Lakshmi Vilas Bank's collapse highlights lack of RBI supervision

The one-month moratorium imposed by the Reserve Bank of India on Lakshmi Vilas Bank on Tuesday (November 17) brings the curtain down on a 94-year-old financial institution that was founded by a group of seven businessmen in the small town of Karur (about 380 km from Chennai) in 1926. The RBI has proposed to merge the private bank with DBS Bank India Ltd (DBIL), the Indian subsidiary of Singapore’s largest lender, DBS Bank Ltd. If and when it materialises, it would be the first instance of an Indian lender being amalgamated with a subsidiary of a foreign bank. 

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The RBI’s draft scheme envisages that the entire paid-up share capital and reserves of LVB will be written off. Naturally, the bank’s shares would be delisted as a result. For a period of two years, the bank would be known as LVB-DBS India. But after this period, the 94-year-old name will fade into oblivion. T N Manoharan, the well-regarded chartered accountant and former non-executive chairman of Canara Bank, who played a key role in the rescue of Satyam Computers, is to administer LVB till its eventual amalgamation. 

Although the development was not entirely unexpected — the bank had been desperately scouting for an investor — the latest collapse has to be placed in the context of the string of collapses of financial institutions in the last two years. In fact, the RBI had earlier appointed a three-member committee of directors with discretionary powers of MD and CEO, which indicates that the central bank was mindful of the serious problems at the bank. 

In September 2019, the RBI had brought LVB under the prompt corrective action (PCA) framework, which severely restricts an institution’s ability to expand business  until it sorts out the underlying problems in its operations. More recently, shareholders voted against seven members of the board, including the bank’s interim managing director and CEO. Unable to raise capital to meet the statutory capital adequacy norms, it was forced to seek external investors. In 2019, it tried to merge itself with Indiabulls Housing Finance Ltd, but this was shot down by the RBI. Ostensibly, the central bank felt that the combined entity would lean too heavily on housing credit, not advisable for a systemically important institution such as a bank. 

A string of collapses 

The spectacular collapse of two leading non-banking finance companies (NBFCs), IL&FS and Dewan Housing Finance Corporation Ltd (DHFL) in quick succession in 2018 was followed by the fall of Punjab & Maharashtra Co-operative Bank a year ago, and then the dramatic collapse of one of India’s biggest private banks, Yes Bank, earlier this year. IDBI Bank is missing from this list only because the financial behemoth Life Insurance Corporation was forced into a shotgun marriage with the beleaguered financial institution. The significance of these failures is illustrated by the fact that the four institutions that collapsed had assets worth ₹5.5 lakh crore under their control when they collapsed. 

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A common factor in all these collapses is the lack of supervision and regulation by the central bank, and of oversight by the finance ministry. Il&FS was known for years as having indulged in “rolling over” its loans, most of it in dubious infrastructure projects. Not only was the RBI negligent, but even several other public financial institutions, among them LIC and the SBI, which held a significant stake in IL&FS, failed to scrutinise the recklessness with which the company acquired projects in its portfolio. 

The case of DHFL was even worse, one of outright fraud. Yes Bank’s eventual collapse was triggered by the massive concentration of dubious loans that were allowed to build, which ought to have been spotted much earlier by a more diligent regulator. A year after the collapse of PMC Bank, depositors remain unable to withdraw their savings and the bank’s entire net worth has been wiped out. Not just individual depositors but even other cooperatives whose deposits were with the beleaguered bank are unable to access their funds. One of the significant factors common to several of these collapses was the fact that they came after a spectacular run — in the case of IL&FS, a prolonged one — of fast-paced growth. In effect, the loan books of these institutions expanded very fast, which ought to have triggered alarm bells at the RBI. Instead, the RBI, it appears, was hesitant to spoil the party. 

Tardy supervison  

Although the RBI has, since the days of Raghuram Rajan at the helm, insisted on a rule-based system for banks primarily intended to safeguard checks and balances, track and keep in check banks’ non-performing assets, much less attention has been paid to the task of supervision of banks, a key responsibility of the central bank. The string of fiascos since the Nirav Modi affair has brought into focus the utter lack of supervision. Stringent supervision by the regulator would have checked the malpractices in banks, especially because many of these have not been one-off affairs but a reflection of systematic neglect of checks and balances in banks.

The PCA framework, which is designed to make a bank fall in line with banking norms, is more of a punitive measure. This is because it punishes the entire institution for specific failures. Thus, banks brought under the PCA regime suffer a throttling of their loan book and are unable to expand their business, which can have serious consequences in the banking industry. Thus, the RBI and the finance ministry’s approach of punishing an entire institution for some of its failings has proved to be counterproductive. 

In 2018-19, LVB made a net loss of Rs 894 crore; in the following year, it made a loss of Rs 836 crore. But even this reduction in loss was only because total revenues of the bank shrunk by more than one-fifth. Gross NPAs as a proportion of the bank’s loan book shot up from 15 per cent to 25 per cent in this period. The bank’s capital adequacy ratio plummeted from 7.72 per cent to 1.12 per cent. It was thus clear to all in April that the bank was bleeding badly. Why did the RBI choose to wait for so long before taking action? Although, superficially, NPAs appeared to be under control, this was only because the bank’s business was highly restricted. This is illustrated by the fact that deposits declined by 11 per cent between December 2019 and September 2020. 

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Unions in the banking industry, which had been demanding early action on LVB, have expressed “shock” at the decision to merge it with a foreign lender. CH Venkatachalam, general secretary of the All India Bank Employees’ Association, said the failure to act in time imperils  millions of households whose savings are deposited in banks. He has also demanded a probe into some of the large loans extended by the bank to large corporate entities. 

The RBI’s role in supervision generally, and its ability to spot early warnings, is, in theory, supposed to be provided by its nominees who serve as directors in many of the banks. In effect, they are supposed to provide the central bank with a ringside view of happenings in these banks. The string of failures has proved that the RBI’s presence inside the boardrooms of banks has not provided either guidance or scrutiny to the functioning of the banks. Indeed, it is surprising that the central bank chose to wait a full year after the first hints of serious problems at LVB surfaced to take action. Perhaps, action taken sooner may have required the RBI to take a less drastic measure than it did on Tuesday.