Frauds in the Banking Sector: Causes, Concerns and Cures

This article on ‘Frauds in the Banking Sector: Causes, Concerns and Cures’ by Stefy Maria Sebastian, a fourth year student from St. Joseph’s College of Law, Bengaluru focuses on the concept of bank fraud and the impact of bank fraud in India along with some case studies of notable scams in India.

“A billion here, a billion there, pretty soon it adds up to real money.”[1]

Introduction

Banks are essential financial institutions for the Indian economy. This sector has expanded in the recent years after the nationalization of banks in 1969 and the liberalization of economy in 1991. According to Section 5(b) of the Banking Regulations Act 1949[2] banking means “accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise”.

RBI, 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”.[3]

Bank fraud is defined as “planning to obtain property or money from any federally insured financial institution”.[4]

In the year 2019, State Bank of India was reported to have the highest number of frauds with 1,197 cases amounting to Rs. 12,000 crores. Allahabad Bank stood first where the bank’s own staff was involved in the frauds with 87 fraud cases followed by Central Bank of India and Punjab National Bank[5].

According to the RBI’s annual report for 2019-20 “bank frauds worth more than Rs 1.85 lakh crore were reported in the year ended June 2020 compared with over Rs 71,500 crore in the previous fiscal”.[6] Furthermore, “frauds have been mainly occurring in the loan portfolio (advances category), both in terms of number and value.

There has been a concentration of large value frauds, with the top 50 credit-related frauds constituting 76% of the total amount reported as frauds during 2019-20.” Public sector banks that witnessed a 234% year-on-year rise in fraud cases was responsible for 80% of the total such reported instances. Private Banks, which reported a more than 500% rise, formed over 18% of the total fraud cases.[7]

In the year 2020, The CBI has registered about 190 cases of bank frauds involving alleged misappropriation of money close to ₹60,000 crore. In about twelve cases, the companies and their top functionaries were accused of cheating the banks of more than ₹1,000 crore. The FIRs revealed that in over 70 cases, the prima facie misappropriated amount exceeded ₹100 crore.

From the above mentioned statics, we can observe that there has been a drastic rise of bank frauds in India. In this article, the author throws light on the concept of bank fraud i.e. the classifications and causes.

It highlights the most prominent bank scams committed in India like the Harshad Mehta scam, Vijay Mallya scam and the PNB scam. Furthermore, it emphasizes on the impact of bank fraud in India, the RBI measures and various legislations enacted to prevent the same.

Lastly, the author points out few recommendations supported by a conclusion to combat bank frauds in India.

Classification of Bank Frauds

The Reserve Bank of India classifies bank frauds in the following kinds[8] :

1. Misappropriation and criminal breach of trust.
2. Fraudulent encashment through forged instruments, manipulation of books of account or through fictitious accounts and conversion of property.
3. Unauthorized credit facilities extended for reward or for illegal gratification.
4. Negligence and cash shortages.
5. Cheating and forgery.
6. Irregularities in foreign exchange transactions.
7. Any other type of fraud not coming under the specific heads as above.

Frauds such as account opening fraud, cheque kiting, cheque fraud, counterfeit securities, computer fraud, loan fraud, money laundering fraud, letters of credit, advanced fees fraud are few other kinds of bank frauds committed by fraudsters.[9]

Causes of Bank Frauds

Some major causes of bank frauds are listed below.

