Budget 2020

Lakshmi Vilas Bank: Has ease of credit availability in our system encouraged fraud?

By Uma Shashikant

There is reason to cheer the move to merge Lakshmi Vilas Bank with DBS. Stakeholders will cry as if they have been cheated, but this solution has its merits. No one will deny that the Indian banking system requires serious repair. There are multiple reasons for the serious systematic risks posed by weak bank balance sheets. The investing public and the depositor population have failed to appreciate that large lenders with a pile of bad debts are a serious risk. Carelessly made loans, unbridled credit growth with poor checks, weak supervision and control, colluding boards and interference from outside interests have all created a mess. And it affects all of us.

How would one look at LVB without this merger? A loss of Rs 400 crore, a loan book of bad debts, a board that has lost the confidence of investors, and the inability to raise any capital to rebuild the bank. It is unfortunate that a traditional bank that has been operating for 90 plus years, built on local relationships and customer service came to this pass. When it comes to finance, the numbers rule. Without this merger, there is no money to pay depositors, no jobs for employees, and no value in the stocks.

Consider failing entities that refused to transfer management control. IFCI comes to mind. Years after being grounded, it simply languished for want of a suitor. Consider the other banks and financial entities that are also in trouble—IL&FS, Yes Bank, PMC Bank, Diwan Housing—there are no suitors in sight. No one knows how the current mess created by irresponsible lending can be set right, if at all.

In the case of LVB, RBI has been able to find a suitor. DBS sees merit in acquiring the many branches, and the books, and is willing to bring in Rs 2,500 crore as additional capital. Though RBI has imposed a moratorium on depositors for a month, and capped withdrawals at Rs 25,000, the mere presence of a new owner protects the depositors.

Those who crib about the difference in interest rates, and cry that depositors now have to contend with lower interest, must take a finance 101 lesson and look at the bank’s balance sheet. A bank borrows from the depositor and lends to others, making a net interest margin as profit. The depositor can be repaid as long as the value of assets is higher than the value of outstanding deposits. A loss making bank with a pile of bad assets, has no money to pay depositors.

That a scheme of merger is in place before a run on the bank happened is welcome. Assume a Rs 100 bank balance sheet. `88 is deposits; Rs 12 is equity (fattened as the bank makes profits); and the loans are `100. The maximum failure in the loan book that a bank can take is Rs 12. Anything more, the depositor is in risk. Failing banks with negative net worth are balance sheets with poor assets that need money to shore the capital up.

They cannot be rescued without a suitor. The curious case of share trading in LVB leaves me bonkers. DBS is privately held. There is nothing on the table in this deal for the equity shareholders in LVB. They are being paid nothing. So based on the terms of the proposed merger, the value of the equity share is zero. So who is buying and selling and why? Eighteen lakh shares have been transacted and one wonders what kind of scam is happening there. It is sad that equity has been wiped off. But again Finance 101—the depositor is the lender and is ahead in the queue. The equity investor gets any residual payout, and there is none in this case.

The other set of stakeholders—employees— will go through all the travails of a merger. Everyone knows that the cultural divide between a traditionally run banking set up and a modern bank that leans on process and technology is bound to be high. While the bank will invest in training and upskilling, risks to job remain. It is too early to say how that integration will play out.

Would it have been better to have a market-based bidding for the assets? Would that have resulted in a better deal? Would an Indian suitor have done better than a foreign bank? Will this investment which seems to be primarily for the branch assets, pay off? These are questions that will be debated for a while. But achieving a closure on a weak bank without creating systemic shocks and run, is a good deal.

But the RBI needs to do more. There have been many attempts to bring about a broad based plan for cleaning up the Indian banking system. We don’t know what the progress there is, and how efficiently the identification, evaluation and realignment of dubious loan assets that have smothered the banking system is happening. There have only been policy approaches, and paper schemes, with so little action on the ground. Which is why to an observer the LVB merger offers a positive reason to cheer.

The financial sector in India suddenly exploded in the last few years, to garner credit growth like never before. It is well known that formal credit penetration in India is low. So the exponential growth in credit was seen as a sign of progress. Sadly, it is now very obvious that this credit growth mostly sidestepped prudential lending processes. Dangerously, the easy availability of credit created willful defaults and schemes to rob the system through active collusion, criminal and fraudulent activity.

Correcting that qualitative failure is the burden not just on the RBI but the society as a whole. How can one legislate for integrity? How can one cultivate trusteeship and fiduciary care with other people’s money? We are not a rule-based society—we break them more than we adhere. We just form cosy relationships as the way to conduct business. Our banking failures show up how dangerous this approach is.

Clean and sensible prudential banking norms are the only way to create good institutions. We have stellar examples that stand up to this basic truth. Until we can make that the norm we need rules, supervision, monitoring, disclosure, penalties, and a whole hoard of timely actions we don’t have a great history of taking. Which is why the quiet merger of LVB feels right.

(The author is chairperson, Centre for Investment Education and Learning.)