The Punjab National Bank (PNB) scam has, at least momentarily, shocked the nation. Some headlines suggest this is the biggest banking fraud since Independence. Just a few days earlier, Bank of Baroda was in the news, but far less prominently, for very similar fraudulent activity in South Africa.
Which leads one to wonder: what is going on Indian banking?
One answer is: nothing new.
Bank frauds and bank crises have been an integral part of Indian financial history. It is not for nothing that in 1913, John Maynard Keynes after surveying the state of banking in the country, wrote in Indian Currency and Finance, “In a country so dangerous for banking as India, (it) should be conducted on the safest possible principles”. His warnings have proven prophetic.
In fact, scams in Indian banking far predate Keynes’s warnings. The year 2017 was the 150th anniversary of the failure of the Presidency Bank of Bombay (PBB). The bank had been started by the East India Company in 1840. It was stable and run prudently till the mid-1860s. This was the period when the British started relying extensively on Bombay cotton markets, as supplies from the US had declined due to the civil war. Thus, lots of cotton companies and banks began to spring up in Bombay catering to a booming demand for capital.
It is in this environment that PBB began to issue loans recklessly against shares of private companies and even on just personal security. Then, as the civil war ended, the euphoria in the Indian cotton market turned to panic. The hitherto stable bank came to a swift close. A new Bank of Bombay was established immediately in 1868—financial institutions were, of course, central to the colonial project.
If one reads into the details of the PBB scam as given in Amiya Kumar Bagchi’s history of State Bank of India, the scam is not all that different from the recent events at PNB. The main difference is that while PBB failed, hopefully neither PNB nor Bank of Baroda is headed in that direction.
Even before PBB, there were several bank failures in Calcutta. Several banking organizations mushroomed in the early 18th century, as economic activity concentrated in Calcutta. However, again, the same problems surfaced—overextended balance sheets, accounting fraud, et cetera. At the time bankers in Calcutta blamed the fact that banks had unlimited liability. Subsequently, in 1861, British authorities allowed banks to have limited liability, only for the PBB collapse to show that accounting regulations and reforms can only do so much for prudent banking.
One response to recent scams has been to point fingers at public sector banks, and suggest that privatization would create the right incentives. But Indian history is, in fact, replete with banking failures in the private and public sectors.
Fast-forward to 1905 and we see another period of euphoria in Indian banking, this time due to the Swadeshi movement. Arising out of the political foment unleashed by the partition of Bengal, the movement called for Swadeshi banks to fund Swadeshi enterprises.
The entrepreneurial response was overwhelming. By 1913, there were 451 banking companies (accoring to Bakhtiar Dadabhoy's Barons of Banking). No prizes for guessing what happened next. Following runs, prominent banks such as Indian Specie Bank and People’s Bank of India collapsed. The case of Indian Specie Bank is interesting—it had forwarded large loans to a prominent pearl merchant. When the merchant’s business collapsed, so did the bank. In December 1913 one newspaper, The Colonist, said that if the bank’s management had released balance sheets, the fraud could have been detected well in advance of the collapse. A refrain that is all too common to this day.
Most of the banking failures in the 1910s took place in Punjab. In 1913-14, out of 54 closed banks, 28 were from Punjab and 11 from Bombay. The location of failures then shifted significantly towards southern India and West Bengal. The period of 1913-66 sees nearly 1800 banks failing—25% in Kerala, 21% in West Bengal and 20% in Madras.
For a while these collapses were blamed on the lack of a central bank. Indeed, nearly 350 banks all over India closed between 1913 and 1934. In 1934 India finally got its own central bank. Sure this central bank could now stem the rot in Indian banking?
Hardly. Banks continued to fail at an alarming rate. Between 1935 and 1947, nearly 900 banks failed followed by 665 banks in the period from 1947 to nationalization in 1969. So much so, in 1950 an elderly citizen from West Bengal wrote to prime minister Jawaharlal Nehru complaining that small depositors who lost their deposits in these banks "scheduled and affiliated [sic] by the Reserve Bank" had come to the conclusion that the central bank was "only meant for the Big Pandas who ... only know how to squeeze" the poor and who were "sleeping with oil in their noses" (RBI History 1951-67).
