Performance of Banking Sector in India & Its Corporate Governance Mechanism

Sujoy Kumar Dhar.

Faculty Member,

IBS Kolkata.

Introduction : Banks in a broad sense are institutions whose business is handling other people’s money.

A joint stock bank also known as commercial bank which is nothing but a company whose business is

banking. Protecting the interest of depositors becomes a matter of paramount interest to banks.

Regulators across the world have recognized the vulnerability of depositors to the whims of managerial

misadventures in banks and therefore regulating banks more tightly than other corporate.

The six basic functions of a financial system according to Merton and Bodie1 are as follows-

a) Clearing and settling the payments to facilitate the trade.

b) The probing of economic resources and subdividing of shares in various enterprises.

c) The transfer of economic resources through time, across borders and among industries.

d) The management of risk

e) The provision of price information to coordinate decentralized decision making by

different sectors of the economy.

f) The overcoming or mitigation of incentive problems due to asymmetric information.

Therefore Corporate Governance is no more a buzzword for the organization like banks who

deal with other people’s money. Commenting on Global Trust Bank imbroglio, one of the

journals2 has rightly pointed that, ---- “the recent GTB episode brings to the fore of fundamental truth that

governance matters. Great performance, higher profits, expanded reach; nothing would act as

safeguards for a company when governance and ethics take a back seat. While a single

wrongdoing is enough to ruin the reputation, it takes ages to build one and that too is possible

only with strict adherence to good governance practices. So Governance matters, in fact

it matters more than anything else.”

Phases of Growth in Indian Banks:

Since Independence , organized Western type of banking in India has evolved through four distinct

phases.

Foundation phase covering the decades 1950s and 1960s: This period witnessed the development of the

required legislative framework or facilitating the organization of the banking system to cater to the

growing and development needs of Indian Economy.

Expansion phase of the mid-1960s : This trend gained momentum after the nationalization of private

banks in the late 1960s.

Consolidation phase since 1985: Greater attention was paid to improve housekeeping, customer service,

credit management, productivity and profitability of banks starting from 1985 onwards.

Reforms phase commencing from 1991: Important and significant initiatives were taken with a view to

reforming the banking system such as the introduction of accounting prudential norms relating to income

recognition , provisioning and capital adequacy since 1991.

1 Merton R.C & Z Bodie (1995) , ‘ A Conceptual framework for Analyzing the Financial Environment’ in Crane ,D.B (ed), the Global

Financial System : a Functional Prospective , Boston ,p 5.

2 “Governance Matters”, Chartered financial Analyst ,June,2001,pp19-25.

Corporate Governance in Public Sector Banks

A substantial chunk of Indian Banking sectors still remains under the control of public sector banks

despite the strong wave of globalization, liberalization and privatization and entrance of private and

foreign banks in the arena .The major shareholding of the public banks with the Government. The reasons

for such ownership may include solving the severe informational problems inherent in developing

financial systems, aiding the development process or supporting the vested interests and distributional

cartels. Basel Committee3 has underscored the need for the banks to establish the strategies and to become

accountable for executing as well as implementing them. The existing legal institutional framework of

public sector banks is not aligned with principles of good corporate governance. The bureaucratic

hassles, red tapes and de motivated work culture adds further fuel to the fire. So far banks have been

burdened with “social responsibility” and compelled to tow the line of thinking dictated by the political

party in power, healthy banking policies will not be able to become the top priority. Monopoly of public

sector banks in banking business had protected them from competition and bank Managements have

thereby became complacent. There is no doubt that post 1991 scenario, PSU banks have to compete with

private and foreign banks to retain the market share.

Though the managers have an incentive to expropriate shareholders’ wealth, they are disciplined by

the managerial labour markets. The managerial labour market determines each manger’s outside

opportunity wage and inside promotion o the basis of economic performance of the firm.4

Removal of restrictions on factor markets as well the markets for corporate control will take care many

of the problems of miss governance since managerial behaviour is highly constrained by the presence

of capital markets and particularly the threat of corporate take over.5 The advocates of Principal Agent

Model6 insist that corporate Governance should be allowed to operate freely. The legislative

intervenes tend to impose costs either on firms or the shareholders.7Such External interventions are

unnecessary, unhelpful and distortionary. 8

The inefficiencies associated with Government owned banks, especially those emanating from a lack

of managerial incentives have led Governments under some pressure from international agencies to

begin divesting their own ownership stake. There is subtle pressure on Government of India also from

International organizations such as IMF & World Bank to withdraw their stakes in commercial banks.

