Risk review report on Indian Banking sector by Alea Consulting

Alea Consulting has come up with a risk review report on Indian Banking Sector. The Indian banking system emerged safe out of the credit crisis of 2008-09, however, the relief was short-lived as Indian banks are swamped by two major challenges - bank frauds and NPA crises leading to stressed balance-sheets at these banks. The Nirav Modi - Punjab National Bank (PNB) scam (US$2 billion) is deemed to be the biggest banking fraud in the history of India and more such are getting exposed.

Key Statistics

Gross NPAs of public sector banks (PSBs) and private sector banks as on September 30, 2017 stood at Rs. 7.34 trillion and Rs. 1.03 trillion, respectively, according to RBI data. Among the top 20 banks (counting GNPAs in absolute terms), 18 are PSBs and 2 are private sector banks. Leading corporate houses and companies accounted for approximately 77% of the total GNPAs from domestic operations for the banks.

GNPAs of Indian banks, after staying below Rs. 1 trillion mark between FY06 and FY11, began to rise from FY12 (Rs. 1.4 trillion in March 2012, to almost six times over the next 5 years.) While PSBs' GNPA ratio stood at 12.95%, the private sector reported 4.05% of their loans as bad debts and for foreign banks, the GNPA ratio was at 3.96%.

PSBs have reported 8,670 "loan fraud" cases totalling Rs. 612.6 billion (US$9.58 billion) over the last 5 financial years up to March 31, 2017.

Initiatives

Strengthening the Legal Framework

The Banking Regulation (Amendment) Ordinance, 2017 empowers the RBI to issue directions to banking entities to initiate an insolvency resolution process in respect of a default, under the provisions of the Insolvency and Bankruptcy Code (IBC).

RBI has put 11 banks under its Prompt Corrective Action (PCA), which restrict the bank's lending activities. It has 5 more PSBs under the radar to place under PCA.

Re-Capitalisation Plan

In 2015, the government had announced a revamp plan Indradhanush to infuse Rs. 700 billion in PSBs over four years, towards meeting their capital requirements in line with global risk norms 'Basel III.' Indradhanush is a 7-pronged plan to address the challenges faced by PSBs - Appointments, Banks Board Bureau, Capitalisation, De-stressing, Empowerment, Framework of accountability and Governance reforms. Many of the measures taken were suggested by PJ Nayak Committee on Banking Sector Reforms (2014). In January 2018, the government announced that it would infuse Rs. 880 billion of capital in 20 PSBs in the current fiscal while proposing reforms package to make them more accountable.

In January 2018 it was reported that the Government is considering hiking FDI cap in the banking sector from 74% to 100%, and increasing the permissible limit for FDI in PSBs to 49% (from 20%).

In 2016 Banks Board Bureau was formed to improve governance and quality of human resources in PSBs. Its function is to recommend candidates that will be heads of PSBs (even from the private sector, if need be) and aid them in formulating strategies to raise additional capital. It has also made suggestions like setting up of nomination and remuneration committees in banks, and refresher trainings to have back-up officers.

Improving Practices

Strong internal control systems through integration of technology (real-time flow monitoring applications), effective internal audit including consistent credit monitoring and regular feedback. RBI has recently revised limits in reporting of fraud cases.

Sensitive positions must be monitored closely, and periodical job rotation should be encouraged. Robust risk assessment and improvement in credit underwriting standards. In Jan 2016 RBI proposed a Central Fraud Registry to have a searchable centralized database for use by banks.

Proposed consolidation of PSBs to bring about rationalisation of resources and improve geographic coverage.

Implementation of policies that encourage moral behavior and demonstrate an ethical culture.

Way Forward

Banking reforms such as IBC, 2016 and bank recapitalization will be ineffective unless governance standards are improved. A comparison with recommendations of PJ Nayak Committee Report suggests that the extent of capitalization in the PSBs is not sufficient to overcome the problem of NPAs and to achieve Basel-III levels of Tier-I capital. There is a need to tighten the system to bring in more transparency and accountability. Higher FDI limits will not change things materially for the state-owned banks, unless the government is able to bring in long-term strategic investors.

Greater usage of data analytics can help make bank policies more effective. A system of continually and repeatedly advising customers must be created so that customers can be protected from electronic banking and payments related fraud.