BANKING FRAUD AND PREVENTION OF CRIMES IN BANKING SECTOR

BANKING FRAUD AND PREVENTION OF CRIMES IN BANKING SECTOR R. Nandakumar & T. Prakash Ph.D Research Scholars, PG & Research Department of Economics, Urumu Dhanalakshmi College, Trichy - 19 1. INTRODUCTION Banking Fraud is posing threat to Indian Economy. Its vibrant effect can be understood be the fact that in the year 2004 number of Cyber Crime were 347 in India which rose to 481 in 2005 showing an increase of 38.5% while I.P.C. category crime stood at 302 in 2005 including 186 cases of cyber fraud and 68 cases cyber forgery. Thus it becomes very important that occurrence of such frauds should be minimized. More upsetting is the fact that such frauds are entering in Banking Sector as well. In the present day, Global Scenario Banking System has acquired new dimensions. Banking did spread in India. Today, the banking system has entered into competitive markets in areas covering resource mobilization, human resource development, customer services and credit management as well. Indian s banking system has several outstanding achievements to its credit, the most striking of which is its reach. In fact, Indian banks are now spread out into the remotest areas of our country. Indian banking, which was operating in a highly comfortable and protected environment till the beginning of 1990s, has been pushed into the choppy waters of intense competition. A sound banking system should possess three basic characteristics to protect depositor s interest and public faith. Theses IJTS, 4(1) January-June 2012 55

R. Nandakumar & T. Prakash are (i) a fraud free culture, (ii) a time tested Best Practice Code, and (iii) an in house immediate grievance remedial system. All these conditions are their missing or extremely weak in India. Section 5(b) of the Banking Regulation Act, 1949 defines banking... Banking is the accepting for the purpose of lending or investment, deposits of money from the purpose of lending or investment, deposits of money from the public, repayable on demand or otherwise and withdraw able by cheque, draft, order or otherwise. But if his money has fraudulently been drawn from the bank the latter is under strict obligation to pay the depositor. The bank therefore has to ensure at all times that the money of the depositors is not drawn fraudulently. Time has come when the security aspects of the banks have to be dealt with on priority basis. The banking system in our country has been taking care of all segments of our socio-economic set up. The Article contains a discussion on the rise of banking frauds and various methods that can be used to avoid such frauds. A bank fraud is a deliberate act of omission or commission by any person carried out in the course of banking transactions or in the books of accounts, resulting in wrongful gain to any person for a temporary period or otherwise, with or without any monetary loss to the bank. The relevant provisions of Indian Penal Code, Criminal Procedure Code, Indian Contract Act, and Negotiable Instruments Act relating to banking frauds has been cited in the present Article. 2. EVOLUTION OF BANKING SYSTEM IN INDIA Banking system occupies an important place in a nation s economy. A banking institution is indispensable in a modern society. It plays a pivotal role in economic development of a country and forms the core of the money market in an advanced country. Banking industry in India has traversed a long way to assume its present stature. It has undergone a major structural transformation after the nationalization of 14 major commercial banks in 1969 and 6 more on 15 April 1980. The Indian banking 56 IJTS, 4(1) January-June 2012

system is unique and perhaps has no parallels in the banking history of any country in the world. 3. RESERVE BANK OF INDIA-ECONOMIC AND SOCIAL OBJECTIVE The Reserve Bank of India has an important role to play in the maintenance of the exchange value of the rupee in view of the close interdependence of international trade and national economic growth and well being. This aspect is of the wider responsibly of the central bank for the maintenance of economic and financial stability. For this the bank is entrusted with the custody and the management of country s international reserves; it acts also as the agent of the government in respect of India s membership of the international monetary fund. With economic development the bank also performs a variety of developmental and promotional functions which in the past were registered being outside the normal purview of central banking. It also acts an important regulator. 4. BANK FRAUDS: CONCEPT AND DIMENSIONS Banks are the engines that drive the operations in the financial sector, which is vital for the economy. With the nationalization of banks in 1969, they also have emerged as engines for social change. After Independence, the banks have passed through three stages. They have moved from the character based lending to ideology based lending to today competitiveness based lending in the context of India s economic liberalization policies and the process of linking with the global economy. While the operations of the bank have become increasingly significant banking frauds in banks are also increasing and fraudsters are becoming more and more sophisticated and ingenious. In a bid to keep pace with the changing times, the banking sector has diversified it business manifold. And the old philosophy of class banking has been replaced by mass banking. The challenge in management of social responsibility with economic viability has increased. IJTS, 4(1) January-June 2012 57

