Sting in the tale

Lessons for RBI and banks from Cobrapost investigation

To its credit, the Reserve Bank of India (RBI) did not hesitate to point out that the three large private banks that were subject to the Cobrapost sting operation had committed serious violations. From ignoring know-your-customer (KYC) requirements to facilitating large cash transactions to allowing their salespersons to be rewarded by insurance companies for generating business for them, the picture that emerges from the inquiry into the matter validates the perception that both internal controls and external supervision either simply failed to notice or refused to act against such actions by bank employees. The inquiry report, therefore, raises questions about the effectiveness of management control as well as that of the supervision process. Since the sting was conducted over a few months during the financial year 2012-13, the RBI could conceivably defend itself by arguing that the latest inspection reports might have picked these activities up. But the standardised nature of the activities does suggest that they had been going on for some time and there is no indication that previous inspections had noticed them. Having arrived at these sobering conclusions, the question is: what next for both the supervisor and the supervised?

Undoubtedly, fines will be levied and some heads, even senior ones, will roll. But these are punitive measures and there should be no complacency about their effectiveness as deterrents against future violations. The RBI's greatest weakness in this regard is the skill levels of its supervisory staff. The long-standing preference for generalist cadres, which comes with the presumption that anybody can do any job with appropriate training and orientation, must make way for the position that certain functions - such as supervision - require specialised skills developed in the course of acquiring a professional qualification. For supervisors to easily spot violations, they must have skills comparable to the people whom they are supposed to be keeping watch over. Recognition of this lacuna is particularly important at a time when new bank licences are being considered. The new entrants will have to be subject to more intense scrutiny as they put their control systems in place.

The episode reveals a basic imbalance in the performance appraisal framework in the banking sector. Revenue growth and profitability are handsomely rewarded, but where is the built-in offset for regulatory violations? The principle of deferred compensation, which has found some favour in the post-crisis debate on regulatory reform, could also apply here. Managers must be hit where it hurts most - their salaries - if failure to comply is unearthed either by internal or by supervisory inspections. It must be remembered, both by operating banks and those who will come into the business after the new licences have been issued, that the most important resource that banks possess is the trust of the average citizen. Lost trust is hard to regain. Unfortunately, the sting and its aftermath can only serve to reduce public trust in private banks. The changes suggested above are first steps in restoring the trust.