Tarnished: What the PNB scandal means for India's public-sector banks

By Rashmi Kumar; additional reporting by Elliot Wilson

Illustration: Spooky Pooka

In the space of just a few months, euphoria over the prospect of a transformative recapitalization for India’s ailing state banks has turned to horror with the discovery that some of these lenders are caught up in the country’s largest-ever fraud, put at $2 billion. 

The scandal dashes hopes of the state banks securing much-needed funds from the market and raises plenty of questions over who shares the blame.

Back in late January when Punjab National Bank accused two clients, jeweller Nirav Modi and his diamond trading uncle Mehul Choksi, of defrauding it of Rs2.8 billion ($43 million), it looked like a blow to the country’s second-largest state lender but, from a wider market perspective, a financially manageable one. It would sting for sure, but it would not draw blood.

But then the Central Bureau of Investigation got involved, and the market gulped. The CBI after all is the agency that is called in when the state expects to discover serious financial malfeasance. Ten days later, the bank confessed to the scale of the problem, admitting that both men had been scamming it for years and that the cumulative loss was far, far greater.

It came as a shock to the entire industry. Senior bankers interviewed by Asiamoney couldn’t conceal their surprise – though the reaction was a mixture of alarm and bafflement, with a dose of ‘there but for the grace of God go we’. 

A senior official at a state bank says it will force “all of us to take a long look at who we do business with”. 

The head of wholesale banking at a large private-sector bank adds: “If this can happen to PNB, it can happen to any state bank, particularly those that have failed to fully integrate their core banking systems”.

What really stood out though, along with the scam’s sheer simplicity, was how long it had gone on, unobserved. 

For years, staff at Brady House, a PNB branch near Horniman Circle in the central Mumbai district of Fort, issued Modi and Choksi with fraudulent guarantees, allowing them to take out cash advances from the overseas branches of rival Indian banks. 

Since all the guarantees were ostensibly approved by PNB, they were taken at face value, stamped and approved.

What happens now? The nature of the scam ensures that the pain is spread across the entire sector.

“It wasn’t an accident that Modi and Choksi only used state banks,” says one banker. “Their systems are old and their software, if they have any, is outdated. If you come in and you’re a regular customer, chances are they won’t ask questions.”

So while PNB remained largely oblivious of the debts that were mounting in its name, so did its guileless state peers, who simply handed the fraudsters bundles of cash at the counters of their overseas branches. 

UCO Bank says its exposure to the fraud is $412 million. At Allahabad Bank, it is $367 million. At Union Bank of India, $300 million, and at State Bank of India, $212 million. State banks all.

“Every bank will tell you this isn’t a systemic issue,” a senior Axis executive tells Asiamoney. “And it’s not – you’re not going to see any of our banks, even PNB, go under or wobble. But it is systemic in that so many of us are involved. There’s a lot of fault to go around.”

At the moment, though, the focus is on India’s public-sector banks. 

Before PNB opened this box of pain, the mood in Mumbai’s financial community was overwhelmingly positive. 

Public-sector banks were still celebrating the massive Rs2.1 trillion ($32 billion) bailout package announced by the government in October 2017 to help them deal with ballooning non-performing assets (NPAs).

Source: National Stock Exchange

The jubilation did not last long. The scandal caused PNB’s share price to collapse, so too the Nifty Bank Index, wiping out all the gains made in the aftermath of the recapitalization announcement.

Then came another shock. Bank of Baroda, India’s third-largest state-owned lender, said on February 12 that it was quitting South Africa, in line with its strategic plan for “rationalization of overseas branches”.

But local media reports later revealed a bigger story, of the bank allegedly having a role in allowing the Gupta brothers – South African businessmen of Indian origin and with political clout in South Africa – to move millions of dollars from shady transactions into offshore accounts.

The impact on Bank of Baroda’s books is admittedly small. The bank said in early March that it has credit exposure equal to Rs1.47 billion ($23 million) in four accounts linked to the family in South Africa, a mere 0.037% of its total advances.

But the mud sticks. 

“Every day, some fraud or the other is being uncovered at the large Indian state banks,” says a Mumbai-based bank analyst at a local ratings agency. “Their profits will obviously come under pressure next year and they will all have to rely ever more on the government to pump money into them.”

It’s too bad, given that banks such as Bank of Baroda and State Bank of India have, for some years now, made concerted efforts to transform their unwieldy institutions into more modern banks.

No doubt some may say that the recent setbacks show they face a losing battle: that both institutional and governmental efforts today have not gone, and cannot go, far enough.

