‘If you owe the bank a US$100,000, the bank owns you. If you owe the bank a US$100 million, you own the bank.’
This American proverb alludes to the dangers of corruption, nepotism and cronyism in the banking sector. Often ignored, corruption in the financial services sector can have deep and far-reaching consequences for an economy, and in an increasingly interconnected world, the entire globe. This has been brought into sharp focus since the 2008 crisis and its aftermath, which included interest rate rigging, money laundering and tax evasion.
In India, corruption in the financial services sector has been in the media spotlight in recent years, with Indian banks labouring under the burden of growing columns of non-performing assets (NPAs) and bad loans. While the government seeks to address issues of debt recovery by way of undertaking an overhaul of existing laws, enforcement actions are bringing to light the corruption in the system and how bank officials have been sanctioning loans to undeserving borrowers.
Why is tackling corruption in the banking industry important?
Combating corruption in the finance sector is a central concern of law-enforcement agencies, central banks and financial regulators. Probity in the conduct of business by banks is crucial, given that they deal with public money; since they are financed through deposits of small savers and their equity is owned by retail investors, either directly on the stock market or aggregated through institutional investors, such as insurance companies, mutual funds and pension funds.
In India, some of the bigger banks are state-owned and therefore their capital is directly supplied by taxpayers. State-owned banks dominate the banking landscape in India – statistics issued by the Reserve Bank of India (RBI), India’s central bank and banking regulator, show such banks have 73.3 per cent of the market share in credit and 73.9 per cent of the share in deposits. This is why they should have standards of integrity, but unfortunately, banks – state-run banks in particular – have very low standards of governance. Governance in banks is also crucial to achieve the ends of banking supervision – whether prudential regulation or consumer protection. Corruption by banks in the manner they extend loans and subsequently recover (or restructure) them has systemic implications on the asset quality of banks – giving loans for extraneous considerations and possibly evergreening or restructuring bad loans could lead to the build up of NPAs in banks, tie up capital and prevent fresh credit offtake. While reliable data linking bank integrity issues to asset quality is difficult to get, the anecdotal evidence is worrying. In the past year, India has completely overhauled its insolvency law by enacting the Insolvency and Bankruptcy Code, 2016, to address the chronic problem of Indian banks building up large portfolios of NPAs.
One of the highest-profile instances was of state-run banks running up exposure of up to 70 billion rupees in respect of an airline company without appropriate credit assessments and against inadequate capital. There were serious accounting, legal and governance violations with respect to the cash flows of the borrowers that the banks should have detected and tackled – and ideally they should not have lent to the borrower unless such transactions were reversed or if such transactions were discovered, they should have been treated as acceleration events under their lending documents. Instead, banks did not address the deterioration in asset quality by taking legal measures against it, but rather they refinanced their loans. Eventually these loans became classed as junk as the airline company shut its operations and several loans had to be written off almost completely – with bank capital remaining interminably stuck and not being free for more productive deployment.
Because of the interconnectedness of the financial sector, such issues threaten to destabilise India’s economy. Corruption and related offences (such as collusion and fraud) significantly impact the consumer protection goal of banking regulators when it takes the form of offences such as interest-rate rigging as well as predatory pricing, which is subsequently accelerated.
Banks also often act as gatekeepers to identify other kinds of offences – for instance, money laundering and tax evasion – are tracked through banks’ processes relating to know-your-customer checks and suspicious transactions reporting, among other things. Banks and their personnel are therefore especially vulnerable to fraud and corruption on potential anti-money laundering offences. An international example of this are the U-turn transactions undertaken by Standard Chartered Bank for routing funds into Iran, a country that was on a sanctions list. In other instances, banks have been used to fund criminal organisations. Meanwhile a list of Indian account holders of a Swiss branch of an international bank was leaked to authorities, leading to an investigation by tax and law-enforcement authorities in India.
In a major recent development, the Indian government on 8 November 2016 demonetised Indian currency notes of 500 rupee and 1,000 rupee denominations (ie, the two highest denominations) with immediate effect, ostensibly to tackle hoarding of ‘black money’ (illegally acquired cash) and as a measure to reduce corruption. The government has introduced new currency notes of denominations 500 and 2,000 rupees and placed limits on the exchange of the demonetised notes and withdrawal of new notes from banks. While the impact of this still remains to be seen, systemic issues are coming to light with the police apprehending persons in possession large amounts of currency, and arresting bank officials for permitting conversion of demonetised notes into new currency in excess of prescribed limits.
The recent India experience
The recent Indian experience on integrity issues in banks is especially instructive for the width and depth of its prevalence. A few years ago, the chairman and managing director of a large state-run bank were arrested for taking a bribe to extend a loan to a steel manufacturing company. Charges have been framed under the Prevention of Corruption Act, 1988, and the Indian Penal Code. The loan was discharged without adequate credit checks on account of the alleged bribing of the lender’s management and collusion with the borrower – and later classified as non-performing on account of defaults, requiring the lender to disclose and provision capital. Regardless, the loan was refinanced and restructured for a period of as long as 25 years, when other recovery, collateral enforcement or liquidation options could have been explored instead. Similarly, a former chair and managing director of United Bank of India was also arrested by the Central Bureau of Investigation for having obtained large amounts of money for herself, or a private firm owned by her husband and son, from private companies to which various credit facilities were granted by the bank.
