor of RBI, stated that most of the bad loans are restructured in the hope that they will stabilise and this is the main cause for banks to fail in their operations. Thus, there is a need for the RBI to institutionally curtail the scope of restructuring bad loans, and to classify them as stressed assets soon upon default. To this end, the RBI has now introduced the Revised Framework for Stressed Assets under which assets are to be classified soon on default and resolution plan has to be devised within a 180-day period after which the banks have to file under Insolvency and Bankruptcy Code (IBC). This is a much-needed step in the direction to dissuade banks from under-reporting NPAs which also ensure timely action and stabilise the financial system.

Another reform that is much needed in the banking regulatory system is to introduce punitive measures to penalise banks on non-compliance. Introduction of such a penal system will act as a deterrent for banks preventing non-compliance with the corporate governance guidelines. The extant rating system is one of an incentive based mechanism, however, non-compliance of it does not invite sufficient adverse consequences. Thus, a formal punitive system is the need of the hour. As has often been echoed, the regulatory norms of RBI are sound and in consonance with international best practices, however, the problem lies in implementation of these norms. Therefore, as a country our focus should lie in how the pre-existing norms can be enforced better.

On the other hand, while it is easy for the RBI to regulate the actions of private sector banks it is equally difficult for it to regulate Public sector banks as they are only partially regulated by the RBI and most of its regulatory power lies with the central government. The duality of regulation, is therefore an issue if paid heed to will be able to ameliorate the lapses of governance especially with Public sector banks.

Prutha is currently pursuing Masters in Public Policy from the Institute of Public Policy, NLSIU, she is interested in the issues of employment, malnutrition & food policy in India. She also keeps a keen interest in addressing social issues at the intersection of Public and Private owing to her dedicated work on PPPs. When she is not thinking policy she can be found anywhere where there’s spicy food or a gang playing PubG. Prutha can be reached at

The opinions expressed in this article are those of the author(s). They do not purport to reflect the opinions or views of NLSIU, Lokniti or its members.

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