There is a wrong perception that NPAs (non-performing assets) are essentially a problem of public sector banks. Private banks are not immune to this problem as they too write off debts from time to time. Even new age fintech companies are saddled with NPAs (perhaps 20 per cent), though hard data are not available.

Debt mutual funds are not exempt from the bad debt problem either (they call it side pocketing — an accounting technique used to segregate the bad assets within the fund), and some high-profile schemes have wound up because of NPAs. Pressure tests indicate stress of nearly ₹1-lakh crore which represents 10 per cent of AUM (assets under management) of that category.

The point being made here is that all sections of the lenders are hit with bad debts and this issue needs to be navigated deftly.

But the road ahead also presents new opportunities. Some lenders are capable of navigating these potholes and grow in a sustainable manner.

Expanding credit base

The challenges and opportunities before lenders are to expand the low credit base in relation to size of economy and at the same time sustain the quality of credit. For instance, India’s private credit/GDP ratio is at around 54 per cent, while the global average is about 148 per cent. In China it is about 180 per cent.

If India has to become a $20 trillion economy, this ratio has to significantly go up to 70-80 per cent over the next decade.

There are still many sections of society that find it hard to access credit from formal sources. It is no surprise that Big Tech, and e-commerce platforms are keen to ride on the credit gravy train. But whenever lenders press the accelerator too hard, they have suffered huge credit losses given the risks involved.

Good governance and robust and dynamic business models are important tools to navigate the potholes along the way. This article focuses on governance issues and suggests possible remedies. Governance has several layers that go beyond the board.

The RBI Governor has been urging lenders to improve corporate governance. At the enterprise level, one dimension of governance is the balance of power between CEO and the board.

Recently, former Deputy Governor of RBI NS Viswanathan said that in the private sector, the CEO is more powerful than the board, while the reverse is true in public sector banks. Both entail significant risks. In some private banks, CEOs, who have been more powerful than the board, have had long and successful stints.

On the other hand, there have also been cases where powerful CEOs have been sacked or eased out. So it is difficult to generalise. In this scenario how should regulation be framed?

New regulatory tools

The regulator needs to take a call and intervene with new supervisory tools. In the case of public sector banks, empowering the RBI for all board-level appointments, in consultation with the Nomination and Remuneration Committee (NRC) may largely mitigate risks. Two centres of regulation/control (government and RBI) lead to sub-optimal results with accountability taking a hit.

Another dimension of governance is conduct risk, which came to the fore during the Global Financial Crisis. Conduct risk is essentially a fallout of ethical misbehavior, self-dealing especially at the senior level, market manipulation and mis-selling of products and services. At times this has proved to be an existential risk. Also, this does not lend itself to any mathematical modelling. Regulators need new supervisory tools to assess this risk. Some countries like the UK have a special Financial Conduct Authority (FCA) and other regulators have formulated guidelines and framework to mitigate this risk.

Conduct risk

Conduct risk is not easy to assess, much less predict. There has been considerable academic research on this issue. Mary Daly and Tom Butler in their paper published in the Journal of Decision Making (2018) present Conduct Risk Model (CRM) and Conduct Risk Diagnostic Systems (CRDS) models which help assess, measure and supervise conduct risk and to provide decisional guidance.

Besides, there is corporate level governance risk — that is, board level oversight of management at the enterprise level. It’s the board’s responsibility to protect shareholders’ rights and interests. And more important is business governance — that is, mechanisms and processes at business unit level — risk at tiers below the board, which the board is likely to overlook. This could be either due to skewed compensation/reward structures or lack of skills. Some of the major governance lapses like related-party transactions and self-dealing have their origin in poor business governance.

Risk governance and operational governance are two other domains of governance, which escape the radar. Attrition as high as 30-40 per cent may manifest itself in these governance layers.

Fintech promise

Fintech is emerging as partner of regulated lenders. It thrives on speed and innovation. But governance norms and systems in the fintech sector are a grey area.

Investors and even the boards approved by them, are hesitant to rock the boat. The government and regulators need to address this issue, but at the same time regulation must not end up stifling innovation as they are emerging as key players in the credit landscape.

Governance has several layers as recent failures have shown even at the global level. Boards and regulators need to take into account these layers of governance. These need to be subjected to assurance audit and boards need to have better oversight of functioning of at these governance layers.

Should bank regulator add one more “C” (conduct risk) to its CAMEL (capital adequacy, asset quality, management, earnings, liquidity) framework? Governance of the supervisory system is no less important.

The writer is former Director and CEO, IDRBT, and Chairman, NPCI

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