L’affaire HDFC Bank

 

On March 18, Atanu Chakraborty, the part-time non-executive Chairman and Independent director of HDFC Bank, resigned, stating that “certain happenings and practices within the bank, that I have observed over the last two years, are not in congruence with my personal values and ethics”. Chakraborty, a 1985-batch IAS officer who last served as Secretary in the Department of Economic Affairs, Union Finance Ministry (2019-20), and was appointed as part-time Chairman of HDFC Bank in May 2021, with his tenure lasting until May 4, 2027, did not cite any ‘personal reasons’ for his exit. 

The HDFC Bank’s top management, including fellow board members, claimed that Chakraborty did not divulge any specific reasons for his resignation even after they were sought. This left the bank’s management, his board colleagues and even the investors and media at large baffled. However, the bank issued a statement stating that there are no governance or financial problems at the bank. 

On March 19, the Reserve Bank of India (RBI), regulator of the banking system in the country, issued a strong and reassuring statement about the bank: “Based on our periodical assessment, there are no material concerns on record as regards its conduct or governance. The bank remains well-capitalised, and the financial position of the bank remains satisfactory with sufficient liquidity”. Simultaneously, the RBI authorised a temporary leadership arrangement—Keki Mistry, Non-Executive (non-independent) Director, was appointed as interim part-time chairman for three months to ensure stability.

But the resignation of a bank’s chairman is never a routine matter, for it signals deeper organisational issues. Unsurprisingly, Chakraborty’s abrupt resignation with an enigmatic comment had already sent shock waves through the market. The result is: HDFC Bank’s market capitalisation plunged by 152,689 cr over three trading sessions between March 19-23. Over the said 12% loss in market cap, it also inflicted significant reputational damage. 

That aside, HDFC Bank is recognised as a domestic systemically important bank, implying that any governance or risk-related issues with the bank could have a wider impact on the entire financial system. Secondly, the bank carries significant weight in the Nifty 50 as well as the Nifty Bank index. Intriguingly, Chakraborty, in a televised interview, later clarified that there was no wrongdoing and there were only ideological differences. A sense of a lack of transparency in the bank’s management became apparent, raising red flags about the corporate governance. 

There are also reports indicating excessive involvement of the former chairman in operational decisions. Such involvement of the board at the proposal formulation stage is more likely to vitiate their independent judgment. It also causes management tensions. There are also reports indicating that three senior executives were asked to leave the bank over the mis-selling concerns of A1 bonds of Credit Suisse in Dubai.  

All this cumulatively created a great amount of uncertainty about the bank—it indeed stirred a hornet’s nest. The bank was on conference calls with analysts, investors and the media, wherein its newly appointed interim Chairman, stressing that the bank operates with strong governance standards, said: “I would not have taken on this responsibility at the age of 71 if it did not align with my principles and the level of integrity that I would expect from the bank”. In a similar vein, its managing director, Sashidhar Jagdishan, tried to portray a bright picture of the bank. But by then, damage has already been done, for resigning from a high-profile non-executive role on ethical grounds is a rare phenomenon in the Indian corporate world. 

The Companies Act requires the directors of any company to act in good faith to promote the objects of the company and in the best interests of all stakeholders. Thus, the former Chairman of HDFC Bank has a fiduciary responsibility to stakeholders to inform the board of his concerns about happenings in the bank and seek appropriate action to set things right. At the same time, the Board has the responsibility to take cognisance of such reports and resolve them. But from what reports indicate, it appears that Chakraborty had not put before the board any such ethical erosion happening in the bank. Nor are there any indications that the board ignored it. Against this backdrop, Chakraborty’s one-line resignation letter raised eyebrows, particularly in the context of a bank, since banks are known to be highly vulnerable to even rumours about their functioning, which can trigger rapid, catastrophic bank runs, as had happened with Silicon Valley Bank in March 2023, leading to its collapse in no time.  

This whole episode underscores the need for independent directors appointed to bank boards to be attuned to market sensitivities and to observe communication discipline to protect banks from such catastrophes. They indeed have a fiduciary obligation towards all the stakeholders.

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US Tariffs: The Unintended Consequences

 

'Protectionism’, once considered an extreme idea in United States politics, has now become a guiding principle for the new regime. As promised, on April 2, Trump announced sweeping “reciprocal tariffs” against all trading partners. These included a basic tariff of 10% across the board, which came into effect on April 5, while individual reciprocal tariffs were set to begin on April 9. 

This move sparked a tariff war between the US and China. In retaliation, China imposed a 34% tariff on US imports. It also imposed sanctions on select US companies, along with a ban on certain rare earth exports critical to the US electronics industry. Angered by this, the US in turn imposed an additional 50% tariff on Chinese imports, raising the tariffs on Chinese goods to an unprecedented 125%. 

The apologists of Trump tariffs argue that there is logic behind imposing such abnormally high tariffs. One key argument is that the significant uncertainty created by these high tariffs may cause panic, leading to a “risk-off” scenario, in which investors may exit stocks and flock to US Treasuries. This automatically lowers yields on the Treasuries. This could make it easier for the US to refinance its debt of $9.2 tn maturing in 2025, potentially with lower interest payments. Furthermore, if the Fed cuts interest rates, the path to roll-over of debt becomes smoother, and hence the call for a rate cut from Fed Chair Jerome Powell.

Secondly, tariffs are considered powerful revenue generators—expected to bring in $600 bn to $700 bn annually. The next argument is that tariffs could be used as strategic tools by the US to force negotiations with allies like Europe, Japan, Australia, South Korea and Taiwan—countries that depend on the US for their security, in such a way that the outcome benefits US trade and investment. Their final argument in favor of tariffs is their potential to reshore manufacturing activities to the US, though no estimates are available about the likely investment, the number of jobs that such a move would create, and how long it would take for them to materialize.

