SEMINAR ON CONCURRENT AUDIT OF BANKS

WIRC – 17TH NOVEMBER, 2012

IDENTIFICATION OF REVENUE LEAKAGE

& AUDIT OF FRAUD PRONE AREAS

Paper Presented by : CA Ismail B. Sonawalla

Audit of Fraud Prone Areas

General Classification of Frauds

Under the provisions of Indian Penal Code, frauds have been classified as follows:

(a) Misappropriation and criminal breach of trust.

(b) Fraudulent encashment through forged instruments, manipulation of books of account or
through fictitious accounts and conversion of property.
(c) Unauthorised credit facilities extended for reward or for illegal gratification.
(d) Negligence and cash shortages.
(e) Cheating and forgery.
(f) Irregularities in foreign exchange transactions.
(g) Any other type of fraud not coming under the specific heads as above

Some basics of Frauds

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Certain Indicators which could lead to identify Irregular Accounts / Frauds

Loans & Advances

While verifying loans and advances, the auditor has to take cognisance of certain indicators,
which may lead to irregular accounts / frauds.

• The branch has 1 or 2 major borrowers constituting more than 50% to 75% of the total
advances of the branch, to whom the branch goes out of its way to give continuous
overlimits or withdrawals against uncleared effects or does not pursue recovery of overdue
bills or stock statements are not received in time and yet drawing power limit is continued
or account is not renewed on due date or adhoc limits are not cleared and yet facility is
continued, etc. etc.

• While verifying CC a/c, OD a/c and bills a/c, the following observations are made
− account remains continuously overdrawn;

− a number of cheques are bounced due to insufficient funds;

− cheques deposited are not honoured and returned unpaid;

− the account has been granted continuous TOL by the branch – for 20 to 25 days
every month moreover, such TOLs have been granted by the Branch Manager, at
times, without having the power to do so;

− the 12 month’s turnover in the account does not commensurate with the sale and
purchase shown in 12 monthly stock statements or the statement of accounts
submitted;

− the realisation of bills purchased / bills discounted is not received on the due date and
subsequently the same are cleared by debit to the borrower’s CC / OD a/c;

− as soon as the above bills are cleared, fresh bills are purchased / discounted;

− the facility has not been renewed on the due date and the reason given is that the
borrower has not submitted the necessary papers;

− all overdue CC limits, OD limits, unrealised bills, unrealised interest are bundled
together and the borrower is granted WCTL – Working Capital Term Loan to avoid the
account becoming NPA. Such bullet loan is an indicator that the account is having
problems;

− for certain accounts, when papers are asked for, the branch is unduly slow in
producing the same or makes a plea that the same have been sent to some authority
and hence is unavailable at the branch;

− in case of certain accounts, the Branch Manager pleads not to put any adverse
remark in the report and that he shall get it rectified after the audit is over;

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− in certain cases, the branch just does not produce the papers, pleading that the same
are not traceable;

• While verifying monthly / quarterly stock statements submitted, the following observations
are made
− generally stock statements are not submitted on time;

− the itemwise details of stock is not given and instead lumpsum figures are shown
without quantitative details;

− if itemwise details are given, a comparison of statements submitted over a period of

time shows that the same stock is repeated over and over again with the same
quantity and value;

− there is heavy “sundry creditors” indicating unpaid stock, but the said amount has not
been deducted from the stock value, before determining the DP – drawing power limit
of the borrower;

− the stock statement contains details of stock, which have actually financed by the
branch under LC limit or Packing Credit limit or some other limits;

− there is a huge difference in the closing stock shown in the stock statement of 31st
March, 2011 and the audited / unaudited accounts submitted subsequently or better
still, the borrower does not submit the stock statement of March or the same is
untraceable in the branch;

− the stock statement reflects an unusually high amount of “stock in transit” every
month, which does not commensurate with the monthly purchases or the monthly
turnover in the accounts;

− though mandated, the Branch has not obtained the “stock audit report”;

− the stock audit report has adverse comments, but

the Branch has not taken any corrective steps; OR

the Branch Manager states that subsequently he has visited the unit and
everything is rectified and regularised;

− the stock inspection done by the branch is superfluous and does not record the details
of the stock verified – a few direct indepth questions to the branch staff, who went for
the concerned stock inspection would reveal the quality of the inspection done;

• While verifying monthly / quarterly book debts statements submitted, the following
observations are made
− book debts due for more than 90 days are not segregated, though the same is
mandated in the Sanction letter;

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− a comparison of last 10-12 month’s statement reveals that there are a number of book
debts, which probably are being shown for more than 8-10 months and may be bad
debts or recovered, but not deducted from the statement;

• A comprehensive 10-12 month’s analysis of monthly sales, purchase and stock as shown
in the stock statements, the book debts, the turnover in the accounts and the audited
financial statements may reveal that the stock statements submitted every month are
highly inflated.

