Bad loans and worse

Restructuring bank boards, better supervision need of the hour

Banks making bad loans is par for the course; those that make too many eventually go out of business. However, recent critiques of lending practices have highlighted the role that factors other than pure business risk have played in them. In particular, cronyism and malfeasance have been seen as significant contributors. This line of thinking resonates strongly in the Indian context. Not so long ago, Kingfisher Airlines and Deccan Chronicle Holdings highlighted the apparent willingness of several banks, including market leaders, to continue to lend to companies that were, by all indicators, going down the drain. More recently, the arrest of the chairman and managing director of Syndicate Bank on charges of having taken bribes to enhance credit limits has raised similar questions. The company that is accused of paying the bribe, Bhushan Steel - whose vice-chairman and managing director has also been arrested - showed clear signs of deteriorating financials, which should have raised red flags. Kingfisher is once again back in the news, with the Central Bureau of Investigation probing loans approved by another public sector bank, despite internal assessments being negative.

Of course, these cases may well be the exceptions. But their high profile and visibility do raise questions about both the integrity of the credit-appraisal processes within banks and the quality of governance and supervision. The formality of credit appraisal is well-established. All banks have some objective and transparent formulae to score loan proposals on a variety of risk parameters. Committees at different levels are supposed to minimise individual influence on specific decisions. Despite all the paraphernalia of objectivity, these and other cases suggest that the process is vulnerable to manipulation. Bribes are paid precisely because the payers believe that decisions can be swayed in their favour. And what about the role of the boards and, ultimately, the bank supervisors? Even if they cannot see bribery, should they not have pulled up managements for making loans patently below the minimum thresholds set by the bank's processes?

The government and the Reserve Bank of India can try to persuade the public that asset quality is not a fatal problem for the banking system; but given such revelations, these assurances ring increasingly hollow. Banks have to raise significant amounts of capital to meet new capital adequacy norms - so an erosion of credibility can prove extremely costly. Investors will simply not risk putting money into institutions with questionable processes, and inadequate governance and supervision. There is certainly a need for a policy response, both strategic and for damage control. As regards damage control, all bank boards must be asked to do an immediate risk assessment to identify cases in which decisions were made contrary to internal assessment. This will indicate how widespread the problem is. On the strategic front, restructuring bank boards with genuinely independent directors is one part of a solution. The other must focus on significantly strengthening the supervision process by using qualified accountants and making much more use of real-time data. Waiting for a situation to precipitate and then sending in the investigators is like closing the stable door after the horse has bolted.