Frauds in banking operations and Preventive vigilance

Definition of fraud :

Bank fraud is the use of potentially illegal means to obtain money, assets,
or other property owned or held by a financial institution, or to obtain
money from depositors by fraudulently posing as a bank or other financial
institution. In many instances, bank fraud is a criminal offence. While the
specific elements of particular banking fraud laws vary depending on
jurisdictions, the term bank fraud applies to actions that employ a trick as
opposed to bank robbery or theft. For this reason, bank fraud is sometimes
considered a white-collar crime.

Types of Bank fraud

Stolen cheques
Kite flying
Forgery and altered cheques
Accounting fraud
In order to hide serious financial problems, some businesses have
been known to use fraudulent bookkeeping to overstate sales and
income, inflate the worth of the company's assets, or state a profit
when the company is operating at a loss. These tampered records are
then used to seek investment in the company's bond or security issues
or to make fraudulent loan applications in a final attempt to obtain
more money to delay the inevitable collapse of an unprofitable or
mismanaged firm.

Demand draft fraud

Demand draft (DD) fraud typically involves one or more corrupt
bank employees. Firstly, such employees remove a few DD leaves or
DD books from stock and write them like a regular DD. Since they
are insiders, they know the coding and punching of a demand draft.
Such fraudulent demand drafts are usually drawn payable at a
distant city without debiting an account. The draft is cashed at the
 payable branch. The fraud is discovered only when the bank's head
office does the branch-wise reconciliation, which normally take six
months, by which time the money is gone.

Rogue traders
A rogue trader is a trader at a financial institution who engages in
unauthorized trading to recoup the loss he incurred in earlier trades.
Out of fear and desperation, he manipulates the internal controls to
circumvent detection to buy more time.

Fraudulent loans

One way to remove money from a bank is to take out a loan, a practice
bankers would be more than willing to encourage if they knew that the
money will be repaid in full with interest. A fraudulent loan, however, is
one in which the borrower is a business entity controlled by a dishonest
bank officer or an accomplice; the "borrower" then declares bankruptcy
or vanishes and the money is gone. The borrower may even be a non-
existent entity and the loan merely an artifice to conceal a theft of a large
sum of money from the bank.

Wire transfer frauds

Wire transfer networks such as the international SWIFT interbank

fund transfer system are tempting as targets as a transfer, once
made, is difficult or impossible to reverse. As these networks are used
by banks to settle accounts with each other, rapid or overnight wire
transfer of large amounts of money are commonplace; while banks
have put checks and balances in place, there is the risk that insiders
may attempt to use fraudulent or forged documents which claim to
request a bank depositor's money be wired to another bank, often an
offshore account in some distant foreign country.

Phishing and Internet fraud

 Phishing, also known as Internet fraud, operates by sending forged e-
mail, impersonating an online bank site. the e-mail directs the user
to a forged web site which is designed to look like the login to the
legitimate site but which claims that the user must update personal
info. The information thus stolen is then used in other frauds.
Fake websites can trick you into downloading computer viruses that
steal your personal information. Security messages are shown that
tell you that you have viruses and need to download new software, by
doing this you are tricked into downloading an actual virus

Money laundering
Money laundering is the process by which large amounts of illegally
obtained money (from drug trafficking, terrorist activity or other
serious crimes) is given the appearance of having originated from a
legitimate source

Accommodation bills
Bill discounting fraud
Payment card fraud
Credit card fraud is widespread as a means of stealing from banks,
merchants and clients

. FRAUDS ON BANKS differently classified

In the case of banks, frauds are generally those wherein they are put to loss
through

1. misrepresentation;
2. breach of trust;
3. passing of fictitious entries;
4. fraudulent encashment of instruments like cheques, drafts and bills of
exchange
5. unauthorized handling of securities charged to them; and
6. tampering with records / vouchers
 Frauds in the area of cash

1. CASH Shortage in cash balances with individual cashiers arising out of

genuine mistakes like short receipts or excess payments which are
detected during the course of or at the end of the day cannot be
categorised as 'frauds' if they are reported immediately by the concerned
staff to their senior officials. However, any one holding or handling over
a smaller cash balance than that which he claims to be holding or handing
over is attempting to perpetrate a fraud on the bank.

