Money & Banking
Indian banking scenario and RBI’s new avatar

To an activist like me, the greatest loss is the fall in the quality of banking services to the smaller customers, more particularly the elders, disabled, home maker-women, widows and pensioners


Any right thinking Indian will certainly question the wisdom of the Raghuram Rajan, the newly appointed governor of Reserve Bank of India (RBI) mooting a proposal to allow foreign banks to take over our over century old  domestic banks. The situation is so bad overseas that our veteran bankers can do well to manage over the badly performing foreign banks.
 

The statement in Washington on unveiling “major banking reforms” that will entail allowing foreign banks to take over domestic banks has rightly raised heckles across the country.  Bharatiya Janata Party (BJP), the main opposition party, has come out with a strong statement to say that this goes contrary to the Centre’s stand that its “policy of nationalisation of banks will not be reversed. Are we importing a financial crisis? The decade-old experience of foreign banks in India is that they only compete with Indian banks in the creamy business segment. Their contribution as far as financial inclusion is concerned is very minimal and below expectations. Even on the concept of new private banks the issue needs to be debated.”
 

The All-India Bank Employees Association states that they “strongly oppose proposals aimed at take overs as they are against our country’s interest. At present 80% of the banking sector in India is under the public sector, 15% under private sector and only 5% are foreign banks. The foreign banks have never contributed to India’s economic growth and development – they are only interested in profits… Some of these have been involved in various scams in the past and their licences ought to have been cancelled. The experience of the US and other countries shows that liberalised banking has led to crises and collapse of banks. In the US alone hundreds of banks have shut down and the US Government had to bale out the bigger banks.”   
 

Over the years, our banking has been robust enough to withstand the Great Depression, the Far East crisis, the Mexican crisis, and the 2008 sub-prime meltdown. How much the nationalisation of major banks contributed to this is still a matter of debate, not many are willing to concede that the great state bailout of the US, British and Irish banks is indeed Backdoor Nationalisation, giving rise to the lesson that governments will not let banks die and tax payer’s monies will be used to rescue them from their greed. Comforted by this, banks all over continue to innovate financially  the ways to transform themselves from traditional deposit-taking retail undertaking, solely guided by their responsibility to their main stakeholders, the depositors and as facilitators of credit for trade and industry and underprivileged through inclusive growth, into universal banks.
 

In the US, Lehman Brothers aggressive loans to sub-prime borrowers became stressed assets and required a massive bailout by the state. JP Morgan agreed to pay the UK and US regulators $920m for the $6.2b ‘London Whale’ trading fraud.  HSBC, Britain’s biggest bank, was accused by the US Senate for abetting money laundering by drug cartels and gun runners running into billions. In 2012, Barclays was fined for LIBOR manipulation and the Swiss UBS was hauled up for tax evasion. The big banks in the UK and Switzerland are mired in major scandals with the US Treasury and regulators imposing massive penalties running into billions and jail terms for violations for offences as bad as cross border money laundering. In the latest money laundering sting operations in India the foreign banks were also caught with their pants down.
 

A Deutsche Bank staff e-mail in 2007, that is cited in Unitech’s court documents filed in the London court on the first day of appeal hearing where the Indian property firm Unitech Ltd is seeking invalidation of the interest-rate swap manipulation of the benchmark interest rates with Deutsche Bank because of alleged rigging of the LIBOR is quite explosive. A similar case is being heard between Guardian Care Homes filed against Barclays Plc. Both Unitech and Guardian state that would not have signed the swap deals with the banks had they been aware of the LIBOR-related misconduct that became a scandal when the London-based Barclays was fined by the UK and US regulators last year.  The global probes are on into the banks’ attempts at manipulation of the benchmark for profit that resulted into fines and settlements totalling $2.6bn for Barclays, Royal Bank of Scotland Group Plc, UBS AG and ICAP Plc.
 

The current Indian scenario
 

Indians, traditionally have inherited a conservative philosophy that is at odds with that propounded by global conglomerates fired by the self-serving urge of super-profits as defining their reasons for existence untouched by the real economic niceties.  Basic regulation is a must to ensure that the system doesn’t collapse—there is fiduciary responsibility.       
 

The economic media carries lively debates on the issue in their editorial pages. Ashoak Upadhyay writing on In banking, don’t ape the West points out “In its urge to ‘liberate’ the banking sector from government control and throw it to private players, India seems to have forgotten the lessons of 2008 financial met down in the West”.
 

