Banking regulatory powers are not ownership-neutral in India. This prevents the Reserve Bank of India from fully exercising its powers to crack down on corporate governance issues at state-owned banks, leading to frauds such as the one at Punjab National Bank recently.
This legislative reality has in effect led to a deep fissure in the landscape of banking regulatory terrain: a system of dual regulation by the finance ministry in addition to RBI. Such fissures or faultlines are bound to lead to tremors such as the most recent fraudUrijit Patel, RBI Governor
The nearly Rs 12,700-crore fraud at state-owned Punjab National Bank saw firms linked to billionaire jeweller Nirav Modi obtain fraudulent letters of undertaking to obtain credit from overseas banks. The fraudulent credit guarantees were issued by officials at a PNB branch.
Patel urged the government to strengthen the Banking Regulation Act, 1949 to give the regulator enough teeth to regulate PSU banks.
The exemptions for PSU banks under this Act prevents the RBI from responding “relatively quickly against banking frauds or irregularities” and taking effective action, he said. Section 51 of the amended Act does not allow RBI to remove the chairman, directors and management of PSU banks. It also does not allow the regulator to move ahead either with liquidation of PSU banks or to order forced mergers of state-owned banks.
Besides, PSU banks are also regulated by the government under the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970; the Bank Nationalisation Act, 1980; and the State Bank of India Act, 1955.
Patel added that from RBI’s standpoint, legislative changes to the BR Act that would make their regulatory powers fully “ownership-neutral” is a minimum requirement. “It might also be the most readily feasible of these options,” he added.
‘Regulators Can’t Prevent All Frauds’
While it is easy to point fingers at the regulator for any fraud that happens, it is not feasible for the central bank to be “in every nook and corner of banking activity to rule out frauds,” Patel said.
If a regulator could achieve such perfect outcomes, it would effectively imply that the regulator can do anything that banks can do, and by implication, can simply perform the entire banking intermediation activity itself.Urijit Patel
Instead, mechanisms to deter frauds and irregularities need to be put in place so that the incidence is low and the magnitude contained, Patel said.
He said that in the specific case at hand – the PNB fraud – RBI had identified the exact source of operational hazard based on its cyber risk considerations. It had issued precise instructions through three circulars in 2016 for enabling banks to eliminate the hazard, but the bank failed to implement them. “It turns out ex post the bank had simply not done so.”
Clearly, the internal processes at the bank failed in allowing the operational hazard to remain in place in spite of clear instructions to close it.Urijit Patel
The temptation to engage in fraud is always there at the employee level irrespective of whether the bank is private or public. The real difference is in whether banks have preventive measures or enough incentives in place to deter employees from undertaking fraudulent activities, Patel said.
He noted three “potentially powerful mechanisms” that could induce discipline against fraud. Criminal investigation of fraud and penalties can serve as an effective deterrent, he said. The other two are market and regulatory discipline, he added.
Watch this discussion with KC Chakrabarty, former deputy governor of RBI, and R Gopalan, former economic affairs secretary.
(The article was first published on Bloomberg Quint.)
(At The Quint, we question everything. Play an active role in shaping our journalism by becoming a member today.)