9

Banks and Corporate Governance

• Banks and Corporates
• Why Corporate Governance in banks?
• Corporate Governance and the World Bank
• Bsel Committee on Corporate Governance
• Sound Corporate Governance Practices for banks
• Corporate Governance in Indian banks
• Review of Indian Experience in Corporate Governance
• Ganguly Committees’s Recommendations

Banks and Corporates

Banks, in a broad sense, are institutions whose business is handling other people’s money.¹ A joint stock bank, also generally known as commercial bank, is a company whose business is banking. These are more particularly institutions that deal directly with the general public, as opposed to the merchant banks and other institutions more concerned with trade and industry. These banks specialise in business connected with bills of exchange, especially the acceptance of foreign bills.² A merchant banker is thus a financial intermediary who helps in transfering capital from those who possess it to those who need it. Merchant banking includes a wide range of activities such as management of customers’ securities, portfolio management, project counseling and appraisal, underwriting of shares and debentures, loan syndication, acting as banker for refund orders, handling interest and dividend warrants, etc. Thus, a merchant banker renders a host of services to corporates and promotes industrial development in the country.³ Further, there are also investment banks which acquire shares in limited companies on their own account, and not merely as agents for their customers. Sometimes, banks are set up to handle specialised functions for particular industries such as the Industrial Development Bank of India (IDBI), National Bank for Agricultural and Rural Development (NABARD) and Export-Import Bank (Exim Bank).

 

Banks are thus a critical component of any economy. They provide financing for commercial enterprises, basic financial services to a broad segment of the population and access to payment systems. In addition, some banks are expected to make credit and liquidity available in difficult market conditions. The importance of banks to national economies is underscored by the fact that banking is virtually universally a regulated industry and that banks have access to government safety nets. It is of crucial importance, therefore, that banks have strong corporate governance.

There has been a great deal of attention given recently to the issue of corporate governance in various national and international forums. In particular, the OECD has issued a set of corporate governance standards and guidelines to help governments “in their efforts to evaluate and improve the legal, institutional and regulatory framework for corporate governance in their countries, and to provide guidance and suggestions for stock exchanges, investors, corporations, and other parties that have a role in the process of developing good corporate governance”.

Why Corporate Governance in Banks?

If we examine the need for improving corporate governance in banks, two reasons stand out: (i) Banks exist because they are willing to take on and manage risks.⁴ Besides, with the rapid pace of financial innovation and globalisation, the face of banking business is undergoing a sea-change. Banking business is becoming more complex and diversified. Risk taking and management in a less regulated competitive market will have to be done in such a way that investors’ confidence is not eroded. (ii) Even in a regulated set-up, as it was in India prior to 1991, some big banks in the public sector and a few in the private sector had incurred substantial losses. This, along with the massive failures of non-banking financial Companies (NBFCs), had adversely impacted investors’ confidence.

 

Moreover, protecting the interests of depositors becomes a matter of paramount importance to banks. In other corporates, this is not and need not be so for two reasons: (i) The depositors collectively entrust a very large sum of their hard-earned money to the care of banks. It is found that in India, the depositor’s contribution was well over 15.5 times the shareholders’ stake in banks as early as in March 2001.⁵ This is bound to be much more now. (ii) The depositors are very large in number and are scattered and have little say in the administration of banks. In other corporates, big lenders do exercise the right to direct the management. In any case, the lenders’ stake in them might not exceed 2 or 3 times the owners’ stake.

Banks deal in people’s funds and should, therefore, act as trustees of the depositors. Regulators the world over have recognised the vulnerability of depositors to the whims of managerial misadventures in banks and, therefore, have been regulating banks more tightly than other corproates.

To sum up, the objective of governance in banks should first be protection of depositors’ interests and then be to “optimise” the sharehodlers’ interests. All other considerations would fall in place once these two are achieved.⁶

As part of its ongoing efforts to address supervisory issues, the Basel Committee on Banking Supervision (BCBS) has been active in drawing from the collective supervisory experience of its members and other supervisors in issuing supervisory guidance to foster safe and sound banking practices. The committee was set up to reinforce the importance for banks of the OECD principles, to draw attention to corporate governance issues addressed by previous committees, and to present some new topics related to corporate governance for banks and their supervisors to consider.

Banking supervision cannot function effectively if sound corporate governance is not in place and, consequently, banking supervisors have a strong interest in ensuring that there is effective corporate governance at every banking organisation. Supervisory experience underscores the necessity of having the appropriate levels of accountability and checks and balances within each bank. Put plainly, sound corporate governance makes the work of supervisors infinitely easier. Sound corporate governance can contribute to a collaborative working relationship between bank management and bank supervisors.

Recent “sound practice papers” issued by the Basel Committee⁷ underscore the need for banks to set strategies for their operations and establish accountability for executing these strategies. In addition, transparency of information related to existing conditions, decisions and actions is integrally related to accountability in that it gives market participants sufficient information with which to judge the management of a bank.

Corporate Governance and the World Bank

The World Bank report on corporate governance is a landmark in the evolution of the theory and its application of this concept of best corporate behaviour. Governance in relation to a business organisation concerns with the intrinsic nature, purpose, integrity and identity of the organisation and focusses primarily on the relevance, continuity and fiduciary aspects of the organisation. It involves monitoring and overseeing strategic direction, socio-economic and cultural context, externalities and constituencies of the organisation. Hence, corporate governance may be called as an umbrella term encompassing specific issues arising from interactions among senior management personnel, shareholders, board of directors, depositors, borrowers, other constituencies and the society at large. It deals with the exercise of power over the directions of enterprise, the supervision of executive actions, acceptance of a duty to be accountable and regulation of the affairs of the corporation.

 

The World Bank report on corporate governance recognises the complexity of the very concept of corporate governance and, therefore, focusses on the principles on which it is based. These principles such as transparency, accountability, fairness and responsibility are universal in their application. The way they are put into practice has to be determined by those with the responsibility for implementing them. What is needed is a combination of statutory and self-regulation, the mix will vary around the world, but nowhere can statutory regulation alone promote effective governance. The stronger the partnership between the public and private sectors, the more soundly based will be their governance structures. Equally, as the report emphasises, governance initiatives win most support when driven from the bottom up rather than from the top down.

It could be argued that international investors and capital markets are bringing about a degree of convergence over governance practices worldwide. But the standards that they are setting apply primarily to those corporations in which they invest or to which they lend. These standards set the target but it is one, which, at present, is out of reach for the majority of enterprises across the world. In the past, these standards might have become diffused by a gradual process of economic osmosis. However, the pace of change today is such that to leave the raising of governance standards to natural forces might put areas of the world, where funds could be put to best use at a competitive disadvantage in attracting them. Adoption of the report’s proposals offers enterprises everywhere the chance to gain their share of the potentially available funds for investment.

Corporate governance is concerned with holding the balance between economic and social goals and between individual and community goals. The governance framework is there to encourage the efficient use of resources and equally to require accountability for the stewardship of those resources. The aim is to align as nearly as possible the interests of individuals, corporations and society. The incentive to corporations and to those who own and manage them to adopt internationally accepted governance standards is that they will help them to achieve their corporate aims and to attract investment. The incentive for their adoption by states is that they will strengthen their economies and discourage fraud and mismanagement. The foundation of any structure of corporate governance is disclosure. Openness is the basis of public confidence in the corporate system and funds will flow to those centres of economic activity, which inspire trust. The World Bank report points the way to the establishment of trust and the encouragement of enterprise. It marks an important milestone in the development of corporate governance.

Basel Committee on Corporate Governance

In 1988, the Bank for International Settlement (BIS)-based Basel Committee on Banking Supervision came out with regulations regarding the capital requirements for banks. Although these were essentially intended for internationally operating banks, in due course, almost all countries adopted these regulations for their banks.

The crux of the Basel I requirements is the assignment of risk weights for different assets in a bank’s book and aggregating the risk-weighted assets of which 8 per cent was recommended as the capital of the bank. The committee’s recommendations were not mandatory, but the world’s central banks speeded up the process of compliance, particularly following the East Asian crisis and the collapse of certain hedge funds in New York which threatened to bring down banking systems of the US and the developed world. India adopted Basel I norms in 1992 closely following the inception of economic reforms.

 

From a banking industry perspective, corporate governance involves the manner in which the business and affairs of individual institutions are governed by their boards of directors and senior management affecting how banks

• set corporate objectives (including generating economic returns to owners).
• run the day-to-day operations of business.
• consider the interests of recognised stakeholders.
• align corporate activities and behaviour with the expectation that banks will operate in a safe and sound manner, and in compliance with applicable laws and regulations.
• protect the interests of depositors.

