Five lessons from bribery scandals The Syndicate Bank bribery scandal may have opened a can of worms for the troubled Indian banking sector. Chairman and managing director S.K. Jain has been accused of accepting money from Bhushan Steel in exchange of increasing its credit limit. Within a few days of this, the Central Bureau of Investigation began enquiring into a controversial loan given to Kingfisher Airlines despite its financial mess by IDBI Bank. There is no reason yet to believe that rampant corruption is the root cause of the massive bad loans festering on the balance sheets of Indian banks. But these two cases provide a good reason to look what broader lessons can be learnt from such episodes. Here are five salient ones. 1. Every credit bubble leaves behind a trail of bad loans. Bank loans grew around 10 percentage points faster than nominal gross domestic product during the boom years. Such lending sprees are usually accompanied by lax standards. Indian banks have not been an exception to this rule. Some economists these days also point out that there is a financial cycle that is often not synchronized with the economic cycle. 2. Chief executives of banks have an incentive problem. The most severe bad loan problems are to be found in state-run banks. The professionals who head these do not have adequate incentives to ensure that the balance sheet is clean over the years. A lot gets written about the fact that public sector bankers get paid a pittance in comparison with their peers in the private sector. An equally important issue is that public sector bank chairmen do not get more than a couple of years at the helm. They have little incentive to institute long-term reforms. And then there is the issue of the metaphorical telephone call from New Delhi to lend money to favoured business groups. 3. Bank boards are often dysfunctional. The P.J. Nayak committee to review the governance of bank boards has not painted a pretty picture in its report released in May. It showed in great detail how these boards were more focused on tactical issues rather than those of long-term strategy, as well as such important problems as taxi bills or the impending visit by the finance minister of the day. Bank boards have also been packed with political favourites who have absolutely no expertise. The average public sector bank board also discusses fewer issues than boards of private banks. The number of issues discussed at board meetings have been positively correlated with profitability but negatively correlated with bad loans. 4. Promoters do not bear the costs of misguided ambition. Successive governments have put in place a more robust ecosystem to tackle the problem of bad loans. But promoters do not personally seem to be affected when loans are restructured or have to be written off. The lender often has a bigger downside than the majority equity owner. And then there are the scandalous cases such as the conversion of debt into equity at a hefty premium in the case of Kingfisher Airlines in 2011. 5. India needs a good corporate bond market. The way banks price corporate risk is opaque. It is worth asking what would have happened to Bhushan Steel in case it had raised all that debt from the bond markets. It is quite likely its bonds would have been hammered to junk status in an alert bond market, even if we assume that the credit rating agencies had been late in flashing the requisite warnings. A strong corporate bond market will lead to more transparent pricing of risk. The current cracks in the banking system should lead to many changes in the way the financial system is managed. The incentives of both the finance ministry and the Reserve Bank of India are aligned in this case. The former does not have the money to recapitalize banks while the latter needs to protect its credibility as an effective banking regulator. Will the entire financial system be at risk if reforms to the banking sector aren’t expedited?
Posted on: Wed, 13 Aug 2014 16:48:01 +0000
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