• Verification of other records at the branch

− verification of immovable property documents under ultra violet rays can reveal
whether the document is genuine or a xerox copy;

− in immovable property loans, the branch has not obtained “search report” of the
property from the Registrar’s office, or the adverse comments in such report have
been ignored;

− the branch has not obtained NOC from the builder / society or such NOC has been
personally brought by the borrower to the branch instead of the same being directly
obtained by the branch from the builder / society;

− in case of loans to limited companies, details of previous charges have not been
obtained or if any adverse observations have been made, the same are ignored – for
eg. the report shows that the borrower has borrowed from other banks without the
knowledge / permission of the existing banker, old charges which were supposed to
have been cleared have not been done indicating that old loans are still outstanding;

− there is correspondence on record, which states that on the same immovable

property, the borrower has obtained loans from more than one bank;

− the branch has filed a suit against the borrower to recover the amount;

Some live examples

• A Bank in AP - "On guarantee of Anakapalle municipality, gave loans to its employees

and some of them defaulted. The municipality deducted the amount from their salaries
but did not remit to the bank. Even the strictures of the AP High Court were ignored by
the municipality.

• Genco Bank C N Shah Group loans of upto Rs 52 crore of the total Rs 100 crore
advances. The group was willing to pay Rs 12.90 crore by December 2003, while the
remaining loans to be paid in 15 years. State co-operation and protocol minister
Vadibhai Patel wrote a letter to the Registrar of Co-operatives and the bank
administrator, asking them to accept this proposal

• Rupee Coop Bank - 11 irregularities identified by the apex bank during its inspection
of the co-operative bank’s affairs.

1. Bank’s gross Non-Performing Assets (NPA) formed 34.2% of total loans and
advances outstanding. Also, it had not correctly followed RBI guidelines on

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assets classification and provisioning, resulting in short provisioning of Rs 78.64

crores and other assets/frauds at Rs 20.16 crores.
2. Bank had treated unrealised interest on loan accounts as income, resulting in
inflating its income to the extent of Rs 18.65 crores.
3. Bank had granted moratorium, ranging from 12 months to 36 months, to certain
ineligible large borrowal accounts to circumvent NPA norms and the interest due
thereon was taken to profit and loss account on accrual basis in contravention of
RBI instructions.
4. Payment for purchase of premises to M/s. M.R. Constructions and six other
parties and the irregularity in this matter.
5. Waiver of interest by the top officials of the bank to the extent of Rs.7.86 crores to
a few large borrowers without mandate of the Board of Directors.
6. Involvement of senior officials in granting unauthorised excess withdrawals to
certain borrowers without any delegated authority.
7. Violation of RBI directive by the bank on credit exposure limit in respect of
individual and group of borrowers.
8. Enrolment of certain co-operative credit societies by the bank as members, in
gross violation of the Banking Regulation Act, 1949 and its own bye-law. Also
disbursal of loans to such co-operative credit societies, taking over the role of
higher financing agency.
9. Grant of unsecured loans to Board of Directors and their relatives far in excess of
ceiling prescribed for individual as well as groups as a whole.
10. Ineffectiveness and ignorance of Board on important items such as waiver of
interest of crores of rupees, unauthorised excess withdrawals allowed in large
borrowal accounts, etc.
11. Failure of the Board in the affairs of the bank and its not paying attention to
review of top 100 NPA accounts, large borrowal accounts, performance of
branches, audit report and funds management, temporary overdrafts, etc.
mismanagement of the affairs of the bank by the Board, resulting in heavy
erosion in value of assets.

