Corruption in bank lending starts at very beginning

Sep 18, 2015

- By Vivek Kaul

Vivek Kaul
"Anyone with any sense had already left town..." - Bob Dylan in Lily, Rosemary and the Jack of Hearts

In the Daily Reckoning newsletter dated September 9, 2015, I had extensively quoted a survey carried out by EY. In this survey 64% of respondents believed that the bad loans of banks resulted primarily because of lapses in the due-diligence carried out by the banks, before the loans were sanctioned.

As the report which came along with the survey pointed out: "Third party agencies such as surveyors, engineers, financial analysts, and other verification agencies, etc., play a critical role in assuring financial information, proposals, work completion status, application of funds, etc. Lenders rely significantly on the inputs issued by such third parties."

And this system is being manipulated. "Reports are made as a routine, with little scrutiny. In some situations, the reports may be drafted under the influence of unscrupulous borrowers," the EY report pointed out.

In response to the column someone with a detailed knowledge of the loan processing and disbursal process of banks got in touch with me. He gave me two examples of the loan disbursal system being manipulated. This ultimately led to several banks ending up with bad loans.

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The first case was of an unlisted entity in the business of manufacturing luggage, borrowing from two big public sector banks. The promoter of the company offered his equity in the company, as well as land and the factory, as a collateral. This transaction took place in 2007. The valuation report by a third party agency put the combined value of all the assets at Rs 35 crore. Against these assets the banks gave a loan of around Rs 27 crore. The promoter took this loan. He also borrowed Rs 3 crore more from the banks.

Later another valuer was brought in to examine the value of the assets, and the value of the assets was put at a much lower Rs 19 crore. The old valuer was dismissed but by then the damage had already been done. The company had given out a loan of Rs 30 crore against assets which were worth only Rs 19 crore. Ideally the situation should have exactly been the other way around.

The second case involves a listed company in the building materials space. The company came out with an initial public offering in 2008-2009. The company was listed at a three digit price. Currently, the price of the stock is in lower single digits.

The company took loans amounting to Rs 325 crore from two big public sector banks and one of the bigger new generation private sector banks. The promoter did not stop at this. He borrowed more using his other listed entities as well. In 2013, he defaulted on the loans citing slowdown in construction activity.

Now he owes banks around Rs 1000 crore to the banks. The book value of the assets that banks have as a collateral is around Rs 225 crore. The market value is expected to be in the region of Rs 325-350 crore. The rest of the money was lent by banks against shares, which are now quoting in single digits.

In both the cases, the banks ended up with losses. Both the companies that we talked about are not very big companies and they were able to do so much damage to banks so easily. Now imagine what must be happening when the banks deal with the bigger corporates.

The Reserve Bank of India (RBI) governor, Raghuram Rajan, summarised the situation accurately in a speech last year when he said: "The promoter enjoys riskless capitalism - even in these times of very slow growth, how many large promoters have lost their homes or have had to curb their lifestyles despite offering personal guarantees to lenders?" Almost none.

In fact, these defaults have pushed Indian banks into a difficult situation. As R Gandhi, one of the deputy governors of the RBI, said in a speech he made on September 15: "The amount of non-performing assets [have] witnessed [a] spurt and as on March 2015, it was at 4.62. per cent of the gross advances of the banks in comparison with 2.36 per cent of the gross advances as at March 2011."

Further, non-performing assets or bad loans have grown at a much faster pace than the overall lending in the last few years. Along with the growth in bad loans, as I have often pointed out in the past, the restructured assets (where the tenure of the loan or the interest on the loan has been changed in favour of the borrower) have also grown.

As Gandhi pointed out: "The ratio of restructured standard assets to gross advances grew to 6.44 per cent as at the end of March 2015 from 5.87 per cent of gross advances as on March 2014. The total stressed assets (i.e., NPAs plus Restructured Assets) as on March 2015 were 11.06 per cent of gross advances."

All this has had a severe impact on profitability of banks. "The sharp increase in stressed assets has adversely impacted the profitability of the banks. The annual return on assets has come down from 1.09 per cent during 2010-11 to 0.78 per cent during 2014- 15," Gandhi said.

This has become a drag on the economy. The increase in bad loans and restructured assets also hurts those borrowers who have been repaying their loans without fail, as they end up paying higher interest rates. As Rajan said last year: "One consequence of skewed and unfair sharing is to make credit costlier and less available. The promoter who misuses the system ensures that banks then charge a premium for business loans." Hence, the next time the businessmen want the RBI to cut interest rates, they should understand they are a major part of the problem.

Other than the fact, that the banks lent more money than they should have [i.e. due-diligence wasn’t proper], they also did not monitor the loans properly. In cases where money had been lent against shares, the falling share price should have led to some action from banks. But that doesn’t seem to have happened.

