The Indian Banking Crisis
This article was written while working for T-Hub
This article aims to analyse the current Indian Banking Crisis due to non-performing assets of corporate defaulters, identify the motivation and cause for the gradual increase in the number of defaulters for NPAs in India, and suggest possible remedies and changes to alleviate the present situation.
The Indian Banking sector was thriving on a wave of optimism that had it roots in the progressive growth rates of mid 2000s, companies were borrowing aggressively for expansion, and banks were trusting, and lenient with their lending rates. Then the Lehman Brothers market crash of 2008 happened, and it severely decapitated repayment abilities in the corporate sector, and banks had to bear the brunt of losses.
In the decade following 2008, the Indian Banking sector has put itself in a precarious situation, owing to bad loans being sanctioned primarily because of lapses in due diligence. A noteworthy point is the lack of transparency in third party agencies like surveyors and financial analysts, on whom lending banks rely to a significant extent for assuring critical financial information, application status of funds, among other due diligence. These agencies are subject to malpractices and manipulation with little scrutiny and play a pivotal role in getting funds to corporations with inferior and non-liquidable collateral by falsifying their credit score.
As per data released by the Reserve Bank of India, over the course of last five financial years, Indian Banks have had to write of loans worth $38.8 billion, largely due to corporate defaulters. This, in turn, has resulted the government injecting $40.3 billion dollars in government-owned banks, to sustain them. Every rupee that goes into these banks is taken away from more important areas like agriculture, education, healthcare and defence. The rise in number of wilful defaulters, and percentage of bad loans in PSBs is alarming, and mitigations are needed to curtail the exploitation of an allegedly slow Judicial System, and corruption at high levels of bureaucracy and banking.
India’s gross NPAs or non-performing assets held by lending institutions in the country including co-operatives and small banks in addition to government and private banks, stands at 9.6% as per RBI’s 2017 Financial Stability Report. Amongst major economies of the world, India has the second highest ratio of NPAs. China, whose growth is based on borrowings, has only 1.7% NPAs according to the IMF Soundness Indicators. Only Italy, with 16.4% NPAs has more stressed assets, aside from debt-ridden countries such as Ukraine and Greece that have 30.5% and 36.3% NPAs respectively.
An alarming fact is, that of the gross NPAs of India, around 14 percent of these bad loans in PSBs are due to wilful defaulters. The total gross NPAs of 21 PSBs stood at Rs 7.33 lakh crore as on September 30, 2017. Whereas, Rs 1.01 lakh crore of loans were termed as those in wilful default in some of the largest PSBs, by corporate defaulters.
In response to a question raised on the Parliament floor, in August 2017, Finance Minister Arun Jaitley stated that gross NPAs of PSBs increased by 311.22% in the four year period from Rs.1,55,890 crores in 2013 to Rs. 6,41,057 crores 2017. An unanticipated revelation was that exponential increase in NPAs is not a phenomenon limited to PSBs, even private sector banks witnessed an increase in NPAs from 19,968 crores in 2013, o 73,842 crores in 2017.
A multitude of Public Sector Banks have been posting staggering losses in the past few quarters, due to loan frauds, wilful defaults, and write-offs. Recently, Canara Bank approached CBI for a loan fraud amounting to Rs.500 crores, while Andhra Bank posted losses of 532 crores in the 3rd quarter of FY18 due to write-offs for bad loans. In the same financial year, Corporation Bank posted a standalone loss of Rs.1240 crores, while SBI lost Rs. 2,416 crores in Q3 for FY18 with its NPAs alone rising to Rs. 2 lakh crores. Following this dismal trend are Central Bank of India with losses of Rs. 1,664 crores, UCO Bank with Rs. 1,016 crores lost, and Syndicate Bank with losses of Rs. 870 crores in Q3 of FY18.
A noteworthy point is, that these enormous losses, instead of causing issues for stakeholders, rather push the bank’s stocks further up, as investor confidence is boosted with the belief that the bank is cleaning up bad loans from its books.
