Amid crisis in banking, fresh risk for the RBI

The banks, especially nationalised ones, in India have been in a perpetual state of crisis.

In any economy, the banking system is the steel frame that holds it all together. Banks can go bust when depositors withdraw money in panic, or when the companies or people to whom they give loans are unable to return them. The system is in crisis when the bad loans equal or exceed the capital of the banks. It is saved only when governments bail out the banks by putting in more money to “recapitsalise” them. The banks, especially nationalised ones, in India have been in a perpetual state of crisis. The bankers on instructions (a phone call) from powerful politicians extend loans to dodgy promoters. The rot starts with top appointments that are made in deals in which both top managers and their political bosses share the cut. The practice has been going on for so long that, it became part of business lore, until RBI Guv Raghuram Rajan clamped down, The crucial factors are the percentage of loans that are “non-performing”, the infusion of public money needed to save the banks, the pressure that can be put on promoters to return the money, and the effect of all this on the economy. The June 2016 Financial Stability Report (FSR) brought out by the RBI quantifies the crisis.

This was because the gross non-performing advances (GNPAs) of banks “sharply increased to 7.6 per cent of gross advances from 5.1 per cent between September 2015 and March 2016.” Besides this, the banking sector’s GNPAs showed a sharp increase year-on-year of 80 per cent despite the low growth of credit. The growth of bad loans was not evenly distributed. It is the large borrowers who do not pay back. The ratio of bad loans of large borrowers increased sharply from 7.0 per cent to 10.6 per cent during September 2015 to March 2016. Moreover, “there was a sharp increase in the share of GNPAs of top 100 large borrowers from 3.4 per cent in September 2015 to 22.3 per cent in March 2016.” The crisis in the banking system is thus largely a result of the big borrowers’ inability or unwillingness to pay. One recalls the ever-flamboyant Vijay Mallya, who did not settle his dues to the banks and took refuge in the UK.

The debt owed by some of the biggest companies in the power, transport and steel sectors made for compelling reading in a report “The House of Debt” by merchant banker Credit Suisse. The report mentioned 10 top debtors. The total debt of these 10 groups was Rs 7.32 lakh crore (or trillion). The debt of these groups has risen seven times over the past eight years and some of these groups are carrying an interest burden that exceeds their earnings before interest and taxes. Not all these loans are bad, and many of these business groups are selling part of their assets to reduce their debt. Still, around Rs 4 trillion will be needed by the government if it is to recapitalise the banks. The pumping of money into banks comes from the government’s budget expenditure.

Bank NPA crisis: Here’s what is crucially missing

RBI Governor Raghuram Rajan will be remembered for his relentless pursuit of India’s monetary policy reforms, controlling inflation and advocating a stable policy framework. His precise diagnosis and direction for “deep surgery” for the chronic NPA problems of the banking sector, especially in public sector banks, is also noteworthy. He minced no words when he said that routine “band-aid” would not clean up the balance-sheet mess and put them back on a healthy trajectory.

RBI has been issuing master circulars from time to time, encompassing entire aspects of ensuring true and fair financial statements of banks. RBI has insisted that the new restructured loans, where the borrower has renegotiated the terms of repayment, must be classified as non-performing assets (NPA) from April 1, 2015, with provisioning of 15% of the outstanding instead of 5% for restructured loans, so that banks can take early recovery action or sell NPAs to asset restructuring companies (a loan turns into an NPA when interest repayments remain due on the 91st day).

Financial audit of banks are done by statutory central auditors (SCAs) and statutory branch auditors (SBAs). On the basis of prescribed eligibility criteria determined by RBI, the CAG prepares graded panel for empanelment and selection of eligible SCAs and the The Institute of Chartered Accountants of India (ICAI) prepares a panel for eligible SBAs in PSBs and send the panels for RBI’s scrutiny before finalisation of the lists. RBI has prescribed the number of SCAs and SCBs to be appointed to audit large, medium and small PSBs, and for audit of their branches.

Also Read: Banking crisis: Why promoters must be removed quickly

The government had delegated selection and appointment of SCAs and SCBs to individual PSBs from 2014-15 from the eligible list of firms, giving enough freedom to choose the auditors of their liking. Banks are free to select statutory auditors from the list with the approval of the Audit Committee of Board (ACB). The selection of audit firms as SCAs and SBAs is subject to RBI approval. The independence of auditors/audit firms is ensured by appointments of SCAs for a continuous period of three years, subject to satisfying the eligibility norms by the firms each year; PSBs cannot remove audit firms during the above period without the prior approval of RBI.

The option to consider whether concurrent audit should be done by bank’s own staff or external auditors is left to the discretion of individual banks. A critical issue is that auditors should be experienced, well-trained and, most importantly, adhere to applicable accounting and auditing standards, mandatory guidelines and the ethical code of conduct. Auditors must be able to function independently with professional autonomy and judgement. Adequate facilities and the requisite records must be made available to auditors with initial and periodical familiarisation of the process. Relevant internal guidelines or circulars or important references including the circulars issued by RBI and/or Sebi and other regulating bodies must be made available to the concurrent auditors.

Remuneration of auditors may be fixed by banks following the broad guidelines framed by the ACB, taking into account coverage of areas, quality of work expected, number of people required for the job, number of hours to be spent on the job, etc. Banks may devise a proper reporting system and periodicity of various check-list items as per risk assessment. Serious irregularities pointed out by the audit should be straight away reported to the controlling offices or head offices for immediate action. The findings of the concurrent audit must be placed before the ACB. An annual appraisal or report of the audit system should also be placed before the ACB.

Whenever fraudulent transactions are detected, they should immediately be reported to the inspection and audit department, and the chief vigilance officer and controlling officers. Follow-up action on the concurrent audit reports must be done promptly by the controlling office and inspection and audit department. When RBI has been insisting on true and fair financial statements by banks through various notifications, master circulars, guidelines and directions time and again, why has the banking sector, especially PSBs, been pursuing window dressing so consistently for years till the position reached the current imbroglio? Statutory auditors finally certify the accounts true and fair. Whenever any falsification of accounts on the part of the borrowers is observed by the banks or financial institutions, the auditors are responsible to bring it to the notice of the management. Auditors must have to follow auditing standards, applicable accounting standards, rules and the professional code of ethics. Being the regulator of chartered accountants, ICAI is duty bound to fix accountability of auditors if they are found lacking in professionalism and ethics.

There should be disciplinary action by ICAI. In fact, ICAI, RBI, the Department of Banking Supervision and Indian Banks’ Association are mandated to circulate the names of guilty chartered accountant firms. RBI is required to share such information with other financial sector regulators, ministry of corporate affairs and CAG. The lenders can obtain a specific certification from the borrowers’ auditors regarding diversion/siphoning of funds by the borrower. The rules also specify that banks and financial institutions may ensure incorporation of appropriate covenants in the loan agreements to facilitate such certification by auditors. RBI stipulates that lenders may engage their own auditors for such specific certification purpose without relying on certification given by borrowers’ auditors for ensuring proper end-use of funds and preventing diversion/siphoning of funds by the borrowers. Bank must invariably exercise basic minimum own diligence in the matter.

Master directions issued by RBI in January 2016 consolidate all regulatory matters under various Acts and are put on the RBI website. Proper medicine is prescribed for chronic NPA infection, but what is missing is strict implementation. Creating more rules, regulators and watchdogs may lead to overlaps, confusion and would prove to be counterproductive. If prompt administration of extant rules is taken care of and due diligence is exercised by regulators, bank management, auditors, audit committee and the board of directors, the NPA crisis can be resolved.