Banking crisis: Re-examine lending practices and fix the incentive problem
There is a fundamental problem at the heart of Indian banking — of perverse incentives. It deserves more attention when the Nirav Modi case has hit the headlines, amid a profound credibility crisis after years of poor lending practices.
The incentive problem was highlighted by economists Abhijit Banerjee, Shawn Cole and Esther Duflo in a research paper, Default and Punishment: Incentives and Lending Behaviour in Indian Banks. The three economists pointed out that banks need to provide incentives to their employees to increase lending while avoiding default, even while these same bank employees earn a fraction of the money they manage. The quest to lend more is often at odds with the need to protect asset quality, and a lot depends on how front-line bankers are rewarded or punished for their efforts.
A lot has been written since the Punjab National Bank case hit the headlines — on failure of internal controls, corporate governance and regulations. These are definitely not trivial issues. However, an equally important question is how to prevent rogue employees buried deep in the branch networks from colluding with fraudsters.
Indian bankers have a very poorly designed incentive system. Pay grades are hostage to the iron laws of seniority. It is almost impossible to sack an employee. The threat of transfer can be used to punish — but it is often used against honest employees who do not play the game. All these factors should be seen in the wider context of a public sector culture where performance of senior bankers used to be judged by quantity rather than quality, or how much is lent out to meet the political preferences of the government of the day, rather than the return on capital. The ongoing bad loan mess is at least partly the result of a credit bubble as well as politically-directed lending to influential infrastructure companies.
Would a better scheme of incentives change the way bankers give loans? Cole later teamed up with Martin Kanz and Leora Klapper to examine how different incentive schemes can alter banker behaviour. They recruited 209 loan officers from various Indian banks for an experiment. These bankers were once again shown a random sample of loan applications from entrepreneurs, but were asked to treat them as new applications. Since these were papers of loans already given, the researchers knew even before the experiment began which applications had been accepted as well as which loans eventually went bad.
There were three incentive structures in play. First, an origination bonus in which officers were given a commission for every loan issued. Second, a low-powered incentive in which officers received small rewards for loans that perform well and small penalties for loans that perform badly. Third, a high-powered incentive in which officers received big rewards for issuing loans that perform well while they had to face big penalties for loans that default.
The results were interesting. The bankers gave out more loans when the stakes were lower but were more careful about the quality of lending when the stakes were higher. The incentive problem was also highlighted in a lot of research following the North Atlantic financial crisis of 2008. Bankers were paid fat annual bonuses based on how their bets worked in the short term but their losses over the long term were underwritten by tax payers.
The incentive problem should be seen in tandem with the opportunities provided by technology. Global experience shows that a lot of banking fraud emerges from the grey areas where databases overlap. It is thus no surprise that the recent fraud at the Brady House branch of Punjab National Bank in Mumbai was possible because the data on letters of undertaking were not integrated with the core banking system, despite regulatory directives to do so. The misuse of the SWIFT messaging system is also at one level a failure to institute controls on the use of technology.
Banking today is about the movement of binary digits, and bank fraud is more than a forged cheque these days. Banks should be able to use advanced data analytics to identify breaches of internal controls on the one hand and outlier lending or guarantee activity on the other. Jayant Verma of the Indian Institute of Management, Ahmedabad, has even made the radical suggestion that banks should use Blockchain technology to track internal activity — though he adds that the principle of banking secrecy would have to be re-examined before this can be done.
All the talk right now is about regulation. At least some of it needs to be redirected to the problem of incentive and the promise of technology.
This is the second in a series of articles on the recent controversies related to PSU banks in India