[By Sourav Kumar and Jyotshna YashaswiI]
Sourav is a student at the National Law School of India University, Bangalore and Jyotshna is a student at the Chanakya National Law University, Patna.
Introduction
In the previous few years, the country has witnessed several banks facing an extreme crisis due to the ballooning Non-Performing Assets (NPAs). In 2018, a fraud of almost $2 billion was discovered at the Punjab National Bank. PMC Bank, Yes Bank, and Lakshmi Vilas Bank have almost collapsed, necessitating an intervention from the RBI to control the situation. Although the reasons for these crises are different, there is one common point among all of them, i.e., lack of internal control. In this article, I argue that the overlap between the board of directors (Board) and the management of the bank deteriorates the corporate governance standards in a bank. This overlap may be in a formal sense (through numbers), or in a factual sense (through influence). I will support my claim by proving that recent bank crises in India were a result of the failure of corporate governance caused by an overlap between the Board and the management. I further argue that prevention of such failure of corporate governance requires the RBI to establish an internal pressure mechanism for all banks by appointing nominee directors to the board of banks, in addition to the external regulatory mechanism that RBI exercises currently through various regulations.
Failure of Corporate Governance in the Recent Past
In March 2020, an excessively large amount of NPAs and constant failure to secure fresh funding prompted the RBI to take over the charge of Yes Bank and supersede its Board. The bank was put under moratorium and the RBI formulated a bailout plan led by the SBI. This crisis at the Yes Bank had been plaguing the bank since 2015 and was concealed from the RBI. The former CEO of the bank Rana Kapoor engaged in aggressive lending to entities like Reliance Industries, Essel Group, DHFL, etc. which were already stressed and could not secure credit from other banks.[i] This aggressive lending resulted in a large amount of NPA, which was flagged for the first time in 2017-18.
In the case of Lakshmi Vilas Bank, directors having substantial shares interfered with the management leading to the granting of loans to the likes of Jet Airways, Religare, CCD, Nirav Modi, etc.[ii] who were already financially stressed. This resulted in the burgeoning of NPAs at the bank, leading to the crisis. In the case of PMC Bank, more than 70% of the loan amount was given to a single entity, HDIL, whose financial credibility was already in question.[iii]
All these crises were a result of a very large amount of NPA. The NPA was accumulated as a result of the unethical lending by the banks without properly accounting for the risk factor involved in such lending. The risk appetite of a bank is decided by the Board, and the management runs the bank in line with the risk approach decided by the Board. Therefore, it is clear that such unethical risk-prone lending can only be possible if the corporate governance structure has collapsed. This collapse of corporate governance structure in Yes Bank could be understood from the fact that one of the independent directors of the bank Uttam Prakash Aggarwal had resigned from the board citing corporate governance failure. He stated that there was a complete failure of corporate governance at the Bank as the bank was being run by the managers and not the Board.[iv]
The Problem of Overlap between the Board and the Management:
Various directors appointed to the Board of a company are also senior management officials of the company. This overlap between the Board and the management allows the executive directors to control or influence the functioning of the board, which was also the case with Yes Bank. Rana Kapoor used his influence to control the independent directors of the Board. On the contrary, in the case of Lakshmi Vilas Bank, the flow of this influence had reversed, where the directors interfered with the management. With respect to PMC Bank, there is no concrete proof to show such influence. However, it is highly improbable for the management to extend 70% of its loans to a single entity without effectively controlling the Board.
An overlap, either in a formal or a factual sense, between these two separate organs of a company contradicts the basic principles on which corporate governance of banks is based. The RBI attempts to ensure corporate governance standards in the banks through various regulations. The most important principles on which the RBI regulations are based are ‘Transparency and Disclosure’.[v] Accordingly, the management of a bank should disclose all material information to the Board and maintain transparency. However, if the Board and the management overlap significantly in any manner, then this principle is rendered futile leading to a collapse of the corporate governance structure.
