Banks in India are reeling from the overhang of bad loans on their books across both the public and private sector. After a prolonged period of stress, which saw the gross non-performing assets (GNPA) of scheduled commercial banks rising drastically.   

The Reserve Bank of India’s (RBI’s) Financial Stability Report (FSR) of December 2020 has stated that banks’ gross non-performing assets (GNPAs) may rise sharply to 13.5 per cent by September 2021, and escalate to 14.8 per cent, nearly double the 7.5 per cent in the same period of 2019-20, under the severe stress scenario. Indian public sector banks collectively owed approximately 6.8 trillion Indian rupees as non-performing assets at the end of fiscal year 2020.

Early Warning Systems are specialized tools, built using a set of parameters and processes that identify probable risks at a nascent stage. A comprehensive and well-structured EWS assists the top-level management to predict possible defaults from borrowers that may adversely affect the institution. Such systems can prevent manual omissions and other oversights, thereby securing the bank’s valued assets.

RBI issued Master Directions on Frauds – Classification and Reporting by commercial banks and select FIs Circular No. DBS.CO.CFMC.BC.No.1/23.04.001/2016-17 Dated July 01, 2016  (Updated as on July 03, 2017). In the context of increasing incidence of frauds in general and in loan portfolios in particular, objective of this framework is to direct the focus of banks on the aspects relating to prevention, early detection, prompt reporting to the RBI (for system level aggregation, monitoring & dissemination) and the investigative agencies (for instituting criminal proceedings against the fraudulent borrowers) and timely initiation of the staff accountability proceedings (for determining negligence or connivance, if any) while ensuring that the normal conduct of business of the banks and their risk taking ability is not adversely impacted and no new and onerous responsibilities are placed on the banks.

In order to achieve this objective, the framework also seeks to stipulate time lines with the action incumbent on a bank. The time lines / stage wise actions in the loan life-cycle are expected to compress the total time taken by a bank to identify a fraud and aid more effective action by the law enforcement agencies. The early detection of Fraud and the necessary corrective action are important to reduce the quantum of loss which the continuance of the Fraud may entail. The government is separately looking into the issue of timelier and coordinated action by the law enforcement agencies.

Early Warning Signals (EWS) and Red Flagged Accounts (RFA): The concept of a Red Flagged Account (RFA) is being introduced in the current framework as an important step in fraud risk control. An RFA is one where a suspicion of fraudulent activity is thrown up by the presence of one or more Early Warning Signals (EWS). These signals in a loan account should immediately put the bank on alert regarding a weakness or wrong doing which may ultimately turn out to be fraudulent. A bank cannot afford to ignore such EWS but must instead use them as a trigger to launch a detailed investigation into an RFA.

The threshold for EWS and RFA is an exposure of Rs. 500 million or more at the level of a bank irrespective of the lending arrangement (whether solo banking, multiple banking or consortium). All accounts beyond Rs. 500 million classified as RFA or ‘Frauds’ must also be reported on the CRILC data platform together with the dates on which the accounts were classified as such. The CRILC data platform is being enhanced to provide this capability by June 1, 2015. As of now, this requirement is in addition to the extant requirements of reporting to RBI.

The modalities for monitoring of loan frauds below Rs. 500 million threshold is left to the discretion of banks. However, banks may continue to report all identified accounts to CFMC, RBI as per the existing cut-offs.

The tracking of EWS in loan accounts should not be seen as an additional task but must be integrated with the credit monitoring process in the bank so that it becomes a continuous activity and also acts as a trigger for any possible credit impairment in the loan accounts, given the interplay between credit risks and fraud risks. In respect of large accounts it is necessary that banks undertake a detailed study of the Annual Report as a whole and not merely of the financial statements, noting particularly the Board Report and the Managements’ Discussion and Analysis Statement as also the details of related party transactions in the notes to accounts. The officer responsible for the operations in the account, by whatever designation called, should be sensitised to observe and report any manifestation of the EWS promptly to the Fraud Monitoring Group (FMG) or any other group constituted by the bank for the purpose immediately. To ensure that the exercise remains meaningful, such officers may be held responsible for non-reporting or delays in reporting.

The FMG should report the details of loan accounts of Rs. 500 million and above in which EWS are observed, together with the decision to classify them as RFAs or otherwise to the CMD/CEO every month.

A report on the RFA accounts may be put up to the Special Committee of the Board for monitoring and follow-up of Frauds (SCBF) providing, inter alia, a synopsis of the remedial action taken together with their current status.

