Lesson from PMC Bank scam: Forensic, active supervision needed; RBI and govt must work to help whistleblowers, protect depositors

It is reassuring to see Finance Minister Nirmala Sitharaman affirm in the wake of the Punjab and Maharashtra Co-operative Bank scam that the government is ready to amend co-operative laws if needed to fix the rot in the system. We could say it has not come a day too soon, but also add that it has come years late.The incumbent NDA government is not to blame for a legacy problem that has plagued India for decades but it has to be careful on the one hand and quick-footed on the other because it is trying to undo the follies of the bank nationalisation wave that began in 1969. In this lies the clear and present danger of throwing out the baby with the bathwater.How does one ensure the safety of depositors while consolidating public sector banks in what seems like a plan to eventually put them effectively in private hands through share issues? The nationalisation process has been faulted for the PSU banks' propensity for politically-blessed loan waivers and non-performing assets (NPAs). But the flip side of this coin is that nationalisation and cooperative banks have also ensured credit to small enterprises and farmers.Public sector ownership has also given a higher degree of safety to depositors, ushering in a new culture of financial inclusion in independent India. Above all, nationalisation stopped industrialists from running banks. In the process it prevented conflicts of interest.Industrialist-banker nexusThe PMC Bank episode compares in scale (with an approximate exposure of Rs 6,500 crore) with the Rs 7,855-crore Satyam Computer Services scandal, which has been dubbed as India's biggest accounting fraud. It is a classic case of an industrialist-banker nexus. The Wadhawan family induced the co-operative bank to lend to their now near-bankrupt realtor HDIL.

Another arm of the clan, though now officially separated runs the troubled, debt-laden mortgage lender DHFL. Technicalities apart, the strange links between a lender, a builder and a bank with a family involving past ties of blood are such as to inspire a melodramatic financial thriller in Bollywood in the land of the Mahabharata. Scratch the surface, and you may find rivalries that tell a murky tale.

Let's go back a bit now. Bank of Karad and the Metropolitan Cooperative Bank were among those involved in the securities scam of 1992 popularly known as the Harshad Mehta scandal after the stockbroker who diverted vast sums of money from the bond market to the stock market using flimsy collateral. A few years later, convicted stockbroker Ketan Parekh's funds were linked to the Madhavpura Mercantile Cooperative Bank. Co-operative banks have been the weakest link in India's already leaking banking pipelines, thanks to a separate legal regime that limits the powers of the RBI.[caption id="attachment_7400291" align="alignleft" width="380"] Representational image. News18[/caption]It must be added that the RBI has been passive and bureaucratic in its approach. Former RBI deputy governor R Gandhi, who has headed a panel on co-operative banks, pointed out in a recent interview that committees had gone into the issue and the central bank's hands were tied because of extant co-operative laws. However, nothing stopped any RBI governor from pleading aggressively for legal changes, and nothing stopped any government from responding. That does not seem to have happened.As defaults of varying styles and degrees loomed, it was governor Raghuram Rajan who introduced the term "non-co-operative borrower" into India's banking lexicon, but it seems he was stopped on his tracks from ushering in some management thinking into the staid world of number-crunching rule-makers in the RBI. Ironically, the term "non-co-operative borrower" and "co-operative bank" seem to go together. The PMC scandal took too long for its lid to be blown off—typical of a regulatory no man's land.The central bank in Mumbai is autonomous and independent but its regulation can be strengthened by legislation or increased empowerment from New Delhi. That is the recommended approach for policy-makers if we wish to avoid a repeat of co-operative bank scandals. We have to be bold enough to ask if co-operative banks are effectively political fiefdoms run from remote locations or below the RBI 's supervisory radars.What must be remembered is that depositors are not investors. Their money cannot be treated as naturally prone to market risks when parked in scheduled commercial banks. Questionable rules of deposit insurance and limiting withdrawal rights (as it has happened in the PMC case) smell of a moral hazard in governance compounding the moral hazard in loan defaults. This adds insult to injury.

Besides PMC Bank, 12 other co-operative banks are also under RBI restrictions, thereby locking a huge amount of depositors' money in these banks

Hindu Co-operative Bank Limited, Pathankot, Punjab

Kapol Co-operative Bank, Mumbai

Padmashri Dr. Vitthalrao Vikhe Patil Co-operative Bank Ltd., Nashik, Maharashtra

Rupee Co-operative Bank, Pune

Shivam Sahakari Bank, Ichalkaranji, Kolhapur, Maharashtra

The City Co-operative Bank, Mumbai

The CKP Co-operative Bank, Mumbai

The Karad Janata Sahakari Bank, Karad, Maharashtra

The Maratha Sahakari Bank, Mumbai

U.P. Civil Secretariat Primary Co-operative Bank Ltd., Lucknow, UP

Vasantdada Nagari Sahakari Bank Ltd, Osmanabad, Maharashtra

Youth Development Co-operative Bank, Kolhapur, Maharashtra

The curative diet to nurse the banking system back to health is for the government and the RBI to jointly implement a pro-active culture of forensic supervision in which effective whistleblower protection and incentives must be built-in along with extra rights for surveillance of accounts. This has to be in addition to forensic audits of which the RBI is well aware.Picture it like a police patrol. Using a combination of technology, stronger laws and whistleblower encouragement seems to be the most cost-effective and impact-intensive method to reform the system. Rules regarding ownership and management must go hand-in-hand.

Prime Minister Narendra Modi's government prides itself on being decisive. For a government that axed Article 370 of the constitution to abolish a special status for Kashmir, staged a cross-border strike in Balakot to check terrorism and surprised the country with a controversial demonetisation of high-value currency notes, a well-planned move to reform banking—cooperative or otherwise—should not be an issue if there is political will. What is needed is not tut-tutting noises of empathy but decisive action.

However, the market-friendly BJP government needs to remember that in targeting its pet peeve—Nehruvian economics—it cannot absolve the state of its responsibility towards depositors, whose plight looked disturbingly sad as PMC's victims went to meet the finance minister.(The writer is a senior journalist and commentator. He tweets as @madversity)