The JSBF Report
Corporate Governance and the Regulatory Structure in the Indian Banking System
Updated: Nov 10, 2020
By: Sarthak Aneja
The roots of most Indian banks trace back to nationalised banks in the ’60s which were operated by the Government. However, over the years, with the entry of the private players in the 90’s and modern banking practices led to the evolution of the Indian banking system. The expansion and evolution of the banking industry were accompanied by the scams and scandals which started rising rapidly. The Stock market scam of 1992 to the NPA scams post 2008, our banking system exhibits a strong need for the adoption of good corporate governance practices.
Incentives for poor corporate governance practices:
The working of any organisation depends on its management practices including the beliefs and principles of the leaders. Today banks with listings need to acquire a certificate of corporate governance from the Securities and Exchange Board of India. However, just acquiring a certificate does not ensure proper governance practices at the bank. Yes Bank is one such example which suffered due to the company’s board members indulging in unethical and illegal practices. In this regard, it must be noted that there are some practices and laws which a bank is supposed to adhere to ensure proper governance which is mentioned below:
1. Executive Compensation: The compensation package for executives comprises of fixed pay, variable pay, perquisites etc. The variable component of payments is usually more than double than that of the fixed component which incentivizes them to indulge in unethical practices of extending bad loans which turn out to be Non-Performing Assets (NPAs) in the future. At Yes Bank, the compensation of the CEOs was linked to the stock prices.
2. Board Members & meetings: It is observed that at most of the major banks in India, the independent directors that are a part of the board of a bank have also taken up the responsibility to be a board member of several other corporations which divides their attention between various corporations. This is one of the reasons that diluted the governance at Yes Bank, the meetings were happening not as frequently as they should have, and key members were missing from the meetings.
3. Market Discipline: Post the Global Financial crisis of 2008, Banks across the globe adopted Basel III norms, under which banks had to maintain certain capital adequacy ratios. Indian banks had to ensure that the Common Equity Tier 1 ratio and Tier 1 ratio was in adherence to the Reserve Bank’s guidelines. At Yes Bank all these requirements were either breached or overstated.
Prevalence of NPAs:
In addition to the problems mentioned above, The Indian banking system is prone to NPAs (Non-Performing Assets). A lot of this NPA remains unresolved with the banks failing to recover the money lost. Cases involving fugitives like Vijay Mallaya, Nirav Modi have been a massive hit to the banking sector, in particular to the public banks like the State Bank of India and Punjab National Bank. However, when we look at private banks the story is completely different. The top-level executives at private banks like Yes Bank, Axis Bank and ICICI bank have been indulging in illegal activities for personal gain. At Yes Bank, the CEO Mr Rana Kapoor was himself providing loans to distressed companies like Jet Airways, DHFL, CCD, Essel Group, and many more in return for kickbacks.
Moral hazard and the problem of too-big-to-fail:
Even with so much at stake the banks keep on with their poor standards of corporate governance as they know they are ‘too big to fail’ and the government will bail them out which creates a moral hazard problem. Banks carelessly misuse the funds of their depositors which leads to the RBI bailing them out with taxpayers money as they are Domestic- Systematically Important Banks (D-SIBs) and their downfall could lead to the collapse of the whole economy. One example is the fall of Lehman Brothers in the United States which had a contagion effect on the world economy.
What steps the Regulator take in order to ensure the stability of the banking system?
Even with so many laws in place, the banks seem to find loopholes to boost their profits and escape liability. One crucial step that the Reserve Bank can take is to place members from the RBI in the board of each bank, especially in private banks. There are arguments that the performance of the banks may suffer due to such interference but in the long run, this would lead to the prosperity and stability of both the bank and the economy. To overcome the problem of manipulating financial statements, banks with lower credit ratings provided by credit rating organisations like CARE and ICRA should be subject to audits at least twice every quarter, and at the same time, the regulator should supervise the bookkeeping departments of these banks. To ensure that the CEOs are not negatively incentivised, the variable pay component should be fixed by the regulator. With the growing number of fugitives, the government should work on its extradition treaties which are currently very weak and thus allows defaulters to flee away. By taking these steps, the regulator might face criticism, but it needs to come up with an efficient solution to solve the growing NPA problem and the ongoing fraudulent practices at banks.
It must be remembered that the Indian economy is the fastest trillion-dollar economy in the world and exhibits great potential for progress and development. However, we shall only be able to reach where we want to be if the banking system functions properly with the highest standards of governance to ensure consumer confidence and trust remains intact in the banking system. Each scam is an opportunity to learn from to improve and strengthen our laws. For the moment, even though the implementation of Basel III norms has been deferred to April 2021, hopefully by 2022 Indian Banks will have implemented BASEL- IV norms and strengthened the system by imposing stricter corporate governance practices as have been recommended above.
Sarthak Aneja is a final year student of B.Com(Hons.) at JSBF. You can connect with him on LinkedIn.
This blog is an abstract from the author’s research paper titled ‘The Modern Banking Experience: The Rise & Fall of Yes Bank’, which can be referred to for detailed analysis, comparison, ratio analysis and more. The research paper highlights the key reasons like poor corporate governance and breaching of rules which led to the fall of Yes Bank. The research study can be referred to have a better understanding of the following abstract.
DISCLAIMER: The Editorial Board of the JSBF Report has edited only this blog post. The larger research paper has not been edited by us.
 Non- Performing Asset- NPAs are loans which have been defaulted upon or are in arrears. They are further classified based on the period of default.  A nonperforming asset (NPA) refers to a classification for loans or advances that are in default or in arrears.  The capital adequacy ratio (CAR) is a measurement of a bank's available capital expressed as a percentage of a bank's risk-weighted credit exposures.  Noronha, G., 2020. Nirav Modi Case: PNB Receives $3.25 Million As Part Of Recovery From Liquidating Modi's Assets. [online] The Economic Times. Available at: <https://economictimes.indiatimes.com/industry/banking/finance/nirav-modi-case-pnb-receives-3-25-million-as-part-of-recovery-from-liquidating-modis-assets/articleshow/77746338.cms?from=mdr> [Accessed 30 October 2020].  Kickbacks- In finance kickbacks are a form of negotiated bribery in which a sum (commission) is paid to the person in exchange of services or facilities provided. Eg- commission paid on approval of the loan.  D-SIBs – A D-SIB is a status awarded by the regulator of banks in their respective nations. A D-SIB is a bank which is very important for the functioning of a bank and its failure could be catastrophic.  RBI Notification dated April 17, 2020, at <https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11870&Mode=0>, and RBI Notification dated September 29, 2020 at <https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11970&Mode=0>