An Understanding of Financial Frauds in the Wake of India’s Market Reform:
It is an established fact that the India financial market is highly regulated with the laws being regulatory in nature. The RBI, SEBI and SFIO have specific roles to ensure protection to investors, customers and creditors. Despite this, there have been a series of security market frauds that disrupted customer confidence and brought into question the need for more stringent monitoring.
Some popular financial frauds include:
- The 1992 Harshad Mehta Scam which involved bureaucratic corruption and poor monitoring by SBI officials[1], and the transfer of government securities between several national banks[2].
- The 2001 Ketan Parekh Scam wherein stocks of large companies such as the Adani Group, Essel Group, and Zee Corp. were first inflated and then used as collateral to get loans from banks. In doing so, he was able to bribe bank executives into exceeding the permissible loan amount as directed by the RBI. This fraud brought to light the poor monitoring and regulation of company operations in the market by the RBI, SEBI and Department of Corporate Affairs[3].
- The Unit Trust of India Scam where fund managers chose to invest in equities which consequently meant more risk and unsure returns. When those stock values fell and the market crashed around 2001, the fund lost most of its value and its net asset value dropped below par. It exposed issues of mismanagement of PSU funds by the government and the highly volatile stock market which put unaware investors at risk that could have been avoided.
Financial frauds have revealed that financial institutions such as banks lack transparency and information flow between executives and external investors is strained which makes it difficult for shareholders of equity and debt of these institutions to monitor and be aware of day-to-day minor internal management activities that are not specifically mentioned in company reports[4]. While internal operations cannot be closely watched by regulatory authorities, the overall financing and management of companies and intermediaries are governed by strict and rigid investment laws and regulations. This becomes a contradictory issue since studies find that such heavy regulation affects a company’s ability to enforce and effectively run its own corporate governance systems[5]. This is a problem seen in rules restricting investment entry and takeovers. Since existing investment policies place a cap on the extent of permissible foreign investments, the complete potential of banking activities cannot be maximized beyond the ceiling fixed and this reduces pressure on bank executives and managers to maximize profits[6].
Another issue is with the fact that while management and functioning of banks and such intermediaries is monitored by investment regulations, the State ownership of some banks doesn’t fall within its purview and thus changes the rules of corporate governance. This is a major cause for mismanagement.
Further, as was recognized in State of Karnataka vs. Vishwabharati House Building Co-op Society[7] there is no clarity as to what legislation applies to regulate the relation between financial intermediaries such as banks and their customers. Certain disputes may come under the Companies Act, while some cases of fraud may be dealt with by civil and criminal courts and inquiries may be held by SEBI through its rules of governance. These disputes rarely have a distinct character and may fall within the ambit of various judicial and quasi-judicial authorities who will take action only in their domain of functioning[8]. This becomes an issue because cases and claims are handled in parts without an entire comprehensive understanding. This could affect the customer in receiving rightful compensation.
An Introduction to YES Bank:
A good example of how private banks suffered due to these issues in the post-liberalization era is the YES Bank scam. This new generation Private Bank had been founded in 2004 by Rana and Ashok Kapoor, and soon grew to be a massive competitor to other established banks. At one point, the Bank was poised to be India’s fifth-largest private lender in terms of market capitalization[9]. YES Bank was one of the first to adopt a unique business model that was geared towards retails loans and technological effectiveness, and was also awarded the number 1 ranked bank[10] in a 2008 survey.
But, the Bank’s fortunes took a dramatic turn when the founder, Ashok Kapoor lost his life in the Mumbai terrorist attack in 2008, following which the Bank began to make progress in its corporate lending segment. More attention and resources were being diverted to real estate, renewable energy, pharmaceuticals, and such other sectors. However, in doing so, the Bank became heavily involved in lending to corporations that had no stable source of income.
Rana Kapoor decided to aggressively adopt a model within this segment that would ensure the Bank received timely repayments. This involved charging a substantially higher upfront fee to the borrowers, ranging from 2 to 10% of the loan amount. Further, the interest on loaned amounts was 3% higher than any other banks in the same segment[11]. This model worked well until 2017, after which the Bank’s stock price began to drop with Rana Kapoor being removed from the position of CEO[12]. This was when reports began to surface that the Bank had been underreporting bad loans which marked the beginning of a steep decline for the Bank.
What went wrong with the Bank’s Business Model?