To an activist like me, the greatest loss presently is the fall in the quality of banking services to the smaller customers, more particularly the elders, disabled, home maker-women, widows and pensioners. In the name of computerisation there are delays in dispensing cash, updating pass books, issuing new cheque books, deleting of names of deceased customers, issuing of certificates and statements of accounts; centralised clearance of cheques in bouncing without the dealing branch being aware are blamed on the ‘back office’ activities. The personal touch of the extremely friendly next door neighbourhood banker is lost for ever with the arrival of these customer un-friendly e-banking processes.
 

Indians, traditionally, have inherited a conservative philosophy that is at odds with that propounded by global conglomerates fired by the self-serving urge of super-profits as defining their reasons for existence untouched by the real economic niceties.  Basic regulation is a must to ensure that the system doesn’t collapse - there is fiduciary responsibility.       
 

Increasing the role for the private sector in contemporary banking—pros and cons
 

Over the years, Indian banking sector has seen Morarjibhai’s Social Control to Indira’s two phases of outright nationalisation of 14+8 banks, later on Narashima Rao’s post-liberalisation partial disinvestment and now the invite into mainstream banking of private players and NBFCs (non-banking finance companies), who are the new kids in the bloc.
 

Our financial mandrins do not seem to be at a loss on in how they really want to go about major banking sector reforms. At one point in time, P Chidambaram, the finance minister, was seen to be gaga to strongly campaign for the merger of , big and small, to make them global competitive because our biggest banking behemoth SBI still does not stand high in the pecking order of the world’s TOP 25 commercial  banks. Our public sector banks (PSBs), as a group, continue to enjoy a dominant market share of 72%.  The finance minister backed by the prime minister have suddenly started ardently espousing with great gusto plans to set up more private banks by business houses. He has got a very reluctant then RBI Governor to draw up the Guidelines.
 

This move has not found favour with 30 member multi-party Parliamentary Committee on Finance headed by Yashwant Sinha, a former union finance minister. The panel unanimously adopted the report on September 27, 2013. It now emerges that Rahul Gandhi and six other Congress MPs (Members of Parliament) in the committee have also lent their weight to reverse the government proposal, though in fact they have not appended any note of their dissent. This happened on a day Rahul Gandhi stunned the government by condemning the Ordinance to protect convicted lawmakers from disqualification by coming out with a strong statement - “I tell you my opinion on the Ordinance is: That is complete nonsense. It needs to be torn out and thrown away. It is my opinion.” Perhaps he’ll say the same of the finance minister’s move too!
 

This Parliamentary Report very rightly urges the government to avoid a recurrence of the pre-nationalisation situation of managements of private banks extending undue favours to their own industry owners – “Given such a background, the committee is apprehensive that industrial/business houses may not be geared to achieve the national objective of financial inclusion and priority sector lending.” It also rightly suggests that industry and banking be kept at arm’s lengths because banking is a highly leveraged business involving public money and public welfare. It also questioned the RBI criteria of ‘sound credentials and integrity’ as being highly ‘subjective, ambiguous and open-ended’. The numbers put out by committee are extremely revealing – Out of the 12 new banks set up after the 1993 and 2001 RBI guidelines  one with serious erosion of net worth had to compulsorily merged with a PSB, two with poor governance amalgamated with other private banks and one started by an individual has survived, albeit with muted growth.  This it ought to raise eyebrows. It is said that only 2,699 or just 17% of the 15,630 of their branches are located in rural areas whereas they are competing cheek-by-jowl with each other in Mumbai, in some cases with more than one branch of the same private within one kilometre radius.
 

Union Finance Minister P Chidambaram, speaking at a function at Bengaluru on 5 October 2013 said, “Banks are meant to serve largely the poor and middle class individuals who need banks more than the corporates...For long we have harboured the myth that banks are meant to provide money to rich people and to corporates. Nowhere in the world, other than India, do corporates come to banks for working capital…Each of the new banks should aim to serve the people differently and not try to become clones of existing banks.” When we are aping all kinds of Western practices the finance minister should instruct the RBI to instruct banks not to extend working facilities.
 

Banks cringe on offering higher rate for the hard earned savings of the elders, disabled, widows and charitable trusts; but in trying to woo rich and corporates offer higher rates for what they term as “Bulk deposits” that now Rs1+ crore which was Rs15+ lakh earlier. Will the Ministry of Finance insist that the new banks go by what the finance minister says?  
 

Not to outdone, the RBI has fielded its executive director, B Mahapatra to argue its stand on allowing private sector operators. He says that the corporates with NBFCs, insurance companies and mutual funds, are already competing with the banks both on the assets and liabilities side. He claims that they have a long history of building and nurturing new businesses in highly regulated sectors like telcom, power, airports, highways, dams and ports. RBI feels that it may not lead to undue concentration of control of banking activities as Indian banking is largely dominated by the PSBs and believes that financial inclusion being the overall objective of the present bank licensing policy that business houses with deep pockets can possibly fill in the gap because financial inclusion is an extremely highly capital and technology project.  RBI further envisages that the new banks will usher newer business models, products, processes, and technologies, higher levels of productivity, efficiency and better customer services. It is expected that the existing banks will re-orient their businesses to withstand competition or risk customers moving over to the new banks.            
 