The Need for Proactive Engagement by the RBI
According to Section 149(4) of the Companies Act, one-third of the directors on the Board of a listed public company should be independent directors (IDs). This requirement for the composition of the Board may be changed by the central government for special classes of companies. The RBI in a recent discussion paper has proposed to tackle this problem of overlapping in a formal sense by proposing that the majority of Board members should be independent directors. It also proposes that the Audit Committee and the Risk Management Committee, the two most important committees of a bank, should comprise of at least two-thirds of independent directors. This proposal will certainly reduce the influence of the management over the Board and its important committees.
However, the independence of the Board cannot still be ensured as there would still be some scope to influence the independent directors. This is because the director’s duties are often followed only in letter and not in spirit. The Yes Bank episode is a perfect example to show how independent directors can be influenced.
The basic idea of corporate governance is to ensure that the Board remains uninfluenced and independent of the management. The various duties of directors such as reporting fraud, unethical behavior, violation of bank’s policy, etc. cannot be fulfilled by a Board that is not independent in the truest sense. This is where a need for the RBI to engage proactively with the banks is felt. As a regulator, RBI has acted as an external pressure mechanism till now. However, it is time when the RBI needs to establish an internal pressure mechanism for banks. This internal pressure mechanism can be established by mandatorily appointing nominee directors in optimum number to each bank, who will report directly to the RBI.
Section 161(3) of the Companies Act, 2013 provides that the Board can appoint a person as a director nominated by any institution mandated under any law. Such directors are also known as nominee directors and the RBI has frequently resorted to appointing nominee directors to the board of banks that are put under corrective action. Till now, the RBI has appointed nominee directors, mostly, as a reactionary mechanism. In all the recent bank crises, the RBI received the relevant information when things had already gone out of hand. As a result, the central bank had to resort to capital infusion or a merger with some big banks in order to save the ailing banks, which is not an ideal situation.
Therefore, the reactive corrective mechanism in the banking sector has not been optimally successful and there is a need for a proactive corrective mechanism that ensures a higher standard of corporate governance. The compulsory appointment of nominee directors will have two positive impacts. Firstly, it will increase the independence of the Board, and secondly, it will set up a channel of quick and reliable information for the RBI. This will also ensure that the interest of the depositors is taken care of, as the RBI nominee will also act as the trustee of the depositors.
A higher standard of caution is necessary for the banking sector as it is highly sensitive and sustains on the trust of the depositors. A report of mismanagement at a bank has the potential to shake the trust of the depositors, which in turn poses a threat to the stability of the bank and the economy as a whole. Therefore, such mismanagement must be preempted by ensuring the independence of the Board in the truest sense. This can be achieved by establishing a reliable and prompt channel of information for RBI through nominee directors.
Endnotes:
[i]The Print Team, ‘Everything you need to know about the Yes Bank collapse, rescue and prospects’ The Print (New Delhi, 9 March 2020) <https://theprint.in/opinion/everything-you-need-to-know-about-the-yes-bank-collapse-rescue-and-prospects/377990/> accessed 12 February 2021
[ii] Venkatesh Ganapathy, ‘Case Study- An Analysis of Corporate Governance Deficit in Lakshmi Vilas Bank’ [2020] Volume 3(2) Catalyst – Journal of Management Studies 1, 8-10 <https://www.cms.ac.in/pdf/An-Analysis-of-Corporate-Governance-Deficit-Lakshmi-Vilas-Bank.pdf> accessed 12 February 2021
[iii]Gopika Gopakumar, ‘Patterns behind the PMC Bank meltdown’ Live Mint (Mumbai, 8 October, 2019) <https://www.livemint.com/industry/banking/patterns-behind-the-pmc-bank-meltdown-11570449287851.html> accessed 12 February 2021
[iv] Mannu Arora, ‘Complete governance failure the reason to resign: Yes Bank Board member Uttam Prakash Agarwal’ The Economic Times (10 January 2020) <https://cfo.economictimes.indiatimes.com/news/complete-governance-failure-the-reason-to-resign-yes-bank-board-member-uttam-prakash-agarwal/73188579> accessed 12 February 2021
[v] V. Leeladhar, ‘Corporate Governance in Banks’ (December, 2004) RBI Bulletin, 1101, 1103-1104 < https://rbidocs.rbi.org.in/rdocs/Bulletin/PDFs/59405.pdf> accessed 24 February, 2021