The PNB story should not mask the big picture
The PNB fraud is an exception. To understand the woes of Indian banking, look to the failure to properly assess economic risks
A scam in the Punjab National Bank (PNB) has been in the news. Policymakers have responded emphatically. The Fugitive Economic Offenders Bill is under active consideration. The National Financial Reporting Authority is being set up. The focus in all this is on checking fraud. It is interesting, however, that the PNB fraud involves a maximum possible loss of Rs11,394 crore for the PNB; this is not even 1% of the total bad loans, which are humongous in India. Ruchir Sharma reported that “... by 2014 ... in all, roughly 15% of state bank loans had gone bad” in India. Bad loans have been huge but surprising as it may sound, relatively speaking, not very many frauds have happened in the larger picture on banks in India. Yet the non-performing assets (NPAs) are humongous. Why?
Joseph Schumpeter, a great economist and finance minister of Austria, taught us about the role of competition and creative destruction in a capitalist economy. Competition and a new idea in technology or management can almost kill an existing, flourishing business in a short span of time. This applies not only to businesses in a market economy but even to those in mixed but dynamic, fast-growing and somewhat continuously liberalizing economies like India. That is why many stock analysts, rating agencies and fund managers are at work making updated assessments of listed firms.
Evaluation of firms is required not just in the stock market but in banks as well. After all, banks cannot always rely on the analysis of others even if they have access to such analysis, which is usually not the case. Moreover, the needs of information and analysis for banks can be somewhat different. Also, banks are dealing with not just listed firms but also unlisted firms, which are typically not covered by stock analysts. So, the banks need to do their own homework and go well beyond the prevailing reputations of businesses. Only then will they be able to lend somewhat safely.
Richard Koo, who coined the term “balance sheet recession”, has shown how equity prices go up in a boom, the debts of firms tend to rise, and the firms overinvest. If asset prices fall subsequently, then there is discomfort with what becomes a high debt-equity ratio. This can lead to a long drawn out process of deleveraging. Then, the NPAs can rise. These can be prevented by keeping in mind that the seeds of a downturn can lie, as Hyun Song Shin at the Bank for International Settlements emphasizes, in the boom itself. This requires considerable restraint and discipline in risk assessment in firms and banks during the boom.
It is true that if financial markets are unambiguously efficient, then asset prices are right. Then, banks can rely on the observed market capitalization of listed firms and accordingly decide on loans to them. Based on the market capitalization of listed firms, banks could make estimates of the market values of unlisted firms, and lend to these accordingly. However, financial markets are, as Nobel laureate Robert Shiller has shown, not unambiguously efficient. So, lenders need to carry out their own independent analysis to evaluate firms. Only then can they keep NPAs to the minimum.
When loans are given to firms in India, bankers often have in mind the real estate holdings of such firms. These holdings are typically evaluated considering their market prices. These prices are expected to remain stable, if not appreciate. This premise is, as research by this author has shown, questionable. Accordingly, there is a need for the banks to carry out a “fundamentals”-based valuation of the real estate assets of firms. Then risk assessment is better.
Assessment of economic risks requires banking personnel who are meaningfully educated, competent, insightful and visionary. Unfortunately, these qualities are hardly emphasized in the process of recruitment and promotions. This needs to change. Economic risks can be present even if frauds are kept in check. Unfortunately, this rather simple economic point is being missed out in policymaking.
The emphasis of policymakers even before the PNB episode was on audits, integrity, legality, judicial process, bankruptcy laws, and the like. This is evident in the work on the National Company Law Tribunal, the Banks Board Bureau, the Insolvency and Bankruptcy Code, and the amendment last year of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests Act, 2002. However, there has been hardly any attempt at improving the assessment of economic risks.
There is also, as Abhijit Banerjee and Esther Duflo at the Massachusetts Institute of Technology have explained, an issue of appropriate incentives for bank managers to make a proper assessment of risks, avoid NPAs, and avoid a delay in recognition of NPAs, if these do arise.
Finally, we can learn lessons from elsewhere. Interestingly, illegal practices, fraud, and weak audits played a very small role in the global financial crisis in 2007-08. Economists like Andrei Shleifer (Harvard University) have related the financial crisis to neglected economic risks. Somewhat similarly, in India, there is a need to pay attention to financial economics and not just to issues of accountancy, procedures, integrity, audits, and legality.
Published with permission from Ideas For India, an economics and policy portal.
Gurbachan Singh is visiting faculty at the Indian Statistical Institute (Delhi Centre) and Ashoka University.
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