Bakhtiar Dadabhoy, in his recently published Barons of Banking (Random House), traces the history of banking in India to the indigenous bankers who created in 1860 the practice of hundis that exist even today. Proper banking began with the Bank of Bombay (1840), Bank of Madras (1843) and Bank of Calcutta (1860) that were amalgamated to become the Imperial Bank of India in 1921; post-independence it became the State bank of India (SBI). Though joint stock banks were first permitted in 1860, many of today’s big banks arrived during 1906-13. The present day Canara Bank and Corporation Bank were incorporated in Mangalore and Udupi respectively, in 1906.
 

I am indeed privileged to hail from the district of South Kanara, at the southern most tip of the state of Karnataka, which was once considered the most banked district in the country, if not all over the world. This district has been the cradle of four of India’s largest banks in the public sector viz Corporation Bank, Canara Bank, Vijaya Bank and Syndicate Bank; besides at one time also of a plethora of twenty two smaller banks that ultimately merged with their big brothers over a period of time. All told they made for a high network of brick and mortar branches in every hamlet dotting the district spreading banking literacy down the line. None of the founding fathers of these banks were any finance or banking wizards—one was a trader, another a lawyer and the third a medical doctor, all making for very successful bankers. Bankers hailing from this district have also made it from the bottom rising to the very top echelons as chief managing directors (CMDs) of banking hierarchy both in the public and private sectors and the RBI too, even to this day. Benegal Narshing Rao was a RBI governor, Kishori Udeshi and Leedhar were deputy governors.  More are  CMDs of PSBs today.
 

Banking then
 

In the good old days, when times were good, banking then was a cakewalk. Both the householders and businessmen wanted someone known to them to take care of their monies and it was a friendly neighbourhood banker who was considered trustworthy to discharge this sacred duty. The hallmark remained the inbuilt safety and security on the credibility of the founders.
 

The banks began with small capital and collected deposits small and large. Syndicate Bank were pioneers in ‘pygmy deposits’ collected by highly mobile deposit collectors roaming from door to door of individuals and cash counters of Udupi hotels to collect amounts as small as an anna each day. It continues to date! The hallmark remained the inbuilt safety and security on the credibility of the founders.
 

In those days, funds were available very cheap as the depositors were paid minimal interest at fixed rock bottom rates, because they had nowhere else to go; there was no competition, besides there were no alternative investment opportunities and above all it was convenient for the depositor as the staff attending to them at the branches were invariably friendly neighbourhood faces.
 

The bankers have now started to take retail depositors for granted and are cold shouldering them by preferring to target the big high net worth individuals—the NRIs and businesses for bulk deposits. The recent electronic media string operations on tape have shown how banks across the both in the public and private sectors, have thrown caution to the winds in trying to mobilise deposits including carrying electronic note counters to depositors’ homes to cart high denomination currency notes for deposits. The RBI has levied massive penalties that each bank coughed up without demur!
 

Now the depositors have woken up to the fact that they are being taken for a jolly good ride for the perceived ‘safety’ – realizing that deposits don’t offer interest rates that manage to beat inflation. The ‘wise’ from among the depositing turned to seek  better  ‘real’ rates of return by switching to other investment destinations in the form of  investments in shares, debentures, bonds, gold, real estate, chit funds and even Ponzi schemes.
 

Banking today 
 

The banks that initially advanced the monies to individuals at much higher market rates, initially to trade and business later graduated to lending to corporates for industrial finance against tangible collaterals. They then moved into higher interest lendings for housing, automobile, education and personal loans.
 

While the personal loans are generally small in numbers and values, it is the larger trade and industrial borrowers who call the shots when they encounter serious erosion in their debt-servicing capabilities due to down slide in sales, rising input costs, sluggish profits, delayed recoveries, build up of inventories and hiccups in delayed project start-ups—in trying to cut back on debt end up in taking on more loans just to keep going and this result in greater borrowings and interest burdens forcing the lending bankers to jump through the loop just to recover their advances. It is rightly said that if you borrow a few thousands from the bank and fail to repay you are in serious trouble, but if you borrow in crores, the bank comes in trouble, it will then keep chasing you to implore you to settle by agreeing to reschedule your instalments, by deferring payments, waive interest and the like, adopting the choice between devil and the deep sea.
 