When Asiamoney visited Mumbai in the week before the PNB scandal broke, there was surprising unanimity among bankers in the private sector: Bank of Baroda, they said, was the unsung hero of India’s state-backed champions.

The chief executive, PS Jayakumar, is an outsider who took the helm in October 2015. 

Before joining Bank of Baroda, Jayakumar was CEO of VBHC Value Budget Housing, a firm he co-founded in 2009 that provides housing for low- and moderate-income households. Before that, he spent more than 23 years at Citi in India and Singapore in various positions, including as country head for the US firm’s consumer business.

When he took over at Bank of Baroda, the banking industry in India was struggling. In the year to March 2015, both credit and deposit growth in the sector slipped to multi-year lows due to the overall economic slowdown, weak investment and stretched corporate balance sheets. 

The bank’s operating profit grew a modest 6% year on year to Rs99.2 billion, while net profit fell 25% to around Rs34 billion because of higher provisioning for NPAs and taxes.

But Jayakumar has been busy turning things around. For the year ending March 2016, the bank reported a net loss of Rs54 billion, which recovered to a net profit of Rs13.8 billion by March 2017. 

Operating profit, meanwhile, was Rs88.2 billion for the year ending March 2016, jumping to Rs109.8 billion the following year.

“He’s brought what many thought not possible at Bank of Baroda,” says an India chief executive of an international bank. “He was the first experiment by the government to bring in a professional CEO from the outside, and have a chairman of standing – the non-executive chairman is Ravi Venkatesan, who was chairman of Microsoft in India before. Both chairman and CEO are very able. And over the last three years, Jayakumar has made a whole lot of changes, but more importantly the government has allowed him to make these changes.” 

Jayakumar’s key objective has been to modernize the firm. That has involved making changes to the products and processes, going digital and focusing on digitization, as well as employee empowerment and building up talent. He also had to lay a solid foundation for compliance.

His first step was to get the control systems in the lender’s consumer banking business in place. Before, Bank of Baroda used what he calls a “judgemental scoring system” when looking at a client’s credit story and risk. That has been transformed to a transparent scoring system based on quantitative variables, where pricing of risk is related to the credit score of the customer.

“Since that was started, growth started to move along very nicely,” he tells Asiamoney. “We are growing, on an average year on year, around 33% to 34% on our mortgage business, and the retail business is growing about 25%. And now, we feel that the branches have started performing. We realized that if we want to continue to make quantum changes, we need to make the distribution much stronger.”

The bank’s distribution model, which was based entirely on branches and on the existing customer base, was expanded to have a direct sales team, with a thrust on digital marketing and direct marketing.

On the corporate banking side, Jayakumar tackled the problem of NPAs by revamping the credit approval process. In the past, if a company was based in Chennai, it would seek credit approval and underwriting from the Chennai team; if a company was in Delhi, it would approach the team in the city. That approval process was centralized to Mumbai, with the bank creating industry-related lines to define the target markets clearly.

In addition, it devised ways to set lending limits for clients even before meeting them, based on internal information. 

“Simultaneous to all this, we launched the first product on our digital platform, which was our supply chain, and then we launched cash management,” adds Jayakumar. “Now we are launching trade finance and then FX, and advisory is the next item.” 

The idea is to be able to compete with peers in offering a broad range of services to customers, he adds. 

The emphasis on modernizing operations and going digital, while improving transparency, has had an impact on Bank of Baroda’s financials. Its average cost of funds fell from 5.08% to 4.82% year on year, while the cost-to-income ratio declined to 45.9% last financial year, from 50.3%. The return on equity moved from a negative 17.64% to a positive 4.53%.

Bank of Baroda has also made efforts to set aside more funds to cover any loan losses with a provision coverage ratio, including technical write-offs, of 66.8% in the year ending March 2017, up from 60.1% the previous financial year. 

Provision coverage ratio excluding technical write-offs was 57.7% versus 52.1%. Its net NPA ratio was 4.7% last financial year, compared to 5.1% as of March 2016. 

In the case of peer PNB, growth has been similar. Its operating profit rose from Rs113.4 billion in the 2016 financial year to Rs145.7 billion last financial year. The cost-to-income ratio fell to 41.6% from 46.8% as the bank also pushed ahead with digitization to improve productivity. 

The chief executive of a domestic bank puts India’s 21 state-owned banks into three categories – the really good and strong banks; the few that are mediocre; and a long list of banks with question marks over their very existence.

In the first group are the likes of SBI and Bank of Baroda. 

