How a few rules can get banks to behave better

Healthy business practices and avoiding recklessness can keep our banking sector robust and relevant

The government recently approved setting up of an independent regulator—the National Financial Reporting Authority (NFRA)—which will have sweeping powers to act against erring auditors. It did so in the wake of the recent fraud detected at the Punjab National Bank. NFRA will regulate the auditors who keep an eye on the actions of bank employees who, in turn, are the custodians of your bank deposits. NFRA will be one more addition to the pantheon of regulators for banking. However, while this may help earlier detection of fraud-based cases, there are other areas to be considered to prevent future crises in banks. 

The solution lies in understanding how other industries prevent fraud. For example, airlines that were flying Airbus A320neos using a certain make of engine were asked to ground their planes. This happened without a single tragedy occurring (thankfully). The mere rise in the probability of a mishap occurring caused the regulator of airlines to issue the diktat. Most industries show such proactive and appropriate responses, but somehow not the banking industry.  

The fact is that banks can manufacture money. Yes, while we all can say it is our money, it is, in fact, a promissory note of a public limited company, a bank. Sovereign money or currency is barely 13% of the total. Even the government borrows from banks.  

The role of banks is to allocate capital efficiently. They borrow from depositors and lend to borrowers. If, in aggregate, they do a good job of it, the economy does well. If not, then the economy suffers. There is a method to measure the performance of all banks in aggregate: by measuring inflation in the economy. If they do not allocate capital efficiently, inflation—which is a result of a poor supply response to demand—is high. 

When banks take deposits and give it to companies that are unable to return it in time or pay timely interest on it, banks become incapable of paying depositors. They have only one way out of such a mess—to manufacture more money (some call it “ever-greening"). When more money is manufactured without the attendant economic output, the value of such money is bound to fall or for inflation will rise. 

A rupee today is worth only 65 paise of the rupee in 2011. In a sense, that is the net asset value (NAV) of a rupee and the performance metric of all banks put together. 

The way to make this situation better is surprisingly simple. But before I propose the solution, let me digress a bit into the recent suggestions to privatize public sector banks. While privatizing banks may have benefits, how could it have prevented the poor state of affairs? Private sector banks are not exactly paragons of prudence and governance. The answer lies not necessarily in the ownership structure of banks but rather in framing rules that recognize the truth and make it mandatory to act upon. 

The first part of the solution is: immediate recognition and action. One has to stop saying a non-performing asset (NPA) is not an NPA when in fact it is. The day the interest or principal payment is missed, the same day the whole amount has to be provided for. Critics would say this would raise the cost of capital for businesses. Yes, it would for poorly conceived business proposals. Immediate unambiguous recognition will not allow anything “to be swept under the carpet".  

The second part of the solution would be to incorporate a fail-safe mechanism. This could be to restrict deposits as a percentage of the total liabilities of a bank. Banks will be forced to raise money from capital markets, which will ensure market discipline. After all, funding borrowers using only deposits that are based on an implicit government guarantee cannot ensure prudence. 

The third part of the solution is to remove incentives to borrow recklessly. The Reserve Bank of India (RBI) governor was right in pointing out that there are many layers of tax on capital. That, however, is one part of the story as it is true only for equity capital. Debt capital, on the other hand, is subsidized by taxpayers, as interest payments are tax deductible. This makes companies seek debt capital with inadequate equity capital causing more failures of business projects.  

Immediate diagnosis and treatment, maintaining healthy business practices and avoiding recklessness can keep our banking sector robust and relevant. This will allow them to provide capital to the most deserving while simultaneously safeguarding the depositor’s hard-earned money.

Huzaifa Husain is head-equities, PineBridge Investments, India