• Panchmahal District Central Coop Bank (PDCB) - in June, 2003 sitting MLAs of
Gujarat were accused of misappropriating Rs 128 crores from this Godhra-based
bank. PDCB’s new managing committee has filed the complaint. The committee had
superseded the board of directors after the bank withdrew from the RBI’s clearing
house citing “liquidity” crisis as reason. Altogether, 29 people were of giving loans to
farmers on basis of fake documents. There is a slew of former MPs and MLAs who
have been named in the complaint Among others who make up the list are the district
registrar of co-operatives for Panchmahals, present and former managers of some of
the branches of PDCB, and officials of some of the village credit societies. The crisis
has been so severe that PDCB was forced to even withdraw their deposits with the
Gujarat State Co-operative Bank, which is essential for maintaining the statutory
liquidity ratio (SLR). The bank had a deposit base of only Rs.192 crore, but made
advances worth Rs 372 crore. Most of the misappropriated funds aggregating to R.s
128 crores was lent to 2 co-operative credit societies run by local MLAs.

• Samta Sahakari Bank - All the 21 directors of the ailing Samta Sahakari Bank have
been booked for defrauding the bank of over Rs 145 crore. The fraud came to light
after a flying squad from the cooperatives department audited its accounts between
March 30, 1997, and October 30, 2007. It is alleged that the bank's officers and
directors took huge commissions and favours for sanctioning unsecured loans to
many clients, most of which have gone bad. The directors had also taken huge loans
from the bank and defaulted on repayment. Some of the bank's directors were also
the key accused in the Nagpur Mahila Sahakari Bank case. The bad loans of the
Mahila Sahakari Bank had led to the intervention of Reserve Bank of India (RBI),
which placed the bank under moratorium. Some of the big business groups of the
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region and 15 others had been sanctioned unsecured loans to the tune of over Rs 100
crores.

• Home Loan Frauds - RBI has warned banks to strictly adhere to due diligence
procedures while disbursing housing loans. The following observations have been
made by RBI :

1. Builders have defrauded banks by pocketing housing loans, which they

managed to obtain in the names of fictitious persons by submitting forged
documents.
2. Banks have extended loans to customers who produced forged documents.
3. There are cases in which same property has been offered as security to
different banks by submitting fake title deeds.
4. In some cases properties, which were mortgaged to banks, did not even exist.
5. Some of the banks have been extending loans to customers without verifying
details. The documents – title deeds, income tax returns, salary certificates etc
– submitted for availing of loans were found to be fictitious.
6. Similarly, there are distortions in the profiles of borrowers too. In some cases,
borrowers added names of co-applicants to avail of a higher loan amount.
7. Some of the foreign and private sector banks had been extending home loans
without the borrower even having to put in any margin money, which has led to
the loan-to-value ratio being 100 per cent or more.

Investments

• Investment of funds to be done only in modes specified.

• Bk - RBI has issued extensive guidelines on investments by banks

• The G-secs fraud of Rs.500 crores by Home Trade Ltd., a broking firm – 25
urban co-op banks & 4 dist. Central Co-op. Banks involved; 12 banks duped

• Home Trade also duped the Seamen's Provident Fund to the tune of Rs. 94 crores.

• Currently, portfolio management in gilts not permitted by banks except in special

cases. However, some banks buy and sell securities on behalf of urban co-operative
banks (UCBs) on instructions. As smaller co-operative banks operating in remote
areas lack expertise in dealing with gilts, brokers dump them with illiquid stocks at
high prices.

Several co-operative banks involved in the latest scam on account for fraudulent
deals placed directly with brokerage firms for investment in gilts. SEBI suspended
Home Trade over transactions that the RBI had termed `fraudulent.' Several UCBs in
Maharashtra and Gujarat which struck deals through brokers are now stuck with
illiquid stocks or have paid high prices for their securities

• Economic Offences Wing of Mumbai police case against Home Trade Ltd for
defrauding Raghuvanshi Co-operative Bank Ltd - Rs 6 crores, Osmanabad bank - Rs
30 crores, Wardha District Co-operative Bank - Rs 25 crores, Shree Satguru Jangli
Maharaj Co-op. Bank - not received gilts worth Rs 27 crores, Nagpur District Central
Co-operative Bank - Rs. 124 crores

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• Replica of the 1992-securities Harshad Mehta’s scam. While Mehta used banker's
receipts to have an easy access to huge funds, this time, Home Trade Ltd., used
government securities (G-Secs) to avail itself of money.

