Banking Central | Why cooperative bank regulations must get a structural makeover

Merger on the cards?

Past cases show that the RBI supersession of a bank board typically ends up in a takeover to safeguard the interests of the depositors. The central bank appoints an administrator to manage the bank’s operations in between. That’s a temporary action.

The central bank then looks for a suitable candidate and facilitate a merger. Such forced mergers happen when there are concerns on the bank in question in terms of capital adequacy and governance standards.

Read: Material concerns: RBI supersedes Board of Abhyudaya Cooperative Bank, appoints administrator

Understandably, the regulator is more worried about deterioration in governance standards since that indicates mismanagement and, in some cases, deliberate wrongdoings.

In the case of Abhyudaya Bank, the RBI has cited material concerns surrounding the governance aspect. It is not clear whether it has found

anything that indicates irregularities. The bank is likely to appeal or challenge the RBI decision which is typical in such cases.

A larger problem

The latest RBI action also reminds us of the state of affairs in the cooperative banking industry — a subject this column has highlighted several times in the past. The latest RBI action proves that there are more problematic cases even among bigger cooperative banks.

These banks are designed very differently from the commercial banks. These are more like cooperative societies confined to local areas with their boards dominated by local politicians than a conventional bank with a professional board and management. Most of the decision-making in cooperative banks are taken by local politicians - as we saw in Kerala’s Karuvannur Bank scam - and related persons. Clearly, such a set up leads to related-party lending and financial frauds sooner than later.

The RBI has strengthened the scrutiny of cooperative banks with more penal actions lined up and cancelled the licence of at least eight lenders and fined several banks in FY2023 alone. The banks that went defunct this year included Mudhol Cooperative Bank, Millath Cooperative Bank, Shri Anand Cooperative Bank, Rupee Cooperative Bank, Deccan Urban Cooperative Bank, Laxmi Cooperative Bank, Seva Vikas Cooperative Bank and Babaji Date Mahila Urban Bank.

So, what needs to be done?

First, the problems often begin with bad governance standards at the board level. An execution body needs to be put in place to look and implement the fit and proper criteria during the appointments on cooperative bank board members. The board appointments need to be vetted by a stricter process. The RBI should make sure that boards of bigger cooperative banks need to have competent individuals as independent directors to identify early signs of deviations from the standard practices.

Local businessmen and politicians, who largely control these coop banks, often have vested interests that eventually lead to a financial mess. Also, the appointment of top executives in cooperative banks need to be done under a framework that is uniform to all banks and based on strict criteria and not through recommendations of local influencers.

Second, once cooperative banks grow beyond an asset threshold, the RBI needs to encourage these institutions to convert to small finance banks or make them comply with bank-like regulations that could help avert failures. Cooperative banks, once they gain certain size, are no different from regular banks, considering the size of deposits and lending operations they engage in. Smaller credit societies can be permitted to continue as they are.

Third, Oversight by the regulator and auditors need to be tightened further. Part of the reasons is the auditors in cooperative banks often operate hand-in-glove with the management to window dress numbers. Proper auditing practices are a must. Concurrent audit in cooperative banks are not strict at this point. This part too needs to be strengthened.

The trust deficit is widening. Recurring cases of governance issues and RBI actions have undoubtedly shaken the trust of public, leading to more loan defaults and flight of deposits to bigger banks. Cooperative banks have played a crucial role in expanding the banking services to India’s far-flung areas, where big banks have no reach. To safeguard these banks and protect customer interest, probably it is time for the central bank to think of an overhaul in the way these banks are governed.

Banking Central is a weekly column that keeps a close watch and connects the dots about the sector's most important events for readers.