Depositor discipline in a time of bank frauds
The recent unveiling of large value frauds in various public sector banks has brought to the fore a level of insecurity in the Indian depositors community akin to the reactions of US depositors during the meltdown in 2007-09. Any scam is bad—but financial scams are the worst because the sector is intricately inter-related within its constituent markets as also with the real economy. Invariably, we find that the perpetrators of frauds have been a step ahead of the stakeholders and the regulators. It is rightly said that fraud is the daughter of greed.
Pillar 3 under Basel III advocates what could be called a “night lamp” in the form of “market discipline” to ensure a well-calibrated response to such unforeseen events. The alternative is to flounder in the dark. This is in addition to the regular control mechanisms for ensuring safety and soundness of the financial system.
Depositor discipline, part of market discipline, implies a depositor’s ability to monitor and control the risk-taking behaviour of bankers. Studies conducted across several countries evidence existence of increased depositors’ discipline measures after banking turbulences. However, in the US, post-2008, when the state bailed out the “too-big-to-fail” banks, its efficacy as a complement to the supervisory process has been widely questioned.
In India, theoretically, depositors are a big force. According to Reserve Bank of India (RBI) data, as on 2 March, public deposits constituted 90.3% of the scheduled commercial banks’ liabilities. Further, at March-end 2016 (latest available data), there were nearly 1.65 billion deposit accounts comprising 90.4% individual accounts holding 58.7% share in total deposits.
Saibal Ghosh and Abhiman Das, in Depositor Discipline in Indian Banking: Separating Facts From Folkloreand Rajkamal Iyer, Manju Puri and Nicholas Ryan in Do Depositors Monitor Banks? examined the issue of depositor discipline in the Indian context. The former paper concludes that depositors “punish” banks for risky behaviour by moving their business elsewhere. According to the latter, depositors monitor not only their banks’ risk characteristics but also observe other banks.
We carried out two exercises. One revealed that deposit growth in the 11 weak nationalized banks (NBs), which were brought under the Prompt Corrective Action framework between May 2017 and January 2018, turned weak. It was below the industry average preceding the above period and thereafter. However, the period coincided with prolonged macro-level sluggishness in credit off-take and high non-performing loans that exacerbated the pressure on the weak banks’ profits. As such, there is a strong probability of these banks deliberately putting the brakes on deposit mobilization.
The second test pertained to the impact of three major frauds from yesteryear. It showed that deposit growth in respect of the primary defrauded banks did relatively decelerate, inter alia, due to rumours and inadequate image management endeavours by these banks.
Even though depositor discipline exists, it is invisibly thin, sporadic, driven by shocks and not preventive. Regular wake-up calls by depositors through proactive monitoring of banks are conspicuously absent.
Due to inadequate financial literacy among depositors, potential depositors are attracted by the higher interest rate offered by local cooperative banks/societies despite their high mortality rate. Moreover, rural and semi-urban centres, where literacy levels are low, command 63.2% of deposit accounts. These situations are not congenial for depositors to exercise discipline.
The Indians perceive banks as fail-safe. This is because of the interplay of government backing of public sector banks, extended forbearance of the problem banks and failure resolution only through mergers. Deposit insurance to a limited extent is also present, although its public awareness is debatable.
Incentives to monitor his/her bank are low even for a financially literate depositor, as banks increasingly strike salary tie-ups with companies and provide easy retail finance to their employees. Studies observe that retail customers with “dual” relationships have less incentives to monitor their banks. Also, being unorganized, they fail to influence banks’ decisions. Today, relationship banking is giving way to customers opting for best-in-class product offers through comparative data available on the net.
Bank customers in India, as in many other countries, prefer to deal with nearby branches for basic banking needs, despite ATMs or online banking facilities, as it saves time and cost. The cost of shifting to another bank would also include the interest to be foregone if fixed deposits are to be closed prematurely. Depositors also avail of ancillary services from branches such as locker facilities, which may be unavailable in another bank. Hence, given this customer “stickiness”, even if a bank slips up, punishing it by relocating to another bank is easier said than done.
Depositor discipline can potentially curb overtly risky behaviour of banks and compel the inefficient and unruly ones to become either efficient or fold up, thereby improving systemic efficiency. If duly recognized, it can also catalyse the supervisory process. Given the technological advances and the advent of fintech, banks would do well to be guided by the old Wells Fargo adage: “Banking is necessary, banks are not.” They should tone up their internal risk management structures and retain the confidence of their depositors.
Ashwini Mehra and Manas Das are, respectively, former managing director and former economist, State Bank of India.
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