1. Big loan advance frauds guide the bank staffs to cooperate with borrowers and third parties such as advocates or chartered accountants.
2. In such cases, the third parties abscond with the money and it is intractable for the banks to the prove the criminal intent of the third parties due to reasons such as lack of clear appreciation of legal matters to bankers, lack of expertise and legal advice on this subject, hesitant to reveal some sensitive data to courts or public domain etc.[10]
3. Self-regulatory bodies of advocates, auditors or accountants like the BCI and the ICAI do not generally punish their guilty minded members. Moreover, the cost of suing such individuals and extensive delay caused by courts often dissuade the PSBs.
4. Frauds also arise from the borrower’s side. Few companies take part in ‘high sea sales’ with investment from Indian banks. In most cases, these funds are either used for other purposes or it is not repaid after the sale has been made which eventually results in an NPA.
5. This breach of contract is considered as fraud since the funds were not utilized for the purpose they were initially taken and based on the project reviewed by the banker.
6. Margins, profitability, and shareholders expectations being under strain, the management passes on to the middle management who in turn transmit the same to the line staff. These staffs may use malicious ways to achieve their respective targets.[11]
7. Poor internal control systems increase the risk of frauds. Internal control symptoms includes poor control environment, lack of segregation of duties, physical safeguards, independent checks, proper authorizations, proper documents and records, the overriding of existing controls, and an deficient accounting system.
8. Some organizations even if they have well versed educated managers, there may be absence of suitable systems to give the necessary signals when a loan turns bad, or a KYC has not been adhered.[12]
9. New technologies adopted by banks increases various risks such as phishing, identity theft, card skimming, vishing, viruses and trojans, spyware and adware, social engineering, website cloning and cyber stalking.
10. Banking transactions today have shifted to debit/ credit cards and to electronic channels and all these alternate channels are being promoted by commercial banks to reduce the pressure on branch banking.

Bank Scams: Disastrous Scenario for Indian Economy

“He’s a businessman I’ll make him an offer he can’t refuse.”[13]

1. Harshad Mehta scam

Harshad Mehta, manipulated the Bombay Stock Exchange along with his partners by taking advantage of loopholes in the banking system.[14] He allegedly cooperated with bank employees to get fake bank receipts issued. These BRs were used to get other banks to lend him money under the impression that they were lending against government securities.

Altogether, Mehta cheated the banks of nearly Rs 4,000cr. Later, when his mode of operation in the stock market was exposed, banks realized that they were in possession of fake BRs holding no value.

After the due course of legal proceedings Mehta was convicted by both the Bombay High Court and the Supreme Court and charged him with 74 criminal offences.

The Harshad Mehta scam paved way to many changes in India’s financial regulatory system. In 1995, the Securities Laws (Amendments) Act was passed which expanded the SEBI’s jurisdiction and allowing it to regulate depositories, FIIs, venture capital funds and credit-rating agencies.

2. Vijay Mallya scam

The fraud amount involved in this scam was Rs. 9,432cr. Till February 2018, the Kingfisher Airlines owned by Mallya had borrowed this amount from 13 banks, in which the biggest lender was the SBI who lent Rs. 1600cr, followed by Punjab National Bank with Rs. 800cr, IDBI with Rs. 650cr and Bank of Baroda with Rs. 550cr.[15]

In November 2015, it was discovered that, Mallya had borrowed an amount of $1.35 billion from Indian banks. In March 2016, several banks approached the Supreme Court of India and pleaded before the Court to stop Mallya from going abroad as his companies owe a huge debt to the banks, later on, a non-bailable arrest warrant was issued by the Court against Mallya.

This case is unique as an individual alone had managed to borrow enormous amount of money from many banks.

3. PNB Scam

A fraud worth Rs 11, 400cr was discovered at a single branch in Punjab National Bank located Mumbai. The bank discovered that two of its employee’s deputy manager Gokulnath Shetty and clerk Manoj Kharat repeatedly issued Letters of Undertaking (LoU) to Nirav Modi’s companies without following the processes[16].

Nirav Modi and his companies allegedly leveraged those LoUs in Hong Kong to secure buyers’ credit from the local branches of Allahabad Bank, Union Bank, Axis Bank, Bank of India, State Bank of India. They issued the LoUs and informed these branches through the international cash transfer service called SWIFT.

They knew that PNB had not integrated its SWIFT network with the bank’s core banking network. They refrained from recording these transactions in the bank’s own system. The fraud came into light when the officials from three diamond firms approached the PNB officials for a bank credit to import rough stones from overseas.

On February 5, 2018, the CBI launched an investigation into the alleged scam. On June 25, 2018, the ED approached a special court in Mumbai seeking Nirav Modi’s extradition. On august 3, 2018, the Indian government transmitted a request for extradition of Nirav Modi to the UK authorities.