Basel Committee published a paper on corporate governance for banking organisations in September 1999.⁸ The committee felt that it was the responsibility of the banking supervisors to ensure that there was effective corporate governance in the banking industry. Supervisory experience underscores the need for having appropriate accountability and checks and balances within each bank to ensure sound corporate governance, which in turn would lead to effective and more meaningful supervision. Sound corporate governance could also contribute to a collaborative working relationship between bank managements and bank supervisors.

Basel Committee underscored the need for banks to set strategies for their operations. The committee also insisted banks to establish accountability for executing these strategies. Unless there is transparency of information related to decisions and actions, it would be difficult for stakeholders to make management accountable.

From the perspective of banking industry, corporate governance also includes in its ambit the manner in which their boards of directors govern the business and affairs of individual institutions and their functional relationship with senior management.

The Basel Committee has also issued several papers on specific topics, where the importance of corporate governance has been emphasised. These include Principles for the Management of Interest Rate Risk (September 1997), Framework for Internal Control Systems in Banking Organisations (September 1998), Enhancing Bank Transparency (September 1998), and Principles for the Management of Credit Risk (issued as a consultative document in July 1999).

 

These papers have highlighted the fact that strategies and techniques that are basic to sound corporate governance include the following:

• The corporate values, codes of conduct and other standards of appropriate behaviour and the system used to ensure compliance with them.
• A well-articulated corporate strategy against which the success of the overall enterprise and the contribution of individuals can be measured.
• The clear assignment of responsibilities and decision-making authorities, incorporating a hierarchy of required approvals from individuals to the board of directors.
• Establishment of a mechanism for the interaction and cooperation among the board of directors, senior management and the auditors.
• Strong internal control systems, including internal and external audit functions, risk management functions, independent of business lines, and other checks and balances.
• Special monitoring of risk exposures where conflicts of interest are likely to be particularly great, including business relationships with borrowers affiliated with the bank, large shareholders, senior management, or key decision-makers within the firm (e.g. traders).
• The financial and managerial incentives to act in an appropriate manner offered to senior management, business line management and employees in the form of compensation, promotion and other recognition.
• Appropriate information flows internally and to the public.

“Stakeholders” in the above context include employees, customers, suppliers and the community. Due to the unique role of banks in national and local economies and financial systems, supervisors and governments are also stakeholders.

The reality that various corporate governance structures exist in different countries reflects that there are no universally correct answers to structural issues and that laws need not be consistent in all the countries. Acknowledging this, sound governance can be practised regardless of the form used by a banking organisation.

There are four important forms of oversight that should be included in the organisational structure of any bank in order to ensure appropriate checks and balances:

1. Oversight by the board of directors or supervisory board.
2. Oversight by individuals not involved in the day-to-day running of the various business areas.
3. Direct line supervision of different business areas.
4. Independent risk management and audit functions.

In addition, it is important that key personnel are fit and proper for their jobs. Government ownership of a bank has the potential to alter the strategies and objectives of the bank as well as the internal structure of governance. Consequently, the general principles of sound corporate governance are also beneficial to government-owned banks.

Sound Corporate Governance Practices for Banks

As mentioned earlier, supervisors have a keen interest in determining that banks have sound corporate governance. The practices to be viewed as critical elements of any corporate governance process are:

1.  Establishing strategic objectives and a set of corporate values that are communicated throughout the banking organisation: It is difficult to conduct the activities of an organisation when there are no strategic objectives or guiding corporate values. Therefore, the board should establish strategies that will direct the ongoing activities of the bank. It should also take the lead in establishing the “tone at the top” and approving corporate values for itself, senior management and other employees. The values should recognise the critical importance of having timely and frank discussions of problems. In particular, it is important that the values prohibit corruption and bribery in corporate activities, both in internal dealings and external transactions.

 

The board of directors should ensure that the senior management implements policies that prohibit (or strictly limit) activities and relationships that diminish the quality of corporate governance, such as:

• Conflicts of interest.
• Lending to officers and employees and other forms of self-dealing (e.g., internal lending should be limited to lending consistent with market terms and to certain types of loans, and reports of insider lending should be provided to the board, and be subject to review by internal and external auditors).
• Providing preferential treatment to related parties and other favoured entities (e.g., lending on highly favourable terms, covering trading losses, waiving commissions). Processes should be established that allow the board to monitor compliance with these policies and ensure that deviations are reported to an appropriate level of management.

2.  Setting and enforcing clear lines of responsibility and accountability throughout the organisation: Effective boards of directors clearly define the authorities and key responsibilities for themselves, as well as senior management. They also recognise that unspecified lines of accountability or confusing multiple lines of responsibility may exacerbate a problem through slow or diluted responses. Senior management is responsible for creating an accountability hierarchy for the staff and must be aware of the fact that they are ultimately responsible to the board for the performance of the bank.

3.  Ensuring that board members are qualified for their positions, have a clear understanding of their role in corporate governance and are not subject to undue influence from management or outside concerns: The board of directors is ultimately responsible for the operations and financial soundness of the bank. The board of directors must receive on a timely basis sufficient information to judge the performance of management. An effective number of board members should be capable of exercising judgement, independent of the views of management, large shareholders or government. Including on the board qualified directors who are not members of the bank’s management, or having a supervisory board or board of auditors separate from a management board, can enhance independence and objectivity. Moreover, such members can bring new perspectives from other businesses that may improve the strategic direction given to management, such as insight into local conditions. Qualified external directors can also become significant sources of management expertise in times of corporate stress. The board of directors should periodically assess its own performance, determine where weaknesses exist and, wherever possible, take appropriate corrective actions.

The board of directors add strength to the corporate governance of a bank when they:

• Understand their oversight role and their “duty of loyalty” to the bank and its shareholders.
• Serve as a “checks-and balances” function vis-à-vis the day-to-day management of the bank.
• Feel empowered to question management and are comfortable insisting upon straightforward explanations from management.
• Recommend sound practices observed from other situations.
• Provide dispassionate advice.
• Are not overextended.
• Avoid conflicts of interest in their activities with, and commitments to, other organisations.
• Meet regularly with senior management and internal audit to establish and approve policies, establish communication lines and monitor progress toward corporate objectives.
• Absent themselves from decisions when their own role or interests are bring discussed or they are incapable of providing objective advice.
• Do not participate in day-to-day management of the bank.

In a number of countries, bank boards as recommended by several committees on corporate governance have found it beneficial to establish certain specialised committees that include the following:

(i)   A risk management committee: This committee is formed with a view to providing oversight of the senior management’s activities in managing credit, market, liquidity, operational, legal and other risks of the bank. (This role should include receiving from senior management periodic information on risk exposures and risk management activities.)

(ii)   An audit committee: This committee is formed with a view to providing oversight of the bank’s internal and external auditors, approving their appointment and dismissal, reviewing and approving audit scope and frequency, receiving their reports and ensuring that management is taking appropriate corrective actions in a timely manner to address control weaknesses, non-compliance with policies, laws and regulations, and other problems identified by auditors. The independence of this committee can be enhanced when it is composed of external board members that have banking or financial expertise.

(iii)   A compensation committee: This committee is expected to provide oversight of remuneration of senior management and other key personnel and ensure that compensation is consistent with the bank’s culture, objectives, strategy and control environment.

(iv)   A nomination committee: A nomination committee is formed with a view to providing important assessment of board effectiveness and directing the process of renewing and replacing board members.

 

4.  Ensuring that there is appropriate oversight by senior management: Senior management is a key component of corporate governance. While the board of directors provides checks and balances to senior managers, similarly, senior managers should assume that oversight role with respect to line managers in specific business areas and activities. Even in very small banks, key management decisions should be made by more than one person (four eyes principle). Management situations to be avoided include the following managers:

• Senior managers who are overly involved in business line decision-making.
• Senior managers who are assigned an area to manage without the necessary prerequisite skills or knowledge.
• Senior managers who are unwilling to exercise control over successful, key employees (such as traders) for fear of losing them.

Senior management consists of a core group of officers responsible for the bank. This group should include such individuals as the Chief Financial Officer, division heads and the chief auditor. These individuals must have the necessary skills to manage the business under their supervision as well as have appropriate control over the key individuals in these areas.

5.  Effectively utilising the work conducted by internal and external auditors, in recognition of the important control function they provide: The role of auditors is vital to corporate governance process. The effectiveness of the board and senior management can be enhanced as given below:

• Recognising the importance of the audit process and communicating this importance throughout the bank.
• Taking measures that enhance the independence and stature of auditors.
• Utilising, in a timely and effective manner, the findings of auditors.
• Ensuring the independence of the had auditor through his reporting to the board or the board’s audit committee.
• Engaging external auditors to judge the effectiveness of internal controls.
• Requiring timely correction by management of problems identified by auditors.