• Scams more or less follow the same pattern — Ketan Parekh — Madhavpura
Mercantile Co-operative Bank (MMCB) scam in 2001 and is also an instance of
diversion of funds from the banking sector to the stock market.

• In 1994, RBI put in place a delivery versus payment (DVP) system under the Public
Debt Office (PDO) of the central bank. This is linked to Subsidiary General Ledger
(SGL) accounts in banks. At the end of the day, the buyer or seller has to fill the SGL
form and deliver it to the RBI. Now with the inception of Clearing Corporation of India
Ltd. (CCIL), the SGL form filling procedure no longer exists. However, co-op banks
are out of the purview of DVP system. RBI could have brought in co-op. banks under
the ambit of DVP system when the MMCB scam broke-out, but RBI waited for a
scam to surface in order to initiate fire-fighting measures. Further, under no
circumstances can the RBI allow a broker to act as a principal (a broker can only act
as an intermediary between principals and cannot assume the role of a principal). In
this case, Home Trade acted as a principal. Another issue is that many co-op. banks
do not have Treasury divisions, which trade in securities. How the RBI allowed any
bank without a Treasury division to operate in a debt market is a question that can be
raised. In the case of co-op. banks, all the decisions of investment in securities are
taken by the board of directors which are elected rather than a full fledged Treasury
that would otherwise be run by professionals. The role of Primary Dealers (PDs) is
also in focus at this point of time. PDs are interested only in large dealings rather
than small deals of co-operatives. Moreover, PDs are interested in running a book to
make proprietary trading profits rather than disseminating debt to and developing the
non-wholesale debt market for which they were set up.

Fixed Assets

• Frauds in immovable and movable property purchases by banks, including renovations,

computers, softwares, etc.

Deposits and Other Accounts

• The Primary Teachers’ Co-op. Bank, Nashik – June, 1998 - the Bank established in
1939 and with 12 branches and 7,303 members in Nashik, the bank was defrauded by
various methods including furnishing of bogus names and papers for loans for various
schemes. Among the depositors defrauded are hawkers, shopkeepers and housewives,
who at regular intervals gave the bank's agents a portion of their money to be deposited
in a small savings scheme. However, instead of depositing the money so collected, the
agents merely pocketed the collection. When the depositors approached the bank at the
conclusion of the financial year in April, they were told that there was no money to pay
them. The then directors and staff not only siphoned off money but also went on a
recruitment drive, employing their family members and relatives. The then chief
accountant and eight directors also helped themselves to the depositors' funds. The
bank's plea to the District Central Cooperative Bank for a loan to return money of the
yearly small saving depositors has been turned down, since against a share of Rs 36
lacs with the district bank, they have already taken a Rs 3.5-crore loan in the past.

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• S. K. Patil Co-op. Bank, Kurundwad, Kolhapur - Fraud of Rs.22 crores - the bank's
founder S K Patil and his son Sanjay Patil took loan of 22 crores on the names of 32 co-
operative societies. Some of the societies and their directors are unknown. Actually,
most of the societies and their directors are only on paper. Recently the S K Patil Bank
liquidated and the liquidator found that the 32 societies have taken loans of Rs 22 crores
from the bank. Then the liquidator issued notice to the directors of the societies about
loan. The directors were shocked because they had never taken any loan from the S K
Patil Bank.

• Pratibha Patil, ex-President of India – In June, 2007 at Jalgaon, old controversies

surrounding the Patil family resurfaced. The Patils own not just a Sugar Co-operative,
but also banks and educational institutions. Pratibha Co-operative Bank 1982-2002 - a
cooperative bank in Pratibha Patil's name had started in 1982 with daily wage earners as
members. The bank went under in 2002 - the result of handing out loans that were never
repaid. Five years later, many of its members are still waiting for their money though no
one was willing to talk about it on camera. There are also rumblings from the nearby
district of Amravati where shareholders of the Amravati People's Co-operative Bank
claim Pratibha Patil's husband, Devi Singh Shekawat, stood guarantor for a loan taken
by Sriram Rolling Mills - a loan that was never repaid. The address of the rolling mill was
listed as Shekawat's Amravati residence. "Despite the fact that the loan receiver later
turned defaulter, Dr Shekawat was made main administrator of the same bank. How
could they do so? This is against the rules. "And now he has exercised one time
settlement at a much lesser amount. Also Muktai Sugar Co-operative 1990-2007 - Like
many other co-operatives run by the state's politicians, the Muktai Sugar Co-operative
took a loan of Rs 12 crore from the Mumbai District Co-operative Bank.

