BW Communities

‘Banks .... Need To be strong intermediaries of economic policy

Timmy Kandhari Sep 23, 2020

We hear of them all the time, we visit them, transact with them and through them. They are a part of our lives for centuries and generations. They are an essential part of the economic chain and contribute massively to the health to the economic system of the country and of the world. Yet they have been sometimes been the cause of misappropriation of public funds, systemic fraud and have been the reason for major disruption in the public financial system. They have been feted and maligned but they continue to remain the public face of monetary policy across the world and in our country. As a institution, they are essential. However its the practice of activities around the principle of the institution also known as banking practices which needs to be understood better and could differ from the ideal. As a layman therefore it is good to understand in layman’s terms what the ‘Bank’ does and what ‘Banking’ practices are to better appreciate why this institution is essential to the economic system.

A Bank in simple terms is an institution which accepts deposits and lends out money. It helps an individual, corporate, social enterprise or society at large to harbour their excess cash and in turn provides the cash to people, businesses and even governments which need it earning a little return in the form of interest or charges which allow them to take care of their costs. They are not built as not for profit organisations but as for profit organisations who function as businesses. Their basic function therefore is safekeeping, borrow and lend money and host of other ancillary activities within the securities ambit where they act as issuers, guarantors or distributors. The one characteristic that defines them is the trust people repose in them. Therefore even though a for profit enterprise their organisation, shareholding and actions need to be beyond reproach and such that engenders trust. Since they deal with public funds, the level of regulatory oversight is huge. Besides their organisation prudence they typically report to the country’s Central Bank which look after them and also use them to regulate monetary policies of the country. Yet besides the importance and the regulatory oversight, large scams or frauds have been committed across the world where Banks have been involved. With technology being the increasingly used medium in most of the processes, while the transaction volumes as well as ease of use has increased, the risk too has increased.

While safeguarding policies are crucial, its the credit function and the credit policy which is where the maximum risk rests. It’s also at the core of the banking function. The bank is always vulnerable to an asset liability mismatch, as its endeavour is to lend at a higher rate than it borrows but if it loses money either because of a wrong credit call or fraud or collection inefficiency then it directly hits at the credibility of its practices and the banking system. In India we have seen such occurrence many times in our short history. One of the key reasons for a less than robust economic growth in recent times has been presence of NPA’s or Non Productive Assets a term one has heard often in recent times. NPA’s are nothing but loans having turned risky, non paying and possibly difficult to recover. If such proportion continues to increase then there could be a run on the bank as it may not be able to meet its liabilities as it could run short of own funds and not be able to raise new deposits from the market. This in turn then reduces the trust,decreases economic activity and could threaten the country’s economic system. In India we have seen this and despite knowledge we have not been able to bring it down to reasonable levels, as stopping it altogether is not a feasible objective to have. While the reasons could be many lets look at the few areas within the credit function where we could have done better.

Credit function is inherently risky and one cannot avoid some losses due to functioning of the markets or for reasons which are process related or even frauds. However this is an essential service of the banks and the endeavour has to be to minimise this risk if one cannot eliminate it altogether. In India the risk is higher due to the following factors-

Structure of the industry- In India today, the key area to be looked at is the ownership and control of the commercial banks. There are public sector banks which are completely or with majority held by the Government, the Private sector banks which are individual or institution owned but not the government,the cooperative banks which have cooperative ownership and other special purpose banks. The ownership and control structure while it may been perceived beneficial in the past, presents a significant barrier to good banking practices. The Public sector banks being government controlled or managed are subject to being utilised as weapons of social policy with indiscriminate loans to groups or projects not having sound financial credentials. Also like in other government organisations, political pressure and inefficient procedures are always omnipresent which becomes a hotbed of questionable practices. Private banks though without the baggage of social policy and inefficient procedures suffer due to conflict of interest specially where private corporates are involved. The Cooperative banks are the entities which suffer from both social objectives of the community, conflicts of interest and insufficient safeguards as well as supervision. Banks even if the structure cannot change immediately need to ensure that their credit functions are free from bias in form of political pressure, able to decide on merits of the case and remain free from conflict of interest situations. Clearly a tough ask where the Government is a major owner and a regulator.
Credit Processes - The most important part of the bank policy is with regard to its credit process. Every bank has it as its core and having been involved in bank audits, its the go to policy to know how the bank functions. The inherent process, the separation of duties, the KYC protocol, the business case assumptions as well as the security required is all a part of it and its well drafted for most banks. Do we follow it? Probably yes on paper but there are subjective interpretations which do happen, which is normal part of business. Successful banking institutions keep the interpretation to the minimum and whenever they do interpret its followed by vigorous supervision. One of the practices the Indian banks usually follow is asset based lending model where your security is more than what you lend always. A safe practice but what happens when your security loses value due to changed market conditions or encashment of personal guarantee being difficult or change of Government policy which is quite possibly the case in India. Where India in general has suffered is the inability of the banks to pay less attention to the expert knowledge of the industry they lend to and their ability to forecast possible future events both in the industry and the company they lend to. In other words inability to forecast risks. Not saying that NPA’s will go away once we do that but they can be reduced.
Regulation and Supervision- Banks are the most regulated entities across the world and rightly so. They deal with public money and are safe keepers to the public at large. Hence Public Trust is their most important badge and not their profit earning ability. They need to keep the public money entrusted to them safe and also be the conduit for earning income for their constituents as they earn a little for themselves. While banking policy and practices are designed to be safe, they need to be reinforced with effective supervision and regulation. Regular contact with your lenders and their industry are a must have besides audits of one’s own systems which are done through the aegis of Reserve Bank of India (RBI) who is also the regulator. Whenever supervision has faltered either by subjective interpretation of policy, political pressure or maybe by fraudulent intent, scams have taken place and NPA’s have arisen. Regulation and supervision is critical and perhaps the most important element in the Bank’s credit function. We unfortunately have not covered ourselves with glory in this area.

History has not been very kind to India where banking industry is concerned in recent times. The fault lines are clearly there for all to see as some of the biggest frauds have been a part of this industry. Repairing the banks in not only recapitalising them but to bring policy changes in its practices and much better supervision. Politics has its advantages in getting the common man its rightful due but doing it through the manipulation of bank policy is bad for country’s economic standing. Bank’s are key to our economic outreach and we need to make them stronger and trustworthy!