Insufficient pre-sanction due diligence and inadequate monitoring has allowed borrowers to siphon money
The gross non-performing assets (NPAs) of the Indian banking sector stood at a staggering Rs 3.4 lakh crore on September 30, 2015. Indian banks’ NPAs have surged rapidly over the last 4 years with gross NPAs rising from 2.36% in March 2011 to 5.1% in September 2015. The sector’s stressed assets (GNPAs plus restructured standard advances) are currently estimated to be Rs 7.5 lakh crore, or 11.3% of total banking sector assets.
While the economic slowdown has affected the debt repaying capability of the corporate borrowers, analysis by Kroll, reveals that insufficient pre-sanction due diligence and inadequate portfolio monitoring has allowed borrowers to divert funds to unrelated activities and siphon money, resulting in defaults. A large proportion of NPAs is on account of wilful defaults—which means the corporates and/or their promoters have the ability to repay but have chosen to default. One analysis of public sector banks suggests that there are more than 7,000 wilful defaulters who owe nearly Ra 59,000 billion ($9 billion) and constitute ~22% of their gross NPAs .
Once a company defaults on its debt, banks find it difficult to assess if the default is wilful. While banks collect information about the performance of the borrower on an ongoing basis as part of their credit monitoring process, when the economic environment is fragile, promoters take cover of weak demand and declining profitability to delay making payments to banks. However, there are indicators which, if monitored closely, can help the bank identify ‘red flags’ that warrant a deeper assessment of the borrower. Kroll’s latest edition of the Global Fraud Report indicates that companies face an increased risk of fraud from within and hence it is important for a bank to ensure that there are adequate layers of checks in their systems to identify fraud.
When a borrower is suspected of conducting fraud, the branch should immediately alert the senior team, gather all the information available on the account and highlight any inconsistencies in the accounts. In such times, often promoters do not provide reliable financial information to banks about the true status of their operations. In such cases, banks can use a specialist firm to conduct a discreet, “outside-in” external investigation of the company. This can provide useful indications of poor business practices or malfeasance on the part of the company, the promoter’s reputation in the market, potential conflicts and their assets; and whether the promoter has been involved in fraudulent practices.
When a company has already defaulted, the bank will have to follow the existing regulatory and legal process to recover its money. While this process can take many years, banks do have a way out. In India, it is a common practice for promoters to issue personal guarantees to banks as part of the security mechanism and loan documentation which means the promoter becomes personally liable to repay to the banks. In such scenarios, banks can try to identify unencumbered personal property of the promoter against which they can recover their dues. Asset searches are complex and require on-the-ground intelligence gathering to identify different forms of assets which are either directly owned by the promoters or held by close confidantes on their behalf. A bank’s ability to identify such unattached assets can enable them to have an “upper hand” when negotiating revised terms with the borrower.
The increased incidence of corporate frauds in India also reflects potentially weak corporate governance standards of borrowers, inadequate credit risk management capabilities of banks and the inability of lenders to take legal recourse due to what is often perceived as a tedious and unwieldy judicial process. In Kroll’s experience, offenders tend to cover their tracks with false documentation that appear genuine and do not raise alarms at the pre-sanction stage. Banks can avoid or mitigate the risk of falling a prey to such misrepresentation by conducting in-depth and independent due diligence on the borrower. Indian promoters closely manage their business and it is important for banks to understand the operating principles of the promoters, their integrity and overall governance standards of the company. This would involve being aware of the background of the promoters and the company, understanding the inter-group linkages and investigating recent performance related red flags that are identified during credit assessment. It is also critical that banks select due diligence providers on a “no compromise basis” to ensure that such providers are truly independent and the integrity of the due diligence process is maintained. It may not be possible for banks to do this on every account but may be necessary for loans above a certain size or of a certain risk profile.
A thorough assessment at pre-sanction stage is a job half done. It is equally important to monitor the performance of the company post disbursement. Most banks rely on the data shared by the borrower and do not ask too many questions as long as the loan is being serviced on time. This is not enough and it is important for the credit officer to keep an eye on the red-flags. Banks should take an active and investigative approach to understanding the on-going business practices and controls in the company and use various fraud prevention tools to protect their interests. Robust fraud identification and fraud management processes help identify fraud at an early stage and can prevent accounts turning into NPAs. A combination of these actions may provide banks a good start to address India’s NPA problem.
The author is MD (investigations and dispute practice), Kroll