Business Line 2012-13 analysis of 500 leading corporates with leverage, reports that their debts increased by 17% when their net worth grew only by 9% with half seeing their leverage worsening with many sporting debt to Equity ratio of eight as against the accepted/ideal of two. Large borrowers thrive in borrowing more and more believing ‘they are too big to fail’ a la Kingfisher Airlines which has got its debts ‘restructured ‘ on its own terms including  forcing the banks to convert its debts into equity at absurd valuations at high premium even though the company has been in the red from day one! The promoters go on with their high profile life despite defaulting in their dues to employees, vendors, suppliers, bankers and tax authorities.
 

Our banks today are estimated to be sitting on Rs2.50 lakh crore of restructured loans on top of Rs1,60,000 crore non-performing assets. Distressed accounts are conservatively put at 10% of their advances portfolio.
 

With the worsening conditions in the West, like the sub-prime crisis and the bankruptcy up of big name banks making it difficult to lend to their domestic borrowers banks there have turned to lending abroad at lower rates. Indians now find it cheaper to raise funds overseas by way of external commercial borrowings (ECBs). But there is the inherent exchange fluctuation risk involved.
 

RBI‘s new Avatar as the banking regulator 
 

In the good old days the RBI played the role of a sombre silent ‘Big Daddy’, as a supervisor maintaining monetary oversight by acting as ‘Banker to the Banks’.  It is rightly now said: “If collecting deposits and loaning it to the credit-worthy has become a tricky endeavour, the RBI as regulator has not been making bankers’ lives easier either, it has co-opted the banking system as its unwilling partner in trying to fix everything that is wrong with the Indian economy.”
 

The RBI ought not to have permitted the commercial banks to hawk third party products like marketing insurance and mutual fund products as well as gold that the banks are simply not sufficiently geared for that and  staff are not qualified to do. RBI by allowing them to move away from their core banking activity of collecting deposits and making advances has compounded the issue. This has brought about a serious fall in monitoring of advances leading to mounting stressed borrowings.
 

Today, it is noticed that there is a shoddy mix up of RBI’s role with that of the central government in drawing lines as to what is fiscal and what is monetary and who has to do what! In an attempt, to arrest the depreciation of the rupee, believing bank money is fuelling currency fluctuations, RBI sought to squeeze every drop of perceived ‘excess liquidity’ from the banking system bringing about a sudden spurt in overnight rates  to escalate their costs and aggravate the bad loans.
 

(Nagesh Kini is a Mumbai-based chartered accountant turned activist.)

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COMMENTS

MG Warrier

4 years ago

A balanced analysis. Even those who may have difference of views on 'opinions' expressed, should ponder over the present crisis of financial sector. The disintegration of established 'Institutions' and migration to the practices the so called developed world is following is doing irreparable damage to Indian Financial System. If one remembers the saying:
"PURANAMITYEVA NA SADHU SARVAM
NA CHAAPI KAVYAM NAVAMITYAVADYAM
SANTAH PAREEKSHYAANYATARAD BHAJANTE
MOODHAH PARAPRATYAYANEYABUDDHI"
(Everything old may not be true and acceptable, all that is new should not be rejected. The wise examines and makes right choices)
good for all.

Is RBI More Pro-customer?

RBI has done more for customers than Sebi and IRDA but it has also often argued that it will not interfere when it comes to products that already have an independent regulator. This is unfair to customers who repose enormous trust in banks

The true measure of a financial regulator’s success ought to be what it does to win the trust of its largest stakeholders—the consumers of financial services. What do these stakeholders usually want? Well, safety of transactions, appropriate regulation and supervision, swift action against wrongdoers and refund of their money through disgorgement of ill-gotten profits. How do our financial regulators measure up to this standard? In our assessment, the Reserve Bank of India (RBI) is a relatively more receptive regulator in the financial sector. And, while we may want it to act faster and to do a lot more, it moves in the right direction most of the time. Consider this:

    On 3rd September, RBI issued a circular to end the pernicious 80:20 loans provided by banks to builders. This had allowed builders to obtain financing for projects under the guise of loans sanctioned to individual purchaser. We know that builders have been paying hefty commissions to brokers to obtain such bookings and many investors were mere fronts. This dubious funding, in collusion with banks, ensured that property prices remained artificially high, because there was no pressure on builders to lower prices. Moreover, the risk of bad loans was entirely that of the banks and investors. Ending these loans has also led to signs that artificially high property prices are likely to crack.

    On 17th September, RBI put an end to the practice of duping customers through zero-interest loans, especially during the festive season. Banks negotiate and retain hefty discounts from manufacturers, while customers are offered zero-interest loans split into equated monthly instalments (EMIs). Similarly, banks did not pass on to the customers the benefit of moratorium on payment for certain products. A determined RBI stood firm even when banks got consumer durables companies to plead their case through the retailers’ lobby.