While these arguments remain largely aspirational, the severe volley of tariffs unleashed by Trump on “Liberation Day” set global markets on fire: Stocks plummeted, portfolios evaporated, and panic swept across global trading floors. The US stock market suffered the worst of it: the S&P 500 was down by 3.3%, the Dow Jones Industrial Average lost 1160 points, down by 2.7%, and the Nasdaq composite was down by 4.5%.

After the meltdown in financial markets, Trump announced a 90-day pause on reciprocal tariffs on all countries except China, which faces a tariff of 125%. However, the baseline tariff of 10% and the tariff of 25% on aluminum and steel imports and the automobile sector remain as it is. With this policy reversal, stock markets rebounded on April 9: The S&P 500 jumped by 9.5%—its largest one-day gain in over a decade, and the tech-heavy Nasdaq Composite also soared. Markets in Europe and Asia followed suit, with the pan-continental STOXX 600 rising 5.3%. Major indices in London, Paris, and Frankfurt surged by 4.1% to 5.6%.

Intriguingly, during this fall and rise of the US and global stock markets, a puzzling phenomenon is noticed. Modern financial history tells that there is a reliable relationship between US equities, Treasury yields, and the value of the dollar. Traditionally, during market panics, investors are known to flock to US Treasuries and the dollar as safe havens. As a result, Treasury yields are driven down, causing the dollar to appreciate.

Surprisingly, after the tariff announcement, US bond yields went up—the 10-year yield jumped from 3.99% to 4.5% within just a week, despite turbulence in the equity market. At the same time, the ICE US dollar index, which measures the greenback against a basket of foreign currencies, fell as low as 97.92, the lowest since March 2022. All this could mean that investors are using less of the US Treasury as a “risk-free” asset.

Analysts suggest that this shift in global investor behavior is a fallout of aggressive tariffs, which have raised concerns about long-term US economic stability. Neel Kashkari, Minneapolis Fed President, observed that the dollar’s decline, alongside the tariffs, offers “credible evidence of investor preferences shifting”.

This divergence from the historical relationship between US equities, Treasury yields, and the dollar points to investors’ reduced confidence in the dollar’s reserve currency status; reassessment of Treasuries as “risk-free” assets given fiscal/policy risks; and potential long-term higher funding costs for the US government. The cycle of large deficits necessitating more borrowing, which in turn drives up interest rates and burdens debt servicing, could have significant economic implications. And that, in itself, is the irony!

 

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Transition from LIBOR to … …

The London Interbank Offered Rate (LIBOR) was originally considered as a very systematic and well-managed international benchmark interest rate for a large volume and variety of financial products and contracts including derivative products, syndicated corporate loans, sovereign bonds, etc.

LIBOR was earlier calculated by adopting a polling method. At a specified time quotations were gathered by the Intercontinental Exchange (ICE) from about 16 to 18 major banks that have a significant role in the London market for their charge rates if they were to lend money in five major currencies—US dollar, Euro, British pound, Japanese yen, and Swiss franc—for seven different maturities: overnight/spot next, one week, and one, two, three, six and 12 months. The extreme rates were removed and the remaining rates were averaged to determine a median borrowing rate. This was announced each morning as LIBOR, at around 11.55 am by the ICE Benchmark Administration.

This procedure went on well for quite some time. But with the eruption of the LIBOR scandal of 2012 that sent shockwaves across the global financial markets, the flaw in arriving at the LIBOR rate came to light. It was revealed that major bank players—Citi Bank, HSBC, Barclays Bank, Deutsch Bank, and JP Morgan— colluded amongst themselves for garnering benefit by quoting mutually decided rates to the market officials. Once this manipulation came to light, market-participants lost their confidence in this widely used benchmark rate.

This string of LIBOR-related scandals made market players feel like going for a new alternative benchmark rate. But replacing LIBOR turned out to be not that easy, for almost all of the then-existing loans were benchmarked against LIBOR. However, in 2017, the US Federal Reserve introduced the Secured Overnight Financing Rate (SOFR) as an alternative to LIBOR. In the same year, the LIBOR regulator announced that LIBOR would be discontinued by December 2021. As a sequel to this, the Reserve Bank of India issued instructions to banks and other RBI-regulated entities to stop entering into new contracts that use LIBOR as a reference rate (as soon as possible) and latest by December 31, 2021.

This had, of course, created a lot of commotion in the market. For, this entailed two challenges: one, it called for banks to ensure that existing contracts in which LIBOR was the reference rate and the contracts fall due after the date on which LIBOR ceases to be effective contain Fall-back Clauses; and two, in the event of its absence banks to ensure that a new benchmark rate is identified, financial risks thereof are mapped along with identification of legal risks involved post the adoption of the new benchmark. Coming to the new contracts, banks have by and large adopted SOFR—a benchmark interest rate for dollar-denominated derivatives and loans arrived at based on observable repo rates—as a replacement for LIBOR.

Simultaneously, the use of LIBOR-based Mumbai Interbank Forward Offer Rate (MIFOR) was restricted to certain specific purposes such as transactions executed to support risk-management activities such as hedging, market-making in support of client activities, etc. They were also to assess the risk emanating out of LIBOR-linked contracts and place a framework in force to handle risks arising from such exposures. Banks are also required to create the necessary infrastructure to offer financial products linked to ARR. All this is a real challenge, which the banks are navigating through with the advisories offered by RBI.

Against this backdrop, and expecting that banks have developed the necessary wherewithal to manage the complete transition away from LIBOR, RBI issued a circular on May 12 asking banks and other financial institutions “to ensure that no new transaction undertaken by them or their customers rely on or are priced using the US $ LIBOR or the Mumbai Interbank Forward Outright Rate (MIFOR)” from July 1, 2023. They were also advised “to take all necessary steps to ensure insertion of fallbacks in all remaining legacy financial contracts that reference US$ LIBOR (including transactions that reference MIFOR)”.  

