How banks are deceived by companies

Two types of frauds take place in our banks. One takes place with the connivance of the bank officials. The Punjab and Maharashtra Co-operative Bank gave loans to a company named HDIL even though they knew that the borrower was in deep financial trouble. They hid these “bad” loans from the RBI by shifting them to about 21,000 small bank accounts. Similarly, the Maharashtra State Co-operative Bank extended loans to insolvent sugar mills apparently under the prodding of its director Shri Ajit Pawar, former Deputy Chief Minister of Maharashtra. The borrowing sugar factories could not repay the loans putting the bank in trouble.

The other type of fraud takes place when large companies mislead the banks, as Nirav Modi did to Punjab National Bank, and Infrastructure Leasing & Financial Services (IL&FS) did to a number of banks to the extent of a whopping Rs 90,000 crores.

I studied a company which has borrowed Rs 76,000 crores from banks—nearly as much as IL&FS. The strategy adopted by this company is to borrow in small amounts—in this case, a paltry Rs 2,400 crores. It has established a good number of subsidiaries, which are separate companies but 100 per cent of their shares are owned by the principal company. This could be compared to the head of a household establishing a shop in the name of his son. The subsidiaries borrowed a total of Rs 71,600 crores from various banks, which is transferred to their principal company by way of work contracts. Six subsidiaries borrowed Rs 3,493 crores from the banks and paid Rs 3,067 crores to their principal company in this manner.

The principal company maintains a “clean” image while the subsidiaries are enmeshed in dirt. To understand how the game is played, I looked closely at a hydropower project being made by a subsidiary in Uttarakhand. It has given all the contracts for the project construction to the principal company. Of the total 14,65,000 units of electricity consumed in making the project in June 2019, only 18,000 units or 1.2 per cent was consumed by the subsidiary, the rest by the principal as a “contractor”. All the work is done solely by the principal company and the subsidiary was created only to form a layer between the project and itself in order to avoid scrutiny. It can even hide behind the subsidiary if the project incurs a loss. The son borrows money from the bank and transfers it to his father through work contracts. The father washes his hands off his son’s business if there is a loss. On the other hand, in case of profits, he enjoys the benefits of the work contracts given.

The actual value of the assets created in this hydropower project is Rs 565 crores as per documents filed with the Government. However, the present investment in the project is about Rs 2,000 crores. Part of this escalation is due to the damage incurred by the project in the floods of 2013, which may sound justified but the investment made in making repairs to the project does not add to the value of the assets. For example, the son may spend Rs 10,000 to repair his car after an accident. The expenditure though justified, would not lead to an increase in the value of the family car. In fact, it would bring it down. In the case of the project, the subsidiary spent some money on repairs after the flood. By showing that the value of the assets is the Rs 2,000 crores, it has hidden the fact that nearly Rs 1,500 crores have gone down the drain.

This is the reason for creating subsidiaries-to hide the losses from the lending banks, the Government and from its shareholders. Everyone continues to think that the principal company is running a profitable business while it is in deep loss. This camouflage is possible because the losses are hidden in the subsidiary while the profits are shown in the principal.

A similar rot appears to exist in other subsidiaries of this company. This becomes clear when we look at their performance and of the company separately. The profits of the principal company were Rs 9,200 crore in 2018-19 while the combined profits of all its subsidiaries were only Rs 5,400 crores. While the former borrowed a meager amount of Rs 2,400 crores from the banks, the combined borrowing of all its subsidiaries as mentioned before is Rs 71,600 crores. In the end, the subsidiaries are left indebted while the principal shines brightly. The son suffers losses while the father shines.

It should be obvious that this manipulation cannot continue ad infinitum. A time will soon come when the banks will realize that the subsidiaries are going under, they will stop extending loans to the subsidiaries, and the castle of the principal company will come crashing down, as it happened in the case of IL&FS. The question is, when?

The banks and the Government must be proactive. All large companies having multiple subsidiaries must be considered inherently suspect. A forensic audit must be undertaken of the assets of the subsidiaries. The failure to undertake such an audit in time is responsible for the losses incurred by PNB and other banks. The banks must look at the profitability of the business of the son, instead of looking at the credibility of the father.

The writer is former professor of Economics at IIM Bangalore.