    In the same 17th September circular, RBI has categorically told banks that merchant establishments cannot levy a fee on debit card transactions. This is a dubious practice, since, unlike credit cards, debit card payments are instantly deducted from customers’ accounts and ought to be transmitted to merchant establishments immediately. RBI has said that banks must ensure that they terminate the relationship with entities that charge fees.

•  RBI has also made it clear to banks that, in cases of electronic and online transactions, the onus of proving that the customer has been negligent has to be on the bank. At a recent meeting with nodal officers of all banks, Dr KC Chakrabarty, deputy governor RBI, was emphatic that banks must treat this as an institutional risk and get themselves insurance cover, if necessary, for possible losses. They cannot penalise the customer without proof of deliberate and wilful negligence. Some bankers responded with the claim that no insurer is offering such a cover; Dr Chakrabarty retorted: “Well, in that case, nobody is compelling you to offer Internet banking.” As a further check, all electronic transactions systems are supposed to allow customers to protect themselves by manually creating their own limits for such transactions.

    The same was the case with ATM transactions. Already, RBI requires complaints to be resolved within seven days and the money credited back to the account, failing which the customer is entitled to a compensation of Rs100 per day of delay. Banks often benefit from the fact that customers are unaware of the rules. Here, again, RBI told banks that it was up to them to reduce their risks by placing limits on each withdrawal.

    Dr Chakrabarty also had some words of wisdom for banks on the interest rate front. He observed that no bank was offering higher interest on savings accounts even though interest on term deposits had shot up to 9%. “You will not be able to stand the scrutiny when interest rates change,” he warned. Clearly, he anticipates that when interest rates finally drop, banks will be in a hurry to cut interest rates on all deposits, as they did in 2003. Banks probably expect to get away with this because the consumer movement in India is weak and there isn’t enough pressure on banks to be fair to consumers.

    The Indian consumer is fortunate that some central bank officials stand up to the finance ministry as well. The latest example is P Chidambaram’s strange idea of providing more capital to banks to enable them to “lend to borrowers in selected sectors such as two-wheelers, consumer durables, etc, at lower rates in order to stimulate demand.” RBI has been quick to point out that this would only create bad loans if interest rates go up further.  

All these examples raise an obvious question: If RBI is so willing to bat for the consumer, why do we still have so many customer complaints? This happens for two reasons. Like other regulators, RBI also has no direct interaction with consumers. It only reacts when the number of consumer complaints to the banking ombudsmen, or through media reports, is large enough to draw the attention of its top brass. Moneylife Foundation, our not-for-profit initiative, has, however, found that when consumers’ voice is conveyed through a detailed memorandum, it is often heard and acted upon—albeit slowly.

Two important issues continue to be work-in-progress. First, the absence of a clear grip on technology costs and the robustness of technology systems. Customers are discovering, to their horror, that even the banking ombudsman fails to understand the implications of tiny errors in the calculation of interest rates or deductions or system-induced mistakes in email identities, registration of nominations, etc. All these will have more serious implications when bank accounts are only based on UID numbers which are often flawed.  

The second serious issue is the brazen mis-selling of mutual funds, insurance and wealth advisory services through banks. RBI has often argued that it will not interfere when it comes to products that already have an independent regulator. We believe this is unfair to customers who repose enormous trust in banks and there is, thus, a serious breach of fiduciary responsibility. Strangely, although RBI was considered the first-among-equals at the high-level coordination committee of regulators, it refused to show appropriate leadership with regard to consumer issues. The finance ministry is too focused on defending itself and the government on a series of bad decisions and scam charges (coal, telecom, steel mining, gas pricing, aviation purchases, among others) to worry about individual investors being cheated. Consequently, the insurance regulator and the capital market watchdog are accountable to nobody and turn a blind eye even to outrageous cases of cheating. Moneylife Foundation has helped 25 victims of AB Capital, a corporate agent of Reliance Insurance, to recover nearly Rs14 lakh collected as premium on the promise that they would get a zero-interest loan that was 10 times the insurance premium. AB Capital probably has thousands of victims and it agents continue to dupe people even today. The regulator has made no effort to stop this. After all, the problems of a few million middle-class Indians is not a priority for the government or the parliament and, therefore, that of the regulators.