• A creative fraud - Viniv Inc Souharda Credit Society has a deposit of Rs. 90.00 lacs
only and out of this, Rs. 85 lacs have been disbursed as loans. All these loans are
secured loans and the recovery rate of the Cooperative is 98%. It was registered in July,
2003, at the Office of the Registrar of Cooperatives, under the Karnataka Souharda
Sahakari Act.

The said financial fraud has happened inside the OTHER Viniv Inc firms namely Vinv Inc
Investments and Viniv Inc Foundation. Both these institutions do not come under the
purview of the Cooperative Act. Though this being the case, upon the request made by
Karnataka State Federal Cooperative Limited, the Registrar of Cooperatives ordered an
Enquiry into the business of this said co-operative, as it became an issue of public
debate.

90% of the deposits given by the people was deposited in these external institutions and
not Viniv Inc Co-operative. People deposited their money in other institutions in the name
of Viniv Inc and NOT in Viniv Inc Souharda Cooperative. Viniv Inc Investments and Viniv
Inc Foundation issued cheques to the depositors bearing the names of State Bank of
Travancore and Vyshya Bank. All these firms were operating from a single building and
the sign board of the Viniv Inc Co-operative was huge among all of them People might
have been misled by this too. Viniv Inc Investments invested money in stock market. It
has been alleged that this firm was an associate of one India Bull, a stock brokering
company. Viniv Inc Foundation collected money in the name of donations. These
institutions took deposits / donations and to pay the interest on these amounts, these
institutions issued cheques. People deposited these cheques with their membership
accounts in the Viniv Inc Cooperative in order to get it encashed. They got their money
as and when these cheques were realised.

General

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• National Agricultural Cooperative Marketing Federation Ltd (Nafed) - Nafed deals

with many products. In case of copra, a study of certain basic facts and figures has
prompted one to look into the following aspects: From April 2000 onwards, Nafed had
procured 1.2 lacs tonne of copra at the minimum support price (MSP) of Rs 3,250 per
quintal as against the market price of Rs 2,000. This, says a Nafed source, is less than
15 per cent of the total production - the rest has been apparently sold off by farmers at
the market price. Well, now the question arises: When all the farmers know about the
MSP, why were they not selling to Nafed at a much higher price of Rs 3,250? The
sources give a four-part answer: 1) Nafed has limited funds allotted to it - about Rs 500
crore. With these funds, if it has to prop up the market price to the MSP, it should buy the
entire quantity in one to two months. But, as it is known now, Nafed does not do this,
probably because the market will crash again when the funds dry up. 2) Since the funds
are inadequate, the meagre procurement by Nafed is far from adequate to raise the
market price to the MSP level. 3) This situation, then, gives ample chance for
discretionary procurement, which facilitates chances for fraud by middlemen and some
Nafed officials. 4) Nafed officials ensure that they do not procure from the farmers
cooperatives that are not in league and buy only from a handful of very powerful,
politically connected middlemen, who buy copra from farmers at the market price of Rs
2,000, and sell it to Nafed at the MSP of Rs 3,250. So far, these middlemen have bought
1.2 lacs tonne of copra at Rs 240 crore and sold it to Nafed at Rs 390 crore. A clean,
cool profit of Rs 150 crore. Simple mathematics - and all at the cost of the national
exchequer. Evidently, the money from the exchequer, which is supposedly meant to help
farmers, does not reaching them. Instead, it goes into wrong hands.

• Bihar State Cooperative Marketing Union Ltd – The Managing Director of this Union
was also secretary of the department of cooperatives as also the registrar
(cooperatives). During 1986-87, he was allegedly party to violating norms in placing
orders for supply of fertilisers without even inviting tenders. An FIR was lodged and
chargesheets filed in the court of Patna CJM. He moved the Patna HC which quashed
the FIR. However, the Bihar government went in appeal to the SC which set aside the
HC order.

Revenue Leakage

Income
• Computerized and auto operated

• Computerized, but manually option

• Non-computerized

Expenses

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