The board should recognise and acknowledge that the internal and external auditors are their critically important agents. In particular, the board should utilise the work of the auditors as an independent check on the information received from management on the operations and performance of the bank.

6.  Ensuring that compensation approaches are consistent with the bank’s ethical values, objectives, strategy and control environment: Failure to link incentive compensations to the business strategy can cause or encourage managers to book business based upon volume and/or short-term profitability to the bank with little regard to short or long-term risk consequences. This can be seen particularly with traders and loan officers, but can also adversely affect the performance of other support staff.

The board of directors should approve the compensation of members of senior management and other key personnel and ensure that such compensation is consistent with the bank’s culture, objectives, strategy and control environment. This will help to ensure that senior managers and other key personnel will be motivated to act in the best interests of the bank.

In order to avoid incentives being created for excessive risk-taking, the salary scales should be set, within the scope of general business policy, in such a way that they do not overly depend on short-term performance, such as short-term trading gains.

7.  Conducting corporate governance in a transparent manner: As set out in the Basel Committee’s paper Enhancing Bank Transparency, it is difficult to hold the board of directors and senior management properly accountable for their actions and performance when there is a lack of transparency. This happens in situations where the stakeholders, market participants and general public do not receive sufficient information on the structure and objectives of the bank with which to judge the effectiveness of the board and senior management in governing the bank.

Transparency can reinforce sound corporate governance. Therefore, public disclosure is desirable in the following areas:

• Board structure (size, membership, qualifications and committees); senior management structure (responsibilities, reporting lines, qualifications and experience).
• Basic organisational structure (line of business structure, legal entity structure).
• Information about the incentive structure of the bank (remuneration policies, executive compensation, bonuses, stock options).
• Nature and extent of transactions with affiliates and related parties.

For example, the International Accounting Standards Committee⁹ (IASC) defines related parties as “those able to control or exercise significant influence.” Such relationships include

1. parent-subsidiary relationships.
2. entities under common control.
3. associates.
4. individuals who, through ownership, have significant influence over the enterprise and close members of their families.
5. key management personnel.

The IASC expects that disclosures in this area should include

• the nature of relationships where control exists, even if there were no transactions between the related parties.
• the nature and amount of transactions with related parties, grouped as appropriate.

Ensuring Sound Corporate Governance Environment

The Basel Committee recognises that primary responsibility for good corporate governance rests with boards of directors and senior management of banks; however, there are many other ways that corporate governance can be promoted, which include the following:

• Government—through laws.
• Securities’ regulators, stock exchanges—through disclosure and listing requirements.
• Auditors—through audit standards on communications to board of directors, senior management and supervisors.
• Banking industry associations—through initiatives related to voluntary industry principles and agreement on and publication of sound practices.

For example, corporate governance can be improved by addressing a number of legal issues, such as the protection of shareholder rights; the enforceability of contracts, including those with service providers; clarifying governance roles; ensuring that corporations function in an environment that is free from corruption and bribery; and laws/regulations (and other measures) aligning the interests of managers, employees and shareholders. All of these can help promote healthy business and legal environments that support sound corporate governance and related supervisory initiatives.

The Role of Supervisors

Supervisors should be aware of the importance of corporate governance and its impact on corporate performance. They should expect banks to implement organisational structures that include appropriate checks and balances. Regulatory safeguards must emphasise accountability and transparency. Supervisors should determine that the boards and senior management of individual institutions have in place processes that ensure they are fulfilling all of their duties and responsibilities.

A bank’s board of directors and senior management are ultimately responsible for the performance of the bank. As such, supervisors typically check to ensure that a bank is being properly governed and bring to management’s attention any problems that they detect through their supervisory efforts. When the bank takes risks that it cannot measure or control, supervisors must hold the board of directors accountable and require that corrective measures be taken in a timely manner. Supervisors should be attentive to any warning signs of deterioration in the management of the bank’s activities. They should consider issuing guidance to banks on sound corporate governance and the proactive practices that need to be in place. They should also take account of corporate governance factors while issuing guidance on other topics.

Sound corporate governance considers the interests of all stakeholders, including depositors, whose interests may not always be recognised. Therefore, it is necessary for supervisors to determine that individual banks are conducting their business in such a way as not to harm depositors.

The New Basel Capital Accord (Basel II)

Efforts were made for 6 years to rectify the deficiencies found in the original accord, now known as Basel I. On 26 June 2004, the committee came out with new Basel norms that are expected to change the complexion of banking throughout the world. The final version of the revised accord, titled, “The International Convergence of Capital Measurement and Capital Standards: A Revised Framework” is known in short as the New Basel Capital Accord or simply Basel II. The first version of Basel II came out in 1999. The version was widely debated and after consultation, a revised Basel II document came out in June 2004.

Basel II aims at correcting most of the deficiencies that Basel I suffered from. Basel II rests on three pillars as given below:¹⁰

Implementation of Basel II and Its Impact

A recent survey conducted by the Financial Stability Institute (FSI), Basel, showed that more than 100 countries would implement Basel II in the next few years. The US has already announced that it would be made mandatory for the ten biggest banking groups that control nearly three-fourth of the country’s banking assets. It is also expected that Basel II will also be implemented fully in Europe.

The Reserve Bank of India (RBI) started its own consultative process involving various banks and other experts. It has now come out with its final draft version of Basel II.

The Basel II version as drafted by RBI in its letter dated 15 February 2005 is a comprehensive set of instructions, which will initiate a parallel run by banks starting in 2006.

The instructions go into great detail regarding the various classifications of the assets and the weights to be assigned.

What remains is for each bank to adopt one of the methods suggested in the circular for assessing its risk weighted capital.

In a meeting of 60 bankers that aimed at sensitising the bank chiefs about the challenges of Basel II norms, which are due to be implemented by March 2006 by all banks globally, the Deputy Governor of the Reserve Bank of India, Mr. K. J. Udeshi, announced that the RBI would adopt a gradual and sequential approach towards implementation of Basel II norms for the capital adequacy of banks. At the meeting, the RBI has formed a Steering Committee, which in turn will have smaller focussed sub-committees for each of the pillars of Basel II. The Steering Committee will review the issues and suggest a roadmap to adopt the new norms of Basel II.¹¹

The Reserve Bank of India has advised Indian banks to adopt Basel II norms by 31 March 2006; however, banks are expected to do a trial or parallel run from 31 March 2005 to fine-tune their systems and procedures.

Once it is implemented, Basel II is likely to have a profound impact on the way banking is conducted worldwide. It could also lead to a shakeout in the industry given the fact that the capital requirements favouring larger banks with better systems in place. This could result in a spate of mergers worldwide, especially among internationally active banks in their struggle to remain competitive.¹²

The implementation of Basel II is imperative in the context of emerging market economies that “may face unique problems in the absence of well-developed credit rating systems, robust data collection mechanisms and other infrastructure”. So, non-implementation, without justifiable reasons, will finally get reflected in adverse credit ratings, higher borrowing costs and the consequent effects on the real economy. This is one reason no country can afford to delay implementation of Basel II indefinitely.¹³

Phases of Growth in Indian Banks

Since Independence, organised Western type of banking in India has evolved through four distinct phases.

1. Foundation phase covering the decades of 1950s and 1960s: This period witnessed the development of the required legislative framework for facilitating the organisation of the banking system to cater to the growing and development needs of the Indian economy.
2. Expansion phase of the mid-1960s: This trend gained momentum after the nationalisation of private banks in late 1960s.
3. Consolidation phase since 1985: Greater attention was paid to improving housekeeping, customer service, credit management, productivity and profitability of banks starting 1985 onwards.
4. 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 and prudential norms relating to income recognition, provisioning and capital adequacy in 1991.

The three constituents of commercial banking structure in India are public sector banks, private banks and foreign banks. Presently, there are 295 banks with 66, 514 branches; out of these, as many as 223 banks and 60,640 branches are in the public sector.¹⁴

Corporate Governance in Indian Banks

Although the subject of corporate governance has received a lot of attention in recent times in India, corporate governance issues and practices by Indian banks have received only a scanty notice. The question of corporate governance in banks is important for several reasons. First, banks have an overwhelmingly dominant position in developing the economy’s financial system, and are extremely important engines of growth. Second, as the country’s financial markets are underdeveloped, banks in India are the most significant source of finance for a majority of firms in Indian industry. Third, banks are also the channels through which the country’s savings are collected and used for investments. Fourth, India has recently liberalised its banking system through privatisation, disinvestments and has reduced the role of economic regulation and consequently managers of banks have obtained greater autonomy and freedom with regard to running of banks. This would necessitate their observing best corporate practices to regain the investors’ confidence now that the government authority does not protect them anymore. Corporate governance in banks has assumed importance in India post-1991 reforms because competition compelled banks to improve their performance. Even the majority of banks and financial institutions, owned, managed and influenced by the government with neither high quality management nor any exemplary record of practising corporate governance have realised the importance of adopting better practices to protect their depositors and the banking public.

