Regulatory updates

Recently, RBI issued three revised Master Directions (MD) on fraud risk management¹⁵ These master directions are: – Master Directions on Fraud Risk Management in Commercial Banks (including Regional Rural Banks) and All India Financial Institutions (Banks MD) – Master Directions on Fraud Risk Management in Urban Cooperative Banks (UCBs) / State Cooperative Banks (StCBs) / Central Cooperative Banks (CCBs) (co-operative banks MD) – Master Directions on Fraud Risk Management in Non-Banking Financial Companies (NBFCs) (including Housing Finance Companies (HFCs)) (NBFC MD), which are applicable to all Regulated Entities (REs) – which include banks (including All India Financial Institutions), Non-Banking Financial Companies (NBFCs) (including Housing Finance Companies (HFCs)) and co-operative banks. In this note, we have summarised the key requirements of banks MD and NBFCs MD (together referred to as revised MDs). The revised MDs focus on the role of the board of directors in the overall governance of the regulated entities and also inculcate the principles of natural justice while declaring or classifying a borrower account as a fraud account. The key requirements prescribed by the revised MD are as follows:

• Wider scope: The scope of the MDs has been extended to Regional Rural Banks and all NBFCs (including HFCs) having asset size of INR 500 crore and above.
• Focus on prevention of frauds: The revised MDs focus on developing principles of ‘prevention’ of fraud in addition to detection and reporting.
• Development of fraud risk management policy: Banks and NBFCs (including HFCs) are required to develop board a pproved fraud risk management policies which are required to be reviewed at least once in every three years. These fraud risk management policies should ensure compliance with the principles of natural justice in a time bound manner.
• Role of special committee and senior management: Banks and NBFCs (including HFCs) are required to set up a special committee, chaired by an independent director which would inter alia review and monitor cases of fraud. The senior management on the other hand would be responsible for implementing the board approved policies.
• Framework for Early Warning Signals (EWS): Banks and certain NBFCs¹⁶ NBFCs in the upper and middle layer of the scale-based framework. have been provided six months from the date of the circular to establish robust EWS systems, integrated with the core banking solution, including a dedicated analytics unit that would capture early warning signals for both credit and non-credit facilities.
• Framework for Red Flagging of Accounts (RFA): A framework for red flagging of accounts needs to be developed by banks. Based on the EWS triggers, each bank would individually assess which borrower account needs to be tagged as RFA. Further, when Law Enforcement Agencies (LEAs) suo moto initiates investigation against a borrower, such borrower should also be tagged as an RFA.
• Requirement for external or internal audit: Once a bank classifies a borrower as an RFA, or an NBFC (including HFC) suspects a borrower of indulging in fraudulent activities, it would need to initiate an audit of such borrower. This audit may be conducted either by an external or an internal auditor.
• Classification of accounts as fraud accounts: Based on findings of the audit and bank’s assessment, banks may classify accounts tagged as RFA as fraud accounts within 180 days of tagging them as RFA. Borrowers that continue to be tagged as RFA beyond 180 days need to be reported to the special committee and would be under a supervisory review of RBI. However, both banks and NBFCs need to ensure that principles of natural justice (which includes issuing show cause notice, providing the borrower a right to represent his/her case, etc.) should be strictly adhered to before classifying an account as a fraud account.
• Reporting of frauds: The revised master directions require REs to report the incidents of fraud to LEAs and to regulators (including RBI) within a prescribed timeline and have provided additional categories within which frauds may be classified while reporting to RBI.
• Closure of fraud cases reported to RBI: The revised master directions provide the following relaxations pertaining to closure of frauds:

• The conditions of write off, recovery, insurance claims, and review of systems and procedures have been eliminated.
• The limits for closure of fraud for statistical/reporting purpose has been increased from INR 2.5 million to INR10 millions.

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To access the text of the RBI notification, please click here

Master Directions on wilful and large defaulters

On 30 July 2024, RBI issued the Master Direction on Treatment of Wilful Defaulters and Large Defaulters (‘the Master Directions’). The Master Directions aim to provide a nondiscriminatory and transparent procedure, having regard to the principles of natural justice for classifying a borrower as a willful defaulter. It also puts in place a system to disseminate credit information about willful defaulters and ensures that further institutional finance is not made available to them. Some of the key aspects discussed in the Master Directions include:

• Applicability: The Master Directions are applicable to All-India Financial Institutions (AIFI)¹⁷ All India Financial Institution (AIFI) means: (i) Export Import Bank of India (EXIM Bank) (ii) National Bank for Agriculture and Rural Development (NABARD); (iii) National Housing Bank (NHB); (iv) Small Industries Development Bank of India (SIDBI); and (v) National Bank for Financing Infrastructure and Development (NaBFID). , banks, or NBFCs (in the middle layer, upper layer and top layers) which have granted a credit facility to the borrower. Further, the reporting requirements stipulated in the master directions are binding on an Asset Reconstruction Companies (ARCs) and Credit Information Companies (CICs).
• Wilful defaulter: It covers, inter alia , a borrower or a guarantor who has committed wilful default and the outstanding amount is INR25 lakh and above, or as may be notified by the RBI from time to time.
• Large defaulter: It covers a defaulter with an outstanding amount of INR1 crore and above and who has a suit filed or whose account has been classified as doubtful or loss.
• Process of identifying a wilful defaulter: The Master Direction requires the identification of wilful default to be made keeping in view the borrower’s track record and not on the basis of isolated transactions/incidents. Lenders should also examine the accounts of certain Non Performing Assets (NPAs). A process for identifying a willful defaulter has been prescribed in the Master Directions. The process of classifying/declaring an account as a wilful defaulter should be completed within six months. Also, principles of natural justice should be adhered to in the process of identifying and classifying a wilful defaulter.

• Measures against borrowers classified as wilful defaulters: The following penal measures would be implemented by the lenders against borrowers classified as wilful defaulters and entities with which a wilful defaulter is associated¹⁸ Entities associated with wilful defaulters are: – Where wilful defaulter is a company- a subsidiary, associate or joint venture of such company (as defined in Companies Act, 2013) – Where wilful defaulter is a natural person- all entities in which the wilful defaulter is a promoter, director or person in charge/responsible for managing the activities (together referred to as wilful defaulters and associates):

• No additional credit facility would be granted by any lender
• Not be eligible for restructuring of credit facility
• Wherever warranted, lenders may initiate action against the borrowers/guarantors for foreclosure/recovery of dues expeditiously
• Once the name of the wilful defaulter has been removed from the List of Wilful Defaulters (LWD) by the lender:

• Bar on additional credit facility to a wilful defaulter and associates for a period of one year
• Bar on credit facility for floating of new ventures to a wilful defaulter and associates for a period of five years.

• Reporting: Reporting requirements on a monthly basis of wilful defaulters and large defaulters to the Credit Information Companies (CICs) has been prescribed in the Master Directions
• Preventive measures: The Master Directions provide a set of preventive measures that can be adopted by the lenders to reduce the possibility of defaults in payments.
• Role of statutory auditors and third parties:

• Where the statutory auditors are found negligent in a case of falsification of accounts by the borrower, a complaint against such auditor can be lodged with the National Financial Reporting Authority (NFRA) or the Institute of Chartered Accountants of India (ICAI)
• Where third parties engaged by the lender for credit sanction/disbursement process were found negligent in their work, details of such third parties would be sent to the Indian Banking Association.