In the context of state-run banks, there are restrictions on recruitment as well as remuneration of managerial staff in state-run banks, which impacts the quality of top management. Boards also tend to have ex officio nominees to the government rather than independent experts that can provide ‘tone from the top’. There are limitations on the tenure of bank chiefs that, coupled with collusive and corrupt practices, means that they are incentivised to ‘extend and pretend’ when a loan goes bad, rather than recognise and address it. This is demonstrated by the fact that the quarterly results following the appointment of the chairman and managing director of India’s largest state-run bank almost always report lower profits on account of higher provisioning for bad loans extended during the tenure of the previous chairperson. For instance, the quarterly results following the appointment of the current chairperson showed the sharpest decline in profitability when compared with those during the two years that preceded it (incidentally, the tenure of the previous chairperson), which was attributable almost entirely to the provisioning against bad assets undertaken after she took over. All of these have lead to a build-up of NPAs in India’s banks to the extent of 4.45 per cent of total advances in March 2015. Loans are extended based on egregious practices rather than rigorous credit checks to borrowers or sectors that need credit.
Part of the reason for the concentration of such practices in the banking sector was the lack of a governance framework for banks that addresses these issues in a concerted manner. The RBI has now put in place various reporting mechanisms that obligate banks and financials institutions to report ‘fraud’, including unauthorised credit facilities extended for reward or illegal gratification. Moreover, in an important recent development, the Supreme Court of India in a recent decision in the case of Central Bureau of Investigation v Ramesh Gelli & Others has held that the term ‘public servant’ under the Prevention of Corruption Act, 1988, includes employees of private banks, thereby extending the ambit of India’s primary anti-corruption law (which primarily targets corruption in the public sector).
The Prevention of Corruption Act, 1988, does apply to state-run banks and the Comptroller and Auditor General of India and the Central Vigilance Commission do have oversight over them. However, the managerial staffs of such banks do not have the tighter conduct rules applicable to other civil servants restricting them from taking gifts, meals and hospitality, and lack severe restrictions on interface with private parties. It remains to be seen how the decision of the Supreme Court in the Ramesh Gelli case impacts private banks and their bank officials and whether it will result in tighter checks and vigilance mechanisms. In addition, due diligence and customer service is often disregarded in the race to meet numerical targets. An RBI-appointed Committee on Customer Service in banks noted that banks are ‘focusing excessively on achievement of quantitative targets rather than rendering quality service to select customers after having carried out the process of due diligence’. This highlights the potential for mis-selling or the unsuitable sale of products because of remuneration structures that place excessive importance on the achievement of sales targets.
There have been some recent reform initiatives in this regard, including the requirement to have independent directors and permitting competitive remuneration of directors. For state-run banks, the RBI formed a committee that made a host of recommendations to improve governance, including competitive recruitment and remuneration, fixed tenures for bank chiefs, clawing back of bonuses when dubious evergreening is detected, etc. The implementation of these recommendations is currently on hold since they are being resisted by bank unions. These recommendations are fundamental and could help transform the banking landscape into a more professional and better-governed one. In addition to the aforesaid recommendations, others could include embedding within performance metrics the performance of loans disbursed under the management’s watch, and making their remuneration contingent on this by penalising management for non-performance of loans, holding up promotions for deterioration in quality of loans, and linking promotions to recoveries. This will bring accountability and disincentivise collusive behaviour. Further, despite fixed tenures, management should be made responsible for loans disbursed in their time if they become non-performing even after they are transferred (if such deterioration can be linked back to acts or omissions of the management). In addition, there must be tighter rules governing the conduct of bank personnel in both private and public sector banks.
The India experience holds some lessons more generally. While other countries do penalise private sector corruption, because of the risks unique to banking, it is appropriate for a special framework on integrity specifically for the banking sector to be present, which could be stipulated and monitored by banking regulators and supervisors. This should include having independent boards to set the tone and monitor, on an ongoing basis, the compliance with an anti-corruption framework and its impact on related parts of the bank’s performance.
The remuneration of bank management has been especially criticised in the wake of the global financial crisis and must be overhauled. Transparency International recommends in its working paper Incentivising Integrity In Banks (working paper #02/2015) that there should be non-financial performance criteria when determining performance-related pay, which places a premium on integrity, behaviour and compliance with anti-bribery and anti-corruption frameworks and in certain instances where such behaviour may pose a threat to a bank’s values or override any positive assessment of financial performance. They also recommend the use of clawback options (with no limitation period) to increase accountability for wrongdoing.
Additionally, in the interest of transparency, the remuneration policies of banks should be published, which would allow stakeholders (such as customers) to know if financial products and their sale are linked to faulty incentive structures.
Other measures include rigorous restrictions on conflicts of interest; the Volcker Rule introduced in the US soon after the financial crisis is one manifestation of this to prevent the moral hazard that could arise when the same entity undertakes investment and commercial banking. Such restrictions should be pervasive and should be enforced strictly. All these are in addition to the existing compliance frameworks for anti-money laundering and combating the financing of terrorism.
Benefit, not cost
The banking industry usually sees compliance as an additional cost and a burden. It is imperative to change that perception and to instead make it see the benefits – that of better-quality talent and leadership that results in better quality assets and stronger balance sheets, lower moral hazards, lower vulnerability to ‘black swan’ events and crises, and, therefore, better bank performance.