Sucheta Dalal is the managing editor of Moneylife. She was awarded the Padma Shri in 2006 for her outstanding contribution to journalism. She can be reached at sucheta@moneylife.in

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COMMENTS

MG Warrier

4 years ago

When the finance ministry’s willingness to give public sector banks more capital, provided they used this to lend more in certain areas and at lower interest rates was reported with an elucidation that ‘ If the finance ministry gives banks Rs100 of additional capital, banks can lend up to Rs1,000 given the current capital adequacy norms.’ I had observed that GOI was using its ‘ownership rights’ on public sector banks even beyond the level IMF used to do through conditionalities while extending ‘aid’ to poor nations decades ago.
Traditional priority sector which has not lost relevance in the development context is being ignored and finance ministry is asking public sector banks to lend at lower interest rates for consumption and luxury. As regards capital adequacy norms and infusion of additional capital, perhaps a relook at SLR norms (which provide captive sources at lower than market rate funds to government), accumulation of bad loans because of GOI policies and need for a level playing field for PSBs may be necessary to assess costs and benefits for the institutions.
Expectations from RBI are getting multiplied now, perhaps because the responses from the central bank have been much faster during the last few months after Dr Raghuram Rajan became Governor. Results of RBI initiatives will depend on how much support Dr Rajan is able to muster from a government which has other priorities.

Economy & Nation Exclusive
Why should RBI immediately disband newly appointed Committee on Financial Inclusion?

Many of the past crisis situations can be linked to lax and laissez-faire regulatory and supervisory frameworks that had either been developed by industry insiders with commercial interests and/or been created with significant input from such insiders - both with a view to benefit the overall industry concerned!

Conflict of interest is an area of significant importance to regulatory ethics and this is something that the Reserve Bank of India (RBI) needs to note with urgency because there are significant conflicts of interest in the both the recently appointed financial inclusion committee as well as the banking selection advisory paneli. If not eliminated, they could spell disaster for the larger Indian financial sector. And this article is a means to record the above warning publicly!

 

First, let us look at what is meant by “conflict of interest”?

 

Conflict of interest is a scenario where a person or firm has an incentive to serve one’s (own) interest at the expense of another’s interest. This might mean serving the interest of the firm (institution) over that of a client and/or serving the interest of one set of institutions/clients over other set of institutions/clients.

 

Why attach so much importance to the same with regard to regulation in the financial sector? This is because if it is not entirely eliminated and/or at least properly reduced, the conflicts of interest can even threaten the entire financial system. At least, this is what past crises situations signifies. In fact, if there is a single most recurring theme in financial crises and scandals globally, it is the failure to manage conflicts of interest. And here are some examples:

 

Let us look this with regard to the financial sector in the United States, which provides very useful learning with regard to conflicts of interest and their relationship to crisis situations. They hold very important lessons for the RBI which seems to be embarking on a very dangerous journey in its effort to turbo charge financial inclusion as well as give out banking licenses in a tearing hurry!

 

As described by former SEC Chairman Arthur Levitt, “Bank involvement in the securities markets came under close scrutiny after the 1929 market crash. The Pecora hearings of 1933, which focused on the causes of the crash and the subsequent banking crisis, uncovered a wide range of abusive practices on the part of banks and bank affiliates. These included a variety of conflicts of interest; the underwriting of unsound securities in order to pay off bad bank loans; and "pool operations" to support the price of bank stocks.”

 

In fact, as Levitt has further argued, it is the significant revelations of ‘uncontrolled conflicts of interest’ (please note this carefully) that provided the basis and rationale for the passing of many subsequent regulations - the Securities Act (1933), the Securities Exchange Act (1934), and the Glass-Steagall Banking Act (1933). In fact, it appears that conflicts of interest were also the major reason for the enactment of the Investment Company Act (1940) and the Investment Advisor Act (1940).

 

Closer to the 1990s, when I lived in the United States for several years, I personally saw numerous examples of conflicts of interest leading to a crisis:
 

  • The insider trading scandals (such as, the Ivan Boesky and Dennis Levine scandals in the 1980s), the closure Drexel Burnham Lambert (the investment bank) and the associated (criminal) conviction of its famous employee (Michael Milken) are still fresh in my memory.
  • And then there were more financial scandals in the early 2000s – for example, the internet bubble in 2000/2001 exposed problems with dubious high flying research analysts (with very significant conflicts of interest) whose reports were in fact influenced by their own institutions’ investment banking interests. This, in fact, led to specific provisions in the Sarbanes-Oxley Act that dealt with conflicts of interest among research analysts.
  • And just about a decade ago, in 2003, SEC found that the use of brokerage commissions to facilitate the sales of fund shares [was] widespread among funds that relied on broker-dealers to sell fund shares. This led to the adoption of new rules to prohibit funds from this practiceii.

 

And then, we had the mother of all financial crises in the recent times—the global financial crisis of 2008, which was again based on significant conflicts of interest in many areas such as the production and sale of mortgage-backed securities, rating of these instruments and so on.

