RBI's Approach To Bank Fraud Has Changed, And That Is Important

Why? Because the guidelines did not specify whether banks should hear the borrower before they classify an account as fraud. Under the 2016 rules, a bank or a group of banks could simply put on a fraud tag on a borrower if they found evidence of impropriety in a forensic audit.

Such a tag had serious implications for the borrower, because a fraudulent borrower cannot access institutional finance, for at least five years after the dues are paid back. Even after this cooling period, lenders have the liberty to deny loans to the borrower. The Supreme Court called it "blacklisting" of such borrowers in its order, adding that a personal hearing would be essential.

After over a year in waiting, the RBI has released its revised guidelines in the matter. While the new norms are mostly the same as the 2016 ones, there are some significant departures, which will affect the future of fraud classification in India.

While the previous guidelines were more inward looking—focussed on the lender's ability to detect and report frauds—the new norms have considerable room for the other side of the equation, the borrowers.

RBI has mandated that lenders must issue a show cause notice to the concerned borrower. The notice must go to the concerned companies, their promoters, whole-time and executive directors, apart from any other linked firms. The notice must detail the transactions, actions and events, basis which declaration and reporting of a fraud is being contemplated.

These recipients must get at least 21 days to respond to the notice. The lender must then examine the responses and submissions, before passing a reasoned order. The order must have all relevant details, including the findings and responses by the concerned borrower.

None of these rules were present in the older norms.

The new norms also suggest that within 180 days after an account is red-flagged, the lenders must decide to classify it as a fraud or remove the red flag. They must also conduct an external or internal audit in the case to record relevant findings.

The previous norms specified timelines on how soon lenders must meet and decide to start a forensic audit, when such an audit should be concluded and how soon lenders must take action. So, to that effect, the new norms are a little more lax.

Another material change is the creation of an effective monitoring and risk mitigation system. The lender must constitute a special committee to monitor and follow-up cases of fraud, under the new norms. This committee must include at least three members, with one whole-time director and two independent non-executive directors. One of the independent directors should lead the committee.

In the 2016 norms, this committee was a five-member group, including the MD and CEO and members of audit committee of the board. The new norms have eased these rules, however, the duties of this group remain pretty much the same.

The new norms suggest that public sector banks must inform the Central Bureau of Investigation, along with the state police, only if the fraud amount is higher than Rs 6 crore. This threshold is higher than the previous norm of Rs 3 crore and above.

Apart from the material changes listed above, there are some problem areas which raise concerns.

The 2016 norms state that in case of multibanking or consortium lending arrangements, all banks must work toward "co-ordinated action". This action must be based on commonly agreed strategy, for legal or criminal actions, follow-up for recovery, exchange of details on modus operandi, achieving consistency in data or information on frauds reported to RBI.

The new norms are silent on this topic. The regulator specifies individual action and responsibility on the lenders' part. Does this mean that lenders are no longer required to build consensus before acting against a borrower?

On the one hand, this will address administrative delays in classifying frauds. While on the other, it may lead to ad-hoc actions by some lenders, which becomes a headache for others.

Another issue is the argumentative Indian promoters. Over the last few years of the Insolvency and Bankruptcy Code, it has become clear that any legal move by the lenders against an errant borrower is immediately met with frivolous and long-running lawsuits. This leads to excessive delays in resolution of the issue and eventual recovery of dues is minimal.

If, under the new norms, lenders are required to pass a reasoned order, it will be subject to scrutiny by a court. Not that borrowers could not approach the courts even under the previous norms, but now they have a piece of paper to support their claims. This could lead to further legal complications for the lenders involved and delay proceedings.

So, in totality, are these guidelines a good or bad development? That depends on who you ask. For the borrowers, more representation is good. For lenders, a more cumbersome process and taking principle-based judgements might be tough.

But for the RBI, it has had to tone down its previous guidance on fraud risk management.