Sentiments about banking mismanagement, then, have changed very little.
Though, to be fair, even at the time of the Reserve Bank of India's inception, there was a feeling that the RBI Act did not give the central bank enough powers to regulate the sector. It was felt that additional separate legislation was needed. This feeling was strengthened following the failure of Travancore and Quilon Bank in 1938. It was only much later, in 1949, that the Banking Regulation Act was enacted which gave RBI additional regulatory powers. The statutory liquidity ratio was introduced to build reserves for safety (which later became a tool for financial repression).
More importantly, both new and old banks were required to apply to RBI for a banking licence. Old banks which could not fulfil new conditions were asked to merge or liquidate their operations. However licensing was a double-edged sword, as RBI could not use it aggressively to clean the system. After all banks are deeply interconnected. You cannot restructure one without unsettling others down the line. For all its regulatory enthusiasm, RBI had to walk a tightrope.
As always it would take yet another major collapse to expedite regulation. And that happened when Palai Central Bank failed in August 1960. RBI hit the panic button, and large-scale closures were enforced. That failure led to the formulation of deposit insurance rules in 1962, thus enhancing stability in the banking system.
In 1951, there were 566 banks of which 474 banks were unfit to be included in RBI’s Second Schedule. In 1967, this figure was pared down to 91 banks of which just 20 banks were unfit. These statistics are staggering but is perhaps still inadequate to fully convey the challenges faced by India’s banking system till 1969.
After 1969, RBI became highly conservative and no new bank licences were issued till 1994. This was also a period when banks were pushed aggressively towards financial inclusion leading to an accumulation of bad loans starting from the 1980s. In 1994, 10 new banks were licenced (of which only a few remain now). In the early 2000s, two more banks were licenced followed by another two in 2014. Some special banks like local area banks, payments banks and small finance banks have since been licensed. In all these new beginnings, the process of consolidation has continued with the eight associate state banks being merged with State Bank of India last year.
Thus the last century and a half of Indian banking has not been without its fair share of crises and controversy. RBI has tried to respond to all these crises by tightening and adding more regulations. Regardless, but to a much smaller degree, banking failures continued in some form or the other. There were stock market scams in 1992 and 2001, but arising out of fraudulent banking. Then there was the Indian Bank scam in 1996. Within the newly licensed banks of 1990s, Global Trust Bank played a major role in the 2001 stock market scam. Then there were bad loan crises in 1980s and 1990s.
All these failures, and the more recent ones,are somewhat puzzling as banking regulations have only got even more stringent over time. Indian banks are now governed by both international Basel norms and domestic regulations. RBI has extensive powers to inspect banks and intervene in their operations.
In its response to the ongoing PNB scandal, RBI responded as follows: “The fraud in PNB is a case of operational risk arising on account of delinquent behaviour by one or more employees of the bank and failure of internal controls.”
However, the regulator cannot absolve itself of all responsibility by just saying this, given that it regularly inspects banks and is expected to address these very risks.
Following the crises arising out of the collapse of Lehman Brothers, Indian banking was lauded. Our bankers, it was said, did not follow so-called “Western fraudulent practices” and stuck to the basics. That idea is now up for question.
The current spate of events reminds this writer of a lecture given by the economist Amartya Sen. In the first Paolo Baffi Lecture on Money and Finance at the Bank of Italy in 1991, he posed the following question on financial activity: “How is it possible that an activity that is so useful has been viewed as morally dubious?”
From 1991 to 2007, the financial sector enjoyed an enviable lustre—several Nobel Prizes went to scholars who contributed to the development of financial economics. Finance became the most preferred sector for young graduates, and big investors became celebrities and role models. After 2007, and with each passing day, finance and banking is again going back to becoming morally dubious.
The Indian government and the regulator could take some comfort from the country's banking history as they have resolved fair number of scams and crises in the past. Having said this, they should also be mindful that these events are far more common than imagined.
Amol Agrawal blogs on mostlyeconomics.wordpress.com.