T C A SRINIVASA-RAGHAVAN: Corruption in banks

OKONOMOS

Corruption amongst bank managers is like one those shameful family secrets that everyone knows about but no one discusses. However, the fact remains: bank managers do accept bribes, more so in the public sector.

Indeed, they would be stupid not to as long as they could get away with it. So, the problem is one of catching them.

One of the commonly prescribed remedies often suggested is a strong supervisory agency. The Reserve Bank of India (RBI), for instance, has been upbraided several times for sleeping on the job.

But is this actually what is required? Apparently not, because in a recent paper *Thorsten Beck, Asli Demirgüç-Kunt and Ross Levine show that this is nonsense. Far from helping reduce corruption, they say, "powerful supervisory agencies lower the integrity of bank lending."

As might be expected from an economist from the World Bank "" Mr Demirgüç-Kunt is from there "" they have done a cross-country study of 2,500 firms across 37 countries. They say their results provide the first empirical assessment of different bank supervisory policies.

"We find that the traditional approach to bank supervision, which involves empowering official supervisory agencies to directly monitor, discipline, and influence banks, does not improve the integrity of bank lending."

Instead, they say, it is far more effective to have better disclosure norms and to have private monitoring of banks, which is what the Basel Committee (Basel II's third pillar) wants. The RBI might agree to the former; but allowing private monitoring of the public sector banks looks like a pie in the sky.

The three main conclusions of the paper are as follows.

First, the data does not show that countries need stronger supervisory agencies. So, all the talk about giving more teeth to the supervisor is futile.

Second, the data show that powerful supervisory agencies get captured by politicians and or regulators. The reason why this happens that is that by and large, it is only countries with weak national institutions of governance that have strong supervisory institutions.

So, it becomes "difficult to identify an independent relationship between supervisory power and bank corruption" when controlling for poor governance.

Third, it turns out that "bank supervisory strategies that focus on forcing accurate information disclosure and not distorting the incentives of private creditors to monitor banks facilitate efficient corporate finance." The point is to recognise is that politicians and regulators will fend for themselves and not necessarily to reduce market frictions.

The paper** by Abhijit V Banerjee, Shawn Cole and Esther Duflo, all of MIT, confirms that vigilance as understood by the CVC leads to reduced lending. They say that since India treats bankers as public servants, they worry that they can easily be charged with corruption.

They have quoted a working group set up by the RBI as saying that it received "representations from managements and unions complaining about the diffidence in taking credit decisions with which the banks are beset at present. This is due to investigations by outside agencies on the accountability of staff in respect of some of the NPAs. The group also noticed a marked reluctance at various level to take any credit decision."

They authors then contrast the possible penalties and rewards. There are no explicit incentives for making good loans, nor ways to penalise officers who make conservative decisions.

"In effect, bankers are accountable to more than one authority "" the loan officer's boss is one of them but central vigilance may be another, and the press may be yet another."

The result is that when bankers do take a decision, they ensure that they don't deviate too much from precedent. The paper also discusses whether there is a "fear psychosis" amongst bankers and concludes "there appears to be a clear effect of vigilance activity on lending decisions. Vigilance activity in a specific bank results in a reduction of credit supplied by all the branches of that bank by about 3-5 percent."

* Bank Supervision and Corruption in Lending, NBER Working Paper No. 11498, July 2005
** Banking Reform in India MIT Dept. of Economics, BREAD *** Policy Paper No. 006 September 2004 (www.cid.harvard.edu/bread/papers/policy/p006.pdf) .
***Bureau for Research in the Analysis of Economic Development