RBI and government are also responsible for the fraud says former PNB chief

India's banking sector seems to be lurching from one crisis to another.

On Feb. 14, Punjab National Bank (PNB), the country’s second-largest government-owned lender, revealed that it had discovered a $1.77 billion fraud at one of its branches in Mumbai. It cautioned that the problem is expected to spill over to other lenders.

This couldn't have come at a worse time as Indian banks battle an ever-growing pile of non-performing assets (NPA), which are expected to rise from Rs8 lakh crore in March 2017 to Rs9.5 lakh crore in March 2018.

KC Chakrabarty, former deputy governor of the Reserve Bank of India (RBI), believes these problems are likely to escalate as governance and regulatory standards hit a nadir.

Chakrabarty, who served as chairman and managing director of PNB between 2007 and 2009, said that since such crises are products of a systemic problems, the banking regulator and government, too, must take responsibility.

He spoke to Quartz about what this fraud suggests, the growing NPA problem, and what measures are needed. Edited excerpts:

A $1.77 billion fraud went unnoticed for seven years. What does it says about Indian banking?

Banking is a risk-taking business and so frauds, bad loans, and wrong decisions will happen. But the business has to be done within a broad risk-management framework. In Indian banking, (this) framework is primitive. In fact, we have no risk-management system at all and this is a systemic issue. It is the responsibility of the board, policy makers, and the regulator, and they all should put in place a strong credit-assessment process. Our entire approach is that if you violate the framework and make profit, you are rewarded; questions are asked only when you make losses. Instead, you should be reprimanded and punished the moment you violate guidelines. 

Who do you think is responsible for these oversights?

Everybody—the regulator, bank boards, management, and even employees. There is very poor control and oversight. Unless you correct this, these things will keep happening.

What should done to ensure these instances are not repeated?

How can one bank branch in Mumbai sanction Rs11,000 crore of contingent liability credit risk (referring to letter of credits) and go unnoticed? In fact, the moment you sanction a letter of credit, it should be reflected on the books as it is a loan, and the name of the approver should also be recorded. We are not ready to follow the global best practice, according to which, people who sanction the loan should not be allowed to talk to the borrower. The credit operation should be segregated from credit-risk assessment. Ideally, loans should not be sanctioned at the bank level, but from a centralised office.

Are these lapses fuelling India's toxic loan problem?

Absolutely. Nobody is questioning why these loans were given in the first place. We are blaming the borrowers for not repaying, but the fact is these bad loans are also a result of governance issue.

In fact, I think the whole NPA problem is much bigger than what is being discussed. We have gross non-performing assets (NPA) of Rs8-9 lakh crore. Then, loans worth Rs6 lakh crore have been written off and that is also NPA. So the NPA problem is already at Rs15lakh crore. But from parliament to RBI to banks, they keep saying that NPA is only around Rs9 lakh crore. They are all lying, as we are not recognising the full problem. Imagine, we don’t even have the basic transparency.

The banks keep saying the worst is behind us. Do you agree?

How can they even say that when they haven’t improved their risk management framework or appraisal methodology? All that we seem to be saying is that god will take care of it and so it won’t happen again! It may not happen for few months, but then again it can recur after a few years.

If the RBI's latest circular is implemented, then the NPA problem will only get bigger. Bad loans will go up by Rs2 lakh crore immediately as all your restructured assets will become NPAs.

Why do public sector bank seem to be in greater trouble?

Because there is no accountability. In private banks, there is pressure from shareholders, the management can get terminated if they do something wrong, and their risk-management framework is slightly better.

How much responsibility do the RBI and government share in this financial mess?

If all banks don't have the risk-management system, then it is a regulatory failure and the owner's (government) failure as well. The owner will feel the heat because it needs to give capital. But what is the accountability of the regulator?

At this rate do you think we can trust Indian banks?

I don't think Indians have an option. Plus, you know that the government will step in and rescue. The problem is that the ordinary taxpayers' money will go in all this.