The Bank had set large scale goals for its growth in the segment, which seemed theoretically sound but were practically difficult to keep up with. At the end of the 2014 FY, the Bank had declared an amount of Rs. 55,633 in its loan books while the deposits were reported to be an amount of Rs. 74,192 crore. With its explosive success and growth, the loan book had increased by four times the amount to Rs. 2.25 trillion in 2019. However, the deposit amount reported had only increased by three times to Rs. 2.10 trillion[13]. It became evident that the deposits were unable to keep pace over the years. This led to a subsequent decline in its asset quality as well. When the RBI decided to investigate, it became apparent that the Bank’s model of aggressive lending had completely ignored appropriate risk limits.
This occurred in 2015 when the RBI decided to conduct an Asset Quality Review which would help highlight and resolve loan issues in the financial and banking sector[14]. As a part of this, Banks were directed to report loan divergences in their quarterly results. This meant that Banks would have to declare any differences between bad loans assessed by RBI and those by respective banks. During this, RBI noted improper reporting by YES Bank on the loan divergences.
The Bank had also been lending to corporations that were facing financial issues and were involved in risky, unstable businesses. Some of these corporations included DHFL and the Reliance Group[15]. The Bank had given bailouts to these businesses as a capital injection to prevent bankruptcy and financial default. These bailouts are usually sent as a loan, cash infusion or purchase of bonds. However, the Bank gave loans amounting to over Rs. 34,000 Crores to these companies which were already reporting losses[16]. The possibility of repayment became slim and the Bank was forced to underreport loans that had gone bad and was also not honestly disclosing NPAs[17].
Another discrepancy in respect of the NPAs was that the Bank had been able to show NPAs at below 2% for several years preceding the Review. The Bank had also reported its gross NPAs at Rs. 748.98 cr in 2016[18] while gross NPA% was at 0.76%. However, the Review results made it clear that this number was really at Rs. 4925 cr, 557% higher than what was actually reported. Further, the gross NPA of 2016 was actually at 5.01% and had been clearly underreported. The Report also found that the net NPA% for March 2016 had been reported at 0.29% while the actual value was at 3.67%[19].
In its report, RBI stated that this discrepancy and underreporting indicated flaws in the Bank’s internal governance systems. The Bank had intentionally not complied with the statutory rules and regulatory laws that govern such disclosures. This also affected the Bank’s internal management as the new CEO; Raveneet Gill was unable to fix the declining deposits which eventually led to one of the independent Directors resigning from the Company’s Board in 2020, partially due to the persisting governance issues. The Bank struggled to raise capital after the report was published as investors had lost confidence.
The Conclusive Findings of the AQR:
The RBI Review found that there were certain reasons that led to this uncontrolled decline which included:
- YES Bank had given loans to certain corporations that had a reputation for being substantial defaulters, including Reliance Group, Essar Power, Mantri Group and IL&FS. When these corporations failed to repay the loans at the high interest rates charged by the Bank, the Bank was forced to raise Capital to protect itself from statutory liabilities which in turn led to the Bank submitting false reports to hide these problems.
- Banks are largely dependent on money deposited by its customers. However, when the Bank spent most of its resources on its loan segment, its customers began rapidly withdrawing their deposits and the Bank saw a sudden outflow of liquidity.
- All of these issues consequently led to a deterioration in its financial health, owing to a lack of capital and potential loan losses. The Bank was forced to downgrade in a lot of aspects with inadequate profits being earned over time.
- The Bank was also facing problems with its internal governance and regulatory mechanisms and had to undergo restructuring. When RBI asked Rana Kapoor to resign, the Bank found it very difficult to promptly fix the resultant organizational framework amidst continuing poor performance.
- External factors also played a role in this crisis. For 11 years, including the time of the start of the YES Bank decline, the Indian economy recorded slow economic growth[20]. This had a negative impact on the Indian Banking sector[21], especially in the case of lenders.
- YES Bank had also attempted to revive itself through fresh investors who could provide the Bank with money for its survival and growth. However, the poor financial health meant that there would be no concrete proposal from these investors and none of them held discussions with the Bank’s senior management which meant that the Bank didn’t get any capital infusion when necessary.
The Measures taken to Resolve this Crisis:
After the conclusion of the AQR, the RBI recognized that certain stringent steps would have to be taken to protect YES Bank from absolute collapse. The Bank’s condition in terms of its liquidity, capital and overall financial health, with the lack of a suitable and effective plan for capital infusion meant that the RBI would have to take measures that would protect the interest of depositors and the public at large. These include[22]:
- Takeover of the Bank Management by RBI:
Having superseded the Bank’s Board, the RBI appointed the formed CFO and Deputy Managing Director of SBI, Mr. Prashant Kumar as its administrator to take over operational management of the Bank.
