Fraud, Failure, and Fear

The Indian Banking system has a well laid out procedure for reporting of banking frauds to the Reserve Bank of India. These need to also adhere to stipulated timelines for preliminary and final reporting. The modus operandi for frauds are also circularised to all banks for their precaution. In the last couple of years we have witnessed a higher number of loan related frauds  reported mostly by the Public sector banks. This may have been partly on account of the spurt in the lending activity during 2005-12 period, partly due to the Asset Quality Reviews (AQR) initiated by RBI, and partly due also to the economic slowdown. Some of these may actually have been only failures ,conservatively categorized as frauds . Both, however, have evoked fear in the minds of the bankers .

How is a fraud defined? It is actually quite wide encompassing. Any undue enrichment is defined as a fraud. Based mainly on the provisions of the Indian Penal Code, and to maintain uniformity, RBI has classified frauds into 7 categories including misappropriation, unauthorised credit facilities extended for reward or illegal gratification etc.  Earlier on there were quite a few grey areas, making distinction between the perpetrator and the victim, between fraud and failure requiring application of mind and exercise of judgement. Things were not made simpler by the three Cs (CBI, CVC, CAG and the SFIO) who insisted that staff complicity be invariably examined and FIRs filed should name the staff involved.  In case no staff member names were given, the FIR was filed generally against “unknown” staff members. Staff involvement need not have been actively complicit but passively negligent or ignorant too. Differences of opinion on staff involvement and naming would be escalated on to the Central Vigilance Commission (CVC) and beyond that in their report to the Parliament as well, though rarely, as no Chairman would carry this forward beyond the CVC. In most cases, while charge sheets would be filed by the Investigating Officials, the initial arrested would, of course, be only the bank officials. We have, yet, no statistics of the number of such officials actually indicted after prolonged legal processes in Special Courts. We also have no statistics on how many perpetrators have actually been punished, at least in the larger cases. A few of them have escaped from the country and most of them have the wherewithal to delay their incarceration in legal processes by hiring the best of legal minds. While most of these cases would be against dishonest officials who have been rightly prosecuted and punished, in the absence of the relevant statistics, there could also be a large number of cases where otherwise honest officials have been proceeded against for their misfeasance, negligence, or ignorance. In such cases, these bank officials, have to fight their own cases and their families have to suffer the ignominy and the pain surviving on subsistence salaries afforded to them during this period. Their self-esteem is lost and so are their savings. It is only when they are exonerated after a prolonged period, of maybe a decade or so, that they are reimbursed their legal expenses and given their back wages and are also considered eligible for their promotions from the original due dates. This not only impacts them adversely but a whole lot others too, especially when the official is known to be honest otherwise.

The CVC always had a Central Advisory Board rechristened as the Advisory Board for Banking Frauds subsequently. The CBI could refer cases involving frauds of Rs 50cr or more or where an officer in the rank of a General Manager was allegedly involved, to the Board and seek their advices before prosecution. Such advice, however, was not binding on the CBI and neither was the reference mandatory. When, therefore, it was directed  that all NPA cases above Rs 50cr be examined forensically, there was sudden spurt of reported cases year on year between 2016 and 2019 and all-time highs of close to Rs 1.82 lac crores were reported in 2019-20 and Rs 63,950cr till Sept 21. The relative figures for 2017-18 and 2018-19 were Rs 22,558cr and Rs 64,548cr respectively. Either, fraud cases were not reported earlier and, therefore, the base levels had been low or there was actually a sharp increase in fraudulent activity during the period or perhaps a few years prior to that. Also reported in such cases were companies which had been in existence for more than two decades.

To be fair to the CBI,usually, they act on complaints reported to them by the banks and its very rare for them to initiate cases suo moto. Additionally, the Investigating Officers in such agencies are accustomed to examining infractions basis  processes/guidelines/manuals usually  stipulated departmentally or under CVC directives for allotment of tenders/allocations of quotas etc. In the case of banks, the Credit Policies and Procedures adopted by boards of banks for sanction of loans by thousands of their branches allows for deviations by successively senior level committees and does not allow discretion at smaller branches and for smaller quantum of loans which are usually templated. The fact that acceptance of deviations is a normal process in the sanction of loans and forces an application of mind is quite alien to the normal investigation process adopted by the agencies, in fact, it is also frowned upon by the regulators. This then discourages use of any discretion by the sanctioning committees for fear of reprisals subsequently and could also be one of the factors contributing to reluctance on the part of bankers in sanctioning loans below AA rated borrowers. In defence of the reporting bankers and Vigilance Officials, it is quite normal for them to fear the worst of being held accountable for exercising their judgement and, therefore, they too tend to be most conservative. 

Regulatorily too, to facilitate and encourage timely reporting of frauds, the RBI in a very well intended framework circularised an illustrative list of Early Warning Signals, more in an effort towards encouraging regular monitoring of loan accounts which had to be red flagged for further enquiry. Some of these required exercise of judgement calls by bankers for materiality. Two unintended consequences ensued; firstly, the bankers adopted a conservative tick the box approach for fear of being held accountable subsequently, and secondly, the process did not provide for the borrower to clarify before any forum, unlike the opportunity afforded to them in wilful default cases.

Retrospectively, with the benefit of hindsight, one can broadly classify these reportage into a couple of categories:

1. Outright frauds as discerned and evidenced in a forensic examination by chartered accountants or such other experts – where though funds have been availed,assets have not been created or forged documents for assets have been submitted to the banks 
2. Suspect frauds as some of the assets earlier reported have vanished, (missing stocks or receivables) diversion of funds including funding of losses through falsification of inventory /receivables and accounts.
3. Grey frauds – where by and large the accounts and assets are reconciled barring a few minor areas which have not been satisfactorily explained.

Let me also delve in the process usually followed once a forensic audit report is made available to the concerned officer in the bank. Mind you, he may not be a very senior officer and all cases above Rs 50cr have to be similarly examined. Based on the forensic report so received by him, he is expected to examine and put up a note to his superior officer detailing all shortcomings with his comments, views, and recommendations.

While in the first category, there is no confusion and conclusions are quite cut and dry; In the second category, while assets may have depleted and there could also be instances of diversion of short-term funds for long term purposes including meeting losses, undue enrichment may have been only conjectured and not particularly evidenced. In the third category of grey cases, however, in the absence of a satisfactory explanation, there could be incidental reporting by the forensic auditor of areas requiring further examination. These may in some cases also be non-material for amount or recurrence of incidence.

However, most of the exercises bear the fact that these reports would also be examined by one of the three Cs and none would like to be held for non-reporting which could be construed to be complicit, so the effort is to err on the conservative and not exercise any judgement calls. While some forensic auditors are experienced and able to differentiate materiality, a lot of them prefer to be conservative in their findings too and mention even minor unexplained transgressions for the banker to take a call. In quite a few cases, admissible evidence which would stand scrutiny of the Courts are generally missing but the fact that they have been mentioned cannot be ignored by the scrutinising banker. The banker examining this, as mentioned earlier, is a junior official and he rightly surmises the reports without taking any judgement calls which would differ from the findings of the forensic auditor. His note goes up the hierarchy in the banks and may require further amplification of the malfeasance by his seniors, however, no one take,s a call on the materiality or the admissibility of the evidence for fear of the possibility of being questioned subsequently. This usually happens in the second and third category of cases. Hence, the numbers of frauds could also get unduly amplified and some businesses and promoters stigmatised forever when they could also have been seen as failures and not frauds.

There should be zero tolerance for any frauds. At the same time, corporates too are not operating in a vacuum. The economy and the environment is also changing gradually. The process of formalisation of the economy has begun and may take a few more years. Coupled with the pace of digitisation in the country, enabling triangulation of data from various sources to validate transactions, going forward, frauds of the nature discerned in the last round may greatly abate, hopefully. Meantime, the system is beset not only with a huge number of fraud cases but also affects a large number of bank officials who have to wait endlessly for their names to be eventually cleared. This has, unfortunately, led to far bigger problems afflicting the banking system- that of a fear psychosis. This fear does not augur too well for exercise of any judgement/discretion and hence encourages only a tick box approach and consequent delays. This vicious cycle continues, as is evidenced by a lack of credit growth in the last four years or so.

While efforts have been made to set up internal committees to vet references to the three Cs, the members of such committees, unfortunately not indemnified for their judicious decisions, are fearful of subsequent actions which may be borne on them.

How do we alleviate this fear psychosis? Having learnt lessons from the last round of failures and taken up steps to strengthen their systems and processes to obviate possibilities of recurrence. Decisions in most banks delegated to committees and not individuals. We should trust their capabilities, competence, sincerity and honesty. Unfortunately, for any bad loan or past frauds or failures, even of the second and third categories, anyone who has been a member of any committee and has had anything to do with this bad loan at any time is questioned. The number of people, some serving, some retired who are called to explain even if not charge-sheeted certainly does not impart any confidence on the remaining. 

We need to restore the confidence of the bankers in taking credit decisions. Mind you, there would always be some risk in credit decisions and that’s why the banks get a premium for the same over the cost of funds.  As a first step, let’s indemnify the committees for their bonafide decisions and delegate the wiggle room to enable them to make such decisions.  As most of the sanctions are audited through a process of credit audit within 6 months of their sanctions, it would be inadvertent for the committee members, who are not permanent but by rotation, to be hauled up for loans going bad subsequently, in some cases even after a couple of years.

While most banks are arranging specialised training for their credit officials and also giving them special allowances (given that what was once considered a prestigious assignment is not so sought after by most officials who are content with less riskier postings these days), what is also important is to impart to them knowledge and techniques to help them distinguish between avoidable and acceptable risks and, most importantly, record cogent reasons at that material point of time, for taking considered decisions.

Simultaneously, while the CVC does proactively try and train the CVOs and other officials, most of the supporting officials may lack relevant experience as far as loans and advances are concerned and may be prone to ascribe reasons for frauds and malfeasance which in actuality may be a case of business failure for reasons beyond the control of the loan official or could also be on account of a non-material misfeasance rather than active complicity. And, as is usual in most bureaucratic functioning, there is little incentive to differ from the noting of the initial examining official. The examining officials should have worked in loans and advances before their selection and posting to the vigilance departments. Certainly, the experience should be relevant, as an officer who has only been a part of the process for sanctioning loans to micro enterprises may lose all proportionality in examining cases related to larger loans.

Process wise, the authority to give permission to prosecute and to decide on the penalty and subsequent appeals is vested as an individual authority, and requires a very detailed examination of the findings of the Investigating/prosecuting enquiry officers  and the defense,  and submissions of the accused. A great application of mind besides time is required. This is not always possible given the other operational responsibilities which these officials at senior levels need to discharge simultaneously. While this is not to suggest that there is undue haste on the part of these officials, perhaps, some intervening help in identifying evidences admissible in courts specially in the second and third category of frauds mentioned above would be of great help to them and would also lessen the pains for those who would have been acquitted subsequently. This would also be particularly helpful in cases where the CBI seeks their approval for prosecuting bank officials.

Additionally, and I quote Mr. N. Vittal, “Intermediaries like lawyers, chartered accountants, Valuers, etc. play an important role in banking and insurance transactions as they certify documents and provide assurance on the basis of which banking transactions are carried out. This is an area of high concern and the integrity of intermediaries needs to be regulated.” We need to formalise the procedures for the same now as with a digitally enabled country, more and more external validation would be possible, required and necessary. Most importantly, while we should expect our bank officers to exercise due diligence as would be expected from a normal person, we should not expect them to be investigators and they should not be expected to investigate further into reports of outsourced agencies from a panel selected by the bank earlier.

It is in this context that we should view the path breaking budget presented by the Finance Minister this year. For the first time, we have seen an intent to break  free from our shackles and embark on an ambitious path towards development. The absence of capital and the lack of fiscal space would necessitate the active participation of the private sector and the banking systems. The banking system is quite comfortable lending to the government or the public sector but when it comes to the private sector, there is discomfort below AA rated companies. One of the reasons for this is a more rule- based approach, but more dangerously the development of an environment which discourages the use of any discretion because of the attendant fear. As long as this psychosis remains , attaining the objectives behind this great budget may become that much more difficult.

We may need to restore the confidence of the bankers to encourage them to take commercial decisions for the country to succeed and for the banks to survive.

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