In response to risks arising from increasing loan frauds, the Reserve Bank of India (RBI), on May 7, 2015, provided specific guidelines to banks for developing a framework for dealing with loan frauds.
Alvarez & Marsal (A&M) has closely followed the RBI’s guidance and has developed an overview of its key guidelines and critical actions that banks are advised to take to ensure compliance. Our process places an emphasis on identifying early warning signals, classifying red flag accounts and determining fraud, reporting to the RBI and relevant agencies, and understanding the related penal measures for fraudulent borrowers.
Key Select Guidelines
Early Warning Signals and Red Flagged Accounts
Banks are now required to identify Early Warning Signals (EWS) that can highlight fraudulent activity in the use of loan accounts. EWS should be developed based upon each bank’s past experience, client profiles and clients’ business models. A few examples of EWS include a large number of transactions with interconnected companies, an unusual pattern of transactions, disputes on the title of the collateral securities, frequent changes in management and actions by regulators. An account, where one or more EWS suggests potential fraudulent activity, should be classified as a Red Flagged Account (RFA).
Robust Appraisal and Effective Credit Monitoring Mechanism
EWS tracking should be integrated with banks’ existing credit monitoring processes so that it becomes a continuous activity during the entire lifecycle of loan accounts. Before sanctioning loans, banks should develop a comprehensive view of the borrower and its activities. Some of the activities recommended by the RBI include collecting independent information and market intelligence on the potential borrowers covering business practices, regulatory issues and legal risks. Post-sanctioning, banks are required to conduct annual reviews of loan accounts. Among other things, such annual reviews should include “the aspects of diversion of funds in an account, adequacy of stock vis-a-vis stock statements, stress in group accounts..." 
The Risk Management Group (RMG) should monitor the market developments of major clients to provide feedback to credit officers.
In addition to the current reporting requirements, banks are now required to report on the Central Repository of Information on Large Credits (CRILC) data platform and to law enforcement agencies those loan accounts that are in excess of INR 500 million and which have been classified as an RFA or ‘Fraud.’ Banks may continue to report all identified accounts to the Central Fraud Monitoring Cell (CFMC).
Delayed reporting of ‘fraud’ loan accounts delays the notification of other banks about the borrowers and also delays the filing of complaints with law enforcement agencies. These postponements may lead to the further loss of funds and evidence, absconding borrowers, untraceable witnesses and a diminishing money trail. Whether a bank is a sole lender or has provided finance under consortium or multiple banking arrangements, the RBI has provided specific timelines and action items that banks should review and follow to prevent such situations.
Incentive for Prompt Reporting
Banks have been provided an incentive for prompt reporting of fraud accounts by allowing the provisioning of such accounts to be spread over four quarters against the current requirement to immediately make the provision covering the full exposure.
Staff Empowerment/Whistleblower Policy
The RBI has advised banks to encourage employees to report fraudulent activity by enhancing existing whistleblowing mechanisms to encourage greater participation and providing adequate protection to combat employees’ fear of victimization.
The RBI has mandated banks to undertake a staff accountability study for all accounts that have been classified as fraud within a period of six months and to report these actions to the Special Committee of the Board for monitoring and follow-up of Frauds (SCBF) and the RBI.
Penal Measures Against Fraudulent Borrowers
In addition to the general penal provisions as applicable to willful defaulters, borrowers (including promoters, directors and whole time directors) would also be debarred from availing bank finance for a period of five years from the date of full payment of the defrauded amount. Further, no restructuring or grant of additional facilities may be made in the case of RFA or fraud accounts. No compromise settlement involving a fraudulent borrower will be allowed unless the conditions stipulate that the criminal complaint will be continued.
Role of Investigative Agencies
The Fraud Monitoring Group (FMG), SCBF and other similar groups have been empowered to stipulate the nature and level of investigations or remedial measures necessary to protect the bank’s interest at the time of classification of an account as RFA or fraud. Banks may use external auditors, including forensic experts or an internal team of investigations, before taking a final view on the RFA.
Accountability of Third Parties
In its circular dated July 1, 2014 on Frauds – Classification and Reporting, the RBI discussed accountability of third parties, such as builders and dealers, and professionals including valuers and chartered accountants, and their role in credit sanction/disbursement to fraudsters. A database of third parties involved in frauds is being compiled by the Indian Banks Association (IBA).
Role of Auditors
Auditors of banks have been advised to highlight fraudulent activity they may observe in the course of their audits to the top management and/or the audit committee.
Central Fraud Registry
The RBI recognizes the need for a central searchable database on fraud perpetrators. The RBI is in the process of designing this database which banks can use at the time of setting up new accounts/relationships, extension of credit facilities and/or during the operation of an account. The Central Bureau of Investigation (CBI) and the Central Economic Intelligence Bureau (CEIB) have also expressed interest in sharing their own databases with the banks.
The manner in which the RBI’s guidelines are incorporated and implemented will impact each bank’s ability to effectively respond to risks of loan frauds individually and collectively. Some critical success factors are summarized below.
Understand and Assess Overall Framework
Banks must incorporate guidelines on EWS, RFA and ongoing monitoring within their current risk management framework, as well as periodically assess the effectiveness of their systems. These institutions should also provide training to employees in order to meet the objectives of this framework.
Know Your Borrower
Banks must maintain a comprehensive view of their borrowers and activities in the pre-sanctioning phase and at the time of conducting annual reviews. Gathering market intelligence and other relevant information about borrowers and related entities will play a critical role across all stages of the loan cycle.
Documenting the procedures performed, findings and basis for decisions will be critical for banks to establish completeness and conduct staff accountability assessments.
Follow Reporting Procedures
Banks must ensure that they follow the outlined reporting procedures. The FMG is required to report accounts with more than INR 500 million wherein EWS are observed to the CMD/CEO on a monthly basis. RFA accounts are to be presented to the SCBF along with any remedial actions taken. An account that is categorized as a fraud must be reported to the RBI, on the CRILC data platform and to law enforcement agencies within stipulated timelines.
Establish Staff Accountability
Banks should establish clear procedures covering staff accountability exercises for fraud accounts. Results of such exercises along with the action taken would need to be presented to SCBF and intimated to the RBI at quarterly intervals.
Collaboration and Information Sharing with Peers and Law Enforcement
To ensure prompt and timely action by enforcement agencies against fraudsters, while banks have been advised to appoint a nodal point/officer who will serve as the single point for coordination, the government is also considering a central point for receiving complaints/first information reports (FIRs) from banks in the CBI.
About Dhruv Phophalia
Dhruv Phophalia is a Managing Director with Alvarez & Marsal and leads the firm’s Global Forensic and Dispute Services practice in India. He has more than 18 years of experience and specializes in anti-bribery and corruption consulting, fraud investigations, anti-fraud programs and controls, regulatory compliance, litigation support and bankruptcy matters. Mr. Phophalia has advised several Fortune 500 companies on a number of large global forensics and dispute engagements around the world.
dphophalia [at] alvarezandmarsal.com (Contact Dhruv) to learn more about bank fraud and compliance-related services, A&M’s Global Forensic and Dispute Services practice and how A&M is advising clients in India and around the world.