“SBI is clearly the best of the public-sector banks – by every definition a high quality bank,” the banker says. “It’s just a shame that because it’s in government hands, it doesn’t get the recognition it deserves. SBI is a class operation.”

In the mediocre category, he places PNB, Canara Bank, Bank of India, Union Bank and IDBI. “They have serious asset quality issues, but there is reason to believe that with a decent management they can be resurrected.” 

Then there are 15 or so banks which, he says, may not be “salvageable franchises. It’s not even clear there is a liability franchise there, not clear there is an HR there, no IT systems worth talking about or any credit assessment skills. They have valuations well below book and have punctured balance sheets.”

A number of Indian state banks trade at very low book values, a clearly unsustainable level. 

For example, Allahabad Bank trades at a price-to-book ratio of 0.38; for Andhra Bank the ratio is 0.35, and for the Bank of Maharashtra and Corporation Bank it is 0.36.

The head of a domestic bank adds that bankers and investors would naturally be more wary of state-owned banks. But he adds that the next steps will be critical. 

“The fraud size at PNB is huge and it is worrying and doesn’t send the right signals, but at the end of the day, Bank of Baroda and PNB are banks that are an important source of capital for the credit story in India,” he says. “What will be key though is how they respond to these allegations, and will they, and others, learn from the problems?”

Baroda’s Jayakumar admits there were failings in the bank’s dealings in South Africa but he is forthright in his denials of wrongdoing. But perhaps it shows just how big a task he faces in modernizing the bank. 

The head of investment banking at a domestic firm says that while Jayakumar has made big changes to improve corporate governance and reduce NPAs in the past three years, there are limits as to what can be done in such a large organization as Bank of Baroda. 

The situation is worse at beleaguered PNB, the investment banker says: “What they have been trying to do recently is what Bank of Baroda started doing three years ago. They don’t have an external CEO yet, but they do now have a chairman that is a professional.” 

PNB recently appointed an external non-executive chairman: Sunil Mehta previously worked at Citi and AIG, spending around 18 years at the US bank, and serving as the latter’s India country head for 13 years. 

The bank appears to be tightening up its surveillance; it appointed AK Pradhan as group chief risk officer, according to a February 27 notice to the exchange. Asiamoney made several requests to speak to PNB’s management, but the bank did not respond.

Bank of Baroda has strengthened its compliance in the wake of the Gupta allegations. It has put limits on concentration of risk to a single customer in some of the smaller countries where it operates and has increased the number of compliance officers in each of the countries. In addition, it has segregated the compliance functions so that officers report to the compliance teams in India. 

The bank plans to step up efforts to automate its banking functions internationally to improve its know-your-customer and anti-money laundering capabilities. These measures should improve what some say is an already strong framework at the bank. 

Jayakumar, whose three-year term comes to an end this year, adds that the bank constantly brings in external talent to advise the board, has help from consultants as well as internal and external independent audit teams, and that the management maintains the highest disclosure standards possible.

The bank’s centre of excellence in technology and analytics are both up and running, and the goal is to have big data and use blockchain technology in the future. 

“We have identified all the change areas; we have put together a roadmap and put together resources behind the roadmap,” says Jayakumar. “Now, we need to focus on completing what we have set up.”

He refuses to be drawn into a conversation around a successor when his term comes to an end later this year, or if he will seek an extension. But for now, the bank’s strength has the endorsement of many of its peers.

“He’s an outsider and a crusader who has brought change to Bank of Baroda,” says the chief executive at the Indian arm of an international firm. “He is an ideas person and that is reflected in his work so far. He’s kept credit growth growing and made the bank more vibrant. He’s been trying to put the ship in shape. They have challenges, but they are trying.” 

An investment banker at a domestic firm adds: “Jayakumar has done what he can, but there is more to do.” 

The crises have focused attention on another arm of Indian state banking: the Reserve Bank of India (RBI), India’s central bank, which regulates and supervises the banking system.

Under governor Urjit Patel, the RBI has ordered all domestic lenders to link their core banking systems to Swift, the global interbank messaging platform, by April 30 – something that most state lenders still haven’t done. 

In the middle of February, the central bank announced a new framework to speed up non-performing loan resolution, forcing banks to report defaults by large borrowers weekly. It seems to be in the press almost every day, urging banks to clean up their balance sheets and to recognize losses faster. 

But the RBI has also taken the flak for not being aware of the PNB scam earlier.

“If you ask me, this one is on the RBI,” says a board member at a private lender. 

“Yes, there’s plenty of blame to go around, and yes the regulator has to sift through a lot of data every day. But it’s the RBI. The buck stops with them, and the banks they oversee are supposed to be 100% audited.”

