Corporate Governance crisis in the Banking Sector: Role of the RBI

[By Ambarin Munir Khambati ]

This Blog is part of a series of posts as a collaboration titled “KAIZEN” between the Centre for Business and Commercial Laws (CBCL), NLIU Bhopal and Law School Policy Review (LSPR). To view this blog on LSPR, please click here.

Ambarin Munir Khambati is a 3rd-year student of NLSIU, Bangalore and an Editor at LSPR.

The RBI crackdown on the top management of several banks, and most recently on YES Bank MD and CEO, Rana Kapoor, has opened a Pandora’s box in the banking industry.

In this post I shall look at the corporate governance failures at major banks that have come to light in the recent months, and how the RBI must play an active role as a watchdog to ensure compliance.

The starkest failure of most banks has been that of Loan Divergence. Banks have been under-reporting their Non-Performing Assets (“NPA”s) or failing to classify them as bad loans post-default. To tackle this, in April 2017, the RBI published a notification requiring banks to disclose their divergence in asset classification, if there was over 15% difference in the assessment made by the RBI and that of the Bank itself. As a result, banks revealed whopping figures of under-reported NPAs which forced the RBI to interfere with appointments and removal of top management in order to ensure compliance. YES Bank, for instance, reported a divergence of Rs.4176.70 crores in 2016, which was 558% higher than the figures they reported themselves. Consequently, the RBI refused to approve an extension of CEO and MD Rana Kapoor’s tenure at the Bank.

The massive scale of loan divergence is problematic for several reasons. Primarily, it misleads shareholders and investors about the credit risk of the bank. It also raises suspicion about related party transactions, and corruption with loans being granted to individuals or companies without adequate collateral security, or background checks. This also puts under the lens auditing firms which allow companies to fudge figures on their annual reports, and fail to caution shareholders and the public. Unchecked loan divergence, on the part of huge banks like YES Bank, ICICI, and Axis Bank puts at risk the entire banking system.

To enforce corporate governance norms, such as adequate disclosures by banks, the RBI must play a punctilious role, and make full use of its wide-ranging powers under the Banking Regulation Act, 1949 (“Act”). First, the RBI must require mandatory disclosures by banks; second, failures to comply must be made public, third, more reliance must be placed on the Insolvency and Bankruptcy Code (“IBC”), and fourth, there must be increased control over top management.

Mandatory Disclosures

Under Sec. 35 of the Act, the RBI has the power to inspect the affairs, and books of accounts of any banking company. Directors, officers, and employees of the company are also obligated to produce any document or statement as required. Moreover, it can also exercise its power to issue directions, and guidelines for disclosure, such as the Revised Framework on Resolution of Stressed Assets which requires lenders to classify loans as stressed, immediately on default. They are also mandatorily required to provide weekly credit information to a special body created for the purpose, the Central Repository of Information on Large Credits. Resolution of bad loans needs to be carried out by the banks under a specified timeline, failing which they must file an application under the Insolvency and Bankruptcy Code.

Mandatory and periodical disclosures to the RBI, shareholders, investors, and general public will ensure much needed transparency. These would have a direct bearing on stock prices, and credit ratings which would incentivize banking companies to comply with governance norms. For example, the developments at YES Bank affected the ability of the bank to raise capital, and so credit ratings agencies such as Moody’s and ICRA have lowered their ratings, forcing the company to begin finding replacements for Kapoor.

Publishing corporate governance failures

The RBI, in a series of letter to YES Bank pointed out, “serious lapses in the functioning and governance of the bank”, and “highly irregular credit management practices, serious deficiencies in governance and a poor compliance culture”. Yet, the full text of these letters remains confidential. The only information available to potential investors comes from cryptic press statements made by the regulator and the Bank, and the inference drawn from the curtailment of Rana Kapoor’s term. In the interest of accountability, the RBI must invoke its power under Sec. 28 which gives it the power to publish, in public interest, any information obtained under the Act, and any credit information disclosed under the Credit Information Companies (Regulation) Act, 2005.

Increased reliance on the IBC

The next step after disclosure of NPAs would be to recover the bad debts, and reliance must be placed on the newly amended Insolvency and Bankruptcy Code which is designed to tackle NPAs in the speediest manner possible. In just 2 years since it came into force, creditors have recovered close to 56% of admitted claims from stressed companies under the IBC. While the jurisprudence on the area is still emerging, the government has shown a keen interest in updating the Act to comply with decisions of the NCLAT, with an aim to promote resolution, as opposed to liquidation.

Control over top management

The massive amounts of divergence that has been reported would have been impossible without the knowledge of the top management. A means of enforcing corporate governance norms is to keep tenures of high-level officials such the CEO, Chairman and Board in check. The problem with having high-profile CEOs with exceedingly long tenures is concentration of power over time, and consequent paralysis of the Board. For example, at ICICI Bank, the Board overlooked deals concluded in conflict of interest by Chanda Kochhar, eventually leading to an RBI crackdown.

Further, any misstep on a CEOs’ part, or a removal, in the worst case, would trigger a panic sale of stock, such as at YES Bank where the stock price halved as soon as Kapoor’s term was reduced. The “cult of the CEO” has been in frequent debate in the West, and for this reason, high-profile CEOs are no longer preferred as they act as a deterrent to potential investors.

The RBI has recently shown a firm resolve to rein in top management, by refusing to grant term extensions, as a means of enforcing its directions on corporate governance. For this, it possess a wide range of powers under section 36AA of the Act, wherein it has the power to remove managerial or other persons from office at a bank if, “is satisfied that in the public interest or for preventing the affairs of a banking company being conducted in a manner detrimental to the interests of the depositors or for securing the proper management of any banking company it is necessary so to do”. At Axis Bank, for instance, it was found that there was a massive 336% rise in gross NPAs over 3 years, which went underreported and there were rumours of CEO Shikha Sharma’s family having benefitted from loans from the bank. In light of this, the RBI asked the bank to reconsider Sharma’s 4th 3 year term, a move after which she resigned.

Another tool in the RBI’s arsenal has been to withhold approval of hefty year-end bonuses to officials at YES Bank, and HDFC Bank, among others. In some cases, it has also mandated promoters to reduce their holding of paid-up share capital, to reduce the influence they wield over the company.

Conclusion

While the YES Bank saga seems far from reaching a quietus, it has indeed made other banks more vigilant. It has also brought focus on the perils of a seemingly well-regulated industry, and the need for corporate governance norms to be strictly enforced, and not treated as mere unenforceable guidelines.

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