The disinvestment of Government owned banks raises several corporate Governance issues. If banks

are completely privatized , there must be adequate deposit insurance schemes & supervisory

arrangements established in order to protect depositors’ interest. But if disinvestment is partial, there

may be opportunities for the government as the dominant shareholder to expropriate the minority

shareholders’ by using banks to aid Fiscal problems or support certain distribution cartels. The

existence of such cartel consists of corporate insiders having close links with Government elite

undermines the credibility of investors’ legal protection and prevents reform in banking system.

3 The Basel Committee on Banking Supervision is a committee of banking supervisory authorities which was established by Central bank Governors of the

Group 10 (G10) countries at the end of 1974 in the aftermath of the serious disturbances in international currencies and banking markets

4 Fama ,E (1989) ‘ Agency Problems and Residual claims’, Journal of Law and Economics ,26: 327-52.

5 Alchian A A and Kessel, R.A (1962) “ Competition, Monopoly and the persuit of pecuniary gain” in aspoects of Labour Economies ,National Bereau of

Economic Research ,Princeton N.J.

6 The principal-agent relationship implies the Principal( Shareholders or Owners) delegates work to the agent ( managers) who performs the work on the

principal’s behalf. Fama ,E (1989) ‘ Agency Problems and Residual claims’, Journal of Law and Economics ,26: 327-52.

7 Hart,Oliver (1995),’ Corporate Governnace ; some theory and implications’, The Economic Journal 105 : 678-89

8 Keasey et al, supra note 1.

Governance in Private Sector Banks: Private sector banks have entered niche areas , listed their

scrip and being market driven they have been more transparent in their functioning. They have also

been more tech savvy , growth oriented and have less of NPAs. Private sector banks has to conform

with standard of good banking practices such as

a) Ensuring a fair and transparent relationship between the customer and bank

b) Instituting comprehensive risk management system & its adequate disclosure

c) Proactively handling the customer complaints and evolving scheme of redressal for grievances

d) Building systems and processes to ensure compliance with the statutes concerning banking.

Banking Sectors Unique Nature:

The special nature of banking system calls for the adoption of broader view of corporate

governance in India. The special nature of banking requires Government intervention in

order to restrain the behavior of Bank Management. Depositors don’t know the true value

of bank’s loan portfolio as such information is incommunicable and very costly to reveal.

As a consequence of this asymmetric information problem, bank mangers are prompted

to invest in riskier asset than they promised they would. There is a popular concept

known as herd behavior that when bulls run together, there is a lot of dust and they are

unable to see where actually they are. When everybody is trying to make the money, they

usually forget the fundamentals of the economy. In order to credibly commit that they

will not expropriate depositors’, banks should make investment in branded capital , as

these schemes give depositors’ confidence ,specially when contracts have a finite nature

and discount rates are sufficiently high.

Ganguly Committee’s Recommendations:

To introduce corporate governance practices in the banking sector , the recommendations

of the working group of directors of Banks financial institutions ,known as Ganguly

group. Committee has made certain recommendations-

1) Boards should be more contemporarily professional by inducting technical and

specially qualified personnel. A proper blending of historical skill set and new

skill set will enhance the efficiency and effectiveness of the board.

2) Director should fulfill certain “ fit and proper “ norms including formal

qualification, experience and track record. There should be a proportional

representation of executive, non executive and independent directors in the board.

3) Banks should not allow a person as director who is holding the post of Member of

Parliament or member of Legislative Assembly.

4) Selection of directors should be done by the nomination committee of the board

and nomination should be headed b an independent directors and majority of

members of the committee should be non executive directors.

5) The Banks may enter into a “Deed of Covenant” with every non executive

directors, delineating his/her responsibilities and making him/her abide by them.

6) Need based training should imparted to the directors to equip them and to upgrade

their skill to govern the banks properly.

7) The Ganguly Committee made the formation of Audit committee, Supervisory

committee, Risk Management Committee mandatory apart from nomination

committee.

Management of NPA, a Real Challenge to Banks:

When debtor defaulted one Equated Monthly Installment (EMI), it can be shown as 30

days DPD that is Days Passed Deal. A person who has defaulted two EMI can be treated

as 60 days DPD that is Days Passed Deal. After default of 2nd

EMI, calling exercise

should be done with a default script. A person who has defaulted consecutive three EMI

can be shown as 90 days DPD .It becomes a NPA (Non Performing Asset).