 

As noted in the 2007 report of the Financial Crisis Inquiry Commission (“FCIC”), conflicts of interest that existed among rating agencies in evaluating collateralized debt obligation (“CDO”) deals was investigated by the SEC which subsequently issued a report in June 2008 that stated that conflicts of interest at Moody’s was indeed a very, very major issue. And I quote from this report:

 

“We introduce some of the most arcane subjects in our report: securitization, structured finance, and derivatives—words that entered the national vocabulary as the financial markets unravelled through 2007 and 2008. Put simply and most pertinently, structured finance was the mechanism by which subprime and other mortgages were turned into complex investments often accorded triple-A ratings by credit rating agencies whose own motives were conflicted. This entire market depended on finely honed computer models—which turned out to be divorced from reality—and on ever-rising housing prices. When that bubble burst, the complexity bubble also burst: the securities almost no one understood, backed by mortgages no lender would have signed 20 years earlier, were the first dominoes to fall in the financial sector.” (Page 28)

 

Just as an aside, I would like to state there are huge problems with securitisation in the Indian micro-finance sector as well and hope the RBI takes note of the same. Getting back to the FCIC report, it cited several other conflicts underlying the crisis such as: a) underwriters assisting CDO managers in selecting collateral; and b) hedge fund managers selecting collateral from their funds to place in CDOs that they offered to other investors. The FCIC report notes in the above connection that:

 

“The SEC investigated the rating agencies’ ratings of mortgage-backed securities and CDOs in 2007, reporting its findings to Moody’s in July 2008. The SEC criticized Moody’s for, among other things, failing to verify the accuracy of mortgage information, leaving that work to due diligence firms and other parties; failing to retain documentation about how most deals were rated; allowing ratings quality to be compromised by the complexity of CDO deals; not hiring sufficient staff to rate CDOs; pushing ratings out the door with insufficient review; failing to adequately disclose its rating process for mortgage-backed securities and CDOs; and allowing conflicts of interest to affect rating decisions.” (Page 212)

 

Yet another conflict cited in the report was about Citigroup offering “liquidity puts” that gave it significant fees in the short term but placed significant financial risk on it in the long term. And I quote the following on Citigroup from the report –

 

“There is a potential conflict of interest in pricing the liquidity put cheep [sic] so that more CDO equities can be sold and more structuring fee to be generated.” The result would be losses so severe that they would help bring the huge financial conglomerate to the brink of failure, as we will see.” (Page 139)

 

Another high profile example of conflict of interest in the recent years is the settlement that the SEC reached with Goldman Sachs, in which that firm paid $550 million to settle charges filed by the Commission, and acknowledged that disclosures made in marketing a subprime mortgage product contained incomplete information as they did not disclose the role of a hedge fund client who was taking the opposite side of the trade in the selection of the CDO. And I quote

 

“2. Goldman acknowledges that the marketing materials for the ABACUS 2007-ACI transaction contained incomplete information. In particular, it was a mistake for the Goldman marketing materials to state that the reference portfolio was "selected by" ACA Management LLC without disclosing the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson's economic interests were adverse to CDO investors. Goldman regrets that the marketing materials did not contain that disclosure. (http://www.sec.gov/litigation/litreleases/2010/consent-pr2010-123.pdf , Page 2, point 3)”

 

After the 2008 financial crisis, there are a couple of examples of problems that arose from poorly controlled conflicts of interest. One is the famous case of Barclays Bank, which acknowledged misconduct related to ‘possible collusion’ to artificially set LIBOR (the London Interbank Offered Rate). As all of us know, LIBOR is a very significant benchmark that is used to set short-term interest rates on different financial instruments including derivates.

 

Second is the 2010 AP micro-finance crisis which is again a classic example of the conflict of interest problem! In the 2010 AP crisis, the lax regulation and laissez-faire supervision of the NBFC MFIs (done at the behest of the micro-finance industry at large and NBFCs in particular and RBI’s own misplaced trust in NBFC MFIs as Dr Y V Reddy, former Governor has admitted) led to the eventual crisis on the ground.

 

Like all of the above, the conflicts of interests prevalent in the recently appointed RBI financial inclusion committee are indeed very serious (as shown in Table 1 below) as the committee has many members representing companies (institutions) that have significant commercial interest in the broad area of financial inclusion including micro-finance. Across the board, these members and the institutions will therefore stand to benefit from the recommendations, regulatory or otherwise made by this committee. This needs to be carefully noted!
 

