Quis Custodio Custodiet: Who Will Guard the Guards Themselves?
Artha Shastry 22 October 2022
The Supreme Court, on 17 October 2022, issued notices to the Reserve Bank of India (RBI) and the central bureau of investigation (CBI) on Dr Subramanian Swamy's plea seeking a probe by CBI into the alleged role of RBI nominee directors in bank loan fraud cases. This author, like many others, has written in the past about the fundamental conflict of interest when RBI, as the banking regulator, also appoints its senior officials on the boards of public sector banks (PSBs). Leaving aside, for the moment, the issue of RBI nominee directors, what is the responsibility and accountability of the RBI’s own department of banking regulation and the department of supervision, when it comes to fraud? 
 
Let us take a moment to review how RBI supervises banks. Apart from the endless stream of circulars on various aspects of banking that the banks must follow, RBI inspects and supervises banks, both offsite as well as onsite. For close to two decades now, RBI, through its off-site monitoring and surveillance (OSMOS) system (now called DAKSH) gets data directly from commercial banks on matters like large exposures, concentration, asset-liability gaps, asset quality and provisioning. 
 
These OSMOS statements are very deep-diving and detailed and must be approved by no lesser officer than the chief executive officer (CEO) of the bank. To be submitted quarterly, by the last date of the month immediately following the quarter-end, the OSMOS gives RBI officials direct insight into the banks’ operations and any likely problems. 
 
Apart from the OSMOS, RBI conducts onsite inspections of banks every year. Typically, a team of senior and experienced RBI officers will arrive at the head office of the bank in question with a letter of authority issued by RBI, requesting and requiring the CEO to ensure that full cooperation is extended to the RBI team and all information provided to them. 
 
The RBI team will sit at the head office or any branch it chooses and has full access to all files and records, and can meet and interview officials, auditors, and directors. They can even ask and be granted access to the IT systems on a read basis. Any delay by the bank in answering the RBI team’s queries or any disrespect shown to them will be followed by a call or missive from the RBI straight to the CEO. In other words, the RBI team is pretty much all-powerful.
 
With so much off-site as well as on-site surveillance, how did famous frauds like Yes Bank, Infrastructure Leasing and Finance Ltd (IL&FS), and Punjab and Maharashtra Cooperative (PMC) Bank happen at all? 
 
Let us rewind a few years to the Yes Bank case. Driven by the hard-charging Rana Kapoor, Yes Bank was, on many parameters, the shining star of Indian banking and was not shy of advertising that. Behind the razzmatazz and façade, however, was a rotten pit. Interestingly, the signs were there for anyone who wished to use his eyes.
 
Consider Yes Bank’s public reporting in the years before it was ignominiously placed under RBI moratorium in March 2020. Let us look at its quarterly reporting (the data is all in the public domain as stock exchange format advertisements and the Bank’s reports). 
 
Many of us bankers were perennially bemused by the incredible numbers reported by Yes Bank every quarter until its shenanigans began to emerge in the public domain around 2017-18:
 
Yes Bank almost invariably reported asset growth of 30%. It was growing its loan portfolio at a terrific speed.
 
Paradoxically, it also reported similar revenue growth, as also the highest net interest margin (NIM) in the banking sector. Paradoxically, because the inexorable laws of economics state that it is not possible, except in the very short run, to increase both market share and profitability. Somehow, Yes Bank was defying the laws of economics!
 
Now, there is only one way to increase both assets as well as NIM and profitability at the same time. The highest NIM in the business could only be obtained from low-rated borrowers since no high-rated borrower would pay such premium interest rates when they could get far better pricing from other banks. However, this would impact asset quality.
 
Logically, therefore, Yes Bank should have the worst asset quality and the highest gross non-performing assets (GNPA) in the sector. Again paradoxically, however, Yes Bank regularly reported the best asset quality and the lowest GNPAs in the sector. 
 
With such phenomenal profitability and excellent asset quality, one would expect Yes Bank to aggressively provision for losses and boast a low net non-performing asset (NNPA) ratio as well as a very high provision coverage ratio (PCR). But surprise, surprise! Yes Bank did not have a low NNPA ratio and its PCR was in the lower percentiles!
 
One could go on about the miraculous happenings at Yes Bank. Sober reality, however, is rarely so euphoric. It is not out of place for a player in any industry to be well ahead (or well behind) the average. On various parameters, being away from the industry mean by up to two standard deviations would not be abnormal. 
 
However, the Yes Bank numbers were so incredible as to be several standard deviations from the industry mean and always in favour of the Bank. 
 
As with the fabled emperor who had no clothes, it took many sycophants and fools before a child pointed out the obvious. 
 
However, in the case of Yes Bank, many a seasoned senior banker known to this author had long ago come to a simple conclusion: the Yes Bank numbers did not add up and were not possible. 
 
While the public information, by way of credit ratings, would have supported high counterparty-exposure limits on Yes Bank, many a bank CEO, to the personal knowledge of the author, had informally placed Yes Bank under the interdict. While the internal exposure models may have allowed higher exposure, several CEOs placed any Yes Bank exposure under close watch beyond a very low threshold and any crossing of it would require explicit written approval. The market was already taking action without waiting for the regulator or the raters. 
 
What was RBI, and its inspectors, doing Could they not see what senior bankers found staring them in the face? Did the senior RBI officials not have informal chats with senior bankers and get their views? Only RBI can answer. 
 
This author is personally aware of at least once when word was passed, with documentary evidence, to an RBI inspector (long since retired) about the modus operandi of one particular Yes Bank shenanigan. Regrettably, no RBI action was discernible thereafter. 
 
The real answer was stunning in its simplicity. Like Ramalinga Raju in a different context, Yes Bank was riding a tiger and someday would have to dismount and be eaten. 
 