This complete move to alternative benchmark rates from LIBOR will take a while for banks to settle on the alternatives. Although SOFR is less likely to be manipulated since the treasury repo market is one of the most liquid markets, it is “backward-looking”. Secondly, there is an argument against Term SOFR that it lags in a rising rate environment. Of course, it is also true that the reverse happens in a decreasing rate environment and thus some argue that over a period of a few years, this difference might average out. Nevertheless, navigating through these nuances is a big challenge for Indian banks.

 

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SVB Hit by the Age-Old Problem— ‘Bank Run’

The stunning shutdown of the Silicon Valley Bank, the 16^th largest bank in the US, at the behest of the US regulators on 10^th instant continues to send shivers through financial markets.  

SVB, the Santa Clara, California-based bank that catered to the credit needs of technology companies, particularly start-ups, is the biggest bank to fail since the 2008 financial crisis. But first things first: let us examine why SVB failed. As we all know, banks accept deposits from the public with a promise to pay them back on demand and in the meanwhile lend the so-acquired funds to businesses to earn interest so that they could service their obligations to depositors in terms of interest on deposits accepted, meet their own establishment expenses, earn profit to distribute dividends to its owners, etc.

Banks thus manage their short-term liabilities (deposits) with the earnings from mostly long-term assets (loans). They thus stand exposed to the risk of the mismatch between their liabilities and assets. However, they successfully manage this risk so long as their deposit customers repose faith in them and continue to retain their savings with banks.

But once they lose faith in the ability of the bank to discharge its liabilities (pay back the deposits), depositors may rush to the bank demanding payment of their deposits. And, if all the depositors at once run to the bank asking for payment of their deposits, Bank will be forced to pull down its shutters for, no bank, as said earlier, keeps all its deposits as idle money in its till, but deploys them as loans/investments elsewhere.

In short, that was what exactly happened with SVB: reports reveal that its depositors in an old-fashioned ‘bank run’, of course, befitting to its client base in an online ride, withdrew $42 billion—almost one-fifth of its total deposits—in a single day, leaving the bank with $ 1 billion in negative cash balance.

Before proceeding further, let us look at the balance sheet of the bank to better understand the trigger for the depositors losing their faith in the bank. As of the end of December 2022, 56% of its loans stood in the names of Venture Capitalists and Private Equity companies. From the end of 2019 to March 2022, SVB’s deposits almost tripled to $198 billion, which is a record growth that outstripped the industry’s average of 37 percent. In normal times this could have been cheered up by any bank but for SVB it became a millstone around its neck.  

For, come Covid-19, SVB found it difficult to deploy these funds as the demand for loans from tech companies waned. It was thus forced to deploy these funds as investments in the market. Initially, it deployed them as short-term investments. But owing to poor returns on these Available for Sale (AFS) investments and to mitigate the resulting mark-to-market losses, SVB, like any other bank in the normal course behaved, switched over to held-to- maturity (HTM) investments.

But with Fed rising interest rates, even these investments proved to be of no use. For, the value of these investments fell drastically, because they paid lower interest compared to the bonds would pay if issued in today’s higher interest rate market. Thus, the unrealized losses from these investments were reported to have been something like $ 16 billion by September 2022. So, with an equity base of $ 11 billion, SVB technically turned insolvent.

In the meanwhile, its deposit customers started withdrawing their deposits from the bank to deploy them elsewhere for capitalizing on the higher returns offered by the market. To meet this demand bank was to sell its investments and in the process booked huge losses. To fill this hole, it attempted to raise additional capital from the market but could not find investors.

Its plans to issue fresh capital and the failure thereof made customers to sense that all is not well with the bank. Once this concern emerged, it took no time for the panic to spread among its rich depositors through social media platforms. Many Venture capitalists appeared to have spread alarm through Twitter among the start-ups advising them to pull their money out immediately. This is followed by founders and CEOs sharing tweets about the alarming position at the bank among themselves/others.

The net result is: everybody, of course, did not run to the bank, instead quickly picked up their laptops, pulled up the web page, logged in, and within a few tries moved every cent in their account to a different bank within no time.  As a professor rightly commented, it was not a ‘bank run’ but true to the digital era, it was a ‘bank sprint’.

Thus, by 12 p.m. of the 10^th instant, the regulators have stepped in and placed SVB in receivership under the Federal Deposit Insurance Corporation. Thus came the end of a fancy bank that exclusively operated around the start-up and venture capital space spreading uncertainty across banks. 

With Fed continuing with its inflation control measures and the raising interest rates worsening banks’ mark-to-market losses, the fear of financial contagion is threatening the global banking system. So, what next? We don’t know!

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Perpetual Bonds: What a Catastrophe!

As the Yes Bank crisis unfolded, which involved write-off of the perpetual bonds worth about 8,700 cr issued by the bank earlier, jittery investors suddenly realized that Additional Tier 1 (AT1) bonds are worse than even equity!

Such an assumption stemmed from the fact that equity of Yes Bank was maintained intact, while it was only the perpetual bonds that were permitted to be written off by the regulator, Reserve Bank of India (RBI). The investor’s money under fixed deposits of the bank too was maintained intact except for a temporary restriction on withdrawal. The Yes Bank saga has no doubt suddenly turned the focus on AT1 bonds. 

Before getting into the details of the current storm around peps, first things first. It was the failure of a bunch of global banks during the global economic crisis of 2008 that led regulators to formulate the Basel III norms to improve the quality and quantity of regulatory capital of banks.

