PNB Rs 11,000 cr fraud: Banks should follow either gold loan principle or asset-based financing to avoid scams

Nirav Modi, prime accused in the Rs 11,400 crore Punjab National Bank fraud, has the gall to accuse the bank of acting in haste, leading to the government unleashing sleuths on his companies, and destroying his brand name and thus jeopardising the chances of repayment of loans. In Hindi, there is a saying ulta chor kotwal ko dante (thief scolding the police). Nirav Modi in fact destructed his own brand, exaggerated though it was. Be that as it may. There are banks in the private sector who are content with retail loans namely – for cars and other durables by tying up with the manufacturers, gold loan and home loan. Why? Because the chances of funds being diverted for extraneous purposes, one of the principal causes of bad debts, is minimal with such loans. Gold loan’s popularity in the country has something to do with craze for the metal and ease of getting the loan sanctioned in just two hours. Two assayers are called by the bank and the jewels evaluated for their gold content in front of the borrower. Thereafter the prescribed percentage (right now 72 percent as per the extant RBI norms) of the value is sanctioned as the maximum entitlement. The loan is released immediately. Of course not all assets lend themselves to such quick and hassle-free ease of valuation. But the larger point is a bank secures itself fully in case of gold loan. Personal guarantees are often not worth the paper they are written on unless the lender takes physical and tangible securities to back such guarantees. Indeed even bank guarantees are not good enough to make the grade as secured loans in the eyes of the ICAI which says unless there are tangible securities; a loan cannot be classified as secured. This despite the fact that bank guarantees are more valuable than physical securities as banks cannot renege on their guarantees. Business loans however defy the gold loan principle because a going concern cannot physically mortgage or pledge the securities like inventories and receivables with the bank though they are capable of being hypothecated. In the event, there is always a possibility of the borrower being tantalised into diverting the funds for self-aggrandisement as the two recent banking cases Kingfisher and Nirav Modi show. To forestall diversion, asset-based financing is the only possible solution as things stand. Islamic banking sets store by financial lease under which the bank and its client jointly select the supplier of the asset required by the client and thereafter the bank closes the deal by buying it on his behalf. It is followed up with a back to back leasing agreement. Hire-purchase agreement is also a species of asset-based financing. Critics aver that banks in that event would be venturing into unchartered territories – purchasing for which it has neither the expertise nor the time nor the resources. Time has come for banks to acquire and find all these and more. They can also hire consultants like gold loan giving banks hiring the services of assayers and pin responsibility on them. Whatever they do, it cannot be business as usual any longer for banks in India reeling under mounting NPAs and banking frauds with or without the connivance of bank staff. Banks have been let down by the concept of floating charge on the assets of the borrower. The floating charge is such a nebulous idea that the bank does not know where and how its interests are secured unless the operations are frozen in a liquidation exercise. And when the charge gets crystallised, the bank finds to its chagrin that bulk of the assets have been spirited away or worthless. Banks must therefore be given more than the wooly comfort of what floating charge gives. They must know what they are lending for and what they are lending against. This becomes possible only in case of pledge like gold loan and asset-based financing. Let banks also not be lax by being careless about non-fund based financing like letters of credit and bank guarantees because when a crisis breaks out it doesn’t discriminate between fund based and non-fund based financing as the still-unraveling PNB fraud shows. One question however remains unanswered in the above discussion – pray what happens to farm loans and other socially desirable lending? The answer is the government simply cannot burden the banking system with social objectives. It must find ways and means to ring fence such social objectives by standing guard against default by the borrowers. (The writer tweets @smurlidharan)