By Sara Sundaram and Somesh Lund

The Reserve Bank of India’s (“RBI”) revised Master Direction on Fraud Risk Management, issued in July 2024, has added another layer of complexity to the existing challenges of stringent compliance for banks regarding fraud management. 

While the regulatory intent is to curb financial misconduct, the updated directives place considerable demands on banks to strengthen their fraud prevention and investigation mechanisms, which will necessitate significant resource allocation.

Enhanced Fraud Management Structure in Banks and NBFCs

The revised Master Directions envisage that banks and select NBFCs implement a comprehensive framework for fraud detection and investigation, overseen by a Special Committee of the Board. Additionally, the directions also mandate enhancements in the Early Warning Signals (“EWS”) systems for timely fraud detection.

For many Banks and NBFCs, particularly smaller institutions like Regional Rural Banks or new-age Small Finance Banks and Payments Banks, setting up such a structure will be a massive undertaking. These requirements have also been extended to NBFCs. 

In light of these directions, the need for trained professionals to investigate loan accounts and examine red-flagged accounts cannot be overstated. Institutions will be required to allocate substantial resources, not only in manpower but also on technology and training, to meet the RBI’s new standards.

Improving Investigation Quality

Banks are now required to conduct rigorous investigations into accounts suspected of fraud, which may include hiring external auditors/forensic investigators. The directions mandate that these investigations be thorough, objective and timely to ensure that the root cause of fraud is identified and addressed. The current reality of prolonged fraud investigations, incomplete findings, or delayed conclusions must give way to a more proactive, forensic and technology-based approach.

Internal audit and risk teams also play a crucial role under the directions, which emphasisze the importance of early fraud detection through mechanisms like EWS and red flagging of accounts. The audit process must scrutinise potential weaknesses in a bank’s risk management framework and detect gaps in internal controls. 

Banks to issue Show-Cause Notices prior to tagging accounts as fraud

Perhaps the most significant change for customers, particularly corporate borrowers, is the introduction of show-cause notices as part of the fraud designation process at banks. The RBI has mandated that banks must issue a detailed Show-Cause Notice (“SCN”) to entities before classifying their accounts as fraudulent. 

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This aligns with the principles of natural justice, offering borrowers a chance to defend themselves and be heard before being tagged as fraud accounts. The move is aimed to shift away from the current process, where banks could unilaterally tag an account as fraud. 

From a customer perspective, the issuance of SCNs ensures greater transparency and fairness in the fraud classification process. Banks can no longer arbitrarily mark accounts as fraudulent without complete due diligence/investigations. 

Further, the directions ask banks to provide a minimum 21-day window to borrowers for responding to the SCN. This procedural safeguard is especially important in cases where discrepancies in loan documentation or market volatility, rather than intentional fraud, might have triggered the red flagging.

The banking sector should view this as an opportunity to enhance customer engagement and trust. Instead of rushing to penalise borrowers or trigger legal processes, banks must establish a responsive, transparent and technology-driven mechanism for issuing these SCNs. The involvement of independent directors and the creation of a reasoned order for declaring fraud will provide an additional layer of accountability and prevent accounts from erroneously being tagged as fraud.

The Long-Term Benefits of Compliance

While compliance with the RBI’s 2024 Fraud Risk Management Master Directions will undoubtedly increase the operational burden on banks, the long-term benefits outweigh the immediate challenges. Borrowers and customers can have greater confidence in the system, knowing that they are afforded transparency. 

We will likely see a surge in banks’ investments in fraud risk management capabilities to modernise their fraud management and investigation process. Further, this shift will push banks to develop more robust fraud management and investigation frameworks potentially leading to a reduction in frauds.

(The authors: Sara Sundaram is a partner and Somesh Lund is a consultant at Cyril Amarchand Mangaldas. Views expressed are the authors’ own and not necessarily those of financialexpress.com.)