Performance of Banking Sector in India & Its Corporate Governance Mechanism

Sujoy Kumar Dhar.

Faculty Member,
IBS Kolkata.
Introduction : Banks in a broad sense are institutions whose business is handling other peoples money.
A joint stock bank also known as commercial bank which is nothing but a company whose business is
banking. Protecting the interest of depositors becomes a matter of paramount interest to banks.
Regulators across the world have recognized the vulnerability of depositors to the whims of managerial
misadventures in banks and therefore regulating banks more tightly than other corporate.
The six basic functions of a financial system according to Merton and Bodie1 are as followsa) Clearing and settling the payments to facilitate the trade.
b) The probing of economic resources and subdividing of shares in various enterprises.
c) The transfer of economic resources through time, across borders and among industries.
d) The management of risk
e) The provision of price information to coordinate decentralized decision making by
different sectors of the economy.
f) The overcoming or mitigation of incentive problems due to asymmetric information.
Therefore Corporate Governance is no more a buzzword for the organization like banks who
deal with other peoples money. Commenting on Global Trust Bank imbroglio, one of the
journals2 has rightly pointed that, ---- the recent GTB episode brings to the fore of fundamental truth that
governance matters. Great performance, higher profits, expanded reach; nothing would act as
safeguards for a company when governance and ethics take a back seat. While a single
wrongdoing is enough to ruin the reputation, it takes ages to build one and that too is possible
only with strict adherence to good governance practices. So Governance matters, in fact
it matters more than anything else.
Phases of Growth in Indian Banks:
Since Independence , organized Western type of banking in India has evolved through four distinct
phases.
Foundation phase covering the decades 1950s and 1960s: This period witnessed the development of the
required legislative framework or facilitating the organization of the banking system to cater to the
growing and development needs of Indian Economy.
Expansion phase of the mid-1960s : This trend gained momentum after the nationalization of private
banks in the late 1960s.
Consolidation phase since 1985: Greater attention was paid to improve housekeeping, customer service,
credit management, productivity and profitability of banks starting from 1985 onwards.
Reforms phase commencing from 1991: Important and significant initiatives were taken with a view to
reforming the banking system such as the introduction of accounting prudential norms relating to income
recognition , provisioning and capital adequacy since 1991.

Merton R.C & Z Bodie (1995) , A Conceptual framework for Analyzing the Financial Environment in Crane ,D.B (ed), the Global
Financial System : a Functional Prospective , Boston ,p 5.

Governance Matters, Chartered financial Analyst ,June,2001,pp19-25.

Corporate Governance in Public Sector Banks

A substantial chunk of Indian Banking sectors still remains under the control of public sector banks
despite the strong wave of globalization, liberalization and privatization and entrance of private and
foreign banks in the arena .The major shareholding of the public banks with the Government. The reasons
for such ownership may include solving the severe informational problems inherent in developing
financial systems, aiding the development process or supporting the vested interests and distributional
cartels. Basel Committee3 has underscored the need for the banks to establish the strategies and to become
accountable for executing as well as implementing them. The existing legal institutional framework of
public sector banks is not aligned with principles of good corporate governance. The bureaucratic
hassles, red tapes and de motivated work culture adds further fuel to the fire. So far banks have been
burdened with social responsibility and compelled to tow the line of thinking dictated by the political
party in power, healthy banking policies will not be able to become the top priority. Monopoly of public
sector banks in banking business had protected them from competition and bank Managements have
thereby became complacent. There is no doubt that post 1991 scenario, PSU banks have to compete with
private and foreign banks to retain the market share.
Though the managers have an incentive to expropriate shareholders wealth, they are disciplined by
the managerial labour markets. The managerial labour market determines each mangers outside
opportunity wage and inside promotion o the basis of economic performance of the firm. 4
Removal of restrictions on factor markets as well the markets for corporate control will take care many
of the problems of miss governance since managerial behaviour is highly constrained by the presence
of capital markets and particularly the threat of corporate take over. 5 The advocates of Principal Agent
Model6 insist that corporate Governance should be allowed to operate freely. The legislative
intervenes tend to impose costs either on firms or the shareholders.7Such External interventions are
unnecessary, unhelpful and distortionary. 8
The inefficiencies associated with Government owned banks, especially those emanating from a lack
of managerial incentives have led Governments under some pressure from international agencies to
begin divesting their own ownership stake. There is subtle pressure on Government of India also from
International organizations such as IMF & World Bank to withdraw their stakes in commercial banks.
The disinvestment of Government owned banks raises several corporate Governance issues. If banks
are completely privatized , there must be adequate deposit insurance schemes & supervisory
arrangements established in order to protect depositors interest. But if disinvestment is partial, there
may be opportunities for the government as the dominant shareholder to expropriate the minority
shareholders by using banks to aid Fiscal problems or support certain distribution cartels. The
existence of such cartel consists of corporate insiders having close links with Government elite
undermines the credibility of investors legal protection and prevents reform in banking system.
3