Taking a more prudent stance, RBI directed Indian banks to maintain a minimum total capital ratio of 11.5%—including a capital conservation buffer of 2.5%—of total risk weighted assets split into Tier1 capital of 8% consisting of equity, reserves, etc., and Tier 2 capital of 3.5% consisting of supplementary reserves and hybrid instruments. It is to meet these Basel III norms that banks have come up with the novel idea of raising capital by issuing “unsecured subordinated perpetual non-convertible bonds”. And Indian banks too, taking a liking to the concept, said to have issued perpetual bonds to the tune of about 84,000 cr to meet their capital requirements under AT1 of the new regulations. 

As the name indicates, these bonds do not carry any maturity date. They, of course, offer to pay a coupon or interest to buyers of the bonds at a fixed date perpetually. As they are of perpetual nature, issuers usually offer higher coupon rate than the prevailing rates on banks’ fixed deposits, etc.

However, these bonds come embedded with varied risks. The first and foremost is the default risk: banks can write-off the AT1 bonds and also stop paying interest if they run short of capital or face bankruptcy. Some issuers may attach a call option to these bonds, which means they can buyback the bonds at the end of the specified period of say, 5/10 years after the issue date. But issuers seldom exercise this option, for interest rates may not fall so drastically to make the bonds expensive for them. 

Investors can, of course, exit from these bonds by trading in secondary market. But in a scenario of rising inflation/interest rates, they are to be sold at a discount to the face value. Thus, investors in these bonds suffer from inflation/interest rate risk. 

It is the Yes Bank crisis—write-off of its AT1 bonds and its impact on the debt mutual funds—that awakened the SEBI to the complexity of these bonds, particularly their valuation. Once alerted by it, as a first step to protect retail investors in debt mutual funds, SEBI imposed a limit of 10% for debt funds to invest in AT1 bonds. Secondly, noticing a lacuna in the valuation of these bonds by MFs, SEBI ordered them to value these bonds as if they were 100-year bonds as against their current practice of valuing them, assuming that issuers would exercise their call option of 5/10 years to reflect their true risk. 

This has obviously stirred up a hornet’s nest: MFs have raised a hue and cry, for the net asset values of several debt schemes are likely to get eroded drastically if this method of valuation is adopted now. Finally, being frantically lobbied by debt MFs that were about to lose heavily, the Finance Ministry requested SEBI to review the instructions given for valuation of AT1 bonds. 

Accordingly, SEBI has now proposed to reset valuation in three phases: till March 2022, residual maturity of AT1 bonds may be valued at 10 years maturity from the date of issue; during the first half of 2022-23 residual maturity will be reset to 20 years; in the second half of 2022-23 it will be extended to 30 years and finally, from April 2023, bonds will be valued at 100 years maturity. 

This rearrangement will, of course, give the much-needed succour to debt MFs, but this whole fiasco posits a battery of questions: How is it that the MFs did not realize this simple valuation challenge and its impact on their NAV while investing in these bonds? How the rating agencies failed to take cognizance of the embedded risks while rating these issues? And, how the regulator, SEBI failed to anticipate the complexities of Peps? 

Ironically, SEBI has now imposed a fine of Rs 25 crore on Yes Bank for mis-selling additional Tier -1 (AT-1) bonds to individual investors—“devious scheme to dump the At-1 bonds on their hapless customers”—after the Yes Bank has written off the entire amount collected through these bonds from their books, to be more precise, after the investors lost their investment in full once for all.  It has also penalised three bank executives, who are held accountable for misleading retail investors.  It is said that the marketing team of Yes Bank misrepresented the bonds as a “super fixed deposit” and sold them as being “as safe as an FD”. This awakening of our financial market regulators after the damage had been inflicted has almost become a routine. So, the only option the investors have is: enquire, probe, read the prospects thoroughly well before committing money for new kinds of investments. 

And of course, the last yet an important question is: How NPA-saddled PSBs will now shore up their Tier 1 capital?

Can Bank Mergers deliver the intended results?

Mergers or no mergers, so long as the owner directs the banks what to do and what not to do, no professionalism and efficiency that is required for their long-term sustainability can be expected in PSBs.

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As a part of the present government’s reform-agenda, Finance Minister Nirmala Sitharaman has recently announced merging of 10 PSBs into four banks to usher in efficiency in their management and also create ‘big next generation banks’ which could by virtue of their resulting national presence and global reach and with a bigger risk appetite, expand the much desired credit flow to boost growth. At the same time, the Finance Minister has also assured bank employees that there would be no retrenchment of workers owing to the proposed mergers.

These strange pronouncements pose an obvious question: Will the move enable the government to accomplish its stated objectives? An honest answer would be a ‘no’ for reasons galore. Let us now examine them one by one. Essentially, mergers involve restructuring of organizational setup which obviously involves staff reduction to realize the anticipated synergy benefits. Strangely, the government thinks otherwise. But the fact remains that so long as the government, the owner of the PSBs, continues to dictate what they can and cannot do, the past woes would continue to haunt them.

Take the case of the recent direction that the Finance Ministry gave to banks: that all banks are to put up Shamianas in 400 districts in association with the NBFCs to grant loans to retail, agriculture and SMEs, obviously to pump-prime the economy. Banks are even asked to bring in “five new borrowers for every one existing customer”. What does it mean? Catching up with these directives would simply mean banks side-stepping the scientific credit appraisal process—proper identification of the prospective borrower, assessment of his creditworthiness, careful due diligence of the proposed purpose of the loan and its ability to generate sufficient cash flows to service the debt besides leaving a fraction of profit with the borrower to incentivize his involvement in running the venture and sustaining its growth—and liberally granting loans to whoever calls at these melas.