Indian Banking Sector’s Unique Nature and Its Implications

The unique nature of the banking firm, be in the developed or developing world, requires a broad view of coporate governance to be adopted by banks which encapsulates both shareholders and depositors. In particular, the nature of the banking firm is such that regulation is necessary to protect depositors as well as the overall financial system. Using this insight, we should examine the corporate governance of banks in India in the context of ongoing banking reforms.

 

The narrow approach to corporate governance views the subject as the mechanism through which shareholders are assured that managers will act to promote their interests. Indeed, as far back as at the time of Adam Smith, it has been recognised that managers do not always act in the best interests of shareholders, leading to a separation of ownership and control. The separation of ownership and control has given rise to an “agency problem” whereby management operates the firm in their own interests, and not those of shareholders. This creates opportunities for managerial shirking or empire building and, in the extreme, outright expropriation. However, there is a broader view of corporate governance, which views the subject as the methods by which suppliers of finance control managers in order to ensure that their capital is not expropriated and that they earn a return on their investment. Thus, the special nature of banking will call for the adoption of the broader view of corporate governance for banks. Besides, the special nature of banking requires government intervention in order to restrain the behaviour of bank management.

Depositors do not know the true value of a bank’s loan portfolio as such information is incommunicable and very costly to reveal. As a consequnce of this asymmetric information problem, bank managers are prompted to invest in riskier assets than they promised they would ex ante. In order to credibly commit that they will not expropriate depositors, banks could make investments in brand-name or reputational capital, as these schemes give depositors confidence, especially when contracts have a finite nature and discount rates are sufficiently high. The opaqueness of banks also makes it very costly for depositors to constrain managerial discretion through debt covenants. Consequently, rational depositors will require some form of guarantee before they would deposit with a bank. Government-provided guarantees in the form of implicit and explicit deposit insurance¹⁵ might encourage economic agents to deposit their wealth with a bank, as a substantial part of the moral hazard cost is borne by the government.

However, the special nature of the banking company also affects the relationship between shareholders and managers. For example, the opaqueness of bank assets makes it very costly for diffuse equity holders to write and enforce effective incentive contracts or to use their voting rights as a vehicle for influencing the bank’s decisions. Furthermore, the existence of deposit insurance may reduce the need for banks to raise capital from large, uninsured institutional investors who have the incentive to exert corporate control.

A further issue is that the interests of bank shareholders may oppose those of governmental regulators, who have their own agendas, which may not necessarily coincide with maximising bank value. Shareholders may want managers to take more risk than is socially optimal, whereas regulators have a preference for managers to take substantially less risk due to their concerns about system-wide financial stability. Shareholders could motivate such risk-taking using incentive-compatible compensation schemes. However, from the regulators point of view, managers’ compensation schemes should be structured so as to discourage banks from becoming too risky.

Government Control and Withdrawal Effects

In India, the issue of corporate governance in banks is complicated by extensive political intervention in the operation of the banking system. Government ownership of banks is a common feature in India. The reasons for such ownership may include solving the severe informational problems inherent in developing financial systems, aiding the development process or supporting vested interests and distributional cartels. With a government-owned bank, the severity of the conflict between depositors and managers very much depends upon the credibility of the government. Given a credible government and political stability, there will be little conflict as the government ultimately guarantees deposits.

The inefficiencies associated with government-owned banks, especially those emanating from a lack of adequate managerial incentives have led governments under some pressure from international agencies to begin divesting their ownership stakes. In the case of India too, there are subtle pressures on the government from international organisations that provide development funds such as the World Bank and International Monetary Fund to withdraw their stakes in commercial banks. The divestment of government-owned banks raises several corporate governance issues. If banks are completely privatised, then there must be adequate deposit insurance schemes and supervisory arrangements established in order to protect depositors and prevent a financial crash.

On the other hand, if divestment is partial, then there may be opportunities for the government as the dominant shareholder to expropriate minority shareholders by using banks to aid fiscal problems or support certain distribution cartels. A further issue, which complicates the corporate governance of banks in India is the activities of “distributional cartels”. These cartels consist of corporate insiders who have very close links with or partially constitute the governing elite. The existence of such cartels will undermine the credibility of investor legal protection and may also prevent reform of the banking system. Obviously, good political governance can be considered as a prerequisite for good corporate governance.

 

Review of Indian Experience in Corporate Governance

Basel Committee norms relate only to commercial banks and financial institutions. Banking and financial institutions stand to benefit only if corporate governance is accepted universally by industry and business, with whom banks and financial institutions have to interact and deal. SEBI, the Indian capital market regulator, only partially attends to this need. SEBI is a functional statutory body and it can prescribe regulations only within its ambit.

The Kumar Mangalam Birla Committee appointed by SEBI confined itself to submitting recommendations for good corporate governance and left it to SEBI to decide on the penalty provisions for non-compliance. In the absence of suitable penalty provisions, it would be difficult to establish good corporate governance in firms including banks. Some of the penalty provisions are not sufficient enough to discipline the corporates. For example, the penalty for non-compliance of the stipulated minimum of 50 per cent in respect of the number of directors in the board that should be non-executive directors is delisting of shares of the company. This would hardly serve the purpose. In fact, this would be detrimental to the interest of the investors and to the effective functioning of the capital market.

Similarly, an audit committee, which is in perpetual conflict with the board, may result in stalemates to the detriment of the company. If a company is to function smoothly, it should be made clear that the findings and recommendations of the audit committee need not necessarily have to be accepted by the board which is accountable to the shareholders for its performance and which, under Section 291 of the Companies Act, is entitled to “exercise all such powers, and do all such things as the company is authorised to exercise and do”.

Policy Implications

Thus the special nature of banking institutions necessitates a broad view of corporate governance where regulation of banking activities is required to protect depositors. In developed economies, protection of depositors in a deregulated environment is typically provided by a system of prudential regulation, but in India such protection is undermined by the lack of well-trained supervisors, inadequate disclosure requirements, the high cost of raising bank capital and the presence of distributional cartels.

 

In order to deal with these problems, some analysts suggest that India need to adopt the following measures: First, liberalisation policies need to be gradual, and should be dependent upon improvements in prudential regulation. Second, India need to expend resources enhancing the quality of their financial reporting systems, as well as the quantity and quality of bank supervisors. Third, given that bank capital plays such an important role in prudential regulatory systems, it may be necessary to improve investor protection laws, increase financial disclosure and impose fiduciary duties upon bank directors so that banks can raise the equity capital required for regulatory purposes. A further reason as to why this policy needs to be implemented is the growing recognition that the corporate governance of banks has an important role to play in assisting supervisory institutions to perform their tasks and allowing supervisors to have a working relationship with bank management, rather than adversarial one.

It is an unquestionable fact that the corporate governance of banks in India is severely affected by political considerations. First, given the trend towards privatisation of government-owned banks in India, there is a need for the managers of such banks to be granted autonomy and be gradually introduced to the corporate governance practices of the private sector prior to divestment. Second, where there has only been partial divestment and government has not relinquished any control to other shareholders, it may prove very difficult to divest further ownership stakes unless corporate governance is strengthened. Finally, given that limited entry of foreign banks may lead to increased competition, which in turn, encourages domestic banks to emulate the corporate governance practices of their foreign competitors, it should be beneficial that India partially opens up her banking sector to foreign banks.

Ganguly Committee’s Recommendations

To introduce corporate governance practices in the banking sector the recommen-dations of the Working Group of Directors of Banks and Financial Institutions, known as the Ganguly Group, will be of interest.¹⁶

Composition of Boards

1. Boards should be more contemporarily professional by inducting technical and specially qualified personnel. There should be a blend of “historical skill” set and “new skill” set, i.e. skills such as marketing, technology and systems, risk management, strategic planning, treasury operations, credit recovery, etc.
2. Directors should fulfill certain “fit and proper” norms., viz., formal qualification, experience and track record. To ensure this, companies could call upon the candidates for directorship to furnish necessary information by way of self-declaration, verification reports from market, etc.
3. Certain criteria adopted for public sector banks such as the age of director being between 35 and 65, that he/she should not be a member of parliament/ state legislatures, etc. may be adopted for private sector banks also.
4. Selection of directors could be done by a nomination committee of the board. The Reserve Bank of India (RBI) also might compile a list of eligible candidates.
5. The banks may enter into a “Deed of Covenant” with every non-executive director, delineating his/her responsibilities and making him/her abide by them.
6. Need-based training should be imparted to the directors to equip them govern the banks properly.

