Asymptomatic India Banking Crises and the ‘Technology’ Vaccine
Mayank Jain, Elena Obukhova, and Sergey Ivanov
June 7, 2020
Indian failing banks problem is no different from novel coronavirus. The financial crises is asymptomatic, lack regulatory testing, and only emerges when it has spread widely. Whether it was the ₹12000 crore forex related fraud at Punjab National Bank (PNB), the failure of Infrastructure Leasing & Finance Services Ltd (IL&FS) or the complete failure of Punjab and Maharashtra Cooperative Bank (PMC) and Yes Bank, it is clear that the Indian Banking system is still exposed to many vulnerabilities. The reasons behind the fiasco of each of these banks is different but to avoid such fallouts in the future is it critical to analyse the circumstances surrounding these banks.
The Problems: Root Cause Analysis
PMC Bank, established in February 1984, failed despite reporting healthy financials until 2019. The main reasons for failure were its large exposure in a single failed entity Housing Development and Infrastructure Ltd (HDIL), weak corporate governance, flouting of Know-Your-Customer guidelines by creation of thousands of dummy accounts, ever-greening of books and failed regulatory structures. The vulnerability highlights the fact that co-operative banks have weak internal supervision, non-regulated board of management and lax dual regulation by the RBI and the Registrar of Co-operative Societies.
Similarly, when the country’s second largest Public sector bank, Punjab National Bank (PNB) reported a fraud, the system was jolted because it revealed how a scam can be conducted in nexus between company’s management and bank officials. The non-integration of banks software systems (CBS and SWIFT), allowed its bank officials to camouflage the reports for seven years. Despite various audits and regulatory compliances, multi-level reporting structure, the bank failed to manage an ongoing fraud at its Mumbai branch leaving the bank with a large unsecured exposure of ₹ 12000 crores in the end.
Yes Bank, a profitable bank until 2018, had seen rapid growth since its inception in 2004. Its major growth happened between 2014-2019 (growth of advances was 34% during this period) when the Indian economy had seen significant decline in GDP, lowest capex cycle, demonetization and rising NPAs across tech-banking sector. However, during the same period Yes bank had grown at the cost of taking large exposures in highly leveraged corporates which were vulnerable to downturn in economic cycles. The weak due-diligence and credit appraisal systems at the bank, high dependence on the main promoter for all decision makings, continuous under-reporting of NPAs and ever-greening of its books made the bank so fragile that ultimately the issue had to be resolved through government interference and supervision.
While the Indian Banks were trying to resolve corporate NPA issues, a AAA (highest safety) rated NBFC, IL&FS failed in September 2018. The same was a big blow to the whole industry because not only had IL&FS borrowed from banks but also from capital markets and debt markets (mutual funds) in the form of Commercial Papers and Non-convertible debentures. IL&FS’s failure shows a clear picture of how management and operational fraud is conducted by manipulation of the corporate structure. The company formed a complex quagmire structure to hide the real weak picture of its financial leverage, cashflows and profitability. Further, it also elucidates how infrastructure project related concerns including regulatory delays, issues in land acquisitions, time and cost over-run in project implementation, lower than expected toll collections and cash inflows can lead to failure of even the biggest of entities. The asset liability mismatch in the balance sheet of IL&FS and number of inter-related and inter-company transactions led to a loss of ₹ 97000 crore to the system.
Whether it was the case of PMC or Yes Bank or PNB, all the fiascos were mainly due to the systemic regulatory failure in early identification of stress. These were clear cases of operational risk getting converted to credit risk resulting in financial loss for the banks and ultimately the depositor’s money. The cost and complexity of these operations had raised regulatory and reputational risks for the banks reducing the bank’s profitability. Is there a way to avoid these frauds?
Technology Vaccines
Most of the current problems derive from most banking and information systems being independent and not interoperable. The banks own software and internal systems are not linked and thus while thousands of reports and MIS gets generated daily, all report present different facts and figures. The regulatory bodies, auditing firms, rating agencies and banks all work independently with defined set of independent guidelines which are not linked to each other thus the problem of accountability for fraud remains a prevalent problem in India. Moreover, no tracking system verifies and tracks all financial transactions in the economy which in turn creates an opportunity to use loopholes in the system to get multiple loans from the same or even different financial organization. Below we discuss a few ‘technology’ vaccines to the banking problems in India:
DISTRIBUTED LEDGER OR BLOCKCHAIN TECHNOLOGY
Distributed Ledger Technology has the potential to eliminate this problem by establishing a system which will govern different financial entities and make sure that they comply with established practices and not violate them. If Blockchain is implemented on the highest level of financial organisations, it would allow all of the relevant information to be stored indefinitely and available to all participants of the system, or partially available if chosen to be so. This can be achieved by deploying multiple private chains, which would be united into one system with perfect accountability, an unerasable record of transactions and full traceability of all the participants of the financial industry. It can further help in bringing different governing and regulatory bodies, auditors, rating agencies and the RBI all at the same page having access to the same database and similar set of reports.