Early Detection and Reporting: At present the detection of frauds takes an unusually long time. Banks tend to report an account as fraud only when they exhaust the chances of further recovery. Among other things, delays in reporting of frauds also delays the alerting of other banks about the modus operandi through caution advices by RBI that may result in similar frauds being perpetrated elsewhere. More importantly, it delays action against the unscrupulous borrowers by the law enforcement agencies which impact the recoverability aspects to a great degree and also increases the loss arising out of the fraud.

The most effective way of preventing frauds in loan accounts is for banks to have a robust appraisal and an effective credit monitoring mechanism during the entire life-cycle of the loan account. Any weakness that may have escaped attention at the appraisal stage can often be mitigated in case the post disbursement monitoring remains effective. In order to strengthen the monitoring processes, based on an analysis of the collective experience of the banks, inclusion of the following checks / investigations during the different stages of the loan life-cycle may be carried out:

  1. Pre-sanction: As part of the credit process, the checks being applied during the stage of pre-sanction may consist of the Risk Management Group (RMG) or any other appropriate group of the bank collecting independent information and market intelligence on the potential borrowers from the public domain on their track record, involvement in legal disputes, raids conducted on their businesses, if any, strictures passed against them by Government agencies, validation of submitted information/data from other sources like the ROC, gleaning from the defaulters list of RBI/other Government agencies, etc., which could be used as an input by the sanctioning authority. Banks may keep the record of such pre-sanction checks as part of the sanction documentation.
  2. Disbursement: Checks by RMG during the disbursement stage may focus on the adherence to the terms and conditions of sanction, rationale for allowing dilution of these terms and conditions, level at which such dilutions were allowed, etc. The dilutions should strictly conform to the broad framework laid down by the Board in this regard. As a matter of good practice, the sanctioning authority may specify certain terms and conditions as ‘core’ which should not be diluted. The RMG may immediately flag the non-adherence of core stipulations to the sanctioning authority.
  3. Annual review: While the continuous monitoring of an account through the tracking of EWS is important, banks also need to be vigilant from the fraud perspective at the time of annual review of accounts. Among other things, the aspects of diversion of funds in an account, adequacy of stock vis-a-vis stock statements, stress in group accounts, etc., must also be commented upon at the time of review. Besides, the RMG should have capability to track market developments relating to the major clients of the bank and provide inputs to the credit officers. This would involve collecting information from the grapevine, following up stock market movements, subscribing to a press clipping service, monitoring databases on a continuous basis and not confining the exercise only to the borrowing entity but to the group as a whole.

Staff empowerment: Employees should be encouraged to report fraudulent activity in an account, along with the reasons in support of their views, to the appropriately constituted authority, under the Whistle Blower Policy of the bank, who may institute a scrutiny through the FMG. The FMG may ‘hear’ the concerned employee in order to obtain necessary clarifications. Protection should be available to such employees under the whistle blower policy of the bank so that the fear of victimisation does not act as a deterrent.

Role of Auditors: During the course of the audit, auditors may come across instances where the transactions in the account or the documents point to the possibility of fraudulent transactions in the account. In such a situation, the auditor may immediately bring it to the notice of the top management and if necessary, to the Audit Committee of the Board (ACB) for appropriate action.

Staff Accountability: As in the case of accounts categorised as NPAs, banks must initiate and complete a staff accountability exercise within six months from the date of classification as a Fraud. Wherever felt necessary or warranted, the role of sanctioning official(s) may also be covered under this exercise. The completion of the staff accountability exercise for frauds and the action taken may be placed before the SCBF and intimated to the RBI at quarterly intervals as hitherto.

Incentive for Prompt Reporting: In case of accounts classified as ‘fraud’, banks are required to make provisions to the full extent immediately, irrespective of the value of security. However, in case a bank is unable to make the entire provision in one go, it may now do so over four quarters provided there is no delay in reporting (cf. Circular DBR.No.BP.BC.92/21.04.048/2015-16 dated April 18, 2016). The option of providing fully for fraud accounts over a period not exceeding four quarters as mentioned in the circular mentioned above will not be available to accounts classified as ‘loss accounts’ otherwise.

Banks may bifurcate all fraud cases into vigilance and non-vigilance. Only vigilance cases should be referred to the investigative authorities. Non-vigilance cases may be investigated and dealt with at the bank level within a period of six months. In cases involving very senior executives of the bank, the Board / ACB/ SCBF may initiate the process of fixing staff accountability. Staff accountability should not be held up on account of the case being filed with law enforcement agencies. Both the criminal and domestic enquiry should be conducted simultaneously.

Books Written by Abinash Mandilwar