Fraud Risk Management in Banks

The increasing incidences of frauds in general and in loan portfolios of banks in particular are the matter of serious concern to all stake holders.  Unfortunately, most often banks even after identifying the frauds, take times to file complaints with CBI / Police on the grounds of cheating, misappropriation of funds, diversion of funds etc. This is mainly because of false hopes of bank men that they will be able to recover full amount from such borrower if they give him some time to fully repay the loan amount. The fraudster make merry of such delays and he is striped clean of value when banks actually go for filing complaint with much delay. The delay in reporting of frauds by the bank might sometime result in loss of documents relied upon, absconding of borrower, non-availability of witness and more so obviously detriment to effective action by the law enforcing agencies. It also delays alerting of other banks about the modus operandi of frauds perpetrated elsewhere through caution advices of Reserve Bank. In the above backdrop, the Reserve Bank of India brought into force the systemized framework for fraud risk management in banks. The framework is built on following ground rules.

Concept of Red Flagged Accounts (RFA)

The concept of Early Warning Signals (EWS) and Red Flagged Accounts (RFA) are measures of fraud risk control. The EWS is an integrated part of credit monitoring process in the bank that act as a trigger for any possible credit impairment in the loan accounts, given the interplay between credit risks and fraud risks. RFA is one where a suspicion of fraudulent activity is thrown up by the 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 turnout 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 RFA. RBI has provided an illustrative list of EWS to banks under the framework of fraud risk management. Individual banks may add other alerts/signals based on their experience, client profile and business models. The EWS so complied by a bank would form the basis for classifying an account as a RFA. The bank may use external auditors including forensic experts or an internal team for investigations before taking a final view on the RFA. At the end of this timeline which cannot be more than six months, bank would either lift the RFA status or classify the account as a fraud. In case the account is classified as a RFA, the Fraud Monitoring Group (FMG) will stipulate the nature and level of further investigations or remedial measures necessary to protect the bank’s interest within a stipulated time which cannot exceed six months. The bank upon identifying the fraud should report the matter immediately to investigative agencies for instituting criminal proceedings against the fraudulent borrowers, besides reporting the same to Reserve Bank. All accounts of beyond Rs.500 million classified as RFA or Frauds must also be reported on the Central Repository of Information on Large Credits (CRILC) data platform together with the dates on which the accounts were classified as RFA or Frauds.

Tracking of EWS is integrated with Credit monitoring process:

The tracking of EWS is integrated with the credit monitoring process, as it acts as trigger for any credit impairment in the loan accounts, given the interplay between credit risks and fraud risks. The credit monitoring system in the banks is an unceasing activity to have a check on possibility of credit impairment in loan accounts.  The process starts with appraisal of the borrower and appraisal of the project. Appraisal of the borrower covers honesty and integrity of the borrower, standing of the borrower, business capacity, managerial competence, financial resources in relation to size of the project. The sources of information for the above are personal interview, credit investigation, trade circle enquiries, market report, existing bank’s report, credit information reports like CIBIL report; RBI defaulter list, assets and liabilities statements submitted by the borrowers, Income Tax assessment orders and wealth tax assessment orders of promoters, Reports from credit rating companies etc.  In respect of appraisal of a projects banks needs to undertake a detailed study of feasible report of the project, analysis of the Annual Report as a whole and not merely the analysis of financial statements. Along with balance sheet and profit and loss accounts, the examination of Audit report and Director’s report are also important to bankers.  The auditor’s report reveals whether the company’s financial position and P&L a/c show a free and fair view of state of affairs. Any unauthorized payments not connected with business or diversion of funds etc., if existed would be reported in auditor’s report. Any understatement/overstatement of liability or income would be reported/ qualified by the auditors. Under the manufacturing and other companies’ order 75, the auditor is required to make a statement on any matter that has a direct significance to banker for monitoring the advance. The Director’s report touches upon many important aspects on working of the company and its prospectus. More importantly the director’s report is required to reply on every qualification appearing in the auditor’s report. Another important issue is compliance of terms and conditions of sanction endorsement at the disbursal stage of the sanction. RBI guidance in the matter spell out that as a matter of good practice the sanctioning authority may specify certain terms and conditions as ‘core’ which should not be diluted. Inspection of factory unit or godown of borrower at regular interval to check the working of the unit as well adequacy of stock vis-à-vis stock statement is an important and desired activity of banker to monitor the borrower’s account. It is also important to be vigilant from fraud prospective at the time of annual review of accounts. The aspects of diversion of funds in account, stress in group accounts etc., must also be commented at the time of review.  Bank may keep the records of pre-sanction checks as part of sanction documentation.

Staff accountability:

The bank in which fraud has taken place shall initiate staff accountability proceedings for determining negligence or connivance if any. The officer who is handling the operation in the account, irrespective of his designation, will be held responsible for non-reporting or delay in reporting any indicator of the EWS promptly to the Fraud Monitoring Group (FMG) or any other group constituted by the Bank. The framework also stipulates mandatory timelines/stage wise actions in the loan life cycle to act upon. The introduction of above stipulations would compress the total time taken by the bank to identify a fraud. In cases involving very senior executives of the bank, the Board/ACB/SCBF [Special Committee of the Board for monitoring and follow-up of Frauds (SCBF)] may initiate the process of fixing staff accountability. The 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.

Whistle Blower Policy of the Bank:

Bank should encourage its employees to report fraudulent activity in an account along with the reasons in support of their views, to the appropriate constituted authority under the Whistle Blower Policy. Such authority may institute a scrutiny through the FMG. Such employees should be provided with full protection so that the fear of victimization does not act as a deterrent.

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