PNB fraud: RBI had no clue on Rs 11,400 cr scam for seven long years; can a super regulator do the job?

The PNB fraud highlighted a larger systemic problem raising questions about the effectiveness of regulatory framework followed by Indian banking system, risk management practices and vulnerability of Indian banks to fraudulent transactions that extends across the border The debate for a super regulator for Indian financial sector is back on the discussion table in the aftermath of Rs 11,4000000000 LoU (Letter of Undertaking) fraud committed by billionaire Nirav Modi in collusion with certain bank employees. The fraud highlighted a larger systemic problem raising questions about the effectiveness of regulatory framework followed by Indian banking system, risk management practices and vulnerability of Indian banks to fraudulent transactions that extends across the border. Former RBI deputy governor and PNB chairman K C Chakrabarty went on to the extent to say that Indian banks have no risk management capacity (read an interview here). Does the current situation call for some radical changes in the regulatory structure? Let’s look at the past efforts in this area. In March 2011, the government constituted the Financial Sector Legislative Reforms Commission (FSLRC). Its mandate was to comprehensively review and redraw the legislations governing India’s financial system. The FSLRC was of the view that the existing regulatory architecture is ‘fragmented and is fraught with regulatory gaps, overlaps, inconsistencies and arbitrage’. The commission submitted its report to the Ministry of Finance on 22 March, 2013, suggesting a draft Indian Financial Code to replace the bulk of the existing financial laws. The most important recommendations of the panel was creation of a super regulator for the Indian financial system but keeping RBI out of its ambit. “The draft Code seeks to move away from the current sector-wise regulation to a system where the RBI regulates the banking and payments system and a Unified Financial Agency subsumes existing regulators like SEBI, IRDA, PFRDA and FMC, to regulate the rest of the financial markets,” it said. Under this proposal, RBI will continue to handle monetary policy, regulation and supervision of banks and payment while all other financial sector activities will come under the unified regulator including stock market regulation, insurance and pension. The proposal, however, didn’t go down well with former regulators. For instance, former RBI governor and former Prime Minister's Economic Advisory Council (PMEAC) chairman C Rangarajan had said that India does not need super regulator for financial sector markets but need better co-ordination among existing ones. "At this particular time, it may be advisable to continue with the existing system, rationalise the overlap if there are any and try to improve the co-ordination among different regulators," Rangarajan was quoted as saying in the report. Similarly, former chairman of IRDA, was quoted as saying, other countries which had opted for a super-regulator model had returned back to the original sector regulator model after realising that it is not working well. “In a large country like India, you need expertise in each field. This proposal would lead to a situation where people at the lateral level would have very little background of the segment (example insurance or stock markets) that they are working for. In some situations, a stock market expert could be working on insurance issue or vice versa," Rao was quoted as saying. But not all former regulators opposed the idea. For instance, G N Bajpai former Sebi chairman favored FSDC as a super regulator, saying it is the ‘need of hour’. In the context of the PNB scam, does the idea of super regulator make sense building on the structure proposed by Srikrishna panel? The RBI can still focus on its core functions---financial stability at a macro level and monetary policy. Perhaps the super regulator can take away certain functions such as risk management and monitoring of accounts from the central bank and other regulators to have a coordinated system? A section of bankers and sector-experts have been advocating this possibility for while now. Particularly in the current context, there may be a case given that increasing interconnectedness of financial institutions and complexity of transactions across segments. A super regulator can perhaps be given the risk management function across verticals while specific regulations pertaining to operations sectors can still be left to those individual institutions. Indeed, the RBI has done a commendable job in managing systemic risks by ring-fencing Indian banking system during the 2008 financial crisis. This was appreciated by the regulators across the world. But, repeated frauds and governance flaws in banking institutions it regulate raise questions on RBI’s ability to ensure risks management tools are indeed operational at bank level. Remember, there are representatives of the central bank in the boards of large banks including PNB, who failed to monitor and identify a fraud of this magnitude for several years. This is despite having all the checks in place. The SWIFT software, purportedly used to conduct the PNB fraud, was subjected to multiple checks and audits but none worked to dig out the dirt. There can’t be any excuses from the part of regulator for such a serious lapse. A super regulator, which will have the mandate on risk management across verticals, can perhaps do the job.