The Nature of the Beast

A frog goes into a bank, and hops up on the desk of the loan officer. “Hi,” he croaks. “What’s your name?”
The loan officer says, ‘’My name is John Paddywack. May I help you?”
“Yeah” says the frog “I’d like to borrow some money.”
The loan officer finds this a little odd, but gets out a form. “Okay,what’s your name?”
The frog replies, “Kermit Jagger.”
“Really,” says the loan officer. “Any relation to Mick Jagger?”
“Yeah, he’s my dad.”
“Hmmm,” says the loan officer.“Do you have any collateral?”
The frog hands over a pink ceramic elephant and asks, “Will this do?”
The loan officer says, “Um, I’m not sure. Let me go check with the bank manager.”
“Oh, tell him I said hi,” adds the frog. “He knows me.”
The loan officer goes back to the manager and says, “Excuse me, sir, but there’s a frog out there named Kermit Jagger who wants to borrow some money. All he has for collateral is this pink elephant thing; I’m not even sure what it is.”
The manager says:
“It’s a knick-knack, Paddywack;
Give the frog a loan;
His old man’s a Rolling Stone.”

EVERYONE IS CARRYING on as if this is the first time a bank has been cheated. They forget Nick Leeson who brought down Barings Bank. Indeed, as Indira Gandhi said about corruption, it is a global phenomenon. The truth is that before she nationalised 14 banks in 1969, people understood the risks. They knew that since money was involved, fraud could not be far behind.

Until 1947, bank collapses were common because of both frauds and poor lending decisions. Between 1947 and 1960 also there had been a few collapses. The RBI, after it was nationalised in 1949, stemmed the rot by becoming the bank of last resort. Post Independence, the major bank collapse was in 1961, when the Palai Bank crashed. Hundreds of thousands of people lost their savings. Global Trust Bank in 1998 was the next to go under.

The background to Indian banking, like so many other things, is rooted in the East India Company’s commercial needs. When it arrived to trade after Jahangir gave it permission in the early 17th century, the Company found it could not deal with local money lenders because of language barriers and other problems. Its officials turned to their own agency houses in Calcutta and Bombay, the forerunners to the managing agency houses of the 19th century’s latter half. They usually had no capital of their own, but did take deposits. Soon, however, they started banks and it was pretty much a free-for-all. The first bank was Hindustan Bank of Calcutta in 1770. Then in 1785 came General Bank of India and Bengal Bank. The Bank of Calcutta started in 1806. It was the first of the Presidency banks. Then Bombay and Madras started their own Presidency banks in the 1840s to finance the opium and spices trade respectively. General Bank of India failed in 1791 as did Bengal Bank. An Act was passed in 1813 to remove all restrictions on setting up banks by White men. Many of them were irresponsible buccaneers and between 1829 and 1833, there was a crisis when almost all these banks failed, mostly due to the malfeasance of their managers.

In keeping with the free trade ideology of the time, however, no lessons were learnt, nor any precautions taken. So in 1860, the same thing happened once again. By then, the British Crown had taken over from the East India Company and it brought some sense into the banking industry by introducing, for the first time, the notion of limited liability. This was to ensure good behaviour by bankers and to protect depositors. These were mostly unsuccessful and the banks kept speculating and failing. Only the three Presidency banks survived.

Then in the first decade of the 20th century, the partition of Bengal and the Swadeshi movement led to the first Indian-owned banks being set up. They were small and efficient and knew the local conditions. Soon, they were giving the European banks a run for their money. So in 1913, in a manner reminiscent of what the RBI does with NBFCs now, an Indian Companies Act was passed to keep these Indian banks under British check. One result was another banking crisis.

Then came the post-War boom and again many banks were set up. Most went bust during the Great Depression. Keynes had told the Government as far back as 1913 that most of these banks were under-capitalised—just as they are now—and didn’t have enough cash reserves. In 1921, the three Presidency banks were merged to form the Imperial Bank of India and it did almost everything that a central bank was expected to do. However, note issue remained with the Government.

The RBI took over all central banking functions in 1935 and would have liked a thorough clean-up of the entire industry. But the Government asked it to wait till after World War II, and it was not till 1949 that comprehensive legislation was passed. In the interim, many banks went under and many also came up. The majority of them indulged in all sorts of malpractices. Free entry and exit were the order of the day. Depositors had no say in anything. The ‘caveat emptor’ rule prevailed. Banks kept failing till 1950, but in lower numbers.

THEN IN 1960, the 33-year-old Palai Bank, a major bank in Kerala which made money but by unconventional business practices, failed because the RBI caused it to be liquidated as it was finally convinced—after watching it and vacillating for nine long years—that the bank had become inherently unstable. The management denied this vehemently. It also cried foul and almost suggested mala fide intent on the RBI’s part because the latter refused to allow the bank to take fresh deposits by the simple expedient of not permitting it to open more branches.