Over it, the Finance Minister has also said that no MSME stressed loan be classified as NPA until March 31, 2020. It means that the banks should restructure these bad loans so as not to declare them as NPAs. Such ad hoc regulatory dispensation would spoil the credit culture, just as it had happened due to the waiver of farm loans by certain state governments. Here it is worth recalling one such regulatory forbearance imposed in 2008-09 that enabled banks to sweep bad loans under the carpet by repeatedly restructuring big ticket loans indiscriminately, the effect of which is still haunting the system in the form of bad loans. The present directive is all set to create such a mess once again. The only difference would be that in 2008 it was big ticket loans for corporates, whereas under the present directive it would be small loans but in large numbers, and the effect remains the same.

There is yet another lurking danger behind this whole exercise: with the falling personal incomes all around owing to poor economic growth in the country, people/businesses are likely to be tempted to borrow more from banks/loan melas to keep up their spending levels intact, irrespective of their credit absorption capacity. Should that happen, the borrowers from agriculture and MSME segments who are less resilient by virtue of their having very little to fall back in the hour of financial crisis are certain to suffer more from overleveraging.

That said, it must also be admitted that involving financial system to facilitate economic growth and poverty reduction is supported by overwhelming evidence from both cross-country and country-specific studies, but not granting of loans en masse. Secondly, the government might be thinking that pump-priming economy through banks would not disturb its fiscal math. But it should bear in mind that it is only a temporary relief, for all this is certain to fall in its lap again, once loans granted in melas turn NPAs demanding for infusion of fresh capital from it, of course, at a future date.

Besides the owner, even the regulator of banks, RBI has given recently an order which is equally disturbing: it directed all the banks to link all floating rate retail loans and loans to micro, small and medium scale enterprises to one of these four: RBI policy repo rate, Government of India three- or six-month treasury bill rate, or any other benchmark market interest rate published by the Financial Benchmarks India. Traditionally, banks price their loans based on the cost of their deposits/source of funds to keep their net interest margin stable. But the present dictate puts banks in jeopardy, for they have to price a part of their assets anchoring against an external indicator while not being permitted to do so on the liabilities.

Besides this freshly imposed burden, PSBs are already suffering from a high legacy burden of NPAs that have peaked to 15.6% of state-owned banks’ total loans. Incidentally, five of the banks in the merger list itself are already under the RBI’s Prompt Corrective Action (PCA) Plan as a large chunk of their capital has already been wiped out by bad loans and another three out of the remaining five are likely to be placed under PCA Plan soon. That being the current health of these banks, they cry for: reforms in governance for delivering the intended results.

Bank Nationalization: 50 Years On ...

Anniversaries of any momentous event inevitably entail celebrations. And if it is the golden jubilee of nationalization of 14 banks in 1969 by the Government “to promote rapid growth in agriculture, small industries and export, to encourage new entrepreneurs and to develop all backward areas”, an act that was then dubbed as “a mighty leap for the nation”, it certainly calls for more than a celebration: it prompts a deep reflection.

The first thing that strikes one’s mind when one reflects on bank nationalization is that it was an act emerging out of political considerations of a Prime Minister who, being frustrated by the growing influence of a group of leaders then popularly known as ‘syndicate’, was anxious to swipe them away to a corner and thereby gain control over the party. And no wonder if a former Governor of RBI described it as an act that happened “at the whim of a Prime Minister”.  Later, in 1980, the government nationalized another six banks.

That being the style in which banks were nationalised no wonder if people, even half a century after continue debating whether nationalization was good or bad. Of course, the honest answer is: it is both. First, let us take a look at what good it did. After nationalization, the number of bank branches has gone up phenomenally: they have gone up from 8,262 as in 1969 to 141,756. Notably, the number of rural branches has gone up from 1,832 to 50,081, a neat rise of about 13%. The share of semi-urban branches has however gone down by about 13%, while there is no significant difference in the percentage share of urban and metropolitan branches between these two periods.

As a corollary to this, aggregate deposits have gone up from Rs 4,646 cr to about Rs 125 tn, while credit has gone up from Rs 3,599 cr to Rs 96.5 tn. The total assets of Public Sector Banks (PSBs) have indeed grown at an annual rate of 4% till 1990. Thereafter, bank credit grew by three times of the GDP growth till 2015. Credit disbursal for agriculture has substantially gone up, for it became mandatory for banks to compulsorily set aside 40 % of their net credit for agriculture, micro and small enterprises, education and ‘weaker’ sections. Further, government’s poverty elevation programs too were extensively supported by PSBs.

And here ends the good part and begins its unintended consequences that are haunting PSBs even today. The first victim of nationalization is: erosion in the efficiency of bank management. In its anxiety to give representation to various sections of the society in the boards of PSBs, the government appointed people from all walks of life to the boards. As a result, boards are often found ill-equipped to monitor the functioning of banks. Over it, owing to no competition, even a negative return on capital failed to alert the managements.  Till economic reforms were launched in 1991, PSBs never acted as autonomous profit-seeking entities, and rather operated more as a part of government’s fiscal mechanism.   

Coming to the specifics, prior to nationalization, banks were engaged in trade finance. But once nationalized, they, despite their poor credit assessment skills, started financing every activity: right from establishment of an industrial setup by a new entrepreneur to a cobbler seeking self-employment, all were lent funds, all under the guise of directed lending. And the result is: accumulation of bad debts. Over it, political patronage played havoc with credit portfolio of banks. The net result is: whopping stressed assets and demand for repeated infusion of new capital to keep banks viable. And today filed up bad debts are even causing acute liquidity crisis in the system.

With the declining profitability of private corporates after 2011-12, corporates found it pretty convenient to pass on their losses to PSBs. With the result PSBs are today saddled with huge chunk of bad debts that are not only eating into their profits but also their owned capital.  Reports indicate that Rs 4 trillion plus worth of bad debts were written off by PSBs during 2014-15 to 2017-18. Although bad debts were mounting up over the years, the regulator of the banking system appears to have remained as a mute spectator.  Even the kind of frauds involving thousands of crores reported in the recent past from the system and the way even private-owned banks and shadow banks are of late defaulting, one wonders if the regulatory mechanism is robust enough to keep the system healthy and agile.

