If Nirav Modi does not pay whatever is due from him to PNB, who will bear the liability?
If one visits a branch of a government-run bank in India today, there is a fair chance he will notice a Rs 5 pen at the counter tied with a string so that no one steals it and a security guard with an ancient-looking rifle to stop thieves. Quips aside, these look glaring because in reality, the banks suffer their largest losses without the wrong-doer even stepping into the branch. The $1.7 billion fraud allegation against the billionaire jewelry tycoon, Nirav Modi, is only the recent case in a long line of illustrious businessmen running riot. In most cases, the banks were the government-run banks, indicating the shortcomings in their operational checks and balances and risk-control mechanisms.
As of September 2017, bad assets in the Indian banking sector had already reached about $130 billion—about five percent of GDP. Of this, about 77 percent came from business clients—the big-ticket business which any reasonable bank would hardly refuse unless absolutely necessary. The Nirav Modi matter came to light when Punjab National Bank (PNB) saw he had received letters of undertaking (LoU) without the sanctioned limits, allegedly the doings of two errant employees. Mismatches between the systems of SWIFT and the bank confirmed mischief. Other banks who lent money based on LoUs issued by PNB are also at risk. As it is, given the pressures to meet business targets after deduction of statutory liquidity ratios and suchlike, bankers are often pulled towards large-ticket business loans as it works better from opex angle. While Modi maintained no wrongdoing, he had already left India. The Vijay Mallya case had recently shown how India’s archaic extradition laws would take ages to bring back any accused.
Let us assume Nirav Modi does not pay whatever is due from him to PNB. In such a situation, who would bear the liability? The bank, of course! They would get a provision-hit or eventually a write-off, which would compress their profits further at a time when government-run banks have already been underperforming private-sector banks. Eventually, shareholders would dump that bank’s stock and its valuation would turn south. Anyone left holding such a wealth-eroding stock, as most retail investors often are, would ultimately bear the loss of such misadventures.
Next is the popular scapegoat—the tax-payers. It is no wonder that tax-compliance is most countries remains sub-par, since small tax-payers may often have to bear the burden of such misadventures. India is in a better shape now, as the demonetization and GST expanded the tax-base. However, it does not reduce the burden on an individual if he does have to bear another new tax-cess, to raise the resources to recapitalize ailing banks. Letting government-run banks to fail can become a socio-political issue. Hence the better pill is to allow them to run even if it is bitter for the tax-payer.
About $110 billion of the $130 billion bad loans originates from government-run banks alone. Why? Do they have sub-par risk-controls, early-warning systems and operational and employee checks? Or does the political patronage often compel these banks to take decisions they may not have done? Whichever the case, ultimately it is the management that has to pay for their operational gaps if they could not sound out a red-alert in time. Depositors place belief on the implicit role of the state to protect their savings, and a bank’s process-gaps cannot be allowed to compromise that.
India is affecting a mega-merger plan of its government-run banks into fewer large banks. That could help average out some of the external recapitalization required, apart from inducing economies of scale. Those few mega-banks would naturally have a mandate to deliver improved outcomes than their previous avatar. That could mean bringing in cost-control and reducing flab. In other words, they may axe people or shrink future hiring to maintain staff-strength at an efficient level. If the cost of bad-loan provisions has to be borne now, it may only eat further into its staff-cost.
Does the product-mix in the market inevitably create risky situations? Indian savings are divided two-third and one-third into physical and financial savings, although it has tilted towards financial products after demonetization and RERA Act. Within the financial space, fixed income and life insurance comprise the lion’s share. In fixed income, most small-savings products do not allow investing beyond the income-tax rebate limit. Hence the lion’s share goes to bank fixed deposits. But banks can only lend a portion of this after meeting their statutory liquidity limits. This can often pressure banks to target big-ticket business as it makes better commercial sense from the perspective of cost to serve and net earnings made. The flipside is that they may resort to reducing deposit rates to cushion themselves if any misadventures cause it continued financial distress. Ultimately, it is the small-savers who bear the brunt.
If the big-ticket clients like Nirav Modi or Vijay Mallya do not make up the losses they allegedly cause, it is ultimately the common-citizens who have to make good, either directly or indirectly. It may be in their role as a retail shareholder, staff, manager, small-saver or tax-payer. But ultimately, it is they who are left holding the bag.