The Ganguly Committee has suggested the formation of the following committees of the board, in addition to the Nomination Committee: Audit Committee, Shareholders’ Redressal Committee, Supervisory Committee and Risk Management Committee. The job of the first two committees is well known in all big corporates in India. Incidentally, the Reserve Bank has prescribed that the audit committee should be presided over by a Chartered Accountant Director, but Ganguly Committee opined that it could be done by any non-executive director.

Risk Management

Risk management has taken centre stage in any discussion on management of banks in the recent past. To be sure, risk taking is as old as banks. Banks are in the business of taking deposits, repayable virtually on demand and lending/ investing the funds in illiquid assets. The action of converting liquid funds into illiquid assets, with maturity mismatches between the two, is a certain recipe for risk. Banks have known and managed this risk fairly well over centuries of their existence. In the last few decades, however, newer varieties of risk have arisen, because, in the pursuit of high returns, banks have embraced higher risks. The risks about which many bankers are not fully familiar are in the realm of off-balance sheet commitment, market risks, interest risks and those associated with derivatives. It will not be an exaggeration to say that a vast majority of directors of banks in India are not aware of the dimension and magnitude of these risks. Since the job of banks is primarily to safeguard the interests of depositors and the shareholders, these risks should be managed professionally.

 

Only in respect of newer business, it is essential that the board should, with the assistance of experts in the field, lay down detailed guidelines and ask the management to report compliance at periodical intervals. Generally in risk taking, each bank will have a different level of appetite, which needs to be clearly spelt out by the board, on the basis of the recommendations of top management. Further, the review of newer businesses should be at more frequent intervals than that of established businesses.

Basel II and Containing Risk

Banks in India were advised by the Reserve Bank of India to adopt by 31 March 2007, a new, proactive approach towards risk management as laid down by the Basel Committee on Bank Supervision, an internationally recognised body of bank supervisors based in the Swiss city of that name. The details of the new regulatory framework, which closely follow what are referred to as Basel II norms, are displayed on the RBIs website and will be of immediate relevance to banks and their regulators. Customers of banks and other laypeople will be more interested in evaluating the practical benefits of what promises to be a more stable financial sector once the norms are implemented. In countries with sound banking traditions including India, financial sector supervisors and banks have long followed risk-minimising practices; while appearing rudimentary in hindsight, these safeguards provided a decent measure of financial sector stability for the less challenging times. Indeed risk management, by whatever name called, has been basic to the banking business, which is more leveraged than any other comparable business. Banks create a multiplier effect by lending (and investing) more than what their level of deposits would normally permit. It is in that context that banking regulators hit upon the idea of asking banks to adjust their capital (the other critical component alongside deposits on (the liabilities side of their balance sheets) in line with their risks profile. The more risks a bank took on, the more it had to provide for by way of capital and reserves. This fairly elementary dictum has been the cornerstone of banking sector regulation over the decades.

 

In a globalising age, with banks dealing extensively with customers and banks in other countries, it became obvious that the supervisory strategies of particular countries had to be dovetailed to the requirements of a global strategy.

Since 1988, banks in India and a hundred other countries have followed what is now referred to as the Basel I standard—a set of regulatory rules designed to cope with the growing uncertainty in the global financial system. The immediate provocation was the spectacular failure in 1974 of the German bank, Bankhaus Herstatt, with disastrous consequences to banks and institutions on either side of the Atlantic. The Herstatt failure prompted international cooperation among bank supervisors on an unprecedented scale covering a number of areas. Basel I has been quite simple to follow. However, it seemed to adopt “a one size fits all” approach that was found wanting as supervisory complexities grew. Besides, the earlier approach did not segregate the different types of risk banks were required to take on top of the well-recognised credit risk, that is, the chances of a borrower defaulting. Risks relating to interest rate and foreign exchange volatility and other operational matters needed to be quantified and measured and ways found to contain them.¹⁷

The new Basel II norms address these two deficiencies. A multi-pronged strategy will recognise all types of risks and comprise measures to contain them. The new approach also recognises the need to supplement regulatory stipulation of capital adequacy requirements—still the first pillar of a more comprehensive framework—with other tools. Better regulation and inculcating market discipline among banks have come to be recognised as equally important; they constitute the second and the third pillars. The three mutually reinforcing elements, it is hoped, will have the way for a superior risk containment strategy. The relevance of all these to India is obvious. Many Indian banks are going global and those that will continue to be domestic players exclusively cannot remain isolated from a rapidly globalising system.

Risk Management and Basel II

As we have seen, the Basel Committee on Banking Supervision, at the Bank of International Settlements (BIS), was first set up to discuss global financial issues in the wake of the collapse of Bankhaus Herstatt in 1974. Basel I came into being in 1988 and changed the complexion of banking. It is early to measure the costs and benefits of the Basel II approach but it will fundamentally alter banking practices including those of the supervisor.¹⁸

 

With the Reserve Bank of India issuing draft guidelines, the stage has been set for banks to migrate to a new risk-management regime under the Basel II norms. The deadline was 31 March 2007 and for 1 year before that banks were expected to do a parallel run to finetune their systems and procedures. Top bankers say the transition may be relatively smooth, given that they have been sensitised to the needs of a more sophisticated risk-containment scheme thanks to the Basel I accord and the various regulatory measures introduced by the RBI in its wake. Most banks require additional capital. While reworking their capital adequacy requirements under the new guidelines, banks have to outlay more capital under certain heads and less under some other categories. This arises out of the essential difference between Basel I and Basel II approaches.

The former was quite a straight-forward “one-size-fits-all” approach; it did not distinguish between the risk profiles and management standards across banks. But under the new guidelines, banks may have to provide less for credit risks but more for operational (in fact, for the first time) and market risks (these have to be reworked more scientifically). One certain outcome will be a spate of public offerings by the government-owned banks as they try and raise additional resources. The government would naturally support such an endeavour by giving the banks, for instance, greater autonomy than now. The overriding goal of the Basel II framework is to provide adequate capitalisation of banks and encourage improvements in risk management, thereby strengthening the financial system’s stability. Towards that it proposes three mutually reinforcing “pillars”, which together constitute a more scientific way of estimating risks and, if need be, providing for capital. As explained earlier the first pillar strengthens the capital adequacy standards of the earlier accord. The second emphasises better supervisory review while the third attempts to incentivise market discipline.

In the long run, the Basel II norms will make banks more risk-sensitive and improve their risk-management systems. The argument that such a complex reworking of the risk-management system is not relevant to many Indian banks that have no major international presence does not stand scrutiny. Regulators worldwide are already pushing for these standards and no Indian bank can stay isolated from international developments. The Basel II framework is loaded in favour of larger banks with better systems. They can provide for lesser capital while implementing the more advanced approaches to risk containment.

Reward and Accountability of Directors

The Ganguly Committee appointed by the Reserve Bank of India has rightly observed that the present remuneration in the form of sitting fees is quite low for the work expected of directors. One way of rewarding them is to give them a share in the profits and another is to give them share options in the bank. The committee has suggested share options. Of course, there is one danger that, like some of the top managers in failed companies in the US, the board might pursue short-term profits at the expense of long-term stability; in some cases, there could be a temptation to boost profits by manipulating accounts. One possible way of curbing it is to stipulate a lock in period of 3 or 4 years for such share options. A question may arise as to weather the nominees of RBI and government should be entitled to such remuneration. The answer is that the Reserve Bank should not have their nominees at all, as suggested by the second Narasimham Committee on Banking Sector Reforms, because a regulator cannot don the role of a participant also. Government should preferably withdraw their nominees from boards of public sector banks and monitor performance only through periodical reports. It is a recorded fact that many such banks faced massive losses, even when government and Reserve Bank nominees were on the boards.

 

If directors are remunerated on the basis of their performance, they should also be held accountable for non-performance. Almost all the expert committees aver that the directors are accountable to shareholders, but none seems to spell out what it means. Peter Drucker is blunt in saying that “without financial accountability, there is no accountability at all”. Thus, if the bank incurs losses over a period or faces sudden collapse, the directors should be made financially accountable. The least that can be done is to ask them to repay the bank a multiple (3, 4 or 5 times) of the money earned by them from the bank in the past few years. It is realised that this is a very crude form of fixing accountability, but a beginning ought to be made in crystallising accountability of directors in some concrete form.¹⁹

To sum up, effective governance of banks must have the following minimum criteria:²⁰

1. The basic objective of governance should be safeguarding depositors’ money and optimising shareholders’ interests.
2. The directors should be competent and persons of integrity.
3. The chairman of the board should preferably be unconnected with the management of the bank.
4. Board can function through committees and Risk Management Committee assumes special importance in the context of rapid changes taking place in the financial markets. In measuring and monitoring risks, the board should enlist the assistance of experts.
5. The board should forbid banks from pursuing business which might be proper in form, but highly improper in substance.
6. As a general rule, the board should ask the management to spell out as to when a transaction, especially in derivative products, could result in losses and take a view on the probability of incurring the losses. On the basis of the overall risk appetite of banks, the transaction may be approved or rejected.
7. Suitable risk and reward system should be put in place for the directors of banks.