That said, even the government’s action to correct the situation, it must be admitted, is not matching the gravity of the crisis. Even the Insolvency and bankruptcy Code enacted in 2016 could not prove to be effective in recovering NPAs quickly. Even the vigilance mechanism of the government is proving to be a hurdle, for continuous surveillance is not conducive for taking bold credit decisions that are always prone to turn out as bad at a future date.  Such mechanism will only dampen the spirit of even honest officers.  

Hence the question: What now? Or, what next? Of course, there are no easy answers. Some are clamouring for denationalisation of banks hoping that private management is the all cure for the present ills of the system. But looking at the performance of some of the much talked about private financial institutes in the recent past, a rationale man is not encouraged to think privatisation as the only right answer to the current problems of the banking system. Over it, if one analyses the performance private management as a whole vis-a-vis the kind of balance sheet management of many industrial establishments in the country, it fails to emerge as the only panacea.   

Under such tiring circumstances, one way forward could be: to make PSBs fully autonomous by endowing them with professional management and making them accountable to the market system. This, of course, calls for political will. Now the question is: Does the government have gumption to stop politicians and bureaucrats from their habitual treating of PSBs as personal fiefdoms and nurture resilience and professionalism in banks that enables the owner to demand for financial accountability from their management? Simply put, government should keep itself away from their management by empowering boards to choose top management cadre and demand for performance, of course, by paying market-determined wages. Government should only be concerned about monitoring banks’ performance against the set goals. And all this simply calls for: Reforms in governance. Else, the system may tumble down pulling down the real economy along with it.

Corporate governance in Indian banks: Embedded conflicts*

Today virtually every industrialized nation is seriously engaged in defining the kind of “corporate governance” that should be put in place to manage the economic activities. Corporate governance is an umbrella term that encompasses the economic, legal and institutional effort that allows companies to diversify, grow, restructure, and exit and do everything necessary to maximize shareholder value. According to Shleifer and Vishny (1997) corporate governance deals with the ways that suppliers of finance to corporations assure themselves of getting a return on their investment. “Doing everything better” is how corporate governance is defined today. As the Nobel laureate Milton Friedman observed today corporate governance has become much more than the conduct of business in accordance with shareholders’ desires.

It became synonymous with a system of making a corporate both a powerful economic entity and an important social institution that uses its economic power to add value to society generally and to people’s lives individually. This new moral compact between the corporate, the individual and the society is essentially aimed to transform corporates as value creating institutions.

Against this backdrop, it is evident that very little attention is being paid towards corporate governance in banks though, ironically, banks arrogate to themselves the role of ensuring right kind of “corporate governance” in the businesses to whom they lent money (Jonathan R. Macey and Maureen O’Hara, 2003). In the light of these realities, this paper makes an attempt to trace; I - Corporate governance: theory and practice; II – corporate governance in banks: specific problems; III – corporate governance & embedded conflicts in India and IV –measurers to resolve conflicts and better the corporate governance.

I - Corporate governance: Theory and Practice

Corporate governance is essentially concerned with the matters arising out of separation of ownership and control and this can be traced back to the works of Adam Smith (1776) and Berle and Means (1932). Narrowly it is considered as a mechanism through which shareholders are assured that managers will act in their interests (Berle and Means, 1932).  However it is argued that managers do not always act in the best interests of shareholder (Henderson, 1986). The separation of ownership and control has given rise to an agency problem whereby the management operates the firm in its own interests but not necessarily those of shareholders (Jensen and Meckling, 1976: Fama and Jensen, 1983).

Several factors are found to be effective in reducing these principal - agency costs. The “market for managers” is one such measure which is found to penalize management teams that tried to advance their own interests at shareholder expense (Fama, 1980). Shareholders can also manage this conflict by creating incentive compatible compensation arrangements.

In this intellectual debate a question has emerged: whether corporate governance should focus exclusively on protecting the interests of equity claimants in the corporation or whether corporate governance should instead expand its focus to deal with the problems of other groups called non-shareholder constituencies. 

The existing difference between Anglo-American model of corporate governance that usually focuses on maximization of shareholder’s wealth and the Franco-German model which looks at corporates as “industrial partnerships” and thus extends its focus beyond the immediate requirements of shareholders appears to have intensified the search for a ‘best-fit’ governance.

One school of thought, looking at corporates as “a complex web of contractual relationships among the various claimants to the cash flows of the enterprise” argues that the fiduciary duties of managers and directors of companies should not confine to maximization of the firm value for shareholders alone but also extend to ensure safety and soundness of the enterprises. 

 II Corporate Governance in Banks

Commercial banks pose unique corporate governance problems for the number of parties with a stake in an institution activity complicates the governance requirements. Besides investors, there are the depositors and regulators who have a direct interest in bank performance. The regulators are concerned about the effect of corporate governance on the performance of banks since the health of the overall economy rests on their performance.

The gravity of the challenges can well be understood from the bank’s balance sheets, which reflect high leverage coupled with embedded mismatch between assets and liabilities and the very special role they play in maintaining the stability of the financial system.

Banks liabilities are mostly in the form of deposits while their assets are mostly loans that have a longer maturity. By holding illiquid assets and issuing liquid liabilities banks create liquidity for the economy (Diamond & Dybig, 1986). Banks are thus special in their liquidity production function.

Banks are quiet opaque. It is very difficult for outsiders to monitor and evaluate banks while its opacity enhances the ability of managers to shift their activities quickly and massively for the own gain.

