Bad loans mess: Forensic audits at PSBs are a good start, but structural reforms are the need of the hour

The directive by the Finance Ministry that public sector banks (PSBs) must start conducting forensic audits on all loan accounts above Rs 50 crore reflects an urgency on the part of the government to reduce non-performing assets (NPAs). In common parlance, a forensic audit is a branch of auditing focused on fraud detection, and looks at a company’s internal controls to determine whether any lapses in such internal controls could have resulted in corrupt practices. Forensic audits in companies may be at two levels. One, a curative forensic audit may be assigned to an independent investigator to conduct a truthful investigation and detection of suspected fraud. At another level, a preventive forensic audit may be adopted by the companies to combat crimes, emanating from ideas of greed and an attitude of frauds not being a crime, endogenous to the company. [caption id=“attachment_4370853” align=“alignleft” width=“380”] Representational image. Reuters.[/caption] Both types of audit are costly affairs and could throw light on the profitability of companies. Such audits may inculcate an environment of mutual suspicion that may hinder risk-taking, critical for economic expansion and job creation. Given the magnitude of NPAs lumbering Indian banks at present, lending is understandably constrained. Forensic audits may heighten risk aversion further, impeding good businesses from getting access to credit. A culture of suspicion may set into the banks, resulting in even lower lending by banks. The lack of loans may force the companies to delay critical capital expenditure investments dampening production and reducing job creation. Despite the drawbacks of forensic audits, regarding potentially slowing down the economy, audits are worth the short-term pain if lessons learnt from an audit can be implemented to reduce the occurrence of frauds in the future and lead to the resolution of broader structural issues plaguing Indian banks. The forensic audit must teach us lessons regarding the type of frauds that have occurred, the length of time of the concealment of frauds, and methods adopted to conceal frauds. More importantly, a road-map must be created to prevent the recurrence of such frauds in the future. Also, the learnings from audits must be used to develop mechanisms to reduce frauds in the future and identify frauds in advance. If a comprehensive approach towards creating a policy framework is adopted, then the potential short-term pain of the forensic audits is worth it. Forensic audits can add significant value only if, in addition to the audit, we look to resolve other structural issues in the banking system. The problems that deserve attention are a lack of information sharing regarding credit quality amongst banks, delayed recognition of NPAs by banks, a mismatch of assets and liabilities on the bank balance sheets, and lending by PSBs to sectors they aren’t technically equipped to understand. Banks need to have a better system to share information on borrowers. Better information sharing will avoid situations whereby a borrower, classified as an NPA with one bank, continues to borrow from another. A better flow of inter-bank information via a centralised database of borrowers would allow PSBs to better track credit quality of borrowers. Credit registries are essential mechanisms in this regard especially for expanding transaction-based lending technologies. Nationalised banks created credit bureaus several years ago, but with limited reach and functionality, they are no cause for cheer. Robust credit registries will create a database that banks can use to develop credit scores to predict repayment based on borrower characteristics. Also, information sharing will significantly assist banks to identify NPAs early in the cycle, thereby avoiding a significant build-up of NPAs. Even though some loans to the infrastructure sector have become non-performing, one must acknowledge the role of PSBs in infrastructure creation. PSBs must not end lending entirely to the infrastructure sector. Instead, policymakers should think of how they could improve lending to the infrastructure sector. PSBs with short-dated liabilities are not equipped to finance long-dated infrastructure assets. Any move away from infrastructure financing will be a gradual process. Specialised institutions and policy framework that allow private capital to fund infrastructure will be required. Lending to specialised infrastructure projects requires significant technical expertise, which PSBs generally lack. Without the necessary expertise, banks risk funding sub-optimal projects. It is crucial for PSBs to identify sectors where they are technically qualified to finance versus which they are not. To summarise, measures such as forensic audits are useful only if the learnings are used to frame better policies and implement substantial structural reforms. Without meeting the two conditions, forensic audits risk being another policy that fail to live up to their full potential. (The writer heads Development Tracks and views expressed in this article are personal. He tweets @Taponeel)