R. Nandakumar & T. Prakash 5. DEFINITION OF FRAUD Fraud is defined as any behavior by which one person intends to gain a dishonest advantage over another. In other words, fraud is an act or omission which is intended to cause wrongful gain to one person and wrongful loss to the other, either by way of concealment of facts or otherwise. 1. Fraud is defined u/s 421 of the Indian Penal Code and u/s 17 of the Indian Contract Act. Thus essential elements of frauds are: 2. There must be a representation and assertion; 3. It must relate to a fact; 4. It must be with the knowledge that it is false or without belief in its truth; and 5. It must induce another to act upon the assertion in question or to do or not to do certain act. 6. BANK FRAUDS Losses sustained by banks as a result of frauds exceed the losses due to robbery, dacoity, burglary and theft-all put together. Unauthorized credit facilities are extended for illegal gratification such as case credit allowed against pledge of goods, hypothecation of goods against bills or against book debts. Common modus operandi are, pledging of spurious goods, inletting the value of goods, hypothecating goods to more than one bank, fraudulent removal of goods with the knowledge and connivance of in negligence of bank staff, pledging of goods belonging to a third party. Goods hypothecated to a bank are found to contain obsolete stocks packed in between goods stocks and case of shortage in weight is not uncommon. An analysis made of cases brings out broadly the under mentioned four major elements responsible for the commission of frauds in banks. 58 IJTS, 4(1) January-June 2012

1. Active involvement of the staff-both supervisor and clerical either independent of external elements or in connivance with outsiders. 2. Failure on the part of the bank staff to follow meticulously laid down instructions and guidelines. 3. External elements perpetuating frauds on banks by forgeries or manipulations of cheques, drafts and other instruments. 4. There has been a growing collusion between business, top banks executives, civil servants and politicians in power to defraud the banks, by getting the rules bent, regulations flouted and banking norms thrown to the winds. 7. FRAUDS-PREVENTION AND DETECTION A close study of any fraud in bank reveals many common basic features. There may have been negligence or dishonesty at some stage, on part of one or more of the bank employees. One of them may have colluded with the borrower. The bank official may have been putting up with the borrower s sharp practices for a personal gain. The proper care which was expected of the staff, as custodians of banks interest may not have been taken. The bank s rules and procedures laid down in the Manual instructions and the circulars may not have been observed or may have been deliberately ignored. Bank frauds are the failure of the banker. It does not mean that the external frauds do not defraud banks. But if the banker is upright and knows his job, the task of defrauder will become extremely difficult, if not possible. 7.1. Detection of Frauds Despite all care and vigilance there may still be some frauds, though their number, periodicity and intensity may be considerably reduced. The following procedure would be very helpful if taken into consideration: IJTS, 4(1) January-June 2012 59

R. Nandakumar & T. Prakash 1. All relevant data-papers, documents etc. Should be promptly collected. Original vouchers or other papers forming the basis of the investigation should be kept under lock and key. 2. All persons in the bank who may be knowing something about the time, place a modus operandi of the fraud should be examined and their statements should be recorded. 3. The probable order of events should thereafter be reconstructed by the officer, in his own mind. 4. It is advisable to keep the central office informed about the fraud and further developments in regard thereto. 8. CLASSIFICATION OF FRAUDS AND ACTION REQUIRED BY BANKS The Reserve Bank of India had set-up a high level committee in 1992 which was headed by Mr. A... Ghosh, the then Dy. Governor Reserve Bank of India to inquire into various aspects relating to frauds malpractice in banks. The committee had noticed/observed three major causes for perpetration of fraud as given hereunder: 1. Laxity in observance of the laid down system and procedures by operational and supervising staff. 2. Over confidence reposed in the clients who indulged in breach of trust. 3. Unscrupulous clients by taking advantages of the laxity in observance of established, time tested safeguards also committed frauds. In order to have uniformity in reporting cases of frauds, RBI considered the question of classification of bank frauds on the basis of the provisions of the IPC. Given below are the Provisions and their Remedial measures that can be taken. 60 IJTS, 4(1) January-June 2012