As put in words by former RBI deputy governor K.C. Chakrabarty in 2013, “PSBs suffer from some structural deficiencies related to the management and governance arrangements. Instances of lax credit management (credit appraisal, credit supervision, etc.,) and poor governance and management standards which, though persisting even before the crisis, were not dealt with in time and, eventually, impacted much more emphatically than was anticipated.” Not much has been done since 2013, even though reformatory measures and laws have been in the bureaucratic pipeline, to curb poor credit management in India, which can be seen as a direct cause for the present number of wilful defaulters and the recent high profile cases of credit frauds emerging in the past few years.
There is a provision of bank guarantee known as a letter of undertaking (LOU) under which a bank can allow its customer to raise money from another Indian bank’s foreign branch in the form of a short term credit. The LOU serves the purpose of a bank guarantee. But, to receive such an LOU, the customer is supposed to pay a margin to the bank on the basis of which, a credit limit for the customer is set.
The Punjab National Bank Fraud Case relates to alleged fraudulent Letter of Undertaking worth ₹11,600 crore that took place at its branch in Brady House, Mumbai, making Punjab National Bank potentially liable for the amount. The fraudulent transactions are linked to designer and jeweler Nirav Modi of Gitanjali Group, against whom a complaint has been filed with the Central Bureau of Investigation which is currently investigating the scam apart from ED.
In this case, while issuing the LOUs, neither were Nirav Modi’s firms Diamond R Us, Solar Exports and Stellar Diamonds asked to pay a margin, nor was a Credit limit set for them to raise money. These severe departures from due diligence were the result of PNB employees being bribed by the accused party over a ten year period starting in 2008. The sidelining of existing norms to prevent such a fraud by corruption of lower level employees is what made this siphoning off of money possible.
The bank said that two of its employees at the branch were involved in the scam, when the bank’s core banking system was bypassed when the corrupt employees issued LOUs to overseas branches of other Indian banks, including Allahabad Bank, Axis Bank, and Union Bank of India, using the international financial communication system, SWIFT. Three Jewellers - Gitanjali Gems Ltd and its subsidiaries Gili and Nakshatra are also under the scanner of investigation agencies. Nirav Modi fled the nation before CBI filed a query against him, and at the time of writing this report, is still at large.
Vijay Mallya, the ex-chairman of United Spirits Ltd, and the erstwhile Kingfisher Airlines, defrauded 17 Indian banks of a net ₹9,000 crores in wilful default of loans over non-performing assets. Prominent Indian PSBs were among Kingfisher’s lenders, including the State Bank of India and IDBI Bank being among others.
In 2010, Kingfisher Airlines pledged its brand as collateral to raise money from PSBs for the airlines survival in the face of mounting losses. The valuation of this brand was done by Grant Thornton, India, and resulting reports helped Kingfisher raise 3 times its market capitalisation. This brand-value was grossly inflated, and other personal assets put in collateral by Mallya were neither liquid, nor sufficient to justify the loaned amount. With operations failing, Kingfisher closed shop in February 2012, and later declared bankruptcy, defaulting on its loans.
Allegations of misappropriation of wealth, money-laundering and tax-evasion, along with wilful default, have also been levied against Mallya, while all his Indian assets have been seized and are being auctioned to recover the bad loans given out to him. Despite the revocation of his Indian Passport and repeated summons from the Supreme Court of India, in light of ongoing investigations against him by the ED and CBI, Mallya is presently in United Kingdom, with a lengthy and often unsuccessful extradition process being pursued by the Indian authorities.
Grant Thornton is being investigated for its unscrupulously inflated valuation of the Kingfisher brand by the Serious Frauds Investigation Office (SFIO), with this being another instance of a third party playing a crucial role in PSBs being defrauded by corporate behemoths.
The inability of government and financial machinery to successfully reprimand Mallya in due time directly resulted in the formulation of the The Fugitive Economic Offenders Bill of 2017 that adds teeth to financial institutions in tackling high profile wilful defaulters. The Amendments to the Recovery of Debts due to Banks and Financial Institutions Act of 1993 (RDDBFI), 2016 was also made to assist the recovery of Kingfisher loans by auctioning Mallya stressed assets.
