The blame game over the PNB crisis

It needed a scam of gigantic proportions—the Rs 12,700 crore and counting Punjab National Bank (PNB) fraud—to bring out the simmering differences between the finance ministry and the central bank out in the open. While the two financial pillars of the government, tasked with the job of keeping India’s growing economy running smoothly, have been at loggerheads for years now, it had always remained under wraps, spoken of only in hushed tones. It has been one of the government’s worst-kept secrets.

The war of words had earlier been limited to the trade-off between high inflation and high economic growth, with the finance ministry singularly focused on high growth, and the RBI busy controlling rising inflation and inflationary expectations. The current sharp exchanges have come to include issues of corporate governance. The debate is no longer just about the central bank fixing repo rates but also about non-performing assets, the role of auditors, operational failures and rising frauds in the system.

The blame game and finger pointing has never been more acrimonious. The first salvo was fired by Finance Minister Arun Jaitley at the 41 st Annual Meeting of the Association of Development Financial Institution in Asia and Pacific in February, nearly two weeks after the scam broke out, by slamming the oversight by regulators and auditors as well as sloppy bank management for their inability to detect the PNB fraud that had been continuing over the past eight years.

He reiterated his dismay and anger a few days later at another summit in New Delhi, saying that the RBI will “have to have a third eye which is to be perpetually be open” and expressed concern that not a single red flag was raised by anyone when the fraud was perpetrated. He added fuel to the fire by suggesting that it was always the politicians who were hauled up for such scams but never the regulators.

The finance ministry also wrote a letter to the central bank asking whether the framework designed by the RBI to prevent and detect such frauds was inadequate or the central bank was unable to ensure its effective implementation.

While everybody agrees that the fraud was a case of systemic failure across all levels, including the bank’s board, its top management, the Bank Boards Bureau, the Central Vigilance Commissioner etc, many were surprised because the finance minister laid most of the blame at the door of internal and external auditors and also the regulator.

However, to be fair to Jaitley and the top mandarins at North Block, there are reasons enough to feel dissatisfied with the oversight role of the regulator. Had the central bank been more serious about using its extensive powers, it is possible that the scam would neither have originated or would have been nipped in the bud.

For instance, Section 12 of the Banking Regulation Act, 1949, allows the central bank to inspect all foreign exchange transactions in order to ensure its compliance with the Foreign Exchange Management Act (FEMA) and other rules. And as both the Central Bureau of Investigation and Enforcement Directorate reports indicate, there were large-scale FEMA violations in the Nirav Modi scam. Moreover, the regulator is also expected to collect information on all large borrowers-- Rs 5 crore and above-- under the Central Repository of Information on Large Credits (CRILIC).

Several other clauses under Section 35 of the Act, that empower the central bank to inspect the books and accounts of any bank, examine any director or officer of a bank, give directions in public interest in the interest of the depositors and secure proper management of the bank, have not been effectively used. Nor were certain powers bestowed on it under Section 36 of the Banking Regulation Act like making direct changes in the management of the bank or Section 21, which allows the bank to decide policy on loans and advances by banks and so on.

Stung by such repeated criticisms, the RBI governors – current and former -- hit back saying that it cannot be held responsible for the biggest scam in the country’s banking history. It had, argued Urjit Patel, the current RBI governor, been issuing necessary instructions to banks from time to time “on a variety of issues of prudential supervisory concern, including the management of operational risks inherent in the functioning of banks”, including linking the bank’s Society for Worldwide Interbank Financial Telecommunications (SWIFT) mechanism with the core banking operations way back in August 2016—one of the chief causes of the scam.

“The risks arising from the potential malicious use of the SWIFT infrastructure, created by banks for their genuine business needs, have always been a component of their operational risk profile. RBI had, therefore, confidentially cautioned and alerted banks of such possible misuse, at least on three occasions since August 2016…,” Patel said.

Similarly, former RBI governor Raghuram Rajan in an interview to a television channel said that the government too was culpable as far as corporate governance is concerned, because as its owner it was responsible for the appointment of the board members as well as the management. “It may be hard to strengthen the governance without first distancing the bank from the government,’’ he added.

Similarly others point to the fact that even the government’s own nominees on the boards of the banks can be criticized for being asleep at the wheel, failing to discharge their duties. They also did not raise the red flag for so many years. However, finance ministry officials point out that all loans above a certain amount –Rs 50 crore and above—are cleared by the managing committee of the bank that does not include the ministry’s nominee. Secondly, they point out that despite repeatedly calling for a list of defaulters, the RBI has consistently refused to furnish the same, citing secrecy issues. It has been a major roadblock in their quest to bring the defaulters to book, they add.

Whatever be the case, the current governor too used his speech at the Gujarat National Law University on March 14, 2018, not just to take pot shots at the government but also highlight the limitations of a regulator in the PNB scam.

The biggest problem in ensuring good corporate governance, he argued, was the system of “dual regulation” of banks by the Finance Ministry and the RBI.

He added that given banks’ government-owned status, the RBI had “no legal power to remove PSU banks directors or management, who are appointed by the government of India, nor can it force a merger or trigger the liquidation of a PSB.” The RBI, Patel reiterated, also has limited legal authority to hold PSB boards accountable regarding strategic direction risk profiles, assessment of management, and compensation or even replacing weak and non-performing senior management and government appointed board members.

“Legal reforms are thus highly desirable to empower the RBI to fully exercise the same responsibilities for PSBs, as now apply to private banks and to ensure a level playing field in supervisory enforcement,’’ he added. “A private bank CEO’s primary concern is whether he/ she will be able to raise capital when the need arises or even whether he/she will be running the bank the next day. The point is that they can be readily cautioned through their boards and even replaced by the RBI in case of large or persistent irregularities.”

However, PSBs are never worried about market failures because they know that they have the sovereign guarantee of the government.

So what can help the RBI become an effective regulator? Patel says: “It is about amending the Banking Regulation Act of 1949 to make the central bank to make it full owners of the bank rather having dual responsibilities.”

So while the two institutions bicker over who is really to blame for the sorry state of the Indian public sector banks, one thing is clear: there have been lapses on both sides and both are equally culpable.