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An overview of financial fraud


Frauds in the Indian Banking Industry
The Indian banking sector has experienced considerable growth and changes since liberalisation of economy in 1991. Though the banking industry is generally well regulated and supervised, the sector suffers from its own set of challenges when it comes to ethical practices, financial distress and corporate governance. This study endeavours to cover issues such as banking frauds and mounting credit card debt, with a detailed analysis using secondary data (literature review and case approach) as well as an interview-based approach, spanning across all players involved in reporting financial misconduct. The report touches upon the case of rising NPAs in the past few years across various scheduled commercial banks, especially public sector banks. The study finally proposes some recommendations to reduce future occurrence of frauds in Indian banking sector. The credibility of third parties such as auditing firms and credit rating agencies is also questioned in the study and is believed to be a significant contributor amongst other causes, such as oversight by banks and inadequate diligence.

Introduction and Issues
In recent years, instances of financial fraud have regularly been reported in India. Although banking frauds in India have often been treated as cost of doing business, post liberalisation the frequency, complexity and cost of banking frauds have increased manifold resulting in a very serious cause of concern for regulators, such as the Reserve Bank of India (RBI). RBI, the regulator of banks in India, defines fraud as “A deliberate act of omission or commission by any person, carried out in the course of a banking transaction or in the books of accounts maintained manually or under computer system in banks, resulting into wrongful gain to any person for a temporary period or otherwise, with or without any monetary loss to the bank”.

Conclusion and Recommendations
It is observed that PSBs fare better than PVBs in terms of total number of bank frauds. However, the total amount involved is much higher in PSBs as compared to the private sector. This can be attributed to large size of loans which PSBs offer to customers.Credit related frauds have maximum impact in all the banking frauds in India because of the high amount involved and the cumbersome process of fraud detection followed by CVC. The frauds may be primarily due to lack of adequate supervision of top management, faulty incentive mechanism in place for employees; collusion between the staff, corporate borrowers and third party agencies; weak regulatory system; lack of appropriate tools and technologies in place to detect early warning signals of a fraud; lack of awareness of bank employees and customers; and lack of coordination among different banks across India and abroad. The delays in legal procedures for reporting, and various loopholes in system have been considered some of the major reasons of frauds and NPAs.

Therefore, following recommendations are suggested for an early detection of frauds.
a) Independent specialized cadre: The government could consider an independent specialized cadre of officers on the lines of all India services, who are equipped with the best financial and legal know-how to detect financial frauds and are capable of carrying out an effective and time bound investigation of such scams. In short term, the government can consider forming this cadre with a pool of commercial bankers, RBI and CBI officials through lateral recruitment.
b) Know your markets: In addition to know your vendor and know your customer, the banks should also focus on know your markets. There should be a dedicated cell within each bank to assess the company/firm to which they are lending and the macro-economic environment of the concerned industry or market where products are marketed. This recommendation even seems relevant in the context of the recent crash of the Chinese market. Several Indian manufacturing companies, which were dependent on import of machinery from China, could not start their projects and generate cash flows, and this in-turn affected the banks from which loans were raised.
c) Internal rating agency: Banks should have a strong internal rating agency, which evaluates big ticket projects before sanctioning loan. The rating agency should strictly evaluate the project on the basis of business model/plan of project without being influenced by brand name or credit worthiness of the parent company, considering current macro-economic situation and exposure of the sector to the global economy. In case ratings of internal and external agencies are not similar then an investigation must be conducted to establish the causes for such differences. Also, bank should seek services of at least 2-3 independent auditors in evaluation of such projects so as to prevent chances of any possible collusion.
d) Use of latest technology: The data collection mechanism in banks is very archaic and needs a revision. The banks should employ the best available IT systems and data analytics in order to ensure effective implementation of the red flagged account (RFA) and early warning signals (EWS) framework suggested by the RBI, which would help in a better profiling of customers by analysing patterns of their transactions and rendering a near real time monitoring possible for banks. Also, we recommend that the Institute for Development and Research in Banking Technology (IDRBT) could consider incentivising development of relevant software for commercial banks at affordable costs. This is vital to enhance their monitoring of suspicious and fraudulent transactions within the branches of their banks.
e) Monitoring outlier movement at regional level: The RBI could consider extending its monitoring ambit and scope, and should monitor the outlier movements of transactions at regional level on the lines of SEBI’s circuit breaker, which might be effective in tracking the earliest possible signs of financial frauds.

Charan Singh

RBI Chair Professor

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