Jatin Mehta was a known face in the banking world in the early 2000s who took credit to purchase gold, turned it into diamond studded jewelry and sold it to clients based in Dubai. The model of this approach ensured that Mehta’s companies enjoyed high credit scores. The Winsome Diamond Group had taken a loan of Rs 6,800 crore from a consortium of banks led by the Standard Chartered Bank. Of the total loan amount, PNB has the highest exposure of Rs 1,800 crore.
Here, the lenders had issued standby letters of credit in favour of international bullion banks to supply gold to Winsome Group companies. The letter of credit was an understanding between Indian banks and the international bullion banks that if the Winsome Group failed to pay the bullion banks, the Indian lenders would pay for the gold purchase. Eventually, the Diamond Group failed to pay the bullion banks, citing significant losses in the Gulf region. In 2013, the Diamond Group defaulted on loans with the bank consortium labelling the group a Wilful Defaulter.
The faults identified on Indian Bank’s part were irregularities in due diligence done, developments in Mehta’s holding companies were not assessed by Indian Banks. This negligence on part of Indian Banks, whether wilful or not, falsified the credit score of Mehta’s companies, and resulted in the largest bank default of its time in India. Board members of PNB was reprimanded by investigation agencies for the negligence of its board in approval of loans, and the Indian Companies Act of 2013 added liability for Board of Directors of a Company in the event that fraud or corruption on the company’s behalf is proven in a court of law.
Ketan Parekh was Harshad Mehta’s protege, and he replicated his methodologies of defraudment: illegal diversion of funds from banks through forged documents to sustain equity market positions. Parekh obtained pay-orders from Ahmedabad-based Madhavpura Mercantile Cooperative Bank without providing sufficient collateral. He would discount these pay-orders with Bank of India in Mumbai and use the proceeds to ramp up shares. Parekh’s operation ultimately collapsed when his favourite stocks were hammered by traders and Mercantile Cooperative outstanding pay-orders exceeded its ability to repay Bank of India.
Sanjay Agarwal was former CEO of Lloyds Brokerage, and was responsible for the creation of the portal Home Trade in 2000. Agarwal inserted himself into the world of cooperative banks, promising to invest in gilts on their behalf and delivering lucrative trading returns. Instead, he diverted the money without delivering the securities or providing the promised returns. The charade continued till one of the cooperative banks complained about not receiving the promised securities.
Harshad Mehta exploited the manual and antiquated settlement systems in trading of government securities. With the assistance of a few pliant bank officers, Mehta conducted fraudulent trades between different banks using forged documents and diverted proceeds to prop up unattainable equities positions in multiple stocks. The scam affected large public sector banks such as the State Bank of India, foreign banks with the likes of Standard Chartered, small private banks like Bank of Karad, which is now non-existent, multiple corporate heads, and securities exchange intermediates.
A slew of reforms were pushed, in an attempt to modernise the Indian trading ecosystem, starting with the Securities Law Amendment Act of 1995, that fixed several of the gaping loopholes that Mehta abused for illegitimate gains.
Multiple parallels can be drawn by an in-depth analysis of all of these high-profile cases that grabbed the eye of mass media. Primarily, either unethical usage of existing system loopholes was undertaken by individuals with the assistance of forged documents and low-level financial institution employees who were party to the crime, or existing systems and frameworks to avoid such a financial misdemeanour were illegally evaded by bribing institution officials and using larger-than-life personas to curtail regulations. Third party agencies, such as financial surveyors, auditors and consultancy firms that PSBs rely upon, were found to be subject to manipulation and were abused in multiple of these high-profile cases, to misrepresent financial details of loan applicants, inflate assets among other coordinated frauds.
Changes at both institutional and constitutional levels were brought in, during the aftermath of these infamous cases, the laws passed are listed in the summarised legal remedies section that follows, while institutional remedies include additional layers of authentication in Securities trading, involvement of an external and theoretically neutral third party agency to achieve a credit score rating for applicant entity, increased multiplayer protection for validation of transactions among others.
