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Do Lenders Need To Tighten Scrutiny Of ‘End Use’ Of Bank Funds?

The Amrapali case, while among the more extreme instances of misuse of bank funds, is certainly not an outlier.

Numbers don’t add up. Source: BloombergQuint
Numbers don’t add up. Source: BloombergQuint

On July 23, the Supreme Court of India came down hard on lenders to the Amrapali Group.

The real estate developer delayed projects and left homebuyers stranded despite borrowing large sums of money from the banking system. Some of these loans, the court found, had been diverted from projects they were intended for.

“Had they (bankers) been slightly more vigilant to monitor and control transfer of funds, the management would have not dared to launder the money from one company to another according to their whims and fancies and the bankers are solely responsible for the negligence on their part,” the Supreme Court said of bankers led by Bank of Baroda and Syndicate Bank.

The court, in its order, said that in some cases money was diverted almost immediately after it was disbursed by banks. The order also spoke of connivance between bankers and company officials.

The Amrapali case, while among the more extreme instances of misuse of bank funds, is certainly not an outlier. Another such instance emerged when the Central Bureau of Investigation filed a First Information Report in the Bhushan Power & Steel Ltd case.

The Bhushan Steel FIR said that between 2007 and 2014, the company received over Rs 47,000 crore in loans from 33 banks. Out of this, nearly Rs 2,400 crore worth of funds were diverted out of the company’s accounts by the directors and staff. Rs 500 crore was diverted to 86 promoter owned entities without any explanation, the FIR said. Bhushan Power is currently undergoing resolution within the insolvency framework.

Instances such as Amrapali, Bhushan Power and many more have raised concerns about the extent of misuse of bank funds and pushed lenders into looking for ways to tighten scrutiny. The efforts are still work in progress.

Monitoring end-use of funds is definitely an issue the banking system is cognizant of. The industry is working on mechanisms to better understand the use of the loans granted to borrowers and also understand the underlying operations to see if there has been any diversion of funds.
VG Kannan, CEO, Indian Banks Association

How Common Is Misuse Of Bank Funds?

Judging the extent of misuse of bank funds is difficult.

However, loan frauds make up the largest part of frauds reported by banks each years. In 2018-19, frauds worth Rs 71,500 crore were reported. Over 90 percent of these frauds were related to ‘loans and advances’, the RBI said in its Financial Stability Report in June.

The December 2018 edition of the India Fraud Survey conducted by Deloitte also showed that siphoning-off or diversion of funds is still one of the most common types of fraudulent transactions.

Typically, banks face two types of frauds with respect to end use of funds.

The first is diversion of funds, where borrowed funds are used for purposes other than what the loan was sanctioned for, a consultant with a large consultancy firm explained, while speaking on conditions of anonymity. This could include using long-term loans for short-term expenses, repaying debt of another lender by borrowing for the project and using funds received for one project to meet the needs of another project.

The other type of fraud is promoters or directors siphoning-off funds from their consortium bank accounts to finance private needs. While this is less common compared to the first type of loan fraud, it’s also more difficult to track, since banks don’t always share information with each other, the consultant cited earlier said.

Regulations Exist; Compliance Challenging

Regulations are clear that the onus to monitor end use of funds lies with the banks. From time to time, the RBI has also asked banks to tighten scrutiny.

As part of its master directions on wilful defaulters released in 2015, the RBI asked banks to widen the scope of their monitoring of use of bank funds. The regulator suggested a host of ways in which end-use of bank funds can be monitored including:

  • Meaningful scrutiny of quarterly progress reports / operating statements / balance sheets of the borrowers.
  • Regular inspection of borrowers’ assets charged to the lenders as security.
  • Periodical scrutiny of borrowers’ books of accounts and the ‘no-lien’ accounts maintained with other banks.
  • Periodical visits to the assisted units.
  • System of periodical stock audit, in case of working capital finance.
  • A comprehensive management audit of the ‘credit’ function of lenders to capture any systemic weakness.

So why are bankers struggling to comply?

Bankers do not necessarily have the skill sets to adequately monitor the functioning of a corporate entity, said a senior public sector banker while speaking on condition of anonymity. As such, banks depend on statutory and independent auditors to study the company’s financials and businesses but there is no proper way to cross verify these reports, this banker said.

Former RBI Deputy Governor SS Mundra said that while monitoring of end-use of funds is important, banks can’t treat every transaction as suspicious. Banks have to rely on the judgement of specialist entities which are trained to do such monitoring.

You have to work with the idea that a borrower is innocent until proven guilty. Else, the system could become paralysed. Having said that, we do need better monitoring of sectors and individual entities to avoid fraud.
SS Mundra, Former RBI Deputy Governor

Ashvin Parekh, managing partner of Ashvin Parekh Advisory Services, agreed, saying that it’s public-sector banks that are lagging.

“Earlier, banking was purely trust-based. Now that’s changing and so is technology. So it would be some time before public sector bankers are able to be up to speed. Private banks have clearly shown that they are better at catching the customer’s pulse and sense whether he is genuine or not,” Parekh said.

What’s The Fix?

To combat misuse of bank funds, lenders are working on improving the response to early warning signals thrown up by fraud detection systems and also considering surprise audits of borrowers.

Bankers have come up with a list of agencies that can help them better monitor the end use of funds and the borrower’s businesses, Kannan of the Indian Banks Association told BloombergQuint. Lenders have drawn up a list of 78 such entities, which includes chartered accountancy firms and transaction advisory firms. Lenders can pick an entity from this list and determine the scope of monitoring.

A senior private sector banker, who spoke on conditions of anonymity, said lenders are also considering a framework under which they would share information regarding a borrower’s spending pattern. This would be along the lines of the RBI’s Central Repository of Information on Large Credits, which is used to monitor aggregate borrowing from the banking system. While this project is still in the early stages, such a system could help banks find out where the funds have moved once they have disbursed them, the private banker added.

State Bank of India Chairman Rajnish Kumar, however, believes banks can only do so much.

“How much oversight can bank do...The methods of lending will also have to undergo change. The consortium discipline or the multiple banking discipline has to be improved and there the regulator also has to play a role,”said Kumar on the sidelines of a recent event.