Besides the frauds arising out of actual shortage of cash, there could be cases
wherein the shortage is attempted to be concealed through a bogus
instrument/voucher being kept alongwith the cash to indicate that the amount
mentioned therein has been paid out of the cash late after the cash balance was
struck. Such an instrument is likely to be a cheque, drawn by a party which
may not have sufficient balance in his account, but it could as well be a
forged/unauthorisedly issued fixed deposit receipt, demand draft or pay order.
As regards a debit voucher, it is more likely to represent cash purported to have
been debited to another branch but it may as well purport to represent some
other payment which may not be a genuine one. To present frauds in this area,
good internal control systems should be followed like joint custody and dual
responsibility, prompt reporting of currency chest transactions to RBI,
exercising due care while issuing / making payment of high value drafts, deposit
of large amounts in to newly opened accounts, checking for benami accounts,
following KYC norms while opening new accounts as well as monitoring the
existing accounts, etc. The RBI has issued detailed guidelines on KYC norms
which have to be followed scrupulously by the banks. Moreover the Prevention
of Money Laundering Act, 2002 which has come into force casts upon banks
the obligation to report cash transactions above a threshold limit as well as
suspicious transactions to the Financial Intelligence Unit- India, New Delhi.

ADVANCES

Advances against merchandise:

These advances are granted by way of either hypothecation or pledge of goods.

If due precautions and adequate counter checks are not observed, banks are
liable to be easily defrauded by the parties availing of such advances. However,
since in the case of advances by way of hypothecation, the goods remain under
the custody of the borrowers and the bank to a large extent relies on the
declaration of the borrowers, the risk of fraud is more in such advances. Some
of the more common devices adopted by the borrowers for defrauding the banks
are
 1. inflating the value of stocks charged;
2. inflating the quality of stocks by arranging them in such a
manner as to give a false impression that the godown is full
and render their verification difficult;
3. filling up the containers/packages with material of a quality
inferior to that declared one;
4. charging of sealed or tightly packed containers/packages
which are actually empty or are filled with trash as security;
5. in the case of hypothecation of advances it is common for
unscrupulous parties to avail themselves of advances against
the same stocks from more than one bank or to dispose of a
portion of the stock/entire stocks without repaying the
amount due to the bank;
6. another common device is to hypothecate stocks which
actually belong to other parties or which have not been paid
for; and
7. in the case of pledge, advances, goods are often removed
unauthorisedly from godowns bearing the bank's locks. This
is possible where godown is not strong collusion with the
bank's godown keeper/officials or the clearing agents to
whom goods were entrusted for custody.

Failure on the part of the top management to establish the sound lending policy
and / or to effectively monitor the implementation of its policy / procedures has
resulted in several frauds. Some of the reasons for frauds in this area are
unwarranted distribution of credit, behest lending (lending at the instance of top
management / Directors of banks), unsound credit appraisal, complacency and
lack of supervision, technical incompetence, poor selection of risks, etc.

1. Advances Against Fixed Assets

The frauds under this category of advances arise out of over valuation of the
security or the title of the borrower thereto being defective or the security
having been already charged to another institution by way of equitable
mortgage at times the borrowers deposit with the banks copies of title deeds
instead of originals with malafied intention of defrauding the bank.

1. Purchase & Discount of bills Kite Flying

Facilities for purchase/discount of clean bills provide fertile ground for parties
to defraud banks when they are in financial difficulties. They draw bills not
backed by trade transactions which are eventually not honoured by the
drawees. Very often, the drawees of such bills are allied/associate concerns of
the drawers. At times, two or more parties avail of bank finance against such
accommodation bills, drawn on each other. As long as all the bills continue to
be honoured the banks are misled about the credit worthiness of the parties.
Further, when one bill in a chain is dishonoured, the entire chain breaks down
resulting in a loss to the bank/banks concerned. Some parties utilize the cheque
purchase facility for raising finance in a similarly dubious manner by
maintaining accounts with two or more banks for this purpose and taking
advantage of the facility allowed by the banks of drawing against uncleared
cheques. Such transactions are called kite flying in banking parlance.