There has been a running argument about what to do with India’s public-sector banks ever since Indira Gandhi nationalized 14 commercial lenders in 1969. 

As a group, they still account for 60% of all banking deposits. A report by the IMF and the World Bank, published in December, warned of a need to make the central bank more independent and to establish a stronger supervisory system for at-risk lenders. 

The same month, the RBI warned of “elevated” risks at state lenders due to poor asset quality, and predicted that NPLs would rise to 11.1% by September 2018, from 10.2% a year ago.

When the pro-reform prime minister Narendra Modi was elected in 2014, many hoped that he would tackle the problem at source by shutting down perennially loss-making state banks, or forcing them to merge.

That hasn’t happened. Instead, aside from the $32 billion financial rescue package, Modi has fiddled around the edges, passing laws that make it easier for banks to seize assets from bankrupt clients. The PNB scandal has led, once again, to calls for state banks to be properly bailed out, then merged, restructured and listed. 

“That’s what should happen,” notes one Mumbai-based banker. “Will it happen? Fat chance.”

The banking industry in India is fast evolving. The sector is broadly split into three groups: public-sector (or state-owned) banks, private-sector banks and international banks. 

In terms of market share, the state banks have 60%, privately owned banks have 35% and foreign firms have the remaining 5%. 

But state-backed lenders are struggling, with shoddy financials and ballooning non-performing assets. The Indian government said in October last year that it would inject as much as Rs2.1 trillion to help them shore up their balance sheets – a move many say is a good sign. 

“It’s a smart way to tide over the banks’ NPA issue,” says Anuj Kapoor, UBS’s managing director, head of investment banking for India. “But what’s going to be critical is to ensure that the problem is addressed systematically. The recap is happening, which will mean the percentage of NPAs will decline and issues around problem assets will start getting resolved. But the underwriting processes and quality of talent that these banks hire, the decision-making and bureaucracy, all of that needs to be addressed over the next few years.” 

In the meantime, a new group of financial institutions is gaining ground. Non-banking financial institutions (NBFCs) are quickly becoming a force to reckon with as state-owned banks work at improving their books. 

NBFCs, which are regulated by the central bank, are defined as firms that provide loans and advances, and which help with the acquisition of shares, stocks and bonds. They exclude companies whose principal activities include agriculture, industry, or the sale, purchase and construction of property. In other words, they can offer a range of specific financial services without providing traditional banking facilities. Also unlike banks, NBFCs cannot accept deposits. 

Pramit Jhaveri, chief executive of Citi India

Citi India’s chief executive, Pramit Jhaveri, reckons that in the next five years, private NBFCs and fintech names will take a bigger share of the financial services market.

“For the first time, strong NBFCs are now taking a bigger share of the market,” he says. “They are formidable institutions with access to capital, technology and talent without the constraints of banks. It is not surprising that some trade at five-to-seven times their book value. And then there are fintech firms which we can’t ignore.”

A number of NBFCs have received a licence from the Reserve Bank of India to operate in the country. Among the larger ones are HDB Financial Services, operated by HDFC Bank, Bajaj Finserv, Indiabulls Group’s IVL Finance, Kotak Mahindra Investments, Muthoot Finance, Sundaram Finance and Reliance Capital. 

Take Indiabulls as an example; its operations span housing finance, real estate and capital markets. Indiabulls Home Loans, which started as an NBFC in 2000, listed on the domestic exchange in the middle of the 2000s.

Its balance sheet grew at a 26% compound annual growth rate over five years to Rs1 trillion in the 2017 financial year. Its loan assets grew by a similar 27% five-year CAGR, its revenues by 25% and its net interest income by 26%. Its gross non-performing asset ratio was a low 0.85% in the 2017 financial year, while its net NPA was 0.36%.

Since prime minister Narendra Modi’s surprise demonetization announcement on November 8, 2016 – a move that effectively made India’s two largest-denomination rupee notes at the time instantly void – banking has been transformed as corporations and consumers were forced to rapidly embrace technology. 

Traditional banks have been forced to react. Last year, for example, Citi ramped up its digital offerings across cash management, trade services and consumer banking. 

“Our mind-set has always been that if we want to be more relevant or more meaningful to our chosen client segments and if our physical footprint represents a constraint, we will have no choice but to be digital and technology-driven,” Jhaveri says. “From a corporate banking perspective, we have always been very digital and this has helped drive our market share and presence. At the consumer end, the quest to be more and more digital is very much on as we speak.”