The tussle went on for four years, from 1956 to 1960, with both sides digging their heels in. An inspection carried out during October- December 1951 showed that the bank’s managing director had sanctioned large advances to his relations and other directors and their concerns. It also warned that the bank appeared to have lost not only its entire paid-up capital and reserves, but also its deposits to the tune of almost Rs 4 lakh. The report also observed that the Palai management did not show any earnestness in following the RBI’s advice on various matters.

Nevertheless the RBI did nothing on the grounds that Palai Bank ‘occupied an important position’. It did however impose some conditions which the bank failed to observe and, instead, ‘contested that these conditions were either unnecessary or not in the interests of its constituents’. The official history of the RBI says that ‘even within the RBI there was a strong realisation to take stringent action, but somehow the entire issue got soft-pedalled’.

The situation went from bad to worse over the next few years and eventually the RBI, at the personal insistence of HVR Iyengar, its governor, ‘directed the bank November 1958 not to declare a dividend until it managed to bring its bad and doubtful debts down to a reasonable level’. But then a Congress MP intervened on behalf of the bank, referring to the contemporary political situation in Kerala. ‘It is debatable whether extraneous considerations, such as the surcharged social and political situation in Kerala, affected its judgment on this question,’ says the official history. In June 1960, there was a run on the bank’s deposits. ‘The proximate cause was the publication the previous day of the annual accounts of the bank for 1959, showing a loss of some Rs. 14.5 lakh. This trend gained momentum in the following months too. It came to be acknowledged that the bank was beyond redemption and it was best taken into liquidation as soon as possible…’

Even now, no one knows what really happened. Was the RBI being vindictive? Were there some political reasons for the action, as many now believe? Even the RBI’s official history suggests that this was a time of socio-political upheaval in Kerala—India’s first elected communist government had been summarily dismissed by the Nehru Government in Delhi. Another theory is that Nehru was not comfortable with community-based financial institutions and Palai Bank was very much a Catholic institution.

Curiously, the RBI resisted plans for making it a subsidiary of SBI, which Travancore Bank had become. Whatever the reasons or combination of reasons, from which the RBI did not escape unscathed, the closure set off a banking crisis that had two positive outcomes: the birth of deposit insurance and the tightening of the RBI’s grip on commercial banks because the Government empowered it to forcibly merge weak banks.

THE PNB SCAM has to be seen in this overall light. It is best captured by the joke at the start of this article, as it sums up the tamasha in the news. Basically, depending on where you stand, you can make whatever you want of it. Since no fact is clearly established, everyone is firing blanks in the air, which has become opaque with smoke, not to mention the sheer noise of it all.

Thus:

1. Has Nirav Modi really made off with Rs 11,400 crore? His lawyer says only Rs 280 crore is owed. Only an enquiry will establish the truth.

2. Did the PNB manager exceed his authority? No one knows because apparently it was the management which vested him with the power to propose and dispose. This is never done, so again, an enquiry is needed.

3. Did Nirav Modi indulge in a ponzi scheme wherein he was rolling over Letters of Understanding? Again we need an enquiry.

4. Who were the beneficiaries of the LoUs? Enquiry needed.

5. Did the Finance Ministry know? Enquiry needed.

6. Did the PMO know? Enquiry needed.

7. Did all this start in 2011? Enquiry needed.

8. Were the auditors remiss? Enquiry needed.

9. How was the Core Banking System bypassed by one man for so many years? Enquiry needed.

10. And in the end, the key question: was fraud in the legal sense really committed? Enquiry needed.

Assuming the answer to all these questions is ‘yes’, the next set of questions are about banking practices and supervision. Are these satisfactory? If not, why not? Is it a competence issue or negligence or mala fide action? If mala fide, on the part of who all?

And what about structural problems? Does public ownership of banks, which means control by politicians, inherently encourage fraud? Is the intent to defraud banks independent of who owns them? What about plain incompetence? How far is that a factor in generating and sustaining malpractice, if not actual fraud?

Are there problems of internal incentives for senior management that prevent fraud from being punished even when detected? Many former bankers say there are. Has this encouraged a lax culture?

These questions come up each time there is a problem of this nature. All sorts of solutions are talked of. And to each solution, there is an equal opposite problem, which suggests that fraud can be minimised but not eliminated altogether. And this is not a peculiarly Indian problem. It is true of banks all over the world. Even in the most stringently regulated and supervised banking jurisdictions, from time to time there are gigantic frauds.

The problem in India’s public sector banks, however, seems to be the increasing incidence of such fraud. There are a large number of reasons for this, not the least of which is the fact that thanks to crony capitalism, bank funds have become a way of funding elections. The borrower, usually a newcomer, is allowed to take a loan in excess of his or her needs. The excess is then passed on to some political party or politician. But when the time comes to repay, the excess becomes a non-performing asset. And, finally, as the cost of elections has increased, so have the amounts involved.

That is why it is necessary to privatise these banks or at least bring down government shareholding to less than 50 per cent. This will not prevent periodic frauds, but it will at least prevent politicians helping themselves to bank funds which are then made good by taxpayers via recapitalisation.

The short point is that fraud is an integral risk in any business, and strive as you will, 100 per cent protection against it is impossible.

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