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Home / Opinion / Views /  RBI penalties have begun to shift from puny to punitive

The staid world of monetary penalties imposed by the Reserve Bank of India (RBI) rarely makes headlines. But in May 2021, RBI imposed a fine of 10 crore on a private bank and this made news for being the highest by India’s bank regulator. However it is a relatively small amount by global standards, even if adjusted for the exchange rate and size of the banking industry. Globally, regulatory fines imposed on banks and other financial institutions started shooting up from 2010. In 2020, as per a Fenegro report, financial institutions were hit by fines and penalties of $10.4 billion in total.

In India, the trend of steeper fines may have started only in 2018. Until 2017 , violations such as lapses of regulatory reporting with respect to laws such as the Foreign Exchange Management Act attracted penalties of less than 1 lakh. In 2019, some banks paid fines of around 2 crore. January 2020 saw RBI revamp its circular on monetary penalties, providing a clearer framework for the sizing of fines. Unsurprisingly, 2020 saw fines further inching up to 3-4 crore , which became even more common in 2021, with 10 crore now a new peak. If the current trend continues, Indian banking must brace itself for potentially higher fine amounts for regulatory breaches.

A tragedy of the commons: Most banks do not believe that their usual business actions could cause breaches of customer privacy, facilitate money laundering, trigger a systemic failure or result in a crisis with profound social costs. Consensus operating norms have evolved to nurture a system-wide belief that such risks are remote. Such norms extend to disclosure levels and risk reporting, internally and externally. A single player has limited motivation to invest in processes and controls for reducing the likelihood of such risks. Further, a bank would argue that its individual contribution to any systemic risk is very low, and that ‘no one else is doing it’. This leads to what’s called a ‘tragedy of the commons’, where society suffers but no specific bank can be pinpointed as the reason. (Economic Rationale For Financial Regulation, Llewellyn, 1999).

However, systemic risk continues to build up for reasons that include under-reporting of bad debts, weak control over credit disbursement (even if norm-compliant), frequent breaches of customer data, and the like. In the absence of well thought-out, objective and justifiable regulatory activism, the banking system ends up setting the stage for a financial crisis.

Size of fines as a nudge for banks: The fines should be comparable to the amount of investment that banks need to make in terms of technology and resources to meaningfully reduce risks. Alternately, fines may be commensurate with profits that banks make through actions or behaviour which may prove detrimental to customers or society at large. Small fines achieve little. They may be taken as just another cost of doing business by banks. If too low, a bank may calculate that the net present value of light fines makes paying them cheaper than investing in systems. However, if fines are well sized, banks would be nudged to invest in reducing risks and preventing behaviour that could have hazardous outcomes. Banks would then find that it’s better to invest in addressing such lapses than paying fines.

The reputational risk of fines is overblown: Small fines of token amounts tend to ‘shame’ the entity and are expected to push its management to act in defence of its reputation, which is often measured by its stock market performance in the period right after a penalty is announced. In May, two large Indian private banks were asked to pay fines ranging from 3 crore to 10 crore. But in the 7-day period after that announcement, their stocks showed positive returns of 0.5% to 1.0%. While a more detailed study is required on the impact of fines on Indian banks, this finding is in line with global research on the topic. The effect of fines on the reputation of banks is nuanced. A study suggests that the fine’s magnitude is directly linked to reputation risk (European Banking Authority, 2014). Others suggest that the reason for the fine is important. If it is for misconduct with customers (say, the mis-selling of products) or investors (accounting issues), the reputational impact is harder. However, if the misconduct is against third parties (tax evasion or an environmental violation), the offender’s stock price may not be significantly impacted (Regulatory Sanctions and Reputational Damage in Financial markets; Armour, et al, 2016). Heavy fines tend to persuade even short-term shareholders to look beyond earnings at the bank’s controls.

Good Start: RBI’s circular of January 2020 was a good start. Yet, awareness and systemic capabilities need to be created. An enhanced ability to quantify social costs and impacts will help. RBI could lend the sizing of fines higher objectivity and transparency. The central bank could consider providing more granular clarifications on fine-sizing factors, such as a bank’s intent behind a lapse, and also offer detailed parameters for qualitative assessments.

Bank customers, shareholders and other stakeholders should take heart from these developments. Well-sized fines, which can act as deterrents against undesirable banking practices, may finally have arrived in India.

One wonders: What if the banking sector’s regulator had started imposing fines of 10-50 crore way back in 2013-14, a period marked by inadequacies in credit control and asset-related disclosures? Perhaps the sector’s bad debt levels of 10 trillion could have been avoided. Better late than never.

Deep Mukherjee is a quantitative risk management professional & visiting faculty at Indian Institute of Management Calcutta

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