8.1. Cheating (Section 415, IPC) Remedial Measures: The preventive measures in respect of the cheating can be concentrated on cross-checking regarding identity, genuineness, verification of particulars, etc. in respect of various instruments as well as persons involved in encashment or dealing with the property of the bank. 8.2. Criminal Misappropriation of Property (Section 403 IPC) Remedial Measure: Criminal misappropriation of property, presuppose the custody or control of funds or property, so subjected, with that of the person committing such frauds. Preventive measures, for this class of fraud should be taken at the level the custody or control of the funds or property of the bank generally vests. Such a measure should be sufficient, it is extended to these persons who are actually handling or having actual custody or control of the fund or movable properties of the bank. 8.3. Criminal Breach of Trust (Section 405, IPC) Remedial Measure: Care should be taken from the initial step when a person comes to the bank. Care needs to be taken at the time of recruitment in bank as well. 8.4. Forgery (Section 463, IPC) Remedial Measure: Both the prevention and detection of frauds through forgery are important for a bank. Forgery of signatures is the most frequent fraud in banking business. The bank should take special care when the instrument has been presented either bearer or order; in case a bank pays forged instrument he would be liable for the loss to the genuine costumer. 8.5. Falsification of Accounts (Section 477A) Remedial Measure: Proper diligence is required while filling of forms and accounts. The accounts should be rechecked on daily basis. IJTS, 4(1) January-June 2012 61

R. Nandakumar & T. Prakash 8.6. Theft (Section 378, IPC) Remedial Measures: Encashment of stolen cheque can be prevented if the bank clearly specify the age, sex and two visible identify action marks on the body of the person traveler s cheques on the back of the cheque leaf. This will help the paying bank to easily identify the cheque holder. Theft from lockers and safe deposit vaults are not easy to commit because the master-key remains with the banker and the individual key of the locker is handed over to the costumer with due acknowledgement. 8.7. Criminal Conspiracy (Section 120 A, IPC) In the case of State of Andhra Pradesh v. IBS Prasad Rao and Other, the accused, who were clerks in a cooperative Central Bank were all convicted of the offences of cheating under Section 420 read along with Section 120 A. all the four accused had conspired together to defraud the bank by making false demand drafts and receipt vouchers. 8.8. Offences relating to Currency Notes and Banks Notes (Section 489 A-489E, IPC) These sections provide for the protection of currency-notes and bank notes from forgery. The offences under section are: (a) Counterfeiting currency notes or banks. (b) Selling, buying or using as genuine, forged or counterfeit currency notes or bank notes. Knowing the same to be forged or counterfeit. (c) Possession of forged or counterfeit currency notes or banknotes, knowing or counterfeit and intending to use the same as genuine. (d) Making or passing instruments or materials for forging or counterfeiting currency notes or banks. (e) Making or using documents resembling currency-notes or bank notes. 62 IJTS, 4(1) January-June 2012

Most of the above provisions are Cognizable Offences under Section 2(c) of the Code of Criminal Procedure, 1973. 9. FRAUD PRONE AREAS IN DIFFERENT ACCOUNTS The following are the potential fraud prone areas in Banking Sector. In addition to those areas I have also given kinds of fraud that are common in these areas. 9.1. Savings Bank Accounts The following are some of the examples being played in respect of savings bank accounts: (a) Cheques bearing the forged signatures of depositors may be presented and paid. (b) Specimen signatures of the depositors may be changed, particularly after the death of depositors, (c) Dormant accounts may be operated by dishonest persons with or without collusion of bank employees, and (d) Unauthorized withdrawals from customer s accounts by employee of the bank maintaining the savings ledger and later destruction of the recent vouchers by them. 9.2. Current Account Fraud The following types are likely to be committed in case of current accounts. (a) Opening of frauds in the names of limited companies or firms by unauthorized persons; (b) Presentation and payment of cheques bearing forged signatures; (c) Breach of trust by the employees of the companies or firms possessing cheque leaves duly signed by the authorized signatures; IJTS, 4(1) January-June 2012 63