- RBI imposed a Moratorium:
The RBI ordered that all activities of the Bank be temporarily suspended until a further notification is issued and all issues have been resolved. As per this Moratorium, the RBI capped withdrawal limits from the saving, current or any other accounts of depositors to Rs. 50,000. However, the RBI also specified that if a depositor faces an emergency including medical, educational expenses or any immediate ceremonial expenditure, they may be allowed to withdraw up to Rs. 5 lakhs.
- RBI developed a Reconstruction Scheme for the Bank:
RBI developed the YES Bank Ltd. Reconstruction Scheme of 2020. Under this, the authorized share capital and number of equity shares were altered. Investments were to be made by various banks such as SBI, HDFC, and AXIS Bank in YES Bank. The Board of Directors was also re-constituted and fresh rules governing the same were proposed, with amended rights and liabilities to apply to the Reconstructed Bank. Specific information regarding these was detailed in the Plan of 2020.
Conclusion:
The existing investment regulations and guidelines to be adopted by issuer companies still have numerous loopholes that are exploited by market intermediaries and institutions to defraud investors lacking the basic knowledge and awareness to protect themselves from fraudulent schemes. While numerous laws under SEBI and rules by the RBI exist to preserve customer interests, the enforcement and execution on-ground becomes a challenge since companies breach standards of corporate governance and ethics in their daily functioning, which becomes difficult to monitor on a microscopic level.
In the case of YES Bank, the Management had made mistakes that proved near fatal and had a prolonged effect with the net worth effectively deteriorating over time. Only the strict, effective and controlled measures taken by RBI could help supervise an improvement in the overall operational management. The RBI must also ensure that regulations place certain responsibility on the auditors of the Bank to ensure that ground-level checks are in place in the Bank’s day-to-day working, and cases of mismanagement are minimized.
An important solution is to efficiently articulate all norms and rules of corporate governance such that the provisions for accountability are made more specific and funneled so that all those involved from top-tier executives to small scale brokers can be held accountable. This is important because protection of customer rights have to be prioritized in accordance with company norms and regulations[23]. Thus, if fraud is treated as a criminal offence, the laws must incorporate provisions to orient the matter with corporate laws such that the customer is also recognized as a stakeholder and is given rightful representation.
[1] Janakiraman Committee Report, “Stock market Scam in India of 1991”, 1992, Economic and Political Weekly, vol 28
[2] Pritam Deuskar, “How investment climate has changed after Harshad Mehta scam broke in 1992”, 2020, The Money Control Editorial, 11th edn, p 26
[3] ibid
[4] Bose, S., “Security market regulations lessons from US and Indian experience”, 2005, ICRA Bulletin, Money and Finance, p 93
[5] S.M. Solaiman, “Investor protection and criminal liabilities for defective prospectuses Bangladeshi laws compared with their equivalents in India and Malaysia”, 2006, Journal of Financial Crime, Vol 13, Issue 4, p 46
[6] Bhasin M. L., “Menace of Frauds in Banking Industry: Experience of a Developing Country”, 2015, Journal of Business and Management Research, 4(12), p 33
[7] AIR 2003 SC 1043
[8] Alesina, A., La Ferrara, E., “Who trusts others?”, 2002, Journal of Public Economics, vol 85, p 227-228
[9] Directorate of Academics, “Unearthing Corporate Frauds – The Ever-Increasing Role And Scope For Governance Professional”, Student Company Secretary, August 2021
[10] Business Today-KPMG Best Banks Annual Survey, 2008
[11] https://economictimes.indiatimes.com/
[12] https://www.business-standard.com/article/finance/rana-kapoor-s-tenure-as-yes-bank-md-and-ceo-to-end-in-january-2019-118091900836_1.html
[13] http://simsree.org/blog/corporate-governance-issues-yes-bank-explained/
[14] Shri N. S. Vishwanathan, Reserve Bank of India, “Risk Management: Key to Asset Quality”, 2016, National Conference of ASSOCHAM
[15] ibid
[16] Reema William Mascarenhas, “Everything You Need To Know About the Yes Bank Scam”, 2020, https://blog.ipleaders.in/everything-need-know-yes-bank-scam/
[17] Non-Performing Assets
[18] https://moneycontrol.com/
[19] ibid
[20] Outlook Fitch, ‘AsiaPacific Emerging Market Banks‘, 2020
[21] https://www.businesstoday.in/
[22] Pooja Pombarla, “A Study on YES Bank Crisis”, IOSR Journal of Business and Management, Vol. 22, Issue 7, July 2020
[23] Caprio, Gerard Jr. and Ross Levine, “Corporate Governance In Finance: Concepts and International Observations”, 2002, World Bank Report on Corporate Governance www.econ.worldbank.orsg/files/16573_caprio_governance.ps.pdf
YLCC would like to thank Dylan Sharma for his valuable inputs in this article.
