The Punjab National Bank (PNB) scandal has stunned the nation. The sudden admission that the bank had detected fraudulent transactions worth a staggering amount—$1.7 billion or roughly a third of the bank’s market capitalization—sent tremors through the entire Indian financial system. As we now understand, the cause of this loss was PNB’s continual rolling-over of bank guarantees (letters of undertaking, or LoUs) to a set of borrowers. These guarantees were issued without the provision of collateral, and in the absence of any real safeguards.

The worries don’t stop at PNB. Providing LoUs is a common practice, and the lack of oversight at PNB is certainly not idiosyncratic to that bank. To make matters worse, the bank reportedly never entered these transactions into its core banking system. This is also likely to be a widespread practice, raising questions about the integrity of basic operations and processes in Indian banks. Such concerns have primarily been expressed about state-owned banks, which have accumulated large amounts of non-performing assets (NPAs), though the rot may be more widespread.

The question is how best to respond to the current situation. Action has to be deliberate and thoughtful. However, it is disturbing that so far, the reflexive response by the Reserve Bank of India (RBI) seems to be to “round up the usual suspects", and to adopt a far more prescriptive stance towards private banks. This is inimical, in the long run, towards the healthier banking system that India so desperately needs.

Clearly, a fuller understanding of the extent and root causes of the PNB matter is urgently required. This will only be possible if a careful forensic investigation is undertaken, which unearths information and documents the full extent of the problems in the operations of the banking system. Any such investigation must also consider the extent to which supervisory failures by the banking regulator have contributed to the problems in the system.

The next step must then be to consider proportionate regulatory action which is the end result of painstaking investigation. This needs to be handled delicately. If dispassionate clinical diagnosis is not properly conducted before any surgery, there is considerable scope to inflict further damage on an already fragile banking system. Alas, this may already be happening.

Of particular concern are recent media reports that the RBI has written a letter to the Axis Bank board, recommending that they fire the chief executive officer, and not consider an extension to her tenure.

It is true that Axis Bank’s NPAs are high. It may be true that Axis has underperformed its peers. And it may also be true that there have been operational lapses within the organization. For such lapses, the bank was recently upbraided and sanctioned by both the RBI and the Securities and Exchange Board of India (Sebi). This is fit and proper action by the regulators—to take corrective action when there are transgressions against the rules of the game, and for such action to be informed by financial stability considerations.

That having been said, the essential point of organizations being private rather than state-owned is that they have the freedom to manage their own affairs and to maximize shareholder value in a fair and transparent fashion. The business decisions of private banks, such as the appointment or reappointment of their leadership and senior management, are a matter for the boards of these organizations rather than for the banking supervisor. To think otherwise is to fundamentally misunderstand the nature of private enterprise and the functioning of the market. The regulator must not micromanage the business decisions of private organizations—this is a misguided action inflicted on a banking system that is already heavily tilted towards nationalized banks.

The many failings of public sector organizations in India are well documented in a range of areas of the economy—Air India is but one example of a more widespread malaise. State-owned banks have accumulated huge levels of NPAs, and have been severely operationally inefficient in comparison with their better performing private counterparts. These banks have created an enormous burden on the taxpayer, culminating in the roughly $15 billion recapitalization plan for the state-owned sector recently announced by the government.

It is ill-advised for the regulator to inflict heavy-handed micromanagement on private banks in this environment as a knee-jerk response to the PNB fiasco. It is reminiscent of the old tale of the man searching under a lamp post for his lost keys—when questioned by the policeman, he reveals that he dropped them in the dimly lit park—but he prefers to conduct his ultimately fruitless search in the greater illumination available under the lamp post.

This is a difficult time for the Indian banking system. In addition to the PNB scandal, the accumulated pile of NPAs in the system is having a chilling effect on the extension of credit, and ultimately, on real economic activity. To make private banks excessively cautious about their actions in fear of regulatory interference in their day-to-day operations will only make a bad situation worse.

The bias towards prompt, as opposed to deliberate, targeted, and proportionate action may yet prove more costly than the initial problem itself. The powers that be should think carefully at this critical time about the long-run consequences of their actions for the conduct of private enterprise in the country.

Tarun Ramadorai is a professor of financial economics at the Imperial College Business School, and a senior non-resident fellow of NCAER.

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