News: Vulnerability of small Indian banks

(BL 03/09/2006) Mumbai - "Too big to fail" is an apt statement when one hears of another small bank being put to sleep by the Reserve Bank of India. All organisations are vulnerable to fail, but banks and financial institutions are more vulnerable than others. And, the world over, Governments, even in the citadel of capitalism (USA), bend backwards to save a bank, if it is really big.

Two decades ago, a big bank, Continental Illinois, was resurrected from doom by the US Government. The authorities there again launched a rescue act when Long Term Capital Management, a financial services firm operating a very big hedge fund collapsed.

While saving banks/financial firms, the US Government allowed a very big firm Enron and its equally big auditor, Arthur Anderson to fold up.

In India too, the authorities have been regularly saving commercial banks from failures, whereas innumerable NBFCs and co-operative banks have had a quiet burial. Big banks in Public Sector (PSBs) were given fresh capital by the Government to meet losses, whereas some small banks were merged with PSB or were taken over by other banks.

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Cases that come readily to mind are Nedungadi Bank, Global Trust Bank, Centurion Bank etc. Banks are unique among all modern businesses in the sense that they operate extensively on borrowed funds. Till a decade ago, there was no limit to a bank's borrowing powers vis-a-vis its owned funds.

Lending Prudently

The fortunes of a bank are based entirely on the capability and willingness of the management to lend out depositors' funds in a prudent manner. Not that one should avoid risk, but quite often, the management is tempted to indulge in extremely risky lending. Such propensity is accentuated in smaller banks where the checks and balances inherent in a big bank might be missing or inadequate. One old bank was brought down because of losses in stock market operations, allegedly, because some influential stock brokers joined as Directors.

Another bank went down, reportedly, due to the overweening ambition of the promoter CEO who possibly wanted to become too big too soon. Another new bank that was started by an NBFC met its doom when the legacies of NBFC were perhaps transferred on to the bank. All small banks, where one person or a Group controls the levers of power, could indulge in imprudent lending, unless the top management is absolutely professional in lending operations.

Opportunities to throw away money are plentiful. To cite a few, stock market operations - in India banks can even play in secondary markets, or lend to known people irrespective of the viability of project (usual excuse of borrowers belonging to "our" community/State etc), or lend to the firms of other banks' Directors, irrespective of merits, as a quid pro quo for that bank lending to its Directors etc.

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There were even reports of banks giving money to buy its own shares, which is specifically prohibited by the RBI. This rule was reportedly circumvented by giving unsecured loans for buying the shares. All these temptations are available to bigger banks also, but the scope for one person to call all the shots is somewhat limited. Yes, the entire capital of one big PSB was wiped out probably because the top man permitted unscrupulous lending; but such cases could be more in number in small banks, where most of the Executives owe personal allegiance to the CEO.

Basel Norms

The RBI is taking various measures to protect the integrity of commercial banks and have evolved a strict monitoring regime. But, like in other spheres, here too there is an uneasy feeling that political influence might be a constraining factor. If a person or group managing a bank indulges in unprofessional lending, corrective measures taken after the event are rarely effective. Proactive steps, as suggested by Basel norms, and lessons learnt from past experience should be put in place well before a bank slides down into bankruptcy.