R. Nandakumar & T. Prakash (d) Fraudulent alteration of the amount of the cheques and getting it paid either at the counter or though another bank. 9.3. Frauds in Case of Advances Following types may be committed in respect of advances: (a) Spurious gold ornaments may be pledged. (b) Sub-standard goods may be pledged with the bank or their value may be shown at inflated figures. (c) Same goods may be hypothecated in favour of different banks. 10. LEGAL REGIME TO CONTROL BANK FRAUDS Frauds constitute white-collar crime, committed by unscrupulous persons deftly advantage of loopholes existing in systems/ procedures. The ideal situation is one there is no fraud, but taking ground realities of the nation s environment and human nature s fragility, an institution should always like to keep the overreach of frauds at the minimum occurrence level. Following are the Relevant Sections Relating to Bank Frauds 11. INDIAN PENAL CODE (45 OF 1860) (a) Section 23 Wrongful Gain Wrongful gain is gain by unlawful means of property to which the person gaining is not legally entitled. (b) Wrongful Loss Wrongful loss is the loss by unlawful means of property to which the person losing it is legally entitled. (c) Gaining Wrongfully Losing wrongfully-a person is said to gain wrongfully when such person retains wrongfully, as well as when such person acquires wrongfully. A person is said to lose wrongfully when 64 IJTS, 4(1) January-June 2012

such person is wrongfully kept out of any property, as well as when such person is wrongfully deprived of property. (d) Section 24. Dishonestly Whoever does anything with the intention of causing wrongful gain to one person or wrongful loss to another person, is said to do that thing dishonestly. (e) Section 28. Counterfeit A person is said to counterfeit who causes one thing to resemble another thing, intending by means of that resemblance to practice deception, or knowing it to be likely that deception will thereby be practiced. 12. BREACH OF TRUST 1. Section 408- Criminal breach of trust by clerk or servant. 2. Section 409- Criminal breach of trust by public servant, or by banker, merchant or agent. 3. Section 416- Cheating by personating 4. Section 419- Punishment for cheating by personation. 13. OFFENCES RELATING TO DOCUMENTS 1. Section 463-Forgery 2. Section 464 -Making a false document 3. Section 465- Punishment for forgery. 4. Section 467- Forgery of valuable security, will, etc 5. Section 468- Forgery for purpose of cheating 6. Section 469- Forgery for purpose of harming reputation 7. Section 470- Forged document. 8. Section 471- Using as genuine a forged document 9. Section 477- Fraudulent cancellation, destruction, etc., of will, authority to adopt, or valuable security. 10. Section 477A- Falsification of accounts. IJTS, 4(1) January-June 2012 65

R. Nandakumar & T. Prakash 14. THE RESERVE BANK OF INDIA ACT, 1934 14.1. Issue of Demand Bills and Notes Section 31 Provides that only Bank and except provided by Central Government shall be authorized to draw, accept, make or issue any bill of exchange, hundi, promissory note or engagement for the payment of money payable to bearer on demand, or borrow, owe or take up any sum or sums of money on the bills, hundis or notes payable to bearer on demand of any such person. 15. THE NEGOTIABLE INSTRUMENTS ACT, 1881 15.1. Holder s Right to Duplicate of Lost Bill Section 45A 1. The finder of lost bill or note acquires no title to it. The title remains with the true owner. He is entitled to recover from the true owner. 2. If the finder obtains payment on a lost bill or note in due course, the payee may be able to get a valid discharge for it. But the true owner can recover the money due on the instrument as damages from the finder. 15.2. Section 58 When an Instrument is obtained by unlawful means or for unlawful consideration no possessor or indorse who claims through the person who found or so obtained the instrument is entitled to receive the amount due thereon from such maker, acceptor or holder, or from any party prior to such holder, unless such possessor or indorse is, or some person through whom he claims was, a holder thereof in due course. 15.3. Section 85: Cheque Payable to Order 1. By this section, bankers are placed in privileged position. It provides that if an order cheque is indorsed by or on behalf of the payee, and the banker on whom it is drawn pays it in due 66 IJTS, 4(1) January-June 2012

