Hi,   

  Welcome to the 118th edition of The Pattern, a weekly newsletter where we delve into the latest in the world of finance, technology and economy. Let’s get started.  

Fraud has been on the RBI radar for a while now. And this week, the apex bank took concrete steps to combat fraud-related risks for regulated entities. It came in the form of master directions on fraud risk management directed at three categories of institutions: corporative banks , NBFCs and HFCs , and commercial banks and financial institutions . 

The directive aims to provide a framework for “prevention, early detection and timely reporting of incidents of fraud”. As went through the framework, RBI's circular seemed comprehensive and clearly thought out. Here are some noteworthy pointers that stood out for me: 

Customer-centricity for the win  

In accordance with a Supreme Court ruling last year calling for “natural justice in a time-bound manner before classifying Persons / Entities as fraud”, the RBI has now dictated REs to issue a Show Case Notice (SCN) to the party against whom allegations of fraud are made. Furthermore, the SCNs should furnish details of the flagged incidents and allow the customer at least 21 days to respond before any action is taken.  

This keeps the customer at the heart of banking services, as it ought to. It ensures fairness, transparency, as well as room to counter accounts that may be wrongfully flagged as fraudulent, However, the RBI circular remains silent on the fate of the account in question during ~21-day window, i.e., the time between the issue and resolution of SCNs. After all, a huge part of mitigating fraudulent activity is taking timely action. It will be interesting to see how financial institutions tackle it.  

Enabling a fraud-risk mitigation ecosystem  

It takes a village – with a combination of strong policies and accountability – to mitigate fraud risks. With the new master directions, the central bank seems to want to foster an ecosystem that can effectively tackle fraud risks. It has called for measures to detect frauds, created a system of accountability to catch and report them, while also backing REs with legal and authoritative reinforcements: 

• Clear definition and classification of fraudulent activities: The RBI has outlined 11 distinct categories of fraud “to ensure uniformity and consistency while reporting incidents to the RBI”. These include misappropriation of funds, fraudulent encashments through forgery, cash shortages on account of fraud, wilful tampering of documents, and more. These classifications make recognising and reporting fraudulent activities easier for REs.  

• A structure of governance: The directive calls for the formation of governance structures that will define policies, enable timely action, and foster an environment of vigilance. RBI asked REs to create a Special Committee of the Board for monitoring and follow-up of cases of Frauds (with at least three members of the board, consisting of the Chief Executive Officer and two independent directors). It also places the responsibility of implementing policies on the senior management. Banks and NBFCs are also required to “set-up an appropriate organisational structure for institutionalisation of fraud risk management”. There are provisions for internal and external audits for individual cases of fraud too. These requirements are sure to enable a compliance-first ecosystem with a strong sense of accountability within REs.  

• Legal and institutional reinforcement: REs are also empowered to take aid of law enforcement and authoritative bodies. The directive instructs REs to immediately report instances of fraud to “appropriate law enforcement agencies”, both domestic and international (in case of foreign-exchange related fraud). Moreover, the directives clearly dictate the bodies to whom instances of fraud need to be reported to. This gives REs a clear protocol to follow while framing their fraud policies.  

• Inclusion of third-party services: RBI, recognising the role that third-party service providers play in the current banking system, also dictates REs to hold such services accountable in “situations where wilful negligence / malpractice by them is found to be a causative factor for fraud”.  

Emphasis on Early Warning Signals (EWS)  

Early warning systems are a crucial pillar in fraud-risk mitigation. The directive has called for REs to have an EWS framework approved by their internal committees. It places the responsibility of implementation, effectiveness, and supervision of these bodies. It also explicitly mentions that the EWS must be integrated with the RE’s core banking and other systems.  

What stood out to me was also the mention of quantitative and qualitiatve indicators of fraud from transactional data, financial performance of borrowers, and market intelligence – it brings to the forefront the importance of using transactional , bureau, and alternative data and the role they could potentially play in fraud-risk mitigation in the years to come.  

All in all, I’d say these master directions are a great framework. It’s well-balanced with clear directives while also giving REs flexibility to work within their systems. Will they pave the way to fraud-free banking? Maybe in a perfect world. But I’m sure that bank frauds will see a steep decline in the years to come!  

That’s all from me this week. As always, leaving some interesting reads below.

Reading List:  

• Stripe's multimillionaire developers are having net worth issues   

• Taylor Swift’s tour kept up inflation – but the Bank of England can just shake it off    

• Tiger Global in talks to lead $500m Revolut share deal   

• Singapore Banks Ditch One-Time Passwords  

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Cheers,  

Mayank