A New Dawn in Banking Transparency: RBI’s Revised Directions on Fraud

Introduction

In a landmark move, the Reserve Bank of India (“RBI”) has issued a revised set of directions aimed at bolstering the transparency and accountability of commercial banks in declaring borrower accounts as “fraud.” This initiative addresses the growing number of legal challenges against banks’ declarations of fraud and the widespread dissatisfaction among borrowers and stakeholders regarding the opaque way these declarations have been handled.

Historically, fraud declarations by banks have often been perceived as arbitrary and unilateral, arguably resulting in significant financial and reputational damage to borrowers without providing them with an adequate platform to defend themselves. This lack of transparency has led to numerous legal challenges and public outcry. The Supreme Court of India’s ruling in State Bank of India v. Rajesh Agarwal (2023) emphasized the necessity of integrating principles of natural justice into the banking sector, setting the stage for the RBI’s proactive measures.

Key Features of the New Circular

The revised circular from the RBI introduces several significant measures designed to ensure fair and transparent procedural adjustments, signalling a fundamental shift in the way banks operate with respect to fraud declarations:

1. Incorporation of Natural Justice Principles: Banks are now mandated to provide detailed information on the basis for initiating fraud declarations within the Show Cause Notice (SCN) itself. This move ensures borrowers are fully informed about the reasons behind the fraud declaration and can prepare an effective response. This aligns with the Supreme Court’s emphasis on natural justice principles, ensuring that borrowers are not blindsided by sudden declarations.
2. Adequate Response Time: A 21-day period is granted to borrowers to respond to the SCN. This timeframe ensures borrowers have sufficient time to gather evidence, consult with legal advisors, and present their case comprehensively. By providing an adequate response period, the RBI aims to prevent hasty decisions that could unfairly penalize borrowers.
3. Systematic Issuance and Examination: The RBI has established a well-defined system for issuing SCNs and examining borrower responses. This ensures all responses and submissions are thoroughly reviewed before a final decision is made, preventing arbitrary decisions and enhancing the credibility of the fraud declaration process.
4. Reasoned Orders: Banks are now required to issue reasoned orders when conveying their decisions. This practice ensures decisions are transparent and that the rationale behind each decision is clearly articulated and documented. Reasoned orders provide borrowers with a clear understanding of why their accounts were declared fraudulent, allowing them to address any misunderstandings or errors effectively.
5. Referral to Advisory Board: The mandatory referral of all fraud cases involving amounts of Rupees 3 crore and above to the Advisory Board for Banking and Financial Frauds introduces an additional layer of oversight and scrutiny. This measure enhances the credibility and fairness of the fraud declaration process, ensuring significant cases receive thorough examination by an independent body.
6. Early Warning Signals (EWS) System: The new directions emphasize implementing an Early Warning Signals (EWS) system to detect and prevent frauds proactively. This system aims to identify potential frauds early, allowing banks to take preventive measures before the situation escalates. By focusing on early detection, the EWS system is expected to reduce the incidence of fraud and protect the interests of both banks and borrowers.
7. Specific Timelines: The directions stipulate specific timelines for various stages of fraud detection and reporting, including a 180-day period to conclude on the status of red-flagged accounts. These timelines ensure the process is conducted efficiently and without undue delays, preventing prolonged uncertainty for borrowers.
8. Engagement of Auditors: Banks are required to engage competent external or internal auditors for investigating suspected fraud cases. This measure ensures investigations are conducted independently and impartially, reducing the risk of biased or incomplete assessments.

Legal Precedents and Their Impact

In SBI v. Rajesh Agarwal, the Supreme Court addressed the procedural fairness required in declaring an account as fraudulent. The Court ruled that borrowers must be given a fair opportunity to present their case before any such declaration is made. This includes issuing a SCN detailing the reasons for the proposed declaration and allowing the borrower sufficient time to respond. The judgment underscored the importance of following the principles of natural justice, ensuring that the rights of borrowers are protected against arbitrary and unilateral actions by banks.

The RBI’s revised directions directly reflect the Supreme Court’s mandate in this case by incorporating the requirement for SCNs and ensuring a fair hearing process. This alignment with judicial standards reinforces the legitimacy and fairness of the new procedures.

Another significant case, R. K. Jain v. Union of India (1993), dealt with the necessity of issuing reasoned orders in administrative actions. The Supreme Court emphasized that reasoned orders are essential for transparency and accountability, as they provide a clear explanation of the decision-making process and the basis for the decision. This practice helps in building trust in administrative processes and ensures that decisions are not arbitrary or capricious.

The RBI’s requirement for reasoned orders in fraud declarations is a direct application of the principles laid down in this case. By mandating that banks provide detailed reasons for their decisions, the RBI aims to enhance the transparency and credibility of the fraud declaration process.

Instances Leading to the ‘Fraud’ Circular Regime

The formulation of these circulars has been a direct response to several high-profile instances where the banking sector’s handling of fraud declarations was scrutinized and criticized:

Vijay Mallya and Kingfisher Airlines

The case of Vijay Mallya and Kingfisher Airlines brought significant attention to the issue of fraud declarations. Kingfisher Airlines was declared a Non-Performing Asset (NPA), and subsequent investigations by banks revealed financial irregularities. However, the process was marred by allegations of inadequate disclosures and procedural lapses. The public outcry and legal challenges highlighted the need for more transparent and fair procedures. This case underscored the importance of having a well-defined and transparent process for declaring accounts as fraudulent. The revised directions aim to prevent similar controversies by ensuring that borrowers are given a fair chance to respond and that all decisions are well-documented and reasoned.

Punjab National Bank (PNB) Fraud Case

The PNB fraud case, involving jeweller Nirav Modi, exposed significant lapses in the banking sector’s internal controls and fraud detection mechanisms. The lack of timely detection and inadequate oversight allowed the fraud to go undetected for years, causing substantial financial losses. The implementation of the Early Warning Signals (EWS) system and mandatory referrals to the Advisory Board for significant fraud cases are measures designed to prevent such large-scale frauds in the future. By ensuring early detection and thorough examination, the RBI aims to mitigate the risks associated with banking frauds.

Challenges and Future Implications

While the RBI’s revised directions are commendable, their implementation will be critical in determining their efficacy. Several pertinent questions remain: Will banks fully adhere to these principles of natural justice? Will borrowers be provided with all relevant documents? Will personal hearings be granted when requested? These questions highlight the challenges ahead in ensuring that the new directions translate into fair and just practices on the ground.

The requirement for engaging external auditors and the referral to the Advisory Board for significant fraud cases are steps towards enhanced scrutiny. However, the success of these measures will depend on their consistent and unbiased application across the banking sector.

(This post has been authored by Debarshi Chakraborty, a practicing lawyer in Delhi)

CITE AS: Debarshi Chakraborty, ‘A New Dawn in Banking Transparency: RBI’s Revised Directions on Fraud’ (The Contemporary Law Forum, 23 July 2024) <tclf.in/2024/07/23/a-new-dawn-in-banking-transparency-rbis-revised-directions-on-fraud/↗/>date of access.