Despite the sweeping reforms brought in, the banking industry finds itself in a poor state today due to severe fallacies in execution. Due diligence is not followed for a multitude of high-profile clients by banks in an attempt to increase their top-tier customer base, which has recently proven to be catastrophic for many PSBs. These misdoings are largely avoidable by making creditory regulations ironclad and strengthening the structure of our financial institutions, while also ensuring proper paperwork and systematic processing of all loans and request irrespective of the personnel involved. In most of the cases, had all existing regulations been strictly adhered too, fraudulent credit and subsequent default could have been avoided.
The FRDI Bill of 2017 aims at streamlining and strengthening the current structure and framework of deposit insurance, significantly benefitting the retail depositors. The Finance Ministry states that the bill seeks to protect customers of financial service providers in times of financial distress, while inculcating discipline among financial service providers in the event of financial crises, by limiting the use of public money to bail out distressed entities.
It’s claimed that the bill would help in maintaining financial stability in the economy by ensuring adequate preventive measures, while at the same time providing the necessary instruments for dealing with crisis events.
Amendments to The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act of 2002 (SARFAESI), 2016
The SARFAESI Act of 2002 enables banks and other financial institutions to auction residential or commercial properties of defaulters to recover loans, and reduce their non-performing assets by adopting measures of recovery or reconstruction. Upon a loan default, the bank is within legal rights to seize securities without any intervention by any court of law. A court of law needs to be approached only in the event of the property in consideration being unsecured.
Amendments to the Recovery of Debts due to Banks and Financial Institutions Act of 1993 (RDDBFI), 2016
Under the Amendment to RDDBFI Act of 1993, now Banks and asset reconstruction companies (ARCs) will be allowed to convert any part of the debt of the defaulting company into equity. Such a conversion would imply that lenders or ARCs would tend to become an equity holder rather than being a creditor of the company. The amendments also allow banks to bid for any immovable property they have put out for auction themselves, if they do not receive any bids during the auction. In such a scenario, banks will be able to adjust the debt with the amount paid for this property. This enables the bank to secure the asset in part fulfillment of the defaulted loan. Banks can then sell this property to a new bidder at a later date to clear off the debt completely.
The Insolvency and Bankruptcy Code, 2016 (IBC) is the bankruptcy law of India which seeks to consolidate the existing framework by creating a single law for insolvency and bankruptcy. The bankruptcy code is a one stop solution for resolving insolvencies which at present is a long process and does not offer an economically viable arrangement. A strong insolvency framework where the cost, time, incurred is minimised in attaining liquidation has been long overdue in India. The code will be able to protect the interests of small investors and make the process of doing business a less cumbersome process.
The Fugitive Economic Offenders Bill 2017 was first mentioned by Finance Minister Arun Jaitley in his Budget speech in 2017-18, against the backdrop of bringing back Vijay Mallya, who owes over Rs 9,000 crore in the Kingfisher Airlines fraud case. The Bill primarily empowers the government and investigating agencies to confiscate property and assets of economic offenders and defaulters who flee India. It covers a wide range of offences, including wilful loan defaults, cheating and forgery, forged or fraudulent document of electronic records, duty evasion, non-repayment of deposits and others. The Bill also proposes setting up of a “Special Court” under the Prevention of Money Laundering Act, which will declare a person a “fugitive economic offender”
Special Committees follow scams, and scams follow special committees, this has been an unfortunate cycle in Indian Financial Institutions over the past few decades. The present context is alarming because today, India’s bad loans have grown to an extent that they can hold the country’s economic progress to ransom. While the economic output has slowed down over the past few quarters due to disruptive government measures such as Demonetisation and GST, gross NPA in Indian financial institutions has spiked from 5.884% in 2015 to 9.6% in 2017.
Strong legal measures are the need of the hour, adherence to due diligence, greater scrutiny of third parties involved in the assessment of a loan application, and institutional reforms to minimize the docility of employees and cohesion to established protocols. Suitable measures taken now can ensure that the vicious wheel of Committees and Scams in the Indian Financial Market could be broken once and for all.
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The Indian Banking Crisis