Prevention of Frauds – Internal Checks and Controls

1. INTRODUCTION

All institutions/organisations which as part of their normal activities, engage themselves in financial transactions, run the risk of being put to loss sometime or other through frauds perpetrated on them.  The probability of being defrauded is more in the case of banks as the transactions which they handle involve monetary and financial dealings.  Further, they are liable to be defrauded not only by their own employees and constituents but also by third parties.  At times persons in two or even all the three of the aforesaid categories collude in perpetration of frauds.  Hence the procedure and systems to prevent/expose frauds need adherence at all times and deserve attention and review on a priority and continuous basis.

2. WHAT IS FRAUD?

Frauds, as they are popularly understood, are acts of criminal deception resorted to by persons singly or in collusion with others with a view to deriving gains to which they are not legally entitled.

3. FRAUDS ON BANKS

In the case of banks, frauds are generally those wherein they are put to loss through –

1. misrepresentation;
2. breach of trust;
3. passing of fictitious entries;
4. fraudulent encashment of instruments like cheques, drafts and bills of exchange
5. unauthorized handling of securities charged to them; and
6. tampering with records / vouchers

4. AREAS OF FRAUD

There is no area of the banks working which does not provide scope for perpetration of frauds.  There are, however, some areas which are more prone to frauds etc. which are discussed below :

A) Assets

1. CASH – Shortage in cash balances with individual cashiers arising out of genuine mistakes like short receipts or excess payments which are detected during the course of or at the end of the day cannot be categorised as 'frauds' if they are reported immediately by the concerned staff to their senior officials.  However, any one holding or handling over a smaller cash balance than that which he claims to be holding or handing over is attempting to perpetrate a fraud on the bank.

Besides the frauds arising out of actual shortage of cash, there could be cases wherein the shortage is attempted to be concealed through a bogus instrument/voucher being kept alongwith the cash to indicate that the amount mentioned therein has been paid out of the cash late after the cash balance was struck.  Such an instrument is likely to be a cheque, drawn by a party which may not have sufficient balance in his account, but it could as well be a forged/unauthorisedly issued fixed deposit receipt, demand draft or pay order.  As regards a debit voucher, it is more likely to represent cash purported to have been debited to another branch but it may as well purport to represent some other payment which may not be a genuine one. To present frauds in this area, good internal control systems should be followed like joint custody and dual responsibility, prompt reporting of currency chest transactions to RBI, exercising due care while issuing / making payment of high value drafts, deposit of large amounts in to newly opened accounts, checking for benami accounts, following KYC norms while opening new accounts as well as monitoring the existing accounts, etc.  The RBI has issued detailed guidelines on KYC norms which have to be followed scrupulously by the banks. Moreover the Prevention of Money Laundering Act, 2002 which has come into force casts upon banks the obligation to report cash transactions above a threshold limit as well as suspicious transactions to the Financial Intelligence Unit- India, New Delhi.

1. BALANCES WITH OTHER BANKS – Frauds under this portfolio are generally those wherein 'banker's account' is debited in respect of transactions which are not genuine.  A fraud may also result from not responding to a debit advice received from the bank with whom the account is maintained.  For example when the banker raises a debit in respect of a returned cheque for which credit had been afforded earlier, the branch concerned should immediately respond to the entry by debiting the account of the party concerned.  If, instead, a debit advice is deliberately destroyed or misplaced, a fraud results.  Debit entries particularly for large amounts made by the bank/banker and not responded to by the bank/bankers within a reasonable time should receive special attention.  Regular reconciliation is very important.
2. ADVANCES
1. Advances against merchandise:

These advances are granted by way of either hypothecation or pledge of goods.  If due precautions and adequate counter checks are not observed, banks are liable to be easily defrauded by the parties availing of such advances.  However, since in the case of advances by way of hypothecation, the goods remain under the custody of the borrowers and the bank to a large extent relies on the declaration of the borrowers, the risk of fraud is more in such advances.  Some of the more common devices adopted by the borrowers for defrauding the banks are –

1. inflating the value of stocks charged;
2. inflating the quality of stocks by arranging them in such a manner as to give a false impression that the godown is full and render their verification difficult;
3. filling up the containers/packages with material of a quality inferior to that declared one;
4. charging of sealed or tightly packed containers/packages which are actually empty or are filled with trash as security;
5. in the case of hypothecation of advances it is common for unscrupulous parties to avail themselves of advances against the same stocks from more than one bank or to dispose of a portion of the stock/entire stocks without repaying the amount due to the bank;
6. another common device is to hypothecate stocks which actually belong to other parties or which have not been paid for; and
7. in the case of pledge, advances, goods are often removed unauthorisedly from godowns bearing the bank's locks.  This is possible where godown is not strong collusion with the bank's godown keeper/officials or the clearing agents to whom goods were entrusted for custody.

Failure on the part of the top management to establish the sound lending policy and / or to effectively monitor the implementation of its policy / procedures has resulted in several frauds.  Some of the reasons for frauds in this area are – unwarranted distribution of credit, behest lending (lending at the instance of top management / Directors of banks), unsound credit appraisal, complacency and lack of supervision, technical incompetence, poor selection of risks, etc.