The RBI has since asked banks to follow a proper credit-risk management system. As Gandhi said during the course of his speech: "The guidelines entail involvement of top Management, including the Board of Directors of the bank in actively managing the credit risk of the banks. Banks are required to put in place proactive credit risk management practices like annual / half-yearly industry studies and individual obligor reviews, credit audit which entails periodic credit calls that are documented, periodic visits of plant and business site, and at least quarterly management reviews of troubled exposures / weak credits."

While this will help banks in not making the same mistakes as they have in the past, it will do nothing about the mess that they already are in. For loans that have gone bad already or are in the process of going bad, all these steps are essentially too little and too late.

Publisher's Note: Vivek Kaul, the India Editor of the Daily Reckoning, just made a bold call - Real Estate prices are headed for a fall. Well, if you are someone who is looking to buy real estate, or is just interested in the space, I recommend you read Vivek's detailed views in his just published report "The (In)Complete Guide To Real Estate". To claim your copy of this Free Report, just reconfirm your Free subscription to the Daily Reckoning...

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.

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5 Responses to "Corruption in bank lending starts at very beginning"


Sep 19, 2015

Should the concerned bank officers and top management not be held accountable for such poor due diligence? The steps mentioned for good credit risk management system are common sense and would have been followed by any person exhibiting ownership without the RBI having to tutor. We don't see news on bank staff and management being penalised with loss of job, imprisonment for criminal conspiracy etc. Wonder whether this lack of stringent action against errant officials is a lapse in written down job responsibilities or in implementation.

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Sep 18, 2015

Its true that corruption starts at a very beginning. But I want to make a correction to this statement. The culture of corruption largely depends on the Organization Culture where corruption is illegally legalised means taken it granted. This is one dimension to the corruption. The other dimension is that the legal system and the Government machinery who are unable to touch the culprits. I feel the one who does the fraud by way of bank loans are economic terrorists and they should be dealt the way the Govt is dealing the Kasabs.

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Sep 18, 2015

As an Ex- PSU banker, who had watched the lending processes closely, i agree 200% with Vivek. The system has become rotten and those who don't toe the line of corrupt bosses are dubbed anti=business and sidelined . Those who still question will get harassed also

Like (1)

.T. George

Sep 18, 2015

Dear Mr Vivek,
Your article is superb.I fully agree with what you say.
Unfortunately no Finance Minister exercised strict control over Public Sector Banks' senior executives like Jain.They did not bother abt lending to unscrupulous loan seekers unsecured loans in crores( how could a senior executive be so stupid as to loan 1000 crores agaist assets worth only 200/250 crores.Was it stupidity or was it manipulation to favour loan seeker for benefits ? Why did Arudathy Bhatcharya offer to give soft loans when the Bank has bad debts in hundred of crores?What is her security for being so generous at the expense of thousands of share holders who lost heavily because of the gross lack of concern forthe shareholders.
Please ensure that the P.S Banks are not allowed loans withoud adequate securities.It is the tax payers; money, NOT bank directors' family wealth.How come HDFC,Yes Bank,even small banks like Federal makes profits,while SBI, Canara etc have BAD DEBTS in thousands of crores.I want directors/Gen.Managers etc. who advanced unsecured loans to be investigated and their assets evaluated,and be given punishments if deserved.Also attach assets of loan defaulters so that the banks are not in the red.
Please ask Mr Modi and Mr Jaitley to take immediate action in this trajic matter.Thosands of share holders
of PS Banks are cursing the Finance deptmt
Thank you

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Sep 18, 2015

Banks have a 'fail safe system', which fails when there is a lot of influence peddling. There is a lot of competition to get business. All these bad loans were once upon a time good loans. The people who got the business would have been rewarded.

In good Banking practices there is a term 'Management Quality'. This is usually not given enough attention. The attention is given to projected numbers.

The making of a proposal for Bank Finance is a complicated one. When the proposal is circulated, a lot of queries are raised in the approval chain. These are answered. A lot of time is consumed. The borrower flexes his muscles and the due diligence process is short circuited as the borrower then passes his papers to another bank. The Sales team usually have run ins with the Credit team and the borrower plays both ends.

The approval process itself is multi-tired. It is not in the hands of one individual. Some times as many as 10 persons have to approve.

Still why do loans go bad?

Due Diligence is not done. Senior Bankers do not become Senior Bankers by shooting down proposals. They become senior Bankers by approving, net working and influence peddling. Some one down the line always will have to take the blame when things go wrong. No one reads proposals and asks questions. Management experience and quality is summed up in a few lines to satisfy the needs of the proposal.

Additionally the monitoring and the follow up of bad loans goes to officials who are considered unfit for better positions. They only need to do 'time-pass' to get to superannuation and retirement.

I suggest that good old pawn broker tactics be used to recover band loans. Break a few knees. Money should come back.

In a land where Vijay Mallaya can get his 'wilful defaulter' tag removed by a court, even long lost virginities can be restored by court order. Reforms are needed. No one is too big to fail.



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