course, the banker is discharged. He can debit his customer with the amount so paid, though the endorsement of the payee might turn out to be a forgery. 2. The claim protection under this section the banker has to prove that the payment was a payment in due course, in good faith and without negligence. 15.4. Section 87. Effect of Material Alteration Under this section any alteration made without the consent of party would be void. Alteration would be valid only if is made with common intention of the party. 15.5. Section 138. Dishonour of Cheque for Insufficiency, etc., of Funds in the Account Where any cheque drawn by a person on an account maintained by him with a banker for payment of any amount of money to another person from out of that account for the discharge, in whole or in part, of any debt or other liability, is returned by the bank unpaid. either because of the amount of money standing to the credit of that account is insufficient to honour the cheque or that it exceeds the amount arranged to be paid from that account by an agreement made with that bank, such person shall be deemed to have committed an offence and shall, without prejudice. 15.6. Section 141(1) Offence by Companies If the person committing an offence under Section 138 is a company, every person who, at the time the offence was committed, was in charge of, and was responsible to, the company for the conduct of the business of the company, as well as the company, shall be deemed to be guilty of the offence and shall be liable to be proceeded against and punished accordingly. 16. SECURITY REGIME IN BANKING SYSTEM Security implies sense of safety and of freedom from danger or anxiety. When a banker takes a collateral security, say in the form IJTS, 4(1) January-June 2012 67

R. Nandakumar & T. Prakash of gold or a title deed, against the money lent by him, he has a sense of safety and of freedom from anxiety about the possible nonpayment of the loan by the borrower. These should be communicated to all strata of the organization through appropriate means. Before staff managers should analyze current practices. Security procedure should be stated explicitly and agreed upon by each user in the specific environment. Such practices ensure information security and enhance availability. Bank security is essentially a defense against unforced attacks by thieves, dacoits and burglars. 17. PHYSICAL SECURITY MEASURES-CONCEPT A large part of banks security depends on social security measures. Physical security measures can be defined as those specific and special protective or defensive measures adopted to deter, detect, delay, defend and defeat or to perform any one or more of these functions against culpable acts, both covert and covert and acclamations natural events. The protective or defensive, measures adopted involve construction, installation and deployment of structures, equipment and persons respectively. The following are few guidelines to check malpractices: 1. To rotate the cash work within the staff. 2. One person should not continue on the same seat for more than two months. 3. Daybook should not be written by the Cashier where an other person is available to the job 4. No cash withdrawal should be allowed within passbook in case of withdrawal by pay order. 5. The branch manager should ensure that all staff members have recorder their presence in the attendance registrar, before starting work. 17.1. Execution of Documents 1. A bank officer must adopt a strict professional approach in the 68 IJTS, 4(1) January-June 2012

execution of documents. The ink and the pen used for the execution must be maintained uniformly. 2. Bank documents should not be typed on a typewriter for execution. These should be invariably handwritten for execution. 3. The execution should always be done in the presence of the officer responsible for obtain them, 4. The borrowers should be asked to sign in full signatures in same style throughout the documents. 5. Unless there is a specific requirement in the document, it should not be got attested or witnessed as such attestation may change the character of the instruments and the documents may subject to ad volrem stamp duty. 6. The paper on which the bank documents are made should be pilfer proof. It should be unique and available to the banks only. 7. The printing of the bank documents should have highly artistic intricate and complex graphics. 8. The documents executed between Banker and Borrowers must be kept in safe custody, 18. CHANGES IN LEGISLATIONS AFTER ELECTRONIC TRANSACTIONS 1. Section 91 of IPC shall be amended to include electronic documents also. 2. Section 92 of Indian Evidence Act, 1872 shall be amended to include commuter based communications 3. Section 93 of Bankers Book Evidence Act, 1891 has been amended to give legal sanctity for books of account maintained in the electronic form by the banks. 4. Section 94 of the Reserve Bank of India Act, 1939 shall be amended to facilitate electronic fund transfers between the financial institutions and the banks. A new clause (pp) has been inserted in Section 58(2). IJTS, 4(1) January-June 2012 69