1. Advances Against Fixed Assets

The frauds under this category of advances arise out of over valuation of the security or the title of the borrower thereto being defective or the security having been already charged to another institution by way of equitable mortgage at times the borrowers deposit with the banks copies of title deeds instead of originals with malafied intention of defrauding the bank.

1. Purchase & Discount of bills – Kite Flying

Facilities for purchase/discount of clean bills provide fertile ground for parties to defraud banks when they are in financial difficulties.  They draw bills not backed by trade transactions which are eventually not honoured by the drawees.  Very often, the drawees of such bills are allied/associate concerns of the drawers.  At times, two or more parties avail of bank finance against such accommodation bills, drawn on each other.  As long as all the bills continue to be honoured the banks are misled about the credit worthiness of the parties.  Further, when one bill in a chain is dishonoured, the entire chain breaks down resulting in a loss to the bank/banks concerned.  Some parties utilize the cheque purchase facility for raising finance in a similarly dubious manner by maintaining accounts with two or more banks for this purpose and taking advantage of the facility allowed by the banks of drawing against uncleared cheques.  Such transactions are called kite flying in banking parlance.

B)        Liabilities

i) Deposit Accounts

Frauds are more common in current and saving bank accounts.  Frauds take place in both payment and collection of cheques and other instruments.  The inoperative accounts also provide opportunity for perpetration of frauds.  The modus operandi generally followed are discussed below:

1. Opening of accounts – Unscrupulous parties often conceal their real identity and open accounts in the names of other parties through misrepresentation for fraudulent collection of cheques, drafts, etc. issued in the name of other parties.
2. Collection of cheques/drafts, etc. – Frauds in this category take place either in the accounts fraudulently opened or through the accounts opened in a regular manner in which case the instrument given for collection would be those which have been drawn unauthorisedly or which might have been tampered with as regards the amount, name of the payee, etc. by chemical or other processes. In the case of these frauds, the collecting bank may be held negligent and made wholly or partially responsible for the loss suffered by the drawee bank/true owner of the instrument.
3. Payment of cheques – Frauds in respect of cheques mostly relate to the foregery of the drawer's signature or stolen cheques or alteration in the amount/date/name of the payee indicated on cheques before presenting them for payment.  Such cheques are presented either across the counter for cash payment or for transfer from the drawer's account to the payee's account in the same branch.  The use of ultra violet ray lamps are of great helps in detecting material alterations on the instruments, but often they remain undetected owing to the short time available at the disposal of the passing officials, the timely detection of forged signatures is entirely dependent upon the vigilance exercised by the passing officials.
4. Head Office Account – The frauds in respect of these transactions would mostly be of two types.
1. Sending of a credit advice to another branch without actually receiving funds therefore or sending an advice for an amount larger than that actually received.  Thus, the branch 'A' may advise branch 'B' that a bill sent for collection by the latter has been realized, while in fact it may not have been paid or it may advise the amount of a Mail Transfer for Rs.5,000/- while the amount paid by the remitter may be only Rs.500/-.  The party to the forgery will then be able to withdraw such amount from branch 'B'.
2. Raising of irregular debit entries in the Head Office account for giving credit of equivalent amount to some other account with fraudulent intention of withdrawing such amount from the latter's account.

C) Other Areas of Fraud:

C.1 Frauds in a computerized environment

The need for a computerized environment can hardly be questioned in the modern day world.  With increasing competition, banks need to invest in information technology to survive and grow.  At the same time they have to take necessary safeguards to avoid the over increasing incidence of frauds in this area.  The following areas need special focus:

1. Sound access control system covering data programmes.
2. Good access monitoring system – a log covering the activities of the system.
3. Physical security for machinery and computer stationery.
4. Training of staff to improve understanding of systems and procedures
5. Comprehensive internal audit / IS audit

C.2 Frauds in Foreign Exchange Transactions (FOREX)

Most UCBs are not doing FOREX business as a part of their banking operations.  However, recently the RBI has permitted UCBs to do FOREX business by obtaining AD category I / II licences based on eligibility criteria laid down.  The frauds in the dealing room operations are due to the following reasons:

1. Frauds in dealing room operations : Dealers may put through fictitious deals with the help of brokers due to non-separation of dealing operations from back-up functions.  If there is no separation of front office and back office, the dealers can manipulate the records and thus not report the true / actual position to the higher ups.  Banks should adhere to the Internal Control Guidelines for FOREX business prescribed by the RBI.
2. The top management of the bank should prescribe and enforce various prudential exposure limits like intraday and overnight open positions, gap limits, bank-wise limits, etc. 
3. Banks which finance imports and exports should strictly follow the related RBI guidelines. There have been many instances of fraud in the area of exports and imports like discounting of bogus export bills, availment of pre-shipment credit from banks on the basis of bogus contracts, opening of import letter of credit without necessary safety clauses / without checking the credentials of the overseas suppliers.

