COVER STORY

Lending, a fear

Banks need to reassess their internal control systems

pnb-bank-cbi CBI officials at Punjab National bank's Brady house branch in Mumbai | Amey Mansabdar

The Nirav Modi scam could not have come at a worse time for public sector banks. The worth of their non-performing assets, Rs 8 lakh crore in March 2017, is expected to reach Rs 9.5 lakh crore this March. Hence, experts said that banks, predictably, are going to be extra cautious while lending to corporates.

They will also be cautious, perhaps more so, about their internal control mechanisms, especially after the scam exposed Punjab National Bank’s inefficiency in dealing with such fraud. “According to Punjab National Bank, the junior-level branch official sent instructions to the foreign branches of the other banks, saying that PNB had issued letters of undertaking on behalf of the companies represented by Modi,” said Vishwanathan Iyer, associate dean (academics), T.A. Pai Management Institute, Manipal. “These instructions were sent through the messaging system of the Society for Worldwide Interbank Financial Telecommunication (SWIFT), which is trusted by banks all over the world. Although the instructions were sent through SWIFT, they were not tallied against PNB’s core banking system, which uses Infosys’s Finacle software. This meant that the instructions were not noticed by the PNB management. The most pressing question is how these SWIFT instructions could bypass the bank’s core banking system altogether.”

Iyer, also a chartered accountant, said such loopholes ought to have been detected while reviewing internal control mechanisms. “It is perfectly possible that neither the internal auditors nor the statutory auditors got wind of it. Not just PNB, all banks need to use this opportunity to revisit the weaknesses in their internal control systems. There are no shortcuts.”

Sudin Baraokar, head of innovation at State Bank of India, said: “If the processes are manual and isolated from the core banking systems, the chances of fraud and suspicious transactions increase. Emerging technologies such as blockchain, which is a distributed ledger system, can be used so that, internally, in the banks, the copy of the transaction can be made available to relevant officials and stakeholders. The transaction cannot be changed, and the record can be made available in real time.”

Moreover, Baraokar said such fraud could be reduced or eliminated if banks came together and shared suspicious or fraudulent transaction information. “SBI has taken the lead in forming a blockchain alliance, called BankChain, of more than 30 banks,” he said. “The banks will be nodal participants on the blockchain network, which will facilitate information exchange and report fraudulent transactions to other member banks in near real time. We plan to operationalise this network shortly.”

Many banking experts said there had been a high-magnitude system failure, in which there was a prima facie compromise on the part of PNB officials. “One of the major gaps has been the non-linking of the SWIFT messaging system with the bank’s core banking system,” said Rajendra Kumar Sinha, chairperson, Centre for Excellence in Banking, IFIM Business School, Bengaluru, and a former senior executive of a large public sector bank.

Interestingly, before the scam, there had been a revival in the performance of a few banks, in terms of NPAs. However, market experts said the scam would now put further strain on them. “A slowdown in corporate lending will result in reduced growth for many of these banks, at least in the next few quarters,” said Siddharth Purohit, research analyst, SMC Institutional Equities. “The corporates are also going to find it tough to get a loan from the banks.”

Banking experts such as Iyer agreed, saying that the current situation could lead to further tightening of credit flow from public sector banks. “PNB and many other affected banks are likely to freeze lending or at least not sanction any fresh projects,” he said. “In such circumstances, the last quarter will be a near washout for many banks.”

Experts said the only way the banking sector could insulate itself was by embracing better risk-management systems and by fixing accountability. “The fixing of the problem needs to start right at the top,” said Iyer. “The idea is never to privatise profits and nationalise losses. It is important that some banks remain with the government, though they could be merged to create a smaller number of banks. The risk-management framework needs to be much better. We are currently staring at what is called a ‘double balance sheet’ problem. On the one hand, we have banks with excessive stressed assets and, on the other hand, corporates with highly leveraged balance sheets. At some stage, the RBI needs to enforce what is known as the ‘big bath’—all existing toxic assets need to be purged from the balance sheet of the banks. If the efforts are undertaken with sincerity and without political pressure, the overall recapitalisation requirements will come down.”