Cooperative Banks – A Problem On Loop

“The more things change, the more they remain the same.” 

This adage sums up developments in the Indian cooperative banking sector. The latest fraud at New India Cooperative Bank has caused considerable distress and hardship to the bank’s hapless depositors and should be a matter of deep concern, not just for those in the financial sector but for the public at large.

Why does this keep happening with cooperative banks, particularly urban cooperative banks? Faith in the safety of bank deposits is the bedrock on which the financial system's stability rests. Take that away, and a calamitous cascade of institutional collapse and social chaos inevitably ensues. The primary objective of banking regulation, whether directed at ensuring the quality of lending, capital adequacy, or fraud prevention, is to protect the depositor, whose concerns take precedence over those of any other party, including shareholders. Yet it has been the depositor who has repeatedly paid the price for cooperative bank failures.

In the case of New India, the fraud involved siphoning off physical cash lying in the bank’s vault—good old-fashioned theft. The more “modern” method of robbing a bank involves taking a loan and deliberately not repaying it or issuing loans to friends and associates in exchange for generous kickbacks. In the New India case, a simple reconciliation of physical cash at regular intervals would have immediately brought the fraud to light. That this blatant theft has been ongoing since 2022 suggests either a complete lack of basic audit procedures or a broader conspiracy within the bank, likely the latter.

Other recent instances reinforce the pattern. Sri Guru Raghavendra Sahakara Bank in Karnataka collapsed in early 2020, leaving thousands of middle-class depositors—many of them senior citizens—in distress. The bank is alleged to have been making loans to dubious or entirely fictitious entities, through which its management is suspected to have siphoned off more than 150 billion rupees. Reportedly, the bank kept creating more fictitious loans to evergreen the earlier ones, disregarding know-your-customer guidelines, operational procedures, and credit audits.

The most infamous case remains Punjab and Maharashtra Cooperative Bank, where most of the asset book consisted of loans made to a single real estate group. Banking guidelines on lending to connected entities set limits linked to the bank’s capital. These limits consider not only ownership but also significant influence and control. In this case, such guidelines were entirely and deliberately ignored.

Governance and Regulation Failures
These failures stem from misgovernance and fraud rather than a lack of rules or guidelines. Unlike commercial banks, cooperative banks fall under dual regulation. The Reserve Bank of India oversees banking operations, while governance, board appointments, and audit functions are controlled by central and state governments through their respective cooperative societies regulators. This structure often leads to politically motivated board appointments and favouritism toward certain borrowers.

In 2020, the Banking Regulation Act was amended to extend key provisions to cooperative banks. The changes allowed The RBI to prescribe qualifications for at least 51% of board members to ensure sufficient banking experience and the authority to supersede non-compliant boards. Crucially, it also gave the regulator control over the audit processes of these banks, including auditor appointments and the power to order special audits when necessary. These were important steps that were to improve governance over time, even though they have not yet prevented recent frauds.

Deposit insurance has become a crucial safeguard. Reports suggest that 98% of claims paid by the Deposit Insurance and Credit Guarantee Corporation have involved cooperative banks, even though these banks contribute only 5.6% of total premiums. The insured deposit limit was raised to ₹500,000 in 2020, up from ₹100,000, providing coverage to a significant portion of affected depositors.

An aspect that has attracted comment is whether the RBI’s enhanced liquidity norms for the banking sector put off for the moment pending wider discussion, would have helped address issues at Cooperative Banks.

However, while the liquidity norms are essential, they would not prevent fraud-driven collapses. The real issue remains systemic governance failures and inadequate regulatory enforcement.

The Path Forward
The RBI has stepped in to facilitate mergers and prevent large-scale bank failures. Yes Bank was rescued in 2020 through a transfer of majority shareholding to the State Bank of India. Lakshmi Vilas Bank was merged with the Development Bank of Singapore, even though it was not an Indian government-owned entity. However, such interventions are challenging with cooperative banks due to their dual regulatory structure and cooperative ownership model, which follows principles of community ownership rather than commercial enterprise.

Cooperative banks play a crucial role in financial inclusion. Farmer cooperatives, for instance, provide timely and localised credit that commercial banks may struggle to offer. However, their governance structures must align with fundamental banking principles. Strengthening the implementation of banking laws and focusing on stringent oversight is essential to prevent recurring crises in the sector.

A misleading perception among depositors is that secured loans automatically ensure the safety of their deposits. However, enforcing asset recovery is arduous in India, particularly against large corporate borrowers with strong legal defenses. Even with stringent laws, repossession and sale of assets remain challenging, especially when bank management is complicit in wrongdoing.

Mergers have often served as a tool to rescue troubled banks, but this has not been as effective in the cooperative banking sector. Unlike commercial banks, where ownership transfer is a straightforward financial decision, cooperative banks are owned and run by their members. This legal and structural difference makes forced mergers difficult unless backed by legal and regulatory clarity.

Interestingly, the government attempted to streamline the resolution of failing banks through the Financial Resolution and Deposit Insurance Bill of 2017. The bill aimed to address financial deterioration well in advance. However, the legislation was shelved, primarily due to the controversial bail-in clause, which proposed using depositor funds as part of the resolution plan if other recovery measures failed. Ironically, depositors in cooperative banks have arguably been treated worse than they would have under a structured bail-in framework.

The cooperative banking sector continues to grapple with structural weaknesses, political interference, and governance lapses. While regulatory reforms have improved oversight, enforcement remains a challenge. Unless governance and compliance structures are significantly strengthened, depositors will continue to bear the brunt of these failures.