Government regulations frequently cripple natural corporate governance mechanisms. For instance, deposit insurance reduces monitoring by insured depositors, reduces the desirability of banks to raise capital from large, uninsured creditors, and increases incentives for shifting bank assets to more risky investments. Regulatory restrictions on entry, takeovers, etc., reduce competition, which in turn reduce market pressures on mangers to maximize profits.

Government interventions in terms of restriction on ownership, pricing of services etc., also limit competitive forces in banking. Banks in emerging markets are subjected to a variety of restrictions: Minimum branching requirements (often in rural areas), directed credit guidelines, portfolio restriction or liquidity requirements, limits on interest rates and fees etc. In banking the most insidious form of intervention that lessens the potential discipline of market forces is perhaps the resistance offered to either allowing a bank to fail or to close the bank because of the government’s concern for depositors, fear of contagion, etc.

In many developing economies, government ownership of banks is a common feature (La Porta et al, 2002). With a government-owned bank the severity of the conflict between depositors and managers heavily rests on the credibility of the government (T.G. Arun and J.D. Turner). Another severe problem that government owned banks face is the conflict between themselves and the bureaucrats who control the bank. Bureaucrats may seek to advance their political careers by catering to special interest groups such as trade unions (Shleifer and Vishny, 1997, p.768).

III. Corporate governance  & embedded conflicts

About four-fifths of banking business in India is under the control of public sector banks. This phenomenon complicates corporate governance in PSBs since the effective management vests with the government while the top managements and boards of banks operate merely as functionaries.

The government as owner of majority of banks in India often found simultaneously performing multiple functions such as the “owner”, “manager”, “quasi regulator” and sometimes as the “super regulator”. In view of this even if tomorrow government dilutes its holdings below 51%, good governance practices are likely to remain at superficial level unless it redefines its very role de novo.

In order to give representation to various sections of the society in the boards of PSBs, government is appointing people from all walks of life, to the boards. At times such government nomination assumes a degree of political patronage too. The rights of private shareholders are also abridged very considerably: they cannot influence the composition of the board or the compensation package or even the selection of statutory auditors. There is no equality among the various board member of the PSBs as certain committees of the board cannot function without the government/RBI directors’ participation. (MG Bhide, A Prasad and Saibal Ghosh, 2001) Further the presence of the Reserve Bank of India nominee on the board of directors engenders conflict of interests with its regulatory function.

The Indian banking system is no exception to the menace of non-performing loans that are incidentally policy induced (Joshi, 1998). The threat posed by the unabatedly rising NPAs, partly owing to the directed lending, etc has already created liquidity problem in the Indian banking sector. Although Narasimham Committee-II recommended for its abolishment, it is more unlikely at least, in the near future as directed-lending in India relates to agriculture, SSI and priority groups ( Montek S Ahluwalia,1999).

Another stumbling block that Indian banks face is the inability to shuffle their loan portfolio based on the changing market scenario. Even during the days of downturn, banks are not in a position to bring down their exposure to industries that are passing through recession. For instance, during the last four years, steel, cement and infrastructure segments of the Indian economy are not doing well and yet there is no perceptible change/reduction in exposure levels of banking sector to these segments.  As information in financial markets is inherently asymmetric (Stiglitz and Weiss,1981) banks are expected to act as agents gathering information and allocating credit to the highest  risk- adjusted-return (Bernanke, 1983) and failure in this regard tantamount to poor corporate governance.

Similarly, the success of ALM hinges critically on the availability of trained and skilled manpower besides the availability of reliable data from branches about the assets and liabilities and the daily movement thereunder across the system. Here, the board of directors has a greater responsibility in laying down risk parameters and management systems for the bank as a whole. But, Indian banks’ boards are today mostly filled with people who are not that conversant with risk management techniques.

Corporate debt restructuring is one of the suggested methods to reduce NPAs: it essentially aims at rescheduling the debt portfolio of the borrowers and helps revive their projects. Such timely restructuring of debt calls for a high degree of imagination and innovativeness, which is sadly missing among the major Indian banks. One of the oft-quoted reasons for such “learned-helplessness” is the fear of “vigilance”.However, with the recently introduced bankruptcy law, this position is likely to be improved. Nevertheless, unless entrepreneurs become honest and fair in their managing businesses, no improvement in the problem of twin-balance sheets can be wished away.

IV.  A resolution mechanism

Board members must be well versed in the complexities of banking and its management in the dynamic globalized economy. It should be capable to bringing in better information, offering new perspectives to manage the risk-profile of a bank. They should focus on debating new strategies and policies rather than reviewing past performances. All this calls for appointment of such professionals to the board who have requisite qualifications and technical expertise on the lines suggested by the BIS.

The independent/non-executive directors should have the necessary wherewithal to raise critical questions relating to business strategy, management of bank and investor relations at the board meetings. They must provide effective checks and balances to protect stakeholders interests. In short the board members should have sufficient-enough expertise to foster effective decisions and reverse failed policies. Their aim should be to decrease the possibility of mistakes and to increase the speed with which they are corrected. (John Pound, 1995)

In order to attract quality professional to the boards, the level of remuneration payable to the directors should be increased proportionate to the quality of inputs expected from them. Besides they must also be provided with wholesome, complete and adequate information to enable them to raise meaningful critical questions and take meaningful decisions.

It is desirable to separate the office of chairman and managing director so that the chairman can focus more on strategy and vision while MD can focus on operational efficiencies. Secondly they must have sufficiently long tenure so that they could leave a mark of their leadership and business acumen on the bank’s performance.

The threat of ‘vigilance’ needs to be re-looked into, so that the executives are encouraged to take radical business decisions with agility.

The viscous problem of NPAs should be addressed through institutionalizing a sophisticated system of credit assessment and an integrated risk management mechanism, backed by a prompt and efficient legal framework. This calls for organizational restructuring, improvement in managerial efficiency, skill up gradation for proper assessment of creditworthiness and an attitudinal change towards legal action (Jalan 2001)

The banking system must be supported with a legal system which facilitates the enforcement of financial contracts promptly (M. G. Bhide, A. Prasad and Saibal Ghosh, 2001).