The banking system would greatly benefit from implementing Blockchain Technology since shadow banking is a prevalent problem in India. Many banks all over the world are already using Blockchain for traceability of transactions, major ones include JP Morgan, Standard Chartered Bank and HSBC. As of today, no government has established a fully functional Blockchain-based banking system due to the early stages of development of the technology, however, this is likely to change in near future.
CENTRAL BANK DIGITAL CURRENCY
Implementation of Central Bank Digital Currency (CBDC) would potentially be the best way to battle current problems in India. It would allow for precise tracking of money flow which would make frauds and shadow banking easily identifiable, as well as allow for quick and efficient implementation of monetary policies. It would remove the need for clearinghouses, prevent illicit activity while maintaining the safety of payment systems.
The banking system would greatly benefit from this as well, as it will allow easier financial inclusion and decrease costs for banking services due to the ease of use and increased competition from banks. It would take time to establish a system like this, however many countries are already working in this direction, with China being the pioneer in CBDC. The system that China developed is currently being tested for full adoption and is likely to become the first CBDC in the world.
INTERNAL DIGITAL IDENTITY SYSTEM
Internal digital identity system can significantly increase controlling efficiency and solve bureaucracy issues. Every employee can have a unique account with secured individual access and its serial number. The system can operate in such a way that all company’s employees can see the business processes lifetime and controlling stages with comments without any sensitive details getting disclosed. The name of controlling parties can be hidden and only indicate the last 4 digits of their serial number. In this way it is possible to exclude the situation when controlling is done by the beneficial party as all employees will be able to see if the numbers are matching and syncing. The full access can be provided to the parties that are permitted to have such access (top-management, shareholders, etc.). An internal controlling system with a digital identity will ensure the higher efficiency of the company’s management and eliminate multiple types of frauds and mistakes in the company’s operations. Such a system guarantees higher data security and transparency with significant time saving due to reduction in bureaucratic procedures and systems.
Moreover, the type of access can be divided into two types: controlling and viewing. This would allow different parties to monitor and observe other participants of the network, thus providing higher transparency and accountability for each participant of the network
AUTOMATIC SCORING METRICS
Automatic scoring metrics development can reduce systematic errors and various issues. For example, it is possible to make a signal trigger for the multiple loans being issued to the same enterprise. This system can be combined with the digital identity (in line with KYC norms) to significantly improve business operations. A good example will be the loans application stage. The company can develop such scoring metrics that will be able to indicate the risk level of the loan together with its relative ranking. It will be easier and faster to conduct a manual screening after a preliminary automated scoring. Scoring metrics system can be a good indicator for the poor loans approval mistakes in case the employee approves the loan with the poor rating and without any reasonable explanation. In this case, before the loan is issued the controlling party can conduct an additional check to guarantee the relevance and security of the approved loan.
Another example can be a bank’s accounting and internal reporting. Key financial metrics can indicate the health of the entity basis analysis and studying of submitted reports and accounting. All these metrics are customizable and can be developed by external specialists that do not have a direct beneficial interest or engagement in the company’s operations. Digital and automated scoring metrics can drastically improve the transparency and security of the system protecting a bank from its failure and operational problems. Besides, this system also enhances time efficiency and is trustworthy for the regulators and auditors.
Conclusion
Indian banks as of now need less of human intervention (social distancing) and greater technology interference. It needs a strong dose of advanced technologies and data analytics to stop the spread of fraud disease in its ancient bureaucratic banking system. The red, green and orange zones needs to be built for each of its processes and departments to understand the vulnerabilities and solutions needs to be developed basis compliances. Overall, the Indian Banking system needs robust regulatory supervision (read ‘testing’) to diagnose both the symptomatic and asymptomatic financial institutions at Stage 1. Regulatory Technology is the novel vaccine needing urgent deployment before the crises becomes a community spread. Indian banks are already at the tip of the iceberg and unless treated immediately the only solution left in the end would be a complete lockdown.