Ways to combat fraud at financial institutions

Banks and financial institutions are required to take the initiative for timely and complete disclosure of fraud to the Reserve Bank of India (RBI). Banks are also required to adopt a regular chain of reporting system for frauds.

Banks may, with the approval of their board of directors, frame internal policy for the fraud risk management and fraud investigation function, based on the governance standards relating to the ownership of the function and accountability for malfunctioning of the fraud risk management process in their banks.

RBI has observed that banks sometimes detect frauds long after their perpetration. Some fraud reports are submitted to RBI with considerable delay and without complete information. On occasion, RBI has learned about large frauds through reports in the press and financial journals.

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Banks must ensure that their reporting system is suitably streamlined so that frauds are reported without any delay, and also fix staff accountability in respect of delays in reporting cases to RBI. Delay in the reporting of frauds and the consequent delays in alerting other banks about the modus operandi and in issuing caution advice against unscrupulous borrowers could result in similar frauds elsewhere.

Banks that fail to strictly adhere to the timeframe for reporting fraud cases to RBI could face penal action under section 47(A) of the Banking Regulation Act, 1949.

With a view to uniformity in reporting, frauds can be classified, based mainly on the provisions of the Indian Penal Code, as follows: (a) misappropriation and criminal breach of trust; (b) fraudulent encashment through forged instruments, manipulation of books of account, or fictitious accounts and conversion of property; (c) unauthorized credit facilities extended for reward or for illegal gratification; (d) negligence and cash shortages; (e) cheating and forgery; (f) irregularities in foreign exchange transactions; and (g) any other type of fraud.

Unscrupulous borrowers

Unscrupulous borrowers, including companies, partnership firms, proprietary concerns and/or their directors, partners or proprietors, commit large frauds by various methods. These include:

(1) Fraudulent discounting of instruments;

(2) Fraudulent removal of pledged stocks, disposing of hypothecated stocks without the bank’s knowledge, and inflating the value of stocks in stock statements and drawing excess bank finance;

(3) Diversion of funds outside the borrowing units, attributable to lack of interest or criminal neglect on the part of borrowers, their partners, etc.; managerial failure leading to the unit becoming sick; or laxity in supervision over the operations in loan accounts by bank functionaries.

Banks should exercise due diligence while appraising the credit needs of borrowing entities, including their directors, partners, proprietors and also borrowers’ associates who have defrauded the banks.

Some unscrupulous borrowers that have credit facilities under a “multiple banking arrangement”, after defrauding one of the financing banks, continue to enjoy the facilities with other financing banks and may even obtain higher limits at those banks. The borrowers use their accounts at other financing banks to siphon off funds diverted from the bank on which the fraud is being perpetrated.

This can happen because of the lack of a formal arrangement for exchange of information among lending banks and financial institutions. In some fraud cases, borrowers have offered the same securities to different banks.

As a precautionary step, all the banks which have financed a borrower under a multiple banking arrangement should agree a common strategy to coordinate their legal/criminal actions and follow-up for recovery, exchange details on modus operandi, and report data and information on frauds to RBI in a consistent manner. A bank which detects a fraud should be required to immediately share the details with all other banks in the multiple banking arrangement.

Reporting of frauds

Fraud reports should be submitted in all cases of fraud of ₹100,000 (US$2,000) and above perpetrated through misrepresentation, breach of trust, manipulation of books of account, fraudulent encashment of instruments (cheques, drafts and bills of exchange), unauthorized handling of securities charged to the bank, misfeasance, embezzlement, misappropriation of funds, conversion of property, cheating, shortages, irregularities, etc.

Fraud reports should also be submitted to RBI in cases where central investigating agencies have initiated criminal proceedings and where the RBI has directed that they be reported.

Banks are required to constitute a special committee for monitoring and follow-up of cases of frauds involving amounts of ₹10 million and above, which can identify any systemic lacunae that facilitated the fraud and put in place measures to plug them.

Banks should vigorously pursue final disposal of pending fraud cases with the Central Bureau of Investigation, police and courts, especially where the banks have already taken action against staff.

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Shardul Thacker is a partner at Mulla & Mulla & Craigie Blunt & Caroe in Mumbai.