It’s all about accountability

Enough and more has been written about India’s banks and NBFCs in the recent weeks. An end-October filing with the Stock Exchanges on ‘Progress and Way Forward’ by IL&FS is worth a read though. The report talks about efforts at unravelling the complexities in a systemically important institution’s problems. The central theme of the report, high aggregate leverage being disproportionate to aggregate value, has several important underlying messages. Difficulties in deconstructing a complex structure of holding structures, entities (as many as 347) and businesses and handling of intra-group transactions are some the obvious messages. The not so obvious ones include lack of a reliable information and gaps in the data, and absence of an empowered central control function. All of these summarised by one somewhat hackneyed phrase: “not enough skin in the game”. The jury is still on whether it’s a contagion or a problem specific to the insitution that is IL&FS.

It is not the first time that we have seen a failure like this. Particularly over the last decade, we have seen cycles of failure hitting everyone from managers in Wall Street to investors in emerging markets. The fear that this may not be the last such event is worrying the regulatory bodies and stakeholders alike. As regulators and supervisory bodies again go back to the drawing board to figure out how to tighten any systemic gaps, it is worthwhile to deconstruct the financial services business itself.

When we say Banking & Financial Services (BFSI), we perhaps repeatedly overlook the importance of the ‘service’ inherent in the business. A service industry, with its people-centric nature, is prone to all the challenges that people cope with, and that means biases, predilections, halo effects… or all that would sit on a platter called “psychologist’s meal”. For the typical banker, the extent of personal contact with the customer/client has also undergone a change with retail banking moving from the branch to the netbanking and ATM spaces. For the customer, the product experience and its tangibility (simply put its ‘touch and feel’), does not resemble anything from a decade ago. All of these indicators point to the need for more mindful supervision and regulation.

To go down that road further, let us deconstruct the micro level (entity level) prudential regulation prescribed by the basel framework. The capital to risk weighted assets (CRAR) and its computation, which incidentally is explained by the RBI in a 300-page-plus document. The first part of this ratio is about the treatment of capital or owned funds, while the second part is about the treatment of risk weighted (for credit, operational and market risk) assets.

Understanding the nature of this ratio could help us see the picture of this service business in its entirety. Take the first part, which looks at the quantum of capital owned by the stakeholders of the business. A softer question that it raises: Should it not give a cue about the desirable levels of a ‘promoter’ versus ‘non-promoter’ holding? Banking regulations elsewhere do talk of the maximum level of shareholding that the promoters can hold. The focus of that, however, is to ensure demutualisation or a broad-based shareholding in the entity. A substantial stake of the promoter group is seen to be an equivalent of concentration of power, translating to concerns about governance.

However, lack of a sound nucleus of ownership leads to quite the opposite set of concerns. Ownership sets the tone for the entity’s operations, which translates to accountability and “ownership behaviour” in the professionals who manage the business. The implication of not having this nucleus — organisational drift and opportunistic growth, as against sound business strategy. The first part, understood thus, points to the need to find the right balance between accountability and possible concerns about concentration of power. 

The second part, with its emphasis on risk weighting, represents the quality of assets. The quality of assets, however, is a culmination of how the entity assesses the credit-worthiness of its customers, how it takes decisions on pricing its products, and how well key information is warehoused and accessed by its managers. To summarise, it is about the quality of investment decisions of the institution. More importantly, it is about the quality of the decision-making processes, or how objectively a manager is able to call out a bad investment from a seemingly good one. The second part then only restates the obvious: That every business has risk and that risk is to be managed well. The implications, again, are accountability and the process that enables a timely calling out of “good versus bad” investments, or recognising the symptoms that a “good” investment may be starting to slip towards the “bad”. In risk parlance, it is about the organisation doing enough to capture information that gives out ‘early warning signals’.

These aspects of accountability and process again loop back to essence of the first part. The issue at the core is: ‘How do we create a nucleus of ownership that sets the tone for driving the organisation by strategy and professionalism?’ Merely complying with quantitative ratios obviously falls short of ensuring the soft aspects of ownership of the service organisation and the quality of its decision making. It is even possible to conclude that the current situation of NPAs and toxic assets has to do more with an inadequte “skin in the game” for the managers/stakeholders that sets the tone for decision-making in our typcial financial services organisation.

That said, experience tells us that there are two kinds of finance managers. The first kind tends to glorify what they do, while the second thinks of demystifying their task. It would be anyone’s guess as to which kind is desirable for running a financial services business. This soft aspect is at the core of “professionalisation” in the industry.

The challenge, therefore, is to create an ownership nucleus in every financial services organisation, that ensures professionalism, accountability and process driven approaches to decision-making. We may not even have a one-size-fits-all answer, pointing thereby to the limitations of mere quantitative ratios.

Is it time for regulators and supervisory bodies, then, to devote more mindspace to the softer aspects of ownership of these services?

Author is Executive Director, PTC India Ltd