The data released by Reserve Bank of India (RBI) in its latest financial stability report of December 2018 (FSR 18) on the bulging volume of bank frauds is a matter of serious concern. It underscores the need for introspection on the part of the government of India (GoI), RBI and bank managements.
Bank frauds, a serious concern
Let us first look at the highlights of the data on frauds. Those of serious concern are:
a. There is spurt in the incidence of frauds and, particularly, large value frauds are rising;
b. Public sector banks (PSBs) continue to lead the pack;
c. Loan related frauds dominate the scene.
The data provided in FSR 18 is instructive. As shown in the accompanying Table, frauds are continuously rising. Out of a quantified amount of Rs10,171 crore during FY13-14, credit-related frauds accounted for as much as Rs8,412 crore (82.71%), and it rose consistently. In FY17-18, the amount involved in fraud was Rs41,168 crore, of which credit-related frauds were of the order of Rs22,559 crore (54.8%). There was a decline in the share, though. But the next half year saw it shooting up to 94.51%. Contrast this with the total paid-up capital of all PSBs amounting to Rs24, 312 crore as on March 2017, and we can perceive the gravity of the risk.
Table: Frauds reported during the past 5 years and H1FY18-19
(amount involved Rs1 lakh and above)
While loans accounted for the highest volume of frauds in terms of amount, during FY17-18 off-balance sheet operations hit a new high at Rs16,288 crore (from Rs63 crore in the previous year) out of a total of Rs41,168 crore (from Rs23,934 crore in the previous year) thanks to the Nirav Modi case that shook the banking sector.
The data published in FSR 18 is not new; much of the information was already in public domain in the form of the earlier FSR 17, RBI’s annual report 2018 and RBI’s report on the trend and progress of banking in India FY17-18. A recent Central Vigilance Commission’s report on 100 top frauds in banks had also highlighted some of the features of the frauds in the PSBs. (Read: The October Vigilance Ritual in Public Sector Banks
FSR 18 lists poor risk management and inadequacy of audit functions as two major factors responsible for the situation.
Poor Risk Management
A major thrust of banking reforms during the past two decades was on proper risk management. RBI concedes that fraud is a proxy for realised operational risk. It is pertinent to recall that after Narasimhan Committee II, risk-based supervision (RBS) became a key strategy to enhance the performance efficiency of the banks.
The Basel Committee had identified seven categories of risks coming under operational risks. Two among them were internal and external frauds. That implied that risk-based supervision was needed to give focused attention on prevention and mitigation of frauds.
To improve the quality of supervisory processes and techniques, RBI had set up a high level steering committee (HLSC) in 2012 under the chairmanship of the then deputy governor Dr KC Chakraborty. The HLSC had emphasised on the need to go into the techniques of supervision, rather than regulatory compliance.
The succession of reports on frauds leads to the conclusion that despite the best of intentions of RBI, banks are yet to translate them into result-oriented actions.
Inadequacy of Audit Framework
The regulator also points out the inadequacy of audit framework—both internal and external. Over years, efforts have been made to strengthen the internal checks on loan sanctions, disbursements and post-disbursement monitoring. If these systems were in place, the risks would have been mitigated. An example will corroborate this argument.
The FSR explains about the frauds in the form of property being mortgaged to multiple lenders in cities like Mumbai. Every bank has a system of legal audit through which at the pre-sanction and pre-disbursement stages the title to the property, the genuineness of the title deeds and the charges, if any, already created could be checked. What I gather from knowledgeable sources within the banks is that much of this job is now outsourced to external agencies. To what extent the agencies undertake the due diligence required is a matter of speculation.
The less said the better about the internal audit. The system of deadlines given to the internal staff and their vulnerability to pressures from the sanctioning authorities to soft-pedal the shortcomings noticed have considerably diluted the efficacy of otherwise a powerful tool of monitoring the credit portfolio.
We need to remember that, at the highest level of every bank there is the audit committee of the board, which has an RBI director, an executive director and a chartered accountant director as its members. Its role is to review the periodic audit reports and prescribe corrective measures. Surely the consequences of poor risk management measures cannot escape scrutiny by such eminent people.
What Needs to Be Done?
In view of the inadequacy of RBS in mitigating the operational risks, RBI suggests what it calls promotion of a ‘risk culture’ in banks. It encompasses values, accountability and a culture of openness.
Elaborating on values and behaviour, RBI thinks that the employees will generally behave in the way they perceive the expectations of the organisation; but that may not necessarily promote a value system. Harmonising the business model of the institution with the employees’ expectation becomes crucial. Is the RBI suggesting that means are as important as ends?
Accountability has long been a contentious issue with scapegoats being made to pay for the unscrupulousness of the decision-makers. The finance minister in a recent reply to a parliamentary question is on record that around 6,000 officers of PSBs have been held accountable for frauds with varying degrees of penalties ranging from dismissal to stoppage of increments. We have no data on how many actual decision-takers have been penalised for their fraudulent decisions. RBI is candid in saying that there is no transparency in fixing the responsibility, and urges the need to fix accountability on the decision-makers.
It is on the issue of cultural traits that the RBI makes observations of considerable contemporary relevance. I quote the statement verbatim:
Cultural traits such as openness, ability to speak up – more importantly, the safety nets to ensure early acceptance and acknowledgement of mistakes and learning from them, foster psychological safety and are said to nurture healthier cultures and tend to be better at addressing wrongdoing and avoiding dysfunctional behaviour in an organisation… A good organisational culture not just ensures that good people don’t do bad things; it enables good people to do better things.
A very laudable statement indeed! The practical difficulty, however, is in carrying out these wishes. Take for instance the ‘ability to speak up’: the scheme of whistle–blowing introduced by the Central Vigilance Commission some time ago is yet to be firmly established and the internal machinery does not encourage the employees to speak up.
That brings us back to the major issue unattended, namely, corporate governance reforms. Building an organisational culture is a Herculean task as it is a long drawn project. Such a project has to begin with concrete reforms in governance. A whole gamut of reforms encompassing the selection of boards, the appointment of CEOs, fixing of accountability at the top level for non-performance and a complete overhaul of human resources management systems is overdue. There is no indication of any such measure as yet. With GoI pushing ahead with its agenda of a contentious merger of three PSBs, the pressing issue of governance reforms is pushed to the backburner.
And there will be no surprise if FSR 19 repeat the advices given in FSR 18.