• Basel Committee
• Composition of Boards
• Implementation of Basel II
• Policy implications
• Reward and accountability
• Risk management
• Sound governance practices
• The role of supervisors
• Unique nature
• Withdrawal effects

1. Why is it necessary that corporate governance is more important in banking companies than in others?
2. What does the World Bank have to say about corporate governance? Analyse the bank’s report on corporate governance critically.
3. Comment on the regulations brought forth by the Basel Committee on corporate governance.
4. Discuss the sound corporate governance practices, as recommended by some of the prominent committees on corporate governance.
5. What are the salient features of Basel II recommendations?
6. Make a critical analysis of corporate governance and Indian banks.

• Birla Kumar Mangalam Committee Report on Corporate Governance—Securities and Exchange Board of India (1999).
• Report of the Consultative Group of Directors of Banks/Financial Institutions (Dr. Ganguly Group)—Reserve Bank of India, (2002).
• Report of the Committee on Banking Sector Reforms, Second Narasimham Committee (April 1998).
• Report of the Working Group to Review the System on On-site Supervision over Banks—(Padmanabhan Committee) Reserve Bank of India (1995).
• Reddy, Y. R. K. and Erram Raju, Corporate Governance in Banking and Finance, New Delhi: McGraw-Hill Publishing Company.

 

 

Case Study

Global Trust Bank: The Bank That Went Bust

(This case is based on reports in the print and electronic media. The case is meant for academic purpose only. The writer has no intention to sully the reputations of corporates or executives involved.)

Liberalisation Ushers in New Generation Banks

Post-1991 the new economic policy of the government of India unleashed a process of liberalisation and deregulation. Like in all other sectors of the economy, there were reforms in the financial sector too and the new policy allowed the creation of private sector banks in the country after a lapse of almost three decades. The Reserve Bank of India opened the doors of the banking industry to new players, and the era of the “New Generation Banks” was on the cards. Private sector banks were being welcomed by the customers and the so-called middle class Indians were awaiting new banking options after growing tired of the poor service of nationalised banks. New banks were vying with one another to get a lead in this unbelievably huge market covering a banking public of almost 200 million people. There was a heady sense of anticipation in this industry and the expectations were high. Giant financial organisations like HDFC, ICICI and UTI started their own commercial banks and were able to leverage their reputation and cash reserves to establish credibility and financial stability. At the same time, the market was so big that there was enough space for all of them.

Emergence of Global Trust Bank

The Global Trust Bank (GTB), one of the earliest private sector banks permitted by the Reserve Bank of India (RBI) and the Union Government, was formed on 30 October 1994. Ramesh Gilli, Sridhar Subasri and Jayant Madhob were some of the major promoters of the bank. Global Trust Bank opened its first branch in Secunderabad in Andhra Pradesh and on the very first day of operation, collected Rs. 100 crore of deposits, which was really a record of sorts at that point of time. GTB’s amazing feat on the first day of its opening showed that it could take on more established and powerful nationalised banks through an ecletic mix of ambitious planning and diligent execution. GTB promoted its products through aggressive marketing and live-wire innovative advertising. As a result of these hitherto unused initiatives in the banking business, the brand of GTB expanded rapidly both in terms of increased number of branches and of products and services. The brain behind it was Ramesh Gelli, a “banking genius” who captured the imagination of the banking public with his banking pyrotechnics. GTB appeared to have a bright future. To Gelli, it was indeed a long time dream come true.

GTB tried to prove that it was as fast as its competitors were, and therefore as good as they were, within a short span of time. The bank settled down quickly to focus on keeping its customers happy. In this, it achieved what few banks do—quick, powerful, foolproof systems that gave the front office executive time to provide the customer with a warm personal touch. To the banking public, it was a new experience. The banker was warm and friendly and their job was done in a jiffy. There was no effort to impress or intimidate the customer, and transactions were quick and uncomplicated. The front office youthful bankers performed their job well on moving the brand beyond the personality of its chairman. The promise of expertise was fulfilled and the transition to a warm but systems-driven GTB brand was complete.

Fast, Ultra-modern Cost-effective Banking Services

Since its inception in 1994, Global Trust Bank has been extremely technology savvy, using the latest technologies to deliver world-class service to its customers. Just as the banking job was done in an unconventionally friendly manner, GTB offered a number of products and services. The bank opened a large network of 275 ATMs, which allowed clients to withdraw and deposit cash, deposit cheques, to know the account balance, get a mini statement of transactions, transfer funds and also PIN change. To many middle class customers it was a delightfully new banking experience. The nationalised banks with which they were banking thus far had not yet started computerising their banking activities, while they could not afford the high cost of service charges of MNC banks.

As competition became intense, phone banking was introduced to attract customers. GTB’s phone banking was the quicktime response and less waiting time. Like in ATM, phone banking too permitted a customer to make a cheque book request, cheque status enquiry, cash credit status, and statement of account by fax.

Anywhere banking was another innovative service offered to delight the customer. One does not need to be an account holder of a specific branch to get the banking job done in any branch. Especially the cheque payments and collection services were very useful to corporate clients. Global Trust Bank also announced its foray into Electronic Commerce on 31 July 1999. Infosys Technologies Limited, India’s leading software company, provided GTB with their software, BankAway, for this initiative. BankAway is a powerful electronic commerce platform that enables banks to provide an integrated financial services offering to both their retail and corporate customers—the one-click access to all their bank accounts, trade finance, cash management, bill payment, investments, on-line shopping and more. Global Trust Bank’s core banking operations were based on Bancs2000, also provided by Infosys. Electronic commerce initiative is a step in the direction of offering to its customers world class banking services. With this, GTB joined a select band of banks across the world that offered this service. Ramesh Gelli, Chairman, Global Trust Bank, boasted: “We have always aimed to provide our customers with world-class products and the best service levels. Our Electronic commerce initiative is another step in this direction, through which our customers will be able to conduct all their financial transactions anytime, from anywhere in the world.” Gelli announced that Global Trust Bank was the first bank in India to provide its customers access not only to their bank accounts, but also to their depository accounts. “Customers of our Global Securities Banking service will be able to inquire on their depository accounts over the Internet,” said Gelli. “As and when the laws of the country allow for depository instructions to be accepted electronically, we will offer that facility also.”

Global Trust Bank which offered phone banking and ATM services to its customers earlier, provided Internet as a delivery channel, enabling it to provide many more facilities to its customers. GTB initially offered its customers a “single view” of all their accounts with any of the bank’s branches. Customers were able to inquire into their accounts and transactions, take a printout of their statement of accounts, request for transfer of funds between their accounts, cheque books and demand drafts etc. Internet banking was thus another out-of-the earth banking service that attracted more and more individual and corporate clients to GTB.

GTB had a huge server network, consisting of 10 Sun RISC-based machines, 10 Alpha servers, and around 50 Intel based boxes. The network essentially connected 104 branches and 275 ATMs across the country, providing a wide array of services including Internet and mobile banking.

Global Trust Bank’s Financials

GTB made a flying start in 1993 but later ran into bad loan problems of Rs. 1500 crore. It had posted Rs. 272.7 crore net loss in the year ended March 31, 2003.

 

GTB’s results for 2003–04 were as follows:

 

Deposits	–	Rs. 6920 crore
Advances	–	Rs. 3276 crore
Exposure	–	Rs. 1560 crore
Capital-adequacy ratio	–	0.7 per cent
Net NPAs/Net Advance	–	20 per cent
Return on assets	–	3.5 per cent
Gross NPA	–	Rs. 1100 crore
90-day provisioning
norm against NPA	–	Rs. 1200 crore

 

 

Better Services, No Doubt, but Problems Galore Inside

While the GTB brand and consumer encounters worked well, there seemed to be a lot of trouble behind the scenes. The bank was said to have funded scamsters like Ketan Parikh and its exposure to the securities market landed it in losses. The bank’s success run was abruptly halted. There were serious allegations of rigging of the GTB share price. GTB’s founder Ramesh Gelli tried to pull off a coup by merging his bank with UTI Bank and exit the company. Chiefs of both UTI bank and GTB had put on their best suits for the merger ceremony, when RBI pulled the plug. GTB’s proposed merger with UTI Bank was called off unceremoniously by the banking regulator. Promoter Gelli was also allegedly sacked and instructed not to hold any post. More problems arose later when the Indian capital market regulator, Securities and Exchange Board of India (SEBI) prohibited GTB from raising money from the capital market. It was reported that GTB was suffering from an overexposure to the capital market and the stock market fall left it with reportedly Rs. 11 billion of non-performing assets and a negative net worth.

