When connected lending led to bank failures

No sooner had the Internal Working Group of the Reserve Bank of India (RBI) recommended that corporate houses be allowed to set up banks, than economists and commentators raised doubts over the possible consequences of connected lending. Raghuram Rajan and Viral Acharya were, however, categorical in their apprehension:

‘The history of such connected lending is invariably disastrous — how can the bank make good loans when it is owned by the borrower?’

Regulation and supervision could help but only up to a point. The massive non-performing asset (NPA) problem across the banking sector as well as the recent debacles faced by specific institutions including Yes Bank, Lakshmi Vilas Bank and IL&FS are unequivocal examples of the limitations of regulation and supervision in the financial sector. Even as experts and policymakers engage in debate and discussion over these new guidelines, it is interesting to go back in history when connected lending led to bank failures.

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Western banking in India was actually introduced by businesses, the ‘agency houses’, soon after the rise of the East India Company (EIC) as merchant-ruler in the last quarter of the eighteenth century. The agency houses were agents for civil and military supplies of the EIC, agents for planters and merchants, ship-owners, and engaged in several other businesses. They combined these operations with banking, namely, receiving deposits, making advances for produce and even issuing bank notes.

The Bank of Hindostan set up by the agency house Alexander & Co. around 1770 was perhaps the first of its kind in India. However, even at that time, as emphasised by Northcote Cooke, they were aware of the necessity to keep banking operations distinct from their trading businesses. This is evident from the fact that some of the partners in the bank had no interests in the business of the agency house.

This situation, however, changed after the monopoly trading powers of the EIC were diluted in 1813, bringing agency houses into even greater prominence. The large agency houses and their affiliated banks including Alexander & Co/Hindostan Bank, Palmer & Co/Calcutta Bank and Mackintosh & Co/Commercial Bank lent huge sums of money to indigo planters whose products were exported to England. The booming indigo business soon tempted the agency houses to take stakes in the planters’ profits — this was essentially a situation in which banks were lending to their own businesses.

There was greater complexity to this relationship between banking and the indigo business of the agency houses.

Post-1813, the EIC faced a problem of transferring its surpluses from territorial revenues collected in India to England. An ingenuous scheme developed: money was advanced to the agency house banks who would make advances to indigo planters and other commodity producers in which they also had a stake in profits. The goods were exported by the agency houses and the importers in England would settle their dues by a payment to the EIC, executed via drawing of bills of exchange.

The abundant availability of credit from the EIC in India was a strong temptation for the agency houses to overlook the actual commercial sustainability of the underlying business. Quality of the exported goods was also compromised. The bubble finally burst in 1829 with a glut in the supply of commodities and a consequent crash in their price. By 1833, most of the agency houses were bankrupt. The estimated loss from crisis was some £11 million.

History soon repeated itself.

The Union Bank was set up in 1829 in Calcutta and by 1838 every director of the bank was connected to a leading commercial house or business. Once again, the bank advanced large sums of money to the connected business houses, in particular, their indigo factories. By 1842, the credit was concentrated in just a handful of accounts, including Colville Gilmore & Co., Cockrell & Co. and Carr Tagore & Co. that added up to a substantial portion of the capital of the bank. When the indigo businesses began to fail, it was decided that the bank must move its investments out of indigo. The question though was how?

Prudential banking principles seemed to suggest that it would have been in the best interest of the bank to stop advances and pull out their investments in the indigo businesses. If these businesses went bankrupt, so be it. Sell the collateral and write off any losses. As Cooke explains, it is here that the problem with connected lending manifested itself:

‘Of this, however, there was no chance, while the Directors were men who were heavily and hopelessly indebted to the Bank. The keeping up the factories they had mortgaged, enabled them to ward off, to an indeterminate period, the fatal date of insolvency.’

Although it was amidst the Commercial Crisis of 1847-48 that rocked the world that the Union Bank ceased operations, JC Stewart, former Secretary of the Bank, delineated the specific reasons for its failure:

‘It is to the excessive credit given to a few particular houses [whose representatives were Directors in the Bank]; and to the purchase of their Bills in 1847; and to the accommodations to them long after they were insolvent; that the Bank’s ruin is truly to be attributed.’

It would be utterly naïve to conclude that the recent recommendations by the RBI’s Internal Working Group will once again lead to a similar crisis that colonial Bengal experienced in 1829 and 1847. It would also be equally naïve to disregard what Mark Twain reportedly once said: ‘history doesn’t repeat itself, but it often rhymes.’

Sashi Sivramkrishna is an author, economic historian and documentary filmmaker. Twitter: @sashi31363. Views are personal.