March 19, 2018

Who should have spotted the Nirav Modi - PNB LoU frauds earlier? Should it have been the government (which is, after all, the owner) or the Reserve Bank of India (RBI)?

During an address to the Association of Development Financing Institutions in the Asia and the Pacific, Finance Minister Arun Jaitley squarely blamed the bank management and also the auditors, internal and external. But he also pointed to the regulator, making a comment that supervisory agencies had to introspect about mechanisms they could put in place so that stray incidents didn't become the norm.

Last week, Reserve Bank of India (RBI) governor Urjit Patel broke his silence in a speech at the Gujarat National Law University, pointing out that the RBI's power vis-a-vis private banks and public sector banks were very different. The RBI found that its authority over public sector banks was weakened because of clauses in the Banking Regulation Act. Clause 51 did not allow it, for example, to remove the chairman, directors or management of the PSU banks. Nor did it allow RBI to force mergers between PSU banks.

It is true that the RBI does not have the same powers over the public sector banks that it has over the private sector banks. Even with more powers, it is unlikely that RBI could have actually spotted the fraud at the PNB branch. Since the employees were colluding in keeping the matter hidden, it is unlikely that its own supervision and regulatory mechanisms could have spotted what was exactly going on. Similarly, it is unlikely that the finance ministry could have spotted the collusion between Nirav Modi and the PNB officials from its own perch.

But Urjit Patel is right in pointing out that the rules are different. The guidelines on ownership by the RBI makes sure that promoter/promoter group shareholding has to be lower than 15 %. And no single entity or person (who is not promoter) can hold over 10% of the equity. This shareholding rule alone ensures that there are counter balances built into the ownership of private banks. Domestic and foreign investors take up big chunks of shares in most private banks, and they are far more active in protecting their investment interests than the minority shareholders of public sector banks.

In the case of public sector banks, the government ownership of most public sector banks is well over 51% in most cases. So other shareholders do not have any significant voting rights to effect any great change. Also, the RBI regulations also need promoters and directors to meet the "fit and proper" criteria on a continuous basis. While that can be strictly implemented in private banks, it cannot enforce that in public sector banks where the government's authority on appointments is supreme.

Beyond this, there are other reasons why private sector banks have some inbuilt safeguards compared to government banks. Private sector banks that plan to grow their business need to tap the markets (both equity and bond) regularly for raising capital. That need alone forces them to run a tight ship.

In the case of public sector banks, the government is the chief provider of capital in most cases. Public sector banks rarely need to tap the markets regularly for their capital needs. That itself creates a certain complacency.

If the government is serious about reforming the public sector banks while retaining ownership, it needs to make sure that the rules and regulations are the same for both private and public sector banks.

[Business Today]