On March 20, 2019 Nirav Modi was arrested in London and was produced before the Westminster court, which denied him bail. The UK court pronounce the judgement in Nirav Modi’s extradition case on February 25,2021 and held that Nirav Modi can be extradited to India to face charges of fraud and money laundering.

Impact of Bank Frauds in India

Many recent frauds are related to fix deposits, loan disbursements, credit and debit card frauds and ATM based frauds. All these frauds undermine the profits, reliability of services, operating efficiencies and can also have an impact on the society and the organization itself.[17]

The rise in the NPA is a serious threat to the Indian Banking Industry which will reflects the distress of borrower and the inefficiencies in the transmission mechanism.[18] Fraud also diminishes the growth of the establishment / industry.

It hampers the business sector and underlying factor to all human endeavors. It also increases the corruption level of a country. Even though various measures are taken by the RBI to limit or decrease the frequency of frauds, the amount of money lost is still on the rise.

Legislations enacted in India to prevent Bank Frauds

The legislations enacted to prevent bank frauds are: –

1. The Indian penal code,1860[19]
2. The Negotiable Instruments Act,1881[20]
3. The Reserve Bank of India Act,1934[21]
4. The Banking Regulation Act,1949[22]
5. Criminal procedure code,1973[23]
6. SARFAESI Act,2002[24]
7. Insolvency and Bankruptcy Code, 2016[25]
8. Fugitive Economic Offenders Act, 2018[26]

Legal Entity Identifier (LEI)

LEI has been introduced by the RBI to scrutinize and prevent banking frauds[27]. LEI was established because money laundering takes place through a big network of companies situated at different locations and thus makes it complicated to keep a check on the company’s transactions.

YH Malegam Committee

The RBI constituted YH Malegam Committee[28] to investigate matters relating to bad debts as well as the effectiveness of audits, rise in the number of cases related to fraud and the classification of bad loans. This committee was headed by the former member of the RBI’s Central Board of Directors, Y.H. Mangalam.

National Financial Reporting Authority (NFRA)

NFRA is constituted under Section 132 of the Companies Act, 2013[29]. The aim of setting NFRA was to set an independent and separate regulatory authority that could assist in enforcing and implementing laws related to accounting and auditing and secondly, to improve the confidence of the public and investors in the entity’s financial reporting.

Measures taken by RBI to prevent Bank Frauds

RBI has set up fraud monitoring cell on June 2016[30] and has directed all banks that fraud risk management, fraud monitoring and fraud investigation function must be owned by the bank’s CEO, Audit Committee of the Board, and the Special Committee of the Board, at least in respect of large value frauds.[31]

A few guidelines ensured by RBI to prevent bank frauds are:-[32]

1. Introduce certain minimum checks and balances like introduction of two factor authentication in case of “card not present” transactions.
2. Converting all strip-based cards to chip-based cards for better security.
3. Issuing debit and credit cards only for domestic usage.
4. Putting threshold limit on international usage of debit/credit cards.
5. Constant review of the pattern of card transactions in coordination with customers; and
6. Send SMS alerts in respect of card transactions, etc., to minimize the impact of such attacks on banks as well as customers.

Recommendations

1. Re-KYC, if done carefully helps to check any fraudulent activities especially on the liability side.[33]
2. Banks should also focus on know your markets. There should be a 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.
3. A special fraud monitoring agency should be established in banks with highly trained officials. A specialized investigating agency is also needed with expertise from agencies such as CBI, RBI, SEBI, and commercial banks.
4. New cases of fraud should be informed to all officials of the bank. Currently, with each bank having their own intranet system for communication, a simple mailer with the names of the officers / parties morphed may be disseminated.
5. Learning sessions for employees on early fraud detection and prevention should be imparted to staff on regular basis.
6. Banks should establish cyber risk management programs to achieve three vital capabilities namely the ability to be secure, vigilant, and resilient.

Conclusion

Banks and financial institutions are inherently fraud – prone. It may not be possible to have a financial system in which no irregular transaction takes place. With computerization and screen based scriptless transactions, there will be more scope for irregularities of highly sophisticated nature, which will be very difficult to be detected however, immediate corrective action must be taken.

The experience of financial frauds and scams clearly points out the area for policy changes and systematic changes in the financial system. Ensuring an adequate legal framework for economic offences is an immediate necessity.