Bank usually takes the help of Debt Reconstruction Company (DRC) when they have

accumulated excessive NPA due to non recovery of loan. Debt Reconstruction company

is a trust. They purchase the NPA of the banks by paying certain amount of cash which

is much lesser than the value of NPA. As the bank is selling their NPA to the DRC, banks

will be able to transfer the collection hazard from their shoulder to the DRC. Debt

Reconstruction Company has to undergo a market research to analyze the extent of NPA,

it will be able to realize by applying different standard conventional techniques and

tactics. Depending on that they sell certain amount of ‘Security Receipts’ to the bank.

Security receipt acts almost like Collateral Debt Security where for the bank,these

‘Security receipts’ are considered as contingent liability. Banks will be able to get the

money against these security receipts provided the Debt Reconstruction Company is able

to realize the receivables from NPA. The way Debt Reconstruction Company is

exercising pressure on the nerve of debtors that raises lots of dispute from the moral and

ethical perspectives.

Application of Credit Scoring Models: Banking Sector has to use credit scoring model

from 1998 onwards. As it is a known fact that prevention is always better than cure,

banks are using credit scoring models to reduce the probability of piling up of bad debt or

non performing assets.

Usually as a common thumb rule, total risk faced by a bank can be decomposed into three

different categories- credit risk 63%, operation risk 25-26% and market risk is 11-12%.

Reasons for using the scoring models are as follows-

Determination of probability of default and expected loss

Ensures that good loan proposals are accepted and bad loan proposals are rejected.

Helps in pricing the loan according to the risk.

Credit score is nothing but numerical forecast of repayment of future loan.

There are different credit scoring methodologies such as FICO, ONICRA( Onida +

Icra), Z Altman’s score etc.

According to FICO Scoring method, FICO score ranges from 300 to 850.

Higher the score, loan will be available at a lower rate.

For credit scoring certain factors are taken into account-

Payment history- 35%

Amounts owed- 30%

Length of history- 15%

New credit-10%

Account Mix(nature of loan)-10%

Change of job frequently may lower score if no history of late payments- bank specific.

Change of residence to negative area may lower score-bank specific.

Use of credit counseling services if reported by creditors may lower the credit score.

Inquiring for more credit may lower credit score.

Current Status of Indian Banks: Banking sector is the unique sector which has to

follow the regulations of both Reserve Bank of India(RBI) as well Security Exchange

Board of India(SEBI).Being the apex body of Indian money market, RBI directly

intervenes in credit control mechanism by monitoring and supervising bank rate, open

market operation, Cash Reserve Ratio, Statutory Reserve ratio, Repo and Reverse repo

rate and sterilization mechanism. Apart from credit control mechanism, CRR, SLR are

devices to maintain the sound liquidity position of the bank. Sterilization is a market

based approach aimed at neutralizing part or whole of the monetary impact of inflows

and outflows of foreign fund. SEBI, being the apex body of Indian Capital Market,

devises stricter rules and regulation to protect the interest of the shareholders. Just like

Sarbanes Oxley Act in USA, SEBI clause 49 unambiguously dictates specific terms for

all the companies including banks for listing their stocks in Indian Stock exchanges.

Conclusion: It can be concluded, in comparison to the global banks, Indian banks are

fundamentally strong. Almost all Indian banks are maintaining 12-13% capital adequacy

ratio which is much higher than the global benchmark. Indian Banks didn’t have huge

exposure to subprime factor, as a result none of the Indian banks had gone for bankruptcy

during 2008-09, when entire globe was caught in deep recession.

Despite all these factors, there is no scope for complacence. After corporate Governance

failure in Satyam, which reminded us the collapse of Enron, time has come to take a

collective call to combat against the corporate fraud. There is no scope to discard the fact

that banking sector is the back bone of an economy. To achieve the desired growth rate in

per capita income, domestic investment has to be enhanced. Source of investment is

savings where saving is composed of both domestic and corporate savings. Efficient

capital market is required to channelize the saving into productive investment. Developed

capital market can not sustain unless and until it is accompanied by sound banking

system.

Bibliography

1) Basics of Banking and Finance

Dr. K.M. Bhattacharya.

O.P. Agarwal.

Himalaya Publishing House.

First Edition, 2006.

2) Basel Accord II : Implications for the Indian Banking System.

Dr. Dilip. M. Nachne.

The Journal of Indian Institute of Banking & Finance.

Vol-74, No-4, October – December 2003.

3) Treasury Management.

Credit Risk Management.

Derivative Book.

Icfai University Press.

March 2009.

4) TAXMANN’s Corporate Governance

Dr. C.L.Bansal

With SEBI Press released dated 30-12.2005.

5) Corporate Governance

Principles, Policies & Practices

A.C .Fernando