By 2003, within 10 years of its existence, the Global Trust Bank had been involved in all sorts of regulatory hassles especially in the last 4 years of its existence. GTB came under the regulatory lens the first time for its association with stock scamsters like Ketan Parikh. Soon thereafter, Global Trust Bank had fallen to its lowest depth.

This came as a hard blow to the 8 lakh customers of the bank who faced the possibility of losing their money. Customers were suddenly unable to transact because of the paralysed bank account, and those who needed more than Rs. 10,000 were unable to do so. The loss of trust, the anger and betrayal that customers felt toward the bank meant that the GTB could no more win back their confidence.

Investigations by Regulators into Sale of Shares by Promoters

RBI and SEBI, together with the market, were taken a back by the unusually large trading volumes in GTB shares that had no value and would be extinguished in due course. The promoters of GTB have been selling their stakes in the bank after the Reserve Bank’s moratorium. Among those who off-loaded the scrip, Girish Gelli, director and son of promoter and former chairman Ramesh Gelli, sold 8,49,238 or (0.70 per cent) shares of the bank. The transaction happened after the RBI imposed the moratorium. Sridhar Subasri, one of the main promoters of the bank, who along with Gelli and Jayant Madhab, had set up the bank was also said to have sold off his entire stake in the bank of over 4 per cent. In July, Gelli had also sold around 3 lakh shares in the bank. In all, around 4 crore shares were traded within 1 week. Foreign stakeholders have also been continuously paring their stake in the bank; stake had fallen from 0.34 per cent in the quarter ended December 2003 to 0.25 per cent in the quarter ended June 2004. IFC Washington had a stake of 10.3 per cent in June 2004. FIIs had also been selling their stake in the bank in the last quarter. Goldman Sachs, along with other FIIs, had a stake of 4.76 per cent in the bank of which the former’s stake was at 4.24 per cent in the quarter ended March 2004. The total FII stake in the June quarter had fallen to 0.98 per cent, after the crisis got worsened.

After that, for the GTB, it had been a trail of regulatory pursuit. The bank came under the glare of the Reserve Bank, the Securities and Exchange Board of India and the Joint Parliamentary Committee probing the stocks scam. Global Trust Bank came under SEBI scrutiny on alleged insider trading charges. Promoter Gelli was later banned by SEBI from conducting any stock market transaction. He was forced to leave the GTB board. The bank’s Capital Adequacy Ratio (CAR) always stayed well below the RBI-mandated 9 per cent. GTB tried to induct Newbridge Capital to bring in the necessary fund. RBI rejected this request of the GTB Board.

SEBI Gets Cracking on GTB Deals

The Securities and Exchange Board of India then asked stock exchanges to disclose the buyers and sellers of Global Trust Bank (GTB) shares, both before and after the Reserve Bank slapped moratorium on the bank. “A full-fledged probe will be done only if we sense any malpractice. Our surveillance wing is looking into the transactions. Exchanges have also been asked to keep a watch,” said a SEBI official. “This is in line with the surveillance exercise that SEBI carries out in case of any abnormal trading,” said the official. “It would be difficult to take a view on the transactions, which took place weeks before the moratorium... the insider trading angle is a touchy issue, since only RBI and the finance ministry were privy to the information that a moratorium would be announced,” said a SEBI official.

Countdown to Collapse of Global Trust Bank

The SEBI enquiry and the issue of the moratorium were the culmination of the crisis in the making since 2001. The genesis of the GTB collapse lay in now ousted promoter Ramesh Gelli’s involvement in the Khetan Parekh securities scam of 2001, when he gave huge unsecured loans to the stock broker and group companies of Zee Telefilms. GTB’s audited balance sheet for 31 March 2002 showed net worth of Rs. 400.4 crore and a profit of Rs. 40 crore. However, RBI’s own inspection revealed that net worth was negative. In view of the very large variance in the assessment of GTB’s financial position as reported by auditors and by RBI’s inspectors, an independent chartered accountant was appointed to reconcile the position. GTB was placed under directions relating to certain types of advances, certain premature withdrawal of deposits, declaration of dividend and its capital market exposure. RBI also started monitoring GTB on a monthly basis. In view of the need to complete the statutory audit and to assess the steps necessary to be taken on the future set up of the bank, RBI permitted GTB time up to 30 September 2003 to publish its annual accounts. On 31 March 2003, GTB announced deposits of Rs. 6921 crore and advances (loans) of Rs. 3276 crore. On its balance sheet, it showed gross non-performing assets of Rs. 915 crore while total provisions (against bad loans) were Rs. 268 crore. RBI issued a press release in this connection which said: “Even though the financial statements show an overall loss, the bank has made an operating profit for the year 2002–03. The RBI welcome the decision taken by the GTB and its board to clean up the balance sheet”. But RBI’s subsequent inspection showed that bank’s net worth had further eroded and capital adequacy ratio (CAR) was negative. GTB was advised to take immediate steps to infuse fresh capital to restore its CAR to 9 per cent and indicate a time-bound programme. The Bank was advised to explore options of raising capital through domestic sources or through merger with another bank. Ealier, Centurion Bank was able to get RBI permission for Sabre Capital of Rana Talwar to infuse capital to bail out the bank. However, GTB’s proposal to RBI for infusion of capital and restructuring by global private equity major NewBridge Capital was rejected by the Central Bank.

The Cause of the Crisis

Ramesh Gelli, one of the promoters and the ex-chairman, refused to take the blame for the failure of Global Trust Bank, but held his management style of total delegation of power to senior managers and his hands-off approach responsible for the bank’s collapse. Though there is a general perception that the woes of private banks were due to priority sector lending, available data disprove this theory. Of GTB’s total NPAs of Rs. 1,500 crore, priority sectors such as agriculture and small industries together accounted for 22.5 per cent (agriculture less than 1 per cent and small industries 21.5 per cent). The bulk of NPAs, viz. 77.5 per cent, was from the non-priority sector lending. GTB had an exposure of about 52 per cent of its advances to the stock market, which was a blatant flouting of RBI directives, so that a part of the problem must have come about from erosion in the value of investments. In the 2 years between 1999–2000 and 2000–01, the bank’s capital market exposure went up to around 30 per cent of its total assets. When the market collapsed in February-March 2001, the value of securities came down drastically and the bank could not recover from this, even though its exposure was reduced by then.

Proposal to Merge GTB with OBC

The RBI that has a mandate to protect depositors of commercial banks had to rush through with the merger proposal in the last 1 month. Almost all nationalised banks including Canara Bank, Andhra Bank, J&K Bank were approached. Even Corporation Bank was also sounded out. The RBI finally zeroed in on ( Oriental Bank of Commerce) as the bank’s NPA level had come down drastically recently. Once the regulator selected the bank, it thrashed out all the merger modalities such as safeguarding the depositor’s money and retention of employees. RBI officials had at the time of the announcement of the amalgamation of Oriental Bank of Commerce said that there would unlikely to be any swap ratio. As a part of the scheme, the entire amount of the paid-up capital and reserves of GTB would be treated as provision for bad and doubtful debts and depreciation in other assets. Estimates showed that GTB had a negative networth of around Rs. 900 crore. The capital of the bank as on 31 March 2003 was at Rs. 121.35 crore while reserves and surplus was at Rs. 146.16 crore. The Reserve Bank’s decision followed hectic activity in the corridors of the Ministry of Finance to save the bank following negative reserves. The RBI and the Securities and Exchange Board of India were to oversee the merger so that it was completed quickly. OBC was to take over GTB, with all its assets, loans and NPAs. The bank was to take over GTB’s Rs. 1500 crore bad loans in exchange for which it would get 104 branches of GTB and 8 lakh customers. The RBI sop of no swap ratio was the icing in the cake for OBC. If any surplus remained after accommodating all appropriations, only then would shareholders get the amount on a pro-rata basis.

Synergy between GTB and OBC

There couldn’t have been a better proposal for merger. North-based OBC got almost a million customers and 104 branches mostly in the southern states of AP and Maharashtra. With GTB’s net worth being negative there was no share swap. But OBC could well be paying a big price. It was adding Rs. 1500 crore of GTB’s bad debts to its clean balance sheet. However, OBC’s CMD, B. D. Narang, was confident of recovering 40 per cent of GTB’s debts. The scheme of amalgamation drafted by the Reserve Bank of India clearly stated that all GTB employees would continue to retain their jobs and get the same salary package and work on the same terms and conditions as applicable prior to the closure of business hours on July 24. But “salary fitment problems” could only be a part of the “people problems” to be faced by OBC.

