Recently, RBI put curbs on Punjab & Maharashtra Co-op Bank and Laxmi Vilas Bank. The directive came as a bolt from the blue for scores of hapless depositors, many of whose entire life savings are with these banks. The lure of co-operative banks is that the depositors get a higher rate of interest on their deposits compared to PSU and private sector banks, which attracts them in large numbers. Thanks to the bank’s lending misadventures, the customers stand to lose their savings although they can claim Rs 1 lakh in compensation from DICGC if the bank goes down.
Apart from these, customers get defrauded by external fraudsters too. The reasons for fraud vary from lack of controls at customer’s end to lack of security at bank’s end. What is intriguing and frustrating for the customer is that despite taking all precautions, he ends up losing money to frauds for reasons not entirely attributable to him. Very few incidents get published in the media, even though in most cases, the bank’s name doesn’t find a mention, while a large number go totally unreported. Given a choice, clients will most certainly prefer to bank with professionally run banks that have the best risk control systems, but the challenge is how does one figure that out?
Investors in the debt capital markets get some sort of risk guidance in that there are rating agencies which rate corporate debt instruments, sovereign bonds etc. They draw comfort from a Triple A or equivalent investment grade rating and decide to invest based on those ratings. But when it comes to a banking relationship that covers bulk of their financial transactions, there is no such independent grading or risk benchmarks. Consequently, the prospective client goes by the reputation of the bank or word of mouth, or he gets driven by high interest rates. Whatever said, he goes in with a blind trust that his financial assets are safe with his bank. After all, banking is all about trust, isn’t it?
Given the recent developments, there is an urgent need to introduce risk ratings in banks, a pragmatic and institutionalized way of dealing with risks. Banks need to undergo periodic risk assessments by independent rating agencies that comprehensively captures their financial health based on set parameters. Such assessments must be made mandatory by the regulator and ratings published on the public domain to enable clients to take informed decisions.
We can follow some basic parameters like:
- Quality of management, corporate governance standards and business ethics
- Whether there is any conflict of interest in the top management?
- Loan classification and NPA numbers
- Number of fraud incidents & losses incurred during the review period
- Whether the Risk-control systems are adequate, and investments made to augment technology?
- Whether the bank has a robust internal risk audit and compliance system?
- Responsible finance etc.
These are only pointers and not an exhaustive list. Banks can be rated based on standards currently in use for corporate debt. For example, AAA will denote highest safety; AAb will indicate one notch below highest safety and so on. We need to publish the final ratings and not the results of individual risk parameters. The assessment and ratings shall be absolute, not comparative, and can be administered on a semi-annual or annual frequency. The rating agencies shall come under the ambit of RBI as far these assessments go.
RISK RATING BENEFITS
- Enables prospective clients to wisely choose a safe bank of their choice
- A higher grading will automatically attract more clients for the bank while retaining the existing ones. As these banks will have the pressure of retaining their top grading, they will continue to stay focused and stay invested
- Banks with consistent low ratings will find it difficult to attract clients and remain competitive. They will automatically bring in more focus and efforts to upgrade their risk-control systems
- More importantly, the ratings will bring in standardization and help strengthen the overall security climate in the banking industry
A flip side to this approach, though, is that there could be a run on the banks initially if their ratings fall to the lowest grade. But that can be managed by giving all banks adequate notice of the risk parameters on which they will get adjudged and providing them enough time to prepare, implement and strengthen their risk-control systems. The gradings can commence from a previously announced date. Another issue could be that the fraudsters will misuse the ratings to target banks with the lowest grades, at least in the initial period. But then these are like any other risk-reward tradeoffs that one needs to factor in when we overhaul our systems.