When a bank extends a loan, it has three broad sources of earnings from that loan, an upfront management fee (anything from 0.25% - 1%) of the loan amount; the rate of interest, reflecting the bank’s cost of funding and risk perception and reimbursement of various legal and other charges. 
 
Banks would like to charge as high a management fee as possible, as this becomes a sunk cost for the borrower, reducing any incentive for him to later refinance the loan with another bank at a lower rate. For the same reason, good corporates with high ratings negotiate very low or non-existent management fees (by whatever name). 
 
What Yes Bank was doing, in a large number of cases, was to negotiate a very low rate of interest and a very high management fee. An accounting quirk comes into play here. Under the Indian accounting standards (IndAS), an upfront fee cannot be recognised as income in full, but must be amortised over the life of the loan. 
 
However IndAs was then a few years away and Indian GAAP which then prevailed, allowed the entire upfront fee to be booked as income in the year of receipt. This became a tiger for Yes Bank; it booked a significant part of loan income upfront with high fees, resulting in fabulous levels of income on its asset base. However, in later years, the low-interest rate would start to bite the Bank unless the upfront fees continued to grow!
 
The only borrowers who would agree to such terms would be the worst-rated and near-NPAs. Yes Bank often withheld the fee from the first disbursement itself, booking the entire income. How then was its asset quality sustained so well? There were too many tricks used to tell here but the emperor’s nudity was revealed when, at long last, an RBI team undertook asset quality reviews in 2017 and 2018 (bolting a meaningless door well after the horses had bolted) and the revelations were shocking.
 
FY15-16 GNPA, per RBI assessment, stood at Rs4,930 crore compared to Rs750 crore reported by Yes Bank. Consequently, provisions during FY15-16 would have been at Rs1,320 crore vs Rs460 crore reported by the Bank. Similarly, Yes Bank had reported GNPAs of Rs2,019 crore for FY16-17 but, as assessed by RBI, gross NPAs should have been Rs8,373 crore for that year. Again, in FY18-19, the divergence was Rs3,277 crore. It should be noted that the divergence was not restricted to GNPA; this automatically increased the level of provisioning required and exposed Yes Bank’s shaky profitability. 
 
Most important of all, how did such glaring divergences occur over such a long period? Clearly, Yes Bank was fudging numbers galore, but what happened to the safeguards?
 
What is the explanation of the statutory auditors who were required to certify compliance with RBI norms and the accuracy of the financial statements?
 
What is the explanation of the audit committee and the full board for the failure to ask the obvious questions?
 
What is the explanation of the credit rating agencies for their egregious failure to see what was going on and be satisfied by arrant rubbish?
 
Finally, and most importantly, what is RBI’s explanation?
 
Who was scrutinising the OSMOS and how were at least some shenanigans not spotted? If spotted, what action was taken by RBI?
 
Ditto for the RBI inspection teams. How were at least some shenanigans not spotted? If spotted, what action was taken by RBI?
 
All RBI inspection reports go to a committee of senior CGMs (chief general managers), then via the concerned executive directors and deputy governors to the governor and the board of RBI; how is it that none of these experienced and knowledgeable persons failed to even ask questions and, if they did, what was the outcome?
 
The case of Yes Bank has been only the most egregious of a group that includes IL&FS, and PMC Bank. It bodes well that Rana Kapoor, the brain behind the criminal activities in Yes Bank, is behind bars. In fairness to him, he could not have done it all by himself. Will any action ever be taken against the others? The auditors, directors, rating agencies and RBI officials themselves? That is exactly what Dr Swamy’s petition has asked.  
 
Quis custodio custodiet?
 
(Artha Shastry is a banker who wishes to remain anonymous.)
Comments
saharaaj
3 months ago
on site inspection seem to be like medical commission examining /inspecting medixal colleges to confer permission every one same staff is circulated when ever new college is to be proves .. Paper work is legal compliant
angelo.extross
3 months ago
No country or organization can ever progress if it has no focus on "Accountability" and fails to take action, even penal, against defaulters.
Meenal Mamdani
3 months ago
Why are the officials of the RBI not under the guillotine?
It must be because there are higher ups involved in the Ministry of Finance, up to the Finance Minister of this govt as well as previous govts.
It need not be personal corruption but it could very well be protecting favorite proteges by Sitharaman, Manmohan Singh and those before him.
I think this nonsense of IAS should be stopped. No person can be good if she/he is a Jack of all trades.
India must have people knowledgeable and credentialed in the area that they supervise or they are sitting ducks to be manipulated by their underlings.
Why are we still holding on to British era procedures, laws, etc.?
If their way of working was so wonderful, then we would not see the shambles that is Britain today.
Yes, we continued with the British way as it was easier immediately after independence but now it is high time India looks at administrative procedures, laws etc that we have just blindly continued to follow.
I wish there was a Sucheta Dalal clone in the various areas where we need to root out the rot and implement modern, foolproof mechanisms.
S.SuchindranathAiyer
3 months ago
Nehru and his gang of thugs, most particularly the Iron Statue of India, Patel ensured that the Colonial administration,judiciary, police, institutions and laws would continue as before after 1949. Colonial rule was based on the assumption that Caesar's wives can do no wrong. In 1947 Caesar's white wives were replaced with coconuts (Brown on the outside and white on the inside). The UPSC, the "convented" educational system and most important, that bastion of alien rule, the judiciary and their collegium, ensured that the loot and plunder of India would remain undisturbed.
crusader1
3 months ago
As long as you have generalist (MA histroy, MA political science etc types) playing specialist's role (Finance, banking, credit etc) these type of questions are bound to occur.
These generalists are YES man types...I guess its high time now that India needs to bust the myth about omniscience of these Generalists
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