  

Conclusion

In Layman’s words, Corporate Governance is understood as “the distributions of rights and responsibilities among different participants in the corporation, such as, the board managers, shareholders and other stakeholders, and spells out rules and procedures for making decisions on corporate affairs”

In the wake of changes brought about by globalization, deregulation and technological advances banks are facing increased risks. Moreover unlike in other firms, banks conduct their business with funds belonging to the depositors. Linked to this is the fact that the failure of a bank not only effects its own stakeholders but may have a systemic impact on the very stability of banking architecture. Hence Corporate Governance is particularly important for banks.

The boards must therefore play a leadership role in approving the strategy and business plans of the banks, monitoring the performance of the managers and ensuring that the internal control and risk managers systems are effective. It should also ensure that the banks conduct its business with integrity and in accordance with high ethical standards.

*Written in the early 2000s, yet has relevancy

LIC to the rescue of ailing IDBI bank: A Risky Proposition

With the cabinet’s approval for conveying no-objection for reduction in government of India’s  shareholding in IDBI Bank to fall below 50 percent on 1st August, the decks are cleared for LIC to infuse Rs 13 000 cr in IDBI Bank. The interim finance minister dubbed such takeover of IDI Bank by LIC as “win-win situation for both LIC and IDBI Bank”, for  LIC will have banking network with 1916 branches of IDBI Bank to sell its policies—an act which LIC could have accomplished more effectively by a bank with even a larger network by merely paying commission—while LIC agents will help IDBI Bank to mobilise low-cost deposits.   Earlier, Insurance Regulatory and Development Authority of India has cleared the proposal of Life Insurance Corporation of India to raise its stake in the ailing state owned IDBI bank to 51%. The approval is of course accorded with caveats: One, it will inject about Rs 13 000 cr in to IDBI as equity; two, it will not get management rights; and three, it has to reduce its stake in the bank to about 15% over a period of 5-7 years. Before getting into the sanctity of LIC’s proposal to hike its stake in an ailing bank, let us first take a look at the financials of IDBI bank, for it alone can equip us to judge the investment decision of LIC fairly. As the non-performing assets of IDBI bank raised beyond a threshold, RBI has placed it under the prompt corrective action frame work in May 2017. The bank has posted a net loss of Rs 8238 cr for the financial year ending March 31, 2018. Its current gross nonperforming assets are hovering around 28%, which is the second highest ratio ever witnessed in the banking system. As a result of this growing menace, even the capital infusion of R10 600 by the government last fiscal, that too, over and above the R 2 200 cr added between fiscal 2015 and fiscal 2017 could not enable it to meet its capital requirements. As the bank’s current Tier I capital stood at 7.4 percent, which hardly meets the mandated requirement of 7.37 percent, it has to freeze its lending and branch expansion plans. Intriguingly, the bank has also reported a negative RoA for the last three consecutive years. The rating agencies (India ratings) have marked 36 % of total loan book as stressed assets. Thus, its prospects for turning into profit in the near future appears to be bleak. Obviously, the bank needs a rescue. It is against this background that the government appears to have asked the state owned LIC to bail out the bank by rising its stake in it from the current level of 10.37% to 51%. With this capital infusion, its immediate problem of capital inadequacy gets partly answered. But the big question is: will IDBI bank be able to turn around within 5 to7 years for LIC to withdraw its capital as directed by IRDA and bring its stake in it back to 15%? The answer to this question is anybody’s guess! The way the NPAs are raising in PSBs and the resulting continued erosion in the capital coupled with falling net interest margin no one is sure when this bleeding will stop. Now turning to LIC, the first thing that strikes our mind is: LIC is an independent body that is answerable to its policyholders. The capital that it is asked to infuse into IDBI is premium collections that are supposed to be invested by LIC mostly in risk-free securities to earn income so as to honour its commitments to the policyholders at a future date. Indeed, IRDA, the regulatory authority that overseas the functioning of insurance business in the country has set certain investment guidelines for insurance companies to follow while investing their premium income with the sole objective of diversifying the risk and thereby ensure safety of the investment and the return thereof. Under the said regulations, LIC is permitted to have an equity exposure up to 15% in a single company. That being the rule, any deviation from the norm would only mean undermining the safety of insures’ funds. And that’s what the present proposition of LIC to invest funds in IDBI exceeding the 15% cut off limit, that too, in an already ailing bank would precisely mean. It is this underlying philosophy that is raising many irritating questions. True, investment of 12 000 cr might be a small fraction of LIC’s balance sheet of Rs 1.24 lakh cr. But how about the prudence of the investment? For the government it might be an easy way out to rescue the bank but as a principle it is bad, for the investment is in no way beneficial. Should the experiment go wrong, will LIC be able to answer its policyholders’ claims? Also, would it not question the wisdom of IRDA in granting such exemptions to rules framed by it? Ironically, we are building institutions, framing prudent regulations but take pleasure in frequently tinkering with them. This playing with the independence of regulatory bodies and financial institutions may not augur well for the system. Over the years, LIC has become the unfortunate milch cow of the government at the centre for bailing it out from many of its share disposal programmes, etc and this is going on unabated irrespective of the political party in power. This is the biggest worry, indeed! So long as the going is good, and institutions continue to be ‘going-concerns’, there may not be any apparent threat to the financial system. But prudence commands us to remember the fate of UTI, the erstwhile behemoth of capital markets that helped government in disinvestment of its stake in Public Sector Undertakings, etc. Institutions of LIC’s magnitude are capable of creating contagion risk in the system and hence command that we handle them with care.