The Basel Committee on Banking Supervision is a committee of banking supervisory authorities which was established by Central bank Governors of the
Group 10 (G10) countries at the end of 1974 in the aftermath of the serious disturbances in international currencies and banking markets

Fama ,E (1989) Agency Problems and Residual claims, Journal of Law and Economics ,26: 327-52.

Alchian A A and Kessel, R.A (1962) Competition, Monopoly and the persuit of pecuniary gain in aspoects of Labour Economies ,National Bereau of
Economic Research ,Princeton N.J.

The principal-agent relationship implies the Principal( Shareholders or Owners) delegates work to the agent ( managers) who performs the work on the
principals behalf.

Fama ,E (1989) Agency Problems and Residual claims, Journal of Law and Economics ,26: 327-52.

Hart,Oliver (1995), Corporate Governnace ; some theory and implications, The Economic Journal 105 : 678-89

Keasey et al, supra note 1.

Governance in Private Sector Banks: Private sector banks have entered niche areas , listed their
scrip and being market driven they have been more transparent in their functioning. They have also
been more tech savvy , growth oriented and have less of NPAs. Private sector banks has to conform
with standard of good banking practices such as
a) Ensuring a fair and transparent relationship between the customer and bank
b) Instituting comprehensive risk management system & its adequate disclosure
c) Proactively handling the customer complaints and evolving scheme of redressal for grievances
d) Building systems and processes to ensure compliance with the statutes concerning banking.
Banking Sectors Unique Nature:
The special nature of banking system calls for the adoption of broader view of corporate
governance in India. The special nature of banking requires Government intervention in
order to restrain the behavior of Bank Management. Depositors dont know the true value
of banks loan portfolio as such information is incommunicable and very costly to reveal.
As a consequence of this asymmetric information problem, bank mangers are prompted
to invest in riskier asset than they promised they would. There is a popular concept
known as herd behavior that when bulls run together, there is a lot of dust and they are
unable to see where actually they are. When everybody is trying to make the money, they
usually forget the fundamentals of the economy. In order to credibly commit that they
will not expropriate depositors, banks should make investment in branded capital , as
these schemes give depositors confidence ,specially when contracts have a finite nature
and discount rates are sufficiently high.
Ganguly Committees Recommendations:
To introduce corporate governance practices in the banking sector , the recommendations
of the working group of directors of Banks financial institutions ,known as Ganguly
group. Committee has made certain recommendations1) Boards should be more contemporarily professional by inducting technical and
specially qualified personnel. A proper blending of historical skill set and new
skill set will enhance the efficiency and effectiveness of the board.
2) Director should fulfill certain fit and proper norms including formal
qualification, experience and track record. There should be a proportional
representation of executive, non executive and independent directors in the board.
3) Banks should not allow a person as director who is holding the post of Member of
Parliament or member of Legislative Assembly.
4) Selection of directors should be done by the nomination committee of the board
and nomination should be headed b an independent directors and majority of
members of the committee should be non executive directors.
5) The Banks may enter into a Deed of Covenant with every non executive
directors, delineating his/her responsibilities and making him/her abide by them.
6) Need based training should imparted to the directors to equip them and to upgrade
their skill to govern the banks properly.
7) The Ganguly Committee made the formation of Audit committee, Supervisory
committee, Risk Management Committee mandatory apart from nomination
committee.

Management of NPA, a Real Challenge to Banks:

When debtor defaulted one Equated Monthly Installment (EMI), it can be shown as 30
days DPD that is Days Passed Deal. A person who has defaulted two EMI can be treated
as 60 days DPD that is Days Passed Deal. After default of 2 nd EMI, calling exercise
should be done with a default script. A person who has defaulted consecutive three EMI
can be shown as 90 days DPD .It becomes a NPA (Non Performing Asset).
Bank usually takes the help of Debt Reconstruction Company (DRC) when they have
accumulated excessive NPA due to non recovery of loan. Debt Reconstruction company
is a trust. They purchase the NPA of the banks by paying certain amount of cash which
is much lesser than the value of NPA. As the bank is selling their NPA to the DRC, banks
will be able to transfer the collection hazard from their shoulder to the DRC. Debt
Reconstruction Company has to undergo a market research to analyze the extent of NPA,
it will be able to realize by applying different standard conventional techniques and
tactics. Depending on that they sell certain amount of Security Receipts to the bank.
Security receipt acts almost like Collateral Debt Security where for the bank,these
Security receipts are considered as contingent liability. Banks will be able to get the
money against these security receipts provided the Debt Reconstruction Company is able
to realize the receivables from NPA. The way Debt Reconstruction Company is
exercising pressure on the nerve of debtors that raises lots of dispute from the moral and
ethical perspectives.
Application of Credit Scoring Models: Banking Sector has to use credit scoring model
from 1998 onwards. As it is a known fact that prevention is always better than cure,
banks are using credit scoring models to reduce the probability of piling up of bad debt or
non performing assets.
Usually as a common thumb rule, total risk faced by a bank can be decomposed into three
different categories- credit risk 63%, operation risk 25-26% and market risk is 11-12%.
Reasons for using the scoring models are as follows Determination of probability of default and expected loss
Ensures that good loan proposals are accepted and bad loan proposals are rejected.
Helps in pricing the loan according to the risk.
Credit score is nothing but numerical forecast of repayment of future loan.
There are different credit scoring methodologies such as FICO, ONICRA( Onida +
Icra), Z Altmans score etc.
According to FICO Scoring method, FICO score ranges from 300 to 850.
Higher the score, loan will be available at a lower rate.
For credit scoring certain factors are taken into accountPayment history- 35%
Amounts owed- 30%
Length of history- 15%
New credit-10%
Account Mix(nature of loan)-10%
Change of job frequently may lower score if no history of late payments- bank specific.
Change of residence to negative area may lower score-bank specific.
Use of credit counseling services if reported by creditors may lower the credit score.
Inquiring for more credit may lower credit score.

Current Status of Indian Banks: Banking sector is the unique sector which has to
follow the regulations of both Reserve Bank of India(RBI) as well Security Exchange
Board of India(SEBI).Being the apex body of Indian money market, RBI directly
intervenes in credit control mechanism by monitoring and supervising bank rate, open
market operation, Cash Reserve Ratio, Statutory Reserve ratio, Repo and Reverse repo
rate and sterilization mechanism. Apart from credit control mechanism, CRR, SLR are
devices to maintain the sound liquidity position of the bank. Sterilization is a market
based approach aimed at neutralizing part or whole of the monetary impact of inflows
and outflows of foreign fund. SEBI, being the apex body of Indian Capital Market,
devises stricter rules and regulation to protect the interest of the shareholders. Just like
Sarbanes Oxley Act in USA, SEBI clause 49 unambiguously dictates specific terms for
all the companies including banks for listing their stocks in Indian Stock exchanges.
Conclusion: It can be concluded, in comparison to the global banks, Indian banks are
fundamentally strong. Almost all Indian banks are maintaining 12-13% capital adequacy
ratio which is much higher than the global benchmark. Indian Banks didnt have huge
exposure to subprime factor, as a result none of the Indian banks had gone for bankruptcy
during 2008-09, when entire globe was caught in deep recession.
Despite all these factors, there is no scope for complacence. After corporate Governance
failure in Satyam, which reminded us the collapse of Enron, time has come to take a
collective call to combat against the corporate fraud. There is no scope to discard the fact
that banking sector is the back bone of an economy. To achieve the desired growth rate in
per capita income, domestic investment has to be enhanced. Source of investment is
savings where saving is composed of both domestic and corporate savings. Efficient
capital market is required to channelize the saving into productive investment. Developed
capital market can not sustain unless and until it is accompanied by sound banking
system.

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