Governance in PSUs

Prof. T T Ram Mohan’s is a well-known and respected academic, who regularly publishes his views on various banking and financial markets related subjects in established newspapers and journals. In his article, The RBI concedes a vital principle, carried by The Hindu, dated 22^nd November 2018 makes a number of valid observations and deductions. However, I would like to differ with him on the following issues: 

a)      The need for the Board to exercise its powers so as to overrule management decisions would not arise if the Board has being giving meaningful strategic direction and the management is up to its responsibilities. Therefore, for a well-functioning organisation the need for Board to exercise its powers so as to overrule management decisions should rarely arise. This is where the criticality of composition of the Board comes into play. Considering the composition of the RBI Board, it is anybody’s guess as to how independent it is in taking considered, non-partisan decisions, and giving broad strategic direction. The composition and functioning of Boards of PSUs, especially PSU Banks, is a readily available glaring example.

b)      Prof. Ram Mohan states that, “The RBI management may or may not accept the inputs of the Board”. Would this not amount to insubordination? If the management of RBI (or any other corporate body howsoever organised) differs from the opinion of the Board, the options available to it are (i) re-represent with cogent arguments (ii) accept Board’s decision and implement, failing which (iii) step down from the management. The luxury of not accepting inputs of the Board is just not available to the management under any circumstances.

c)      If RBI’s revaluation reserves have arisen due to changes in rupee value of its gold and foreign currency holdings, will it not violate the matching concept accounting principle by netting it off against government securities? And if such netting is done, would it not amount effectively to “stealing” from Paul to pay Peter? Well one of the qualities which make money valuable is its “fungibility”!

d)     Prof. Ram Mohan also suggests and justifies need for relaxation in PCA norms. Which is in other words nothing but support for regulatory forbearance - one of the principal contributing factors to present mess which is Indian banking industry. The concern for adequate, timely, and reasonably priced credit flowing to various economic agents is not just valid but extremely pressing and critical. However, regulatory forbearance (by any name / form including loan write-offs, directed and cheap credit, Mudra Loans, 59 minutes loans etc.) does not address the issue and as has been repeatedly seen contributes in making the problem even more complex and intractable, ultimately adversely affecting all and sundry.

In this context, I would like to mention that the lending procedures / standards which are followed in Indian banking primarily evolved to address financing of trade. Credit risk in terms of Moral Hazard was covered by having security charge over the commodity being financed (preferably under banker's lock and key) and risk of Adverse Selection was addressed by stipulating margins and periodic valuation. This was further supported by stock statements / inspections and worked fine as long the lending was restricted to financing trade in commodities, valuation of which was fairly well predictable. For commodities with high volatility in valuation, suitable higher margins were stipulated. However, once financing of manufacturing is considered there is no way the borrowing entity can continue as a going concern without both long and short term debt. As such, the dichotomy of working capital finance vs term / project finance is not just anachronistic but also illogical. There are several other conceptual inconsistencies in the existing lending framework used by the Indian banking industry.

For example, coming to the financing of services (which now constitute more than 50% of the Indian economy) with virtually no tangible primary security, the existing processes fail all together leaving the financing of this sector to the ministrations of the equivalent of quackery.

The conceptual framework under which lending is done in India is therefore in my considered opinion no more relevant to cater to Indian conditions - agriculture, manufacturing, trade, or services. Therefore the difficulties in accessing bank credit, prolonged delays, and the high levels of NPAs arising periodically should not be surprising. 

In the absence of a suitable, coherent, workable, conceptual framework for lending, bankers have fallen back primarily on provision of collateral security. This in turn brings other complications. First, collateral security does give comfort but hides the nature of risk being taken on by banks on their lending book - in terms of debt risk versus equity risk. Now since both debt and equity risk is indistinguishably mixed up in the overall portfolio of Indian banks, while the pricing is wholly debt related, it is but natural that NPAs arise since the overall portfolio is sub-optimally priced. Second, provision of collateral blinds banks to the basic fact that their primary security is a going concern generating surpluses, which can be pre-empted for debt servicing. No bank can survive by resorting to foreclosure of security especially since they are highly leveraged entities, work on wafer thin operating margins in the lending business, and therefore have very little margin of safety in making mistakes. Let alone relying wholly on rectification of past mistakes.

The lack of coherent conceptual framework for lending is also amply displayed by the decision making process in banks, with extremely long appraisal notes, multiple iterations and queries which prolong the time for decisions to be made, stipulation of all kinds of irrelevant and unworkable loan covenants etc. All these aberrations are essentially insurance policies being taken by officials involved in taking lending decisions. Poor guys are just trying to protect their backsides with the ever present vigilance sword hanging over them.

The present situation of Indian banking is the direct result of mis-governance practised by different governments over the past 50 years plus. Irrespective of persuasion or ideology, the political class has strongly entrenched perverse incentives to control the financial markets – it helps in getting votes by controlling rural elites with promises of cheap credit and lone waivers and at the same time helps in garnering funds for fighting elections from the large capitalist class. Over and above all this, the icing on the cake is the ability to twist the arms of PSUs for financing pet projects through resort to CSR funds.  The strategy is especially endearing since the benefits are highly concentrated, while the consequences are highly diffused over the entire populace and prolonged over time.

To achieve this state of affairs, the first step was emasculation of management – which has been largely achieved for nearly all PSU organisations. Maybe RBI is one of the remaining bastions to be overcome!