How RBI can prevent frauds

Historically, the RBI has tried to keep the crooks at bay by issuing a circular a day.
What it needs is more onsite supervision.
Merely checking high-frequency data with the help of technology is insufficient, notes Tamal Bandyopadhyay.

After M Rajeshwar Rao took over as its fourth deputy governor recently, the Reserve Bank of India reshuffled the portfolios of its deputy governors.

Rao will oversee regulations and risk monitoring; supervision will remain with M K Jain; M D Patra will continue to have the monetary policy department under him; and B P Kanungo, the most senior of the four, will have currency, foreign exchange and debt management, information technology and payments and settlements in his portfolio.

Meanwhile, we have not heard the latest on the central bank's plan to create a specialised supervisory and regulatory cadre.

The decision to restructure the regulation and supervisory functions was taken at the RBI's central board meeting in March 2019.

It seems that the RBI has not been pushing for it at the moment.

The emphasis on strengthening regulation and supervision was a fallout of the growing incidents of fraud in the Indian banking industry.

In 2015, 4,639 cases of fraud involving Rs 19,455 crore were detected.

The comparable figures for financial year 2020 are 8,707 cases and Rs 185,644 crore.

Of course, these figures relate to incidents of fraud that were detected in a particular year; typically, there is a lag between a fraud taking place and its detection.

The debate on well-rounded central bankers versus specialists in chosen areas is as old as the RBI itself.

At the initial stage, the focus was on specialisation.

During the first decade after its inception in 1935, the RBI had three departments: Banking, issue and agricultural credit.

The last one was trifurcated into three divisions in August 1945.

The exercise of regrouping the departments and setting up new groups continued till 1965.

More than a decade later, in 1978, the RBI abolished the group-wise system of seniority and opted for a combined seniority for certain segments with retrospective effect.

A section of employees challenged this in the Supreme Court but the petition was quashed.

For at least the past four decades, the RBI has been focusing on generalisation.

The recent attempt to return to specialisation has faced stiff resistance from its employees.

A balance between specialisation and generalisation needs to be struck as there is a trade-off between creating a holistic view and specialisation, which runs the risk of missing the woods for the trees.

Career central bankers have usually been the jack of all trades and master of some.

Some RBI employees feel they will miss out on exposure to different facets of running a full-service central bank, while others are weighing the risks of the new department morphing into a separate entity carved out of the RBI.

The trigger for the move is the flak that the RBI has got for a series of large, high-profile frauds that hit the financial sector.

It started with Punjab National Bank.

And while the RBI was still grappling with it, the Punjab and Maharashtra Cooperative Bank went belly up.

The Enforcement Directorate said in its prosecution complaint that the Housing Development & Infrastructure Ltd had laundered at least Rs 2,500 crore of the Rs 6,700 crore that the company had taken as loan from PMC Bank between 2007 and 2013.

We all know what has happened at Infrastructure Leasing & Financial Services, Dewan Housing Finance Corporation Ltd and Yes Bank Ltd.

Historically, the RBI has tried to keep the crooks at bay by issuing a circular a day.

What it needs is more onsite supervision. Merely checking high-frequency data with the help of technology is insufficient.

Earlier, onsite supervision was the mainstay of RBI supervision; it has been reduced and replaced by reliance on offsite inspection, which essentially consists of tracking data -- daily, weekly, fortnightly, monthly.

Onsite supervision must be done across India and not restricted to bank headquarters alone.

The assumption that everything is centralised in all banks (because they have a centralised processing system) may not be correct.

The regional offices and select branches must also be put under the scanner.

Earlier, onsite supervision was theme-based, across banks -- with a focus on treasury, priority sector lending, and so on.

That must be restored along with city-specific and geography-specific scrutiny of bank practices.

The RBI used to carry out transaction testing, but stopped after it set up a new supervisory framework -- Supervisory Programme for Assessment of Risk and Capital -- based on the recommendations of a high-level steering committee for the supervision of commercial banks.

Following this, the RBI shifted to the so-called risk-based supervision (RBS) -- a rather complex model.

In the first phase of the roll-out, 29 banks were brought under the framework from the financial year 2013.

The revised framework -- which underscores a comprehensive evaluation of both present and future risks, identification of incipient issues, determination of a supervisory stance based on the evaluation, and facilitating timely intervention and corrective action -- marks a radical shift from the earlier CAMELS supervision, which was compliance-based and oriented towards transaction testing.

Under CAMELS, the banks were grouped into five categories, based on their business model.

This consisted of SBI, other public sector banks, old private banks, new private banks and foreign banks for the purpose of supervision.

In the new supervisory regime, the banks were re-grouped, based on homogeneity.

For instance, Citibank, Standard Chartered and HSBC had earlier been grouped as foreign banks; under the RBS, they migrated to the group of medium-sized banks.

Historically, the RBI has been an onsite, inspection-heavy and offsite, supervision-light regulator.

The RBS has reversed the trend.

Along with this, the focus has shifted from onsite inspection to offsite supervision and the transaction testing samples have shrunk.

The inspections have been made mostly headquarter-oriented and all designated foreign exchange and treasury branches, administrative offices and sensitive branches, which were under the scanner of onsite inspection, have been excluded.

The upgrade of the offsite surveillance system is welcome, but it should not have coincided with the dilution of the rigour of onsite examination.

The challenge is how to create capacity, with continuity and convergence between offsite supervision and onsite inspection.

Only data analytics and transaction testing can red-flag impending dangers.

Closer coordination with the capital market regulator to track the flow of funds across the financial system will also help.

Tamal Bandyopadhyay, a consulting editor with Business Standard, is an author and senior adviser to Jana Small Finance Bank Ltd.