5.         GENERAL SAFEGUARDS/PRECAUTIONS

Frauds can not be prevented merely by laying down well conceived and well defined procedural instructions.  What is more important is the strict adherence to the implementation of such instructions at the various levels.  The need for the banks to be on their guard all the time and to make available suitable machinery for ensuring proper checks and counter checks at various stages need hardly be emphasized.  Some general precautions which may help early detection of frauds are listed below:

1.   Balancing of books of accounts with the general ledger balances should be done every month and this should be checked by a responsible officer.  An element of rotation should also be introduced in the balancing of books of accounts.  Differences in balancing should be got reconciled promptly.
2. Prompt reconciliation of bank accounts and inter branch transactions should be done atleast every month and this should be checked by a responsible officer. Unreconciled entries especially which are old, large value and having debit balances need to be reconciled as quickly as possible.
3. All debit and credit vouchers pertaining to a day's transactions should be serially numbered and the totals of the same recorded in the main cash book.  The vouchers should be in the custody of passing officials who should hand them over to another Officer for independent checking the next day.
4. Number of accounts as per the monthly balancing books should be tallied with accounts opened closed register and account opening forms.
5. Inoperative accounts should be transferred to a separate register and all precautions taken while allowing operations in such accounts.
6. The blank passbooks, cheque books, deposit receipts, specimen signature cards and other important documents should be done in the custody of a responsible officer.
7. Specimen signature cards should be in the custody of passing officials only and withdrawal slips should be serially numbered and the stocks accounted.  The slips should be issued to account holders over the counter against acknowledgement and passing officials should verify the balances in the accounts before passing cheques for payment.
8. Balance confirmation should be obtained from depositors periodically.
9. In the case of withdrawal by means of withdrawal slips, pass books should invariably accompany the slips.
10. For remittance by borrowers, supervisory officials should issue serially numbered chalans after posting the number of the chalanas in the loan accounts.  At the end of the day it should be ensured that all the chalans have been tendered to the bank.
11. Pledged jewels and other valuables should be verified independently by officials unconnected with their custody.  Surprise element for such verification should be introduced.
12. Periodic rotation of duties among staff should be introduced.
13. Books of accounts of the bank should be periodically checked up by the Chief Executive and other Senior Executives to ensure that unauthorized entries and unauthenticated corrections do not exist.
14. After yearly closing of accounts, verification should be done to ensure that inflated credit balances are not carried forward and differences, if any, are reconciled immediately.
15. Banks should introduce a sound system of internal audit.  The report of the auditor and the action taken to rectify the defects should be placed before the Board of Directors.
16. Banks should prescribe suitable periodical returns for branches and submission of the same should be watched at Head Office.

6. Reporting of frauds by the UCBs to RBI

6.1 Frauds less than Rs.1 lakh – They need not be reported individually to RBI.  However, the data regarding them should be submitted in the quarterly report on frauds outstanding to the RO of UBD of the RBI under whose jurisdiction the Head Office of the banks falls.

6.2 Frauds of Rs.1 lakh and more but less than Rs.25 lakh – The cases of individual frauds should be reported to the concerned RO of UBD of RBI within three weeks from the date of detection

6.3 Frauds involving Rs.25 lakhs and above – Individual cases should be reported to the Fraud Monitoring Cell, DBS, CO, RBI, Mumbai within three weeks from the date of detection.  Additionally, banks may report the fraud by means of a DO letter addressed to the CGM-in-Charge, DBS, CO, RBI within a week of the fraud coming to notice of the banks head office, with a copy endorsed to RO, UBD, RBI.  The letter should contain particular such as amount involved, nature of fraud, modus operandi, names of parties / officials involved, complaint lodged with the police etc.

6.4 Quarterly progress reports on frauds of Rs.1 lakh and above are required to be submitted to the RO, UBD, RBI.

6.5 Reports to Board of Directors (BoD) – Bank should report all frauds of Rs.1 lakh and above to the BoD promptly on their detection, quarterly review of frauds (March, June and September) and annual review of frauds for the year ended December which may be reported by the end of March of the following year.   The review should cover whether frauds have occurred due to laxity in following the systems. 

7. Case Exercises

Please indicate the shortcomings in the system of internal checks and procedures that had facilitated the commission of frauds in the following cases:

1. Demand Draft

Two demand drafts for Rs.25/- each were issued by a bank which were presented for payment by changing the names / date / amounts to Rs.14,500/- and Rs.13,500- respectively.  The drafts were presented and paid.

List out deficiencies.

2. Cheque

A cheque for Rs.2,500/- was deposited in the S.B. Account of the customer and the drawal for full amount was allowed.  A fictitious S.B. Account was opened in the name of the same customer and the paid cheque was removed from the voucher and deposited again to the newly opened bogus account and drawal was allowed.  In another case a cheque for Rs.2,600/- was deposited and the drawal for full amount was allowed.  Subsequently, the paid cheque was removed from the voucher and by changing the date of the cheque it was again deposited in the same account and drawal was allowed second time also on the same cheque.

List out deficiencies.

CAB H No.1165 Prepared by Shri S L Gaur and updated by Smt. Uma Sankar