B) Liabilities

i) Deposit Accounts

Frauds are more common in current and saving bank accounts. Frauds take
place in both payment and collection of cheques and other instruments. The
inoperative accounts also provide opportunity for perpetration of frauds. The
modus operandi generally followed are discussed below:

1. Opening of accounts Unscrupulous parties often conceal their real

identity and open accounts in the names of other parties through
misrepresentation for fraudulent collection of cheques, drafts, etc. issued
in the name of other parties.
2. Collection of cheques/drafts, etc. Frauds in this category take place
either in the accounts fraudulently opened or through the accounts opened
in a regular manner in which case the instrument given for collection
would be those which have been drawn unauthorisedly or which might
have been tampered with as regards the amount, name of the payee, etc.
by chemical or other processes. In the case of these frauds, the collecting
bank may be held negligent and made wholly or partially responsible for
the loss suffered by the drawee bank/true owner of the instrument.
3. Payment of cheques Frauds in respect of cheques mostly relate to the
foregery of the drawer's signature or stolen cheques or alteration in the
amount/date/name of the payee indicated on cheques before presenting
them for payment. Such cheques are presented either across the counter
for cash payment or for transfer from the drawer's account to the payee's
account in the same branch. The use of ultra violet ray lamps are of great
helps in detecting material alterations on the instruments, but often they
remain undetected owing to the short time available at the disposal of the
passing officials, the timely detection of forged signatures is entirely
dependent upon the vigilance exercised by the passing officials.
4. Head Office Account The frauds in respect of these transactions would
mostly be of two types.
 1. Sending of a credit advice to another branch without actually
receiving funds therefore or sending an advice for an amount larger
than that actually received. Thus, the branch 'A' may advise branch
'B' that a bill sent for collection by the latter has been realized,
while in fact it may not have been paid or it may advise the amount
of a Mail Transfer for Rs.5,000/- while the amount paid by the
remitter may be only Rs.500/-. The party to the forgery will then
be able to withdraw such amount from branch 'B'.
2. Raising of irregular debit entries in the Head Office account for
giving credit of equivalent amount to some other account with
fraudulent intention of withdrawing such amount from the latter's
account.

C) Other Areas of Fraud:

C.1 Frauds in a computerized environment

The need for a computerized environment can hardly be questioned in the

modern day world. With increasing competition, banks need to invest in
information technology to survive and grow. At the same time they have to
take necessary safeguards to avoid the over increasing incidence of frauds in
this area. The following areas need special focus:

1. Sound access control system covering data programmes.

2. Good access monitoring system a log covering the activities of the
system.
3. Physical security for machinery and computer stationery.
4. Training of staff to improve understanding of systems and procedures
5. Comprehensive internal audit / IS audit

C.2 Frauds in Foreign Exchange Transactions (FOREX)

Most UCBs are not doing FOREX business as a part of their banking
operations. However, recently the RBI has permitted UCBs to do FOREX
business by obtaining AD category I / II licences based on eligibility criteria
laid down. The frauds in the dealing room operations are due to the following
reasons:

1. Frauds in dealing room operations : Dealers may put through fictitious

deals with the help of brokers due to non-separation of dealing operations
from back-up functions. If there is no separation of front office and back
office, the dealers can manipulate the records and thus not report the true
/ actual position to the higher ups. Banks should adhere to the Internal
Control Guidelines for FOREX business prescribed by the RBI.
 2. The top management of the bank should prescribe and enforce various
prudential exposure limits like intraday and overnight open positions, gap
limits, bank-wise limits, etc.
3. Banks which finance imports and exports should strictly follow the
related RBI guidelines. There have been many instances of fraud in the
area of exports and imports