'Errant Borrowers Manage To Be Off Radar'
La affaire Vijay Mallya has bought the entire credit mechanism -- from its appraisal to the recovery of bad debts in the country -- under the scanner. Credit decisions do go bad all over the world, but resolution happens to be quicker in the matured markets. In an integrated financial world, there can be no space for “islands” given the contagion effects.
Kroll is a global leader in risk-mitigation process and investigative services; in an interaction with BW Businessworld, Omer Erginsoy, its Senior Managing Director and Reshmi Khurana, Managing Director and south-Asia Head shared their views on corporate governance environment in India and how it impacts the banking sector. And compared it with Kroll's experience in other emerging markets. Here are the excerpts from an interview with BW’s Raghu Mohan
To what extent is the dud-loan mountain in India a reflection of the information gaps that banks suffer from when it comes to borrowers?
Reshmi: There is often a significant gap in information that lenders possess about a potential borrower at the time when the loan is made. The current due-diligence process of most banks focuses on regulatory checks on companies such as the Reserve Bank of India’s (RBI) defaulters list, CIBIL’s records and the index of charges filed with the Ministry of Corporate Affairs This is not sufficient because these lists are not exhaustive. Secondly, the financial information that banks use to analyse a company’s performance is provided by the borrowers themselves and is often taken at face value.
It is not verified independently. Finally, when it comes to reputation checks, most bankers check the conduct of account with existing bankers and they may speak to suppliers referred by the company. In summary, the lending decisions appear to be based mainly on the state of the industry and the individual company’s proposal. The due-diligence process doesn’t vary significantly by size of loan, type of industry, and whether the loan is part of a consortium or stand-alone.
Omer: In India corporate governance standards of promoters are still evolving and auditing and accounting standards of companies are not fully matured. Hence, banks often do not have access to good quality financial performance on companies, who can often manipulate financial information to hide their true business performance. Hence lenders in India face serious challenges when applying due-diligence and risk-mitigation practices from developed markets to India. Simply put, these practices do not work when lending in India as the recent figures of non-performing assets (NPA) of India’s banking sector show.
Is all this peculiar only to Indian banking?
Omer: Poor asset quality in the banking system is a global issue, especially since the great financial crisis of 2008. We have advised banks and other creditors in Europe, the US, Russia, and the middle-East on issues related to NPAs. In fact, in the last three years we have conducted successful investigations for several foreign banks that have exposure to Indian borrowers or Indians who have raised money in Dubai, Europe and other locations. We have successfully identified evidence of diversion of funds and we have identified assets that banks have gone after.
Reshmi: India’s NPA problem is especially large but various other countries have faced similar issues in the past – Thailand, Turkey, Italy – to name a few. They dealt with it primarily by tightening credit underwriting standards but by making examples out of a few defaulters. Bankers and regulators did whatever was necessary to bring a few select defaulters to task, including following them in foreign jurisdictions and using all the tools that corporates use in international disputes.
We did away with mandatory consortium banking in the late-90s and introduced “multiple banking” to boost competition amongst banks. Is it not ironical for bankers within a consortium to now claim the latter short-circuits credit discipline even as those within a consortium say they are blind-sided!
Omer: In an environment where access to good quality financial information is poor, it should be each bank’s responsibility to do conduct in-depth financial information on possible borrowers and not take comfort in the fact that the borrower has an exposure to another banks `that must have done the necessary due-diligence’.
Borrowers in India are known to negotiate with individual banks to keep their names off defaulters’ lists so a borrower not being on such a list does not mean that they have the ability to pay. In fact, two lenders that have an exposure to the same borrower may have divergent interests and may not be willing to share information on a borrower. We have seen that tension even between equity owners and lenders of the same distressed borrowers. In one case, we were advising an equity owner of a distressed company, whose lenders were supporting the company even though there was evidence of distress and possible fraud, because the banks did not want the dispute with the borrower to escalate.
Globally, successful banks are proactively conducting due diligence on potential borrowers and actively monitoring large and risky assets, relying on independent research and investigation to understand “what is going on behind the scenes”.
Do you think state-run banks are paying the price (when it comes to credit evaluation and monitoring) for not having “sectoral specialists”. Most are “generalists”. Is there a case for this to be revisited in these complex times wherein markets are integrated?
Omer: A case can always be made for sectoral specialists, but if those specialists are also only evaluating financial information that has been provided by the borrower itself, and that financial information is manipulated or false, then the sector focus will not be helpful. What is needed is a deeper due-diligence strategy and more active, investigative monitoring of borrowers.
Reshmi: Banks need to conduct in-depth evaluation of the financial information that the company provides and investigate what is happening on the ground, in terms of the company’s actual business practices. This will require them to discreetly and independently talk to vendors, customers, employees and competitors of the company. They need to combine all these sources of information -- financial and investigative -- to arrive at a good understanding of the borrower’s financial position.
What are the early-warning signals that banks have to look out for? Are banks sensitised about these matters in the first place anyway?
Omer: The early warning signals usually include whispers in the industry of poor business practices or malfeasance on the part of the promoter, conflicts of interest and undisclosed liabilities. These can be uncovered by talking to discreet sources, review of corporate, litigation and other records, discreet site visits and various other means.
Reshmi: From a financial perspective, bankers should look for gaps between book profits and cash profits, indications of fake sales, fake receivables, fake purchases etc. Bankers should also look for capex overload like international acquisitions that seem over-priced, or suspect revenue recognition methods. Any of these signs would constitute red flags.
Omer: Experienced bankers understand these early warning signals. Regional and local managers who first pick up these signals need to escalate them to the headquarters as soon as possible.
Just how good is the Indian regulatory environment with respective to corporate governance and fraud? Will you concede the fact that a Bankruptcy Bill still “floats around” is indication that we have some distance to travel on this front?!
Reshmi: There are various institutions and policies in place in India that, if followed in spirit, should encourage Indian companies to adopt good corporate governance practices and prevent fraud. The Companies Act (2013) is one such measure. However, the external environment in the country is such that business, politics, bureaucracy often overlaps very closely. And hence, entrepreneurs are often pushed to adopt practices which are not transparent or would not be considered good corporate governance. But the trend is in the right direction. The new generation of entrepreneurs is being rewarded for adopting good governance practices.
Omer: A good Bankruptcy Bill is absolutely essential to relieve some of the pain of the NPAs that the banks are experiencing. The Bankruptcy Bill will allow creditors, lenders and investors to take control over distressed assets. It will also allow potential buyers of the distressed assets a transparent, competitive and regulated way to assess and bid for distressed assets.
Out here, it’s fashionable for banks and promoters to claim that a “personal guarantee” has been issued as additional security cover. How competent are banks to verify these claims – that there are adequate or near liquid assets backing them? As in do they have the skill-sets to ensure there’s no falsification of documents? In any case, you will agree that’s not a bank’s core competency.
Omer: Globally, it is not uncommon for banks for lend against personal guarantees and brand value of assets. What they need is a robust way to independently value those assets and to monitor their value after the loan is made.
One gathers that Kroll is helping out banks to trace assets of Indian promoters. Just how does Kroll get this information even as banks claim that they have no idea and leave it to other central agencies like the CBI and Enforcement Directorate to sniff this out?
Omer: Asset traces are complex assignments that combine various skills – it requires the ability to conduct in-depth research of public records globally, conduct inquiries with knowledgeable sources and pull ownership records of asses around the globe. Plus it requires knowledge of regulations and laws of various jurisdictions, an ability to change course and be creative to identify assets, determine who owns them and if they are encumbered or not. It’s very much an art that we have learned through conducting complex assets searches across the globe, including in tax havens.
What is the scale of Kroll’s ambitions in India? Can you also share the key learnings it can pass onto its potential clients here? I would greatly appreciate if you can a give a specific instance of having helped put a client – though I know I am pushing my luck here!
Omer: India is a key market for us and we are very optimistic about the forensics advisory business here over the next five years. This is in line with the growth and reform expectations everyone has for India. We are also hiring senior level staff locally. And of course we have entered into an important strategic alliance with BMR Advisors, which hosts one of India’s top financial advisory practices. Overall, we are very excited about India and this shows in our recent investments.
Reshmi: Specifically, we want to double in size over the next 2 years and we want our client base to be predominantly domestic companies. Currently 60 per cent of our clients are local companies. We want this to be 80 per cent next year.
Omer: Kroll was retained by the Icelandic-government appointed Resolution Committee of Glitnir Bank to investigate whether unlawful transactions had taken place between the Bank and its shareholders and connected parties prior to its collapse. Kroll identified suspicious transactions totalling nearly $2bn and devised and implemented, with Icelandic, UK and US counsels, an international asset recovery exercise securing injunctive relief and disclosure orders in London, Reykjavik and New York.