Table 1 : Conflict of Interest Origins in The 13 Member RBI Financial Inclusion Committee

Conflict of Interest Origins in 13 Member RBI Financial Inclusion Committee

(Based on Facts Available with Writer and Best Available Judgement of the Writer)

Number of Members of the RBI Financial Inclusion Committee Who have This Conflict of Interest

Number of Members in RBI Financial Inclusion Committee with Specific Conflict of Interest as a proportion of Total Committee Members

  1. Commercial Interest in Financial Inclusion/Micro-Finance area

12

92%

  1. Members Whose Institutions Could Benefit from Recommendation of Committee

12

92%

  1. Banking License Applicants

2

15%

  1. Related to Banking License Applicant (Excluding the two Banking license applicants themselves)

7

64%

  1. Direct/Indirect Relationship of Committee Member with Major Institutions That were Involved in the 2010 MF Crisis

9

69%

  1. On-Going Relationship with RBI/Related Institutions as part of Other Responsibilities (One member has six separate such relationships with RBI as on date. So, total members adjusted to reflect this) 

9

50%

  1. Lender/lending institutions/equivalent

7

54%

  1. Close Working Relationship Between Members

9

69%

  1. Members Who Could Gain from Suitable Regulatory Recommendation or Favourable Regulatory Framework

10

77%

Note: Conflict of interest in points 3 and 4 arise because the chair of the RBI financial inclusion committee is also a member of the RBI banking selection advisory panel, which is to meet roughly at the same time.


 

What needs to be emphasized here is the fact that the ‘broad industry of financial inclusion’ which needs to be regulated surely cannot decide on its own regulation. In fact, many of the past crisis situations given earlier, can be linked to lax and laissez-faire regulatory/supervisory frameworks that had either been developed by industry insiders with commercial interests and/or been created with significant input from such insiders - both with a view to benefit the overall industry concerned!

 

Thus, the financial inclusion committee under Dr Nachiket Mor needs to be disbanded forthwith and immediately. Also because the MFIDR Bill (2013) is under the consideration of the Parliamentary Standing Committee of Finance (PSCF), it would be advisable for the RBI to wait for the recommendations of PSCF before taking any steps towards the development of regulatory architecture in the area of financial inclusion/micro-finance! This is especially necessary because in the past, the RBI has had lots of committees comprising of micro-finance industry insiders who decided on how to regulate and supervise themselves and the results are there for all of us to see – the Krishna district AP 2006 micro-finance crisis, the Kolar 2009 localised micro-finance crisis and the state wide 2010 AP micro-finance crisis to name a few

 

Protecting independent committees that are looking into regulation/supervision in the financial sector - from the influence of the companies (institutions) operating in the same financial markets - is a strong prerequisite to ensure effectiveness of the regulatory architecture being developed. Otherwise, the threat arises that, instead of being guided by public and larger client interests, such committees (like the RBI financial inclusion committee) will promote the interests of the companies and institutions whose activities are supposed to be regulated and supervised. And the RBI can ignore this important fact concerning its own financial inclusion committee at its own peril!



i The conflicts of interest in the banking selection advisory panel are similarly analysed in a separate article

ii Please see http://www.sec.gov/rules/final/ic-26591.pdf - Prohibition on the Use of Brokerage Commissions to Finance Distribution, Investment Company Act Release 26591 (Sept. 2, 2004), 69 Fed. Register 54728, 54728 (Sept. 9, 2004).

 

(Ramesh S Arunachalam has over two decades of strong grass-roots and institutional experience in rural finance, MSME development, agriculture and rural livelihood systems, rural and urban development and urban poverty alleviation across Asia, Africa, North America and Europe. He has worked with national and state governments and multilateral agencies. His book—Indian Microfinance, The Way Forward—is the first authentic compendium on the history of microfinance in India and its possible future.)

 

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COMMENTS

Ramesh S Arunachalam

4 years ago

Please see this associated article

http://www.moneylife.in/article/reorgani...

jaideep shirali

4 years ago

Ironically, the government keeps on showing the "conflict of interest" flag to citizens, but when it comes to its own activities, this does not apply. A noteworthy example is Pay Commissions, where babus involve almost no common citizens and decide their own salaries & perks. This, when the citizen pays the bill. A similar case is the Railways recruitment policies, which have attracted criticism. The point is, somehow conflict of interest does not apply to netas & babus, just to the citizen. This article reinforces the point.

samir k barua

4 years ago

Well argued article. Even if one has confidence in the professionalism and integrity of individuls concerned, good governance is all about eliminating the possibility where there could be even a hint of doubt that self interest may dictate the dcisions or recommendations. Samir K Barua

REPLY

Ramesh S Arunachalam

In Reply to samir k barua 4 years ago

Thanks sir. You have put it so well. Conflict of interest is not an accusation - it is a situation that often erodes trust and should be avoided preferably. Thanks again sir!

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