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India's state banks need tighter controls to stop US$2B fraud repeat

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India's state banks need tighter controls to stop US$2B fraud repeat

India's state-owned banks need to improve risk controls and heed warnings from regulators so they can more effectively clamp down on fraud of the kind recently seen at Punjab National Bank, analysts say.

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Punjab National Bank
Source: Associated Press

As PNB, the country's second-largest public bank, deals with the fallout from an alleged US$2 billion fraud connected to high-profile jeweler Nirav Modi, industry figures have pointed to flaws in current practices and argued that lenders should, among other things, centralize loan approval practices.

The PNB case centers around "letters of undertaking," which allow bank customers to raise money from an overseas branch of another Indian bank. Staff at a Mumbai branch of PNB allegedly used cross-border payments company SWIFT's encrypted messaging system to send requests to other banks without the required approvals, circumventing PNB's "core" banking system, and allowing Modi and his associates to fraudulently obtain money.

Modi has denied the charges but has left the country despite authorities calling him in for questioning.

Indian authorities are also investigating two other potential scams. One involves pen-maker Rotomac Global, which has allegedly defaulted on loans worth US$569.5 million from seven state-owned banks: Bank of Baroda, Bank of India, Bank of Maharashtra, Indian Overseas Bank, Union Bank of India, Allahabad Bank and Oriental Bank of Commerce. The other case involves Simbhaoli Sugars, which has caused an alleged loss of US$16.8 million to Oriental Bank of Commerce.

Shares in state banks have suffered; PNB's fell by 30.08% between Feb. 14, the date on which the alleged fraud was first revealed, and March 6. The share price of State Bank of India fell 5.16%, while Bank of Baroda's share price fell 19.98% for the same period. India's public sector banks control more than 70% of lending assets.

The PNB case, India's largest bank fraud, began in 2011, CEO Sunil Mehta was cited by Business Standard as saying.

"The case is clearly reflective of process failures at multiple levels," said Tarun Bhatia, the Mumbai-based managing director of investigations and disputes at Kroll, which provides risk solutions. Particularly concerning is the fact that it had been going on for seven years, he said in an interview.

PNB did not respond to a request for comment from S&P. A government official told Business Standard that the bank is conducting a "forensic" audit of the bank's accounts to ascertain what went wrong.

Figures from India's finance ministry show that there were some 22,949 cases of fraud at the country's banks over the five years between 2012 and 2017, BBC News reported. The banks incurred related aggregate losses of US$10.8 billion, with PNB facing the highest individual loss of US$1.4 billion. More recently, the ministry revealed in February that a total of 12,778 cases of fraud were reported by all local banks between the 2014-15 and 2016-17 fiscal years. Of these, public sector banks accounted for 8,622 cases while private sector ones accounted for 4,156 cases. More than 13% of the cases involved staff.

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Not reacting fast enough

Edelweiss Securities analysts Kunal Shah and Prakhar Agarwal, cited by Forbes India, said public sector banks "continue to grapple with weak systems, raising questions about why the processes are not centralized." This is unlike most nonstate banks, where bypassing the core banking system is not easy, they said.

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Banks should eliminate branch level authorization and tighten risk controls, Karthik Velamakanni, a research analyst in Mumbai at Investec Bank, said in an interview.

Technological advances are also exposing differences between private and public sector companies. Bhatia said private banks have been able to implement technology "in a much more holistic manner," and are using technology to improve their systems far more than their public sector counterparts. The latter are not necessarily more prone to frauds than private ones, though, he added.

Vikram Kuriyan, a finance professor at the Indian School of Business in Hyderabad, said a lack of staff incentives at state-owned banks could also encourage fraudulent activity. They may be tempted to make poor loans if there are other benefits, he said in an email.

Meanwhile there are suggestions banks are not properly taking on board regulators' warnings about possible security flaws. In a Feb. 20 statement, the central bank said that it has warned banks of the possible misuse of the SWIFT system on at least three occasions since August 2016, advising them to put in place safeguards.

"Banks have, however, been at varying levels in implementation of such measures," the Reserve Bank of India said.

Rohit Karnatak, the Delhi-based managing director of global screening for India, APAC & EMEA at risk solutions company Pinkerton, said in an email that banks have fallen short in implementing risk measures set out by the central bank.

For its part, PNB has announced measures to beef up its internal controls on SWIFT payments, including banning clerks from sending messages through the payments network, and limiting the size of loans that bank officers can approve.

But Karnatak said it is crucial for banks to react with "speed and effectiveness" to implement the regulatory framework at ground level to prevent defaults occurring in the first place. The current system sees multiple independent systems working in silos; an additional layer of "approver" needs to be created to close loopholes, he said.

There is no foolproof way of preventing frauds, Bhatia noted, but banks need to ensure their systems are strong enough to recognize when an event happens and respond accordingly — and not seven years later.

As of March 6, US$1 was equivalent to 64.88 Indian rupees.