We need a strong will and determination to effectively implement the lessons drawn from the experience and ensure transparency and accountability in the financial system. This is the only way to avoid scams and frauds in the future. Making mistakes is understandable. But not learning from mistakes is unpardonable.

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Reference

[1]Everett Dirksen, US Senator.

[2] Banking Regulation Act, 1949, § 5(b), No. 10, Acts of Parliament, 1949 (India)

[3]“Fraud in the banking sector – causes, concerns and Cures”, speech by Dr K C Chakrabarty, Deputy Governor of the Reserve Bank of India, during the National Conference on Financial Fraud organised by ASSOCHAM, New Delhi, 26 July 2013, Available Here

[4]Chanchal Sharma, Sapna Yadav, Monika Rani, Bank Frauds- Types and Prevention INTERNATIONAL JOURNAL OF RESEARCH, Available Here

[5]Aysuh Verma, “Acquainting with the recent banking frauds and laws encompassing them” I PLEADERS, Available Here

[6]Adavait Rao, RBI Annual Report 2019-2020: Bank Frauds more than double, BLOOMBERG, Available Here

[7] Id. at 2.

[8] Id. at 1.

[9]Dr. Anil Dogra, BANKING FRAUDS IN INDIA: CASE STUDIES OF NIRAV MODI AND VIJAY MALLYA CASE, International Journal of Creative Research Thoughts (IJCRT), Available Here

[10] Charan Singh, Deepanshu Pattanayak , Divyesh Satishkumar , Kiran Antony , Mohit Agarwala , Ravi Kanta, WORKING PAPER NO: 505 Frauds in the Indian Banking Industry, IIMB-WP N0. 505, (pg.14), (2016), Available Here

[11] Dr. Sukhamaya Swain, Dr. Lalata K Pani, Frauds in Indian Banking: Aspects, Reasons, Trend-Analysis and Suggestive Measures, International Journal of Business and Management Invention, (Volume 5 Issue 7), (July 2016),(Pg 6), Available Here

[12] “KYC – compliance vs convenience”, speech by Mr R Gandhi, Deputy Governor of the Reserve Bank of India, at the Federation of Andhra Pradesh Chambers of Commerce and Industry, Hyderabad on 23-May 2014.

[13] Mario Puzo, The Godfather

[14] Nishant Kumar, Harshad Mehta scam: 10 key points of the scam that jolted India in 1992, MONEYCONTROL, Available Here

[15] Id.at .2.

[16] India TV, Available Here

[17] Id. at.1.

[18] Ainsley Granville Andre Jorge Bernard, Brahma Edwin Barreto, Rodney D’Silva, Impact of Frauds on the Indian Banking Sector, International Journal of Innovative Technology and Exploring Engineering (IJITEE), Available Here

[19] The Indian penal code,1860, No. 45, Acts of Parliament, 1860 (India)

[20] The Negotiable Instruments Act,1881, No.26, Acts of Parliament, 1881 (India).

[21] The Reserve Bank of India Act,1934, No.2, Acts of Parliament, 1934 (India).

[22] The Banking Regulation Act,1949, No.10, Acts of Parliament, 1949 (India).

[23] Criminal procedure code,1973, No.2, Acts of Parliament, 1973 (India).

[24] SARFAESI Act,2002, No.54, Acts of Parliament, 2002 (India).

[25] Insolvency and Bankruptcy Code, 2016, No.31, Acts of Parliament, 2016 (India).

[26] Fugitive Economic Offenders Act, 2018, No.17, Acts of Parliament, 2018(India).

[27]Reserve Bank of India, Available Here

[28] Sana Gangwani, Report Summary Malegam Committee on Microfinance (January 2011), PRS legislative Research, Available Here

[29] National Financing Reporting Authority, https://nfra.gov.in/about-us, (Apr 27th, 2021,12.40pm)

[30] “RBI sets up fraud monitoring cell”, news article of Economic Times (22-Jun 2016).

[31] Id. at. 3.

[32] Circular No. DBS.FrMC.BC. No. 1/23.4.001/2013-14.

[33] Id.at.3.

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