The OBC said it had made the offer to merge GTB with itself as it perceived synergy between the two banks. The OBC got customers from the GTB and its branches, many of which were based in South India wherein the nationalised OBC has a limited presence. The two banks also shared a common technology platform. “There is a terrible amount of synergy between the two banks. We are a north-based bank and they are a south-based one. We should be able to clean up the books in a very short time,” Oriental Managing Director B. D. Narang told reporters.

Who is to Be Blamed for the GTB Fiasco?

This was a classic case where the gullible investors were made to pay a heavy price for their trust in a crafty and manipulating banker and the inefficiency of the regulator. The 8 lakh and odd investors placed their hard-earned money into GTB because of the reputation of the promoter Ramesh Gelli, considered to be a wizard in the banking circles; the bank did remarkably well in the early days; it provided excellent customer-friendly services and all their banking operations were modern and computerised; and above all, there were no plausible adverse reports about its stricky investment from the regulators. Then, why blame and penalise them? The fiasco does throw up several uncomfortable questions pertaining to Reserve Bank’s regulatory policies with regard to the banking industry. One of the questions, uppermost on the minds of the unwary GTB depositors, is why did the RBI wait so long despite being aware of the murky goings-on in GTB?

(1) The RBI could have moved against GTB in 2002 itself when its inspectors stumbled upon the bank’s crooked ways and could have superceded the GTB Board under the Banking Regulation and RBI Act. Having done so, it could have appointed its own executives to clear up the mess, before putting it up on the block or inducting a new management, like it did in case of the Centurion Bank.

(2) Some analysts recall that the RBI indicted Gelli in 2001 for being hand-in-gloves with the scamster Khetan Parekh in the stock market manipulations. Gelli was later removed as the Chairman of GTB. That there were skeletons in the GTB cupboard was known since the Gelli-Khetan-Parikh connection was unearthed in the aftermath of the 2001 stock scam. Even after the replacement of Gelli as the Chairman of GTB, why did the RBI fail to address the fundamental problem with GTB, its murky management practices and shady financials? Matters did not mend in GTB even after the RBI brought in R. S. Hugar as Chairman and provided substantial liquidity support. Should not serious action have been initiated then itself so that the gullible investors who lost everything now would have been adequately protected?

(3) The Central Bank was also aware of the fact that GTB was misleading investors and depositors by overstating its net worth, profits and understating its NPAs. To be doubly sure, the RBI got an external auditor to scan the books, and the findings were confirmed in February 2003. With the result, GTB came under the RBI scanner for certain advances, capital market exposure, premature withdrawal of deposits, and was tracked on a monthly basis. GTB was advised to change its auditors and given time till 30 September 2003 to publish results for FY03. On 30 September 2003, the RBI said it welcomed GTB’s move to clean up the balance sheet after the GTB turned in an operating profit. Did not all these show that the RBI itself was gullible enough to be taken for a ride by GTB executives?

(4) After all, in just 10 months, the RBI had gone back on its view about the GTB, and placed it under a 3 month moratorium, creating a needless liquidity crisis for the poor GTB depositors. The RBI could have taken action against GTB 2 years earlier, but because of its procrastination everyone who had anything to do with the bank had to suffer. If this is the case, is there not a need for regulating the regulator?

Global Trust Bank Is now Oriental Bank of Commerce

The government of India sanctioned the scheme for amalgamation of the Global Trust Bank Ltd with the Oriental Bank of Commerce. The amalgamation came into force on 14 August 2004. All the branches of Global Trust Bank Ltd now function as branches of Oriental Bank of Commerce with effect from this date.

1. Customers/Depositors of GTB: Customers, including depositors of the Global Trust Bank Ltd, operate their accounts as customers of Oriental Bank of Commerce with effect from August 14, 2004. Oriental Bank of Commerce has made the necessary arrangements to ensure that service, as usual, is provided to the customers of the Global Trust Bank Ltd.
2. Shareholders of GTB: In accordance with the Scheme of Amalgamation, if any surplus remained after meeting all the liabilities out of the realisation of assets of the Global Trust Bank Ltd, the shareholders might receive pro-rata payment. As part of the merger proposal, OBC would get Income Tax exemptions in transferring the assets of GTB in its book during the merger process, while all the bad debts of the merged entity would be adjusted against the cash balances and reserves of GTB.

OBC was confident of turning around the GTB within one year. According to OBC chairman B. D. Narang, GTB “suited it” because of synergies. While weakness of GTB has been bad assets, strength of OBC is recovery. Since the GTB is a south-based bank, it would give OBC the much needed edge in the southern part of the country. Moreover, both the banks have a common core banking solution “Finacle,” which will help in the consolidation.

Post-merger Scenario

Soon after the merger, skeletons started tumbling out of GTB’s cupboard and Oriental Bank of Commerce, with which GTB was merged, lodged a complaint with the CBI about advances made by the latter that had serious financial improprieties. According to Oriental Bank, internal investigations revealed that GTB had taken high credit exposures in certain accounts. In some cases the exposures exceeded the norms prescribed by the Reserve Bank of India. OBC found a high degree of imprudence on the part of GTB officials in exercise of sanctioning powers. GTB had abetted certain group of borrowers to siphon off funds through the banking channel. The conduct of most of these accounts revealed that deliberate attempts had been made to camouflage the position of non-performing assets (NPAs) by making fresh sanctions in sister or allied concerns including some front companies.

On the basis of internal investigations, Oriental Bank filed criminal complaints with the CBI in the following cases:

(i) A case was filed against Unitel Software Limited for having caused wrongful loss to the tune of Rs. 676.79 lakh to the erstwhile Global Trust Bank in the matter of sanction, disbursal and utilisation of the credit facilities.

(ii) The CBI registered a case against Ashok Advani of Business India Publications, Mumbai, and concerned officials of the erstwhile GTB for cheating the bank to the tune of Rs. 15 crore by obtaining credit facilities through misrepresentation. Whereas the publication had been the client of GTB since 1994 and had defaulted in repayment of credit facilities sanctioned earlier, it was falsely mentioned in the process note that the account of Business India was a new one.

(iii) The CBI registered a case against Petro-Energy Products Co. Ltd, since the company cheated GTB to the tune of Rs. 78.41 crore at Bandra, Mumbai branch and Rs. 23.15 crore at the Chennai branch.

(iv) The CBI registered a case against Shonk Technologies International Ltd, for a wrongful loss to the tune of Rs. 38.49 crore caused to the erstwhile GTB through misrepresentations and diversion of funds for purposes other than for which the loan was sanctioned.

(v) The CBI has registered a complaint at Bangalore against Pearl Distilleries Ltd, for having caused wrongful loss of Rs. 10.28 crore to GTB in the sanction, disbursal and utilisation of credit facilities.

A finance ministry statement on the complaints filed by OBC said that some other cases were also being looked into and further complaints would be lodged with the CBI in due course. OBC’s move comes days after the Finance Minister, P. Chidambaram, assured the Parliament that criminal cases would be filed in matters relating to GTB shortly. Stating that “serious financial improprieties” were revealed in the five accounts during the post-merger due-diligence conducted by OBC, the Finance Ministry said “High degree of imprudence in exercise of sanctioning powers have been observed where the bank appears to have abetted certain group of borrowers to siphon off funds through banking channel.”

1. The collapse of the Global Trust Bank should be attributed not only to the lack of ethics and avariousness of its promoters, but also to the lack of competence and alacrity of the regulators. Would you agree? Explain your stand the Global Trust Bank.
2. From the hindsight of ultimate failure, trace its emergence as the most technology-based bank in Inida.
3. Explain the causes that contributed to the collapse of the Global Trust Bank.
4. Comment: “The failure of the GTB is also the failure of the banking regulatory system in the country.”
5. What was the cause of the crisis of the Global Trust Bank? To what extent the promoter of GTB played a leading role to accentuate the crisis?

• “Draft Scheme of the Merger” “Moratorium Details”, RBI Websites, www.rbi.org.in
• Infosys’ Press Release, “Global Trust Bank launches Electronic Commerce Initiative with BankAway from Infosys”.
• JM “GTB depositor? You had it coming?” http:www.dancewithshadows.com/gtb_jacked.asp.
• “Global Trust Bank to be Merged with OBC”, Tribune News Service (27 July 2004).
• “GTB Skeletons Tumble out”, domain-com (4 January 2005).
• “GTB Amalgamation…can OBC bring back the trust?” India Infoline (26 July 2004).
• “Global Trust Bank”, Brand features profile, brand channel.com
• “SEBI Gets Cracking on GTB Deals”, Times News Network (4 August 2004).