In September, Reserve Bank of India (RBI) had to impose restrictions on Punjab and Maharashtra Co-operative Bank (PMCB) as the latter was found to be involved in a mega loan fraud. RBI has taken steps to revamp its supervision and regulatory framework and the ongoing PMCB fiasco can provide pointers. In this post, K Srinivasa Rao discusses inadequacies that led to the crisis and the task ahead to bring more stability to the financial system.
The collapse of Punjab and Maharashtra Co-operative Bank Ltd (PMCB) this year after the Non-Banking Financial Companies (NBFCs) fiasco in 2018 is disappointing to the Indian financial sector. It exacerbated the sufferings of a large number of small and marginal bank depositors. PMCB, a multi-state cooperative bank, started operations in 1984 and gradually strengthened its position. Its business reached Rs. 200 billion by March 2019 – deposits at Rs. 116 billion, credit at Rs. 84 billion, and close to Rs. 1 billion of profits. Its ignominy began when a mega loan fraud of Rs. 43.56 billion surfaced and the Reserve Bank of India (RBI) had to impose restrictions on 24 September 2019 to stop its operations for six months.
The freeze of functioning, limiting withdrawal of deposits, appointment of administrator andsuspension of the board, calling for forensic audit, and events that followed the collapse of PMCB are standard regulatory steps that were taken to protect the interest of stakeholders. However, the collateral damage of such sudden failure of the financial entity is immense exposing the vulnerability of hapless community of small depositors.
The events that followed due to suffering of innocent depositors who fear loss of their precious financial resources kept with PMCB is a sad social consequence upon restrictions imposed by RBI on withdrawal of deposit in PMC Bank. Looking at the dire straits depositors are in, the permissible limit for withdrawal of deposits per customer that was set at Rs. 1,000 by the RBI has now been raised to Rs. 40,000 on 14 October 2019, easing the sufferings of close to 70% of its depositors.
The modus operandi of fraud
The unholy alliance between PMCB and promoters of Housing Development and Infrastructure Ltd (HDIL) had begun way back in 1986 as a depositor on PMC Bank that relationship eventually turned into a lender-borrower nexus breaching all lending norms and regulatory standards. Over the years, it precipitated into toxic loans taking the single borrower exposure to a whopping Rs. 65 billion to HDIL. Such large exposure formed 73% of total credit portfolio that works out to four times of the regulatory cap, causing concern to key stakeholders. PMCB could conceal such lapse from RBI for close to 6-7 years resulting in fraud amount mounting to Rs. 43.55 billion. In order to conceal the fraudulent exposure to HDIL, PMCB had to create 21,000 fictitious loan accounts to escape their classification into bad and doubtful loan accounts as per prudential norms. The fact that such a big fraud was concealed exposes the wrongful involvement and tacit consent of board members, top management, concurrent auditors, statutory auditors, and the line management responsible for running day-to-day operations.
Missing systemic controls
Drilling down the sequence of events leading to the fraud clearly exposes the inadequacies in: (i) internal systemic controls, reporting systems, and corrective actions that follow inspection of transactions,(ii) subverting the nexus between top management and the rogue borrower, (iii) implementing the whistleblower policy, (iv) the form of (marginalized) role of line management in credit administration, (v) loan policies that allowed concentration of credit risk in single borrower, (vi) supervision, follow-up, and regulatory surveillance of corporate governance (CG) practices, (vii) enforcing of dual regulatory framework by RBI and Registrar of Cooperative Societies that dissipated the regularity and quality of oversight, and (viii) keeping an arm’s length distance from statutory auditors and audit committee of the board. As a result, they became part of the fraud duping millions of bank customers and shaking confidence of the public.
The admission and arrests of the top management of PMCB and promoters of HDIL is not a panacea against the sufferings of millions of innocent customers of the bank. It is therefore necessary to introspect and find effective methods to insulate such weaknesses in governance to protect similar entities in future. Despite such instances, customers usually repose high degree of confidence on banks and its regulatory system despite deposit insurance restricted to mere Rs. 1,00,000 by Deposit Insurance and Credit Guarantee Corporation (DICGC). It is high time that amount of deposit insurance be increased to at least a million rupees and systemically important non-banks be also brought within its ambit.
More important is to initiate that claims should be process quickly by DICGC whenever RBI restrictions are imposed on the insured entity. Even ad-hoc relief could be given in specified emergent cases of health and maintenance. The increased insurance premium can be borne by the stakeholders to ensure safety of deposits and stability of financial system.
The quality and robustness of governance is so weak that few disgruntled elements could come together to swindle the fortunes of millions of small and marginal depositors. The woes of such large number of low-value bank users at the bottom of the pyramid impedes microeconomic activities slowly that can potentially trigger protracted slowdown and prolong revival of the economy. Hence, instances of failures of even micro-financial institutions need to be curbed building appropriate safeguards and proactive systemic controls.
Therefore serious introspection is needed to fix the missing links in monitoring CG. The regulatory reforms in financial sector have been a constant journey of transformation since the opening up of the economy and are well calibrated to align with global standards. Various expert committees have gone into bringing robustness in CG standards but still financial entities are exposed to such strategic risks.
The supervisory and regulatory systems have to be further fine-tuned to focus on capturing early signs of weaknesses in CG and functioning of subcommittees of the board. The institutionalisation of Chief Compliance officer and Chief Risk Officer could sensitise and bring cultural shift towards risk and compliance but more is needed to make them stronger. Since they continue to form part of internal top management team, they remain subordinate to the Chief Executive Officer (CEO) limiting their role. An inter-institutional exchange of experts in compliance and risk as full-time external resources reporting to the regulator may be needed rather than nominating them as a board nominee. Full-time external surveillance may be useful to fix the rot.
The continuous offsite monitoring through management information system (MIS), onsite supervision, and risk-based supervision should be able to bring about seminal improvements in due course but more intense and pointed discussions on business models and how they actually pan out in managing balance-sheet risk needs qualitative stress tests and proactive use of simulations to alert the financial entities.
RBI has rightly taken steps to revamp its supervision and regulatory apparatus and the ongoing PMCB fiasco can provide enough pointers. Better boardroom counseling on risk and surveillance through data analytics will be essential to protect the long-term interest of stakeholders of the financial system. Regulatory prescriptions may have to be supported with boardroom education on the nuances of managing sustainability and stability. Lot of brainstorming and collaborative home work is needed to strengthen dynamic regulatory shield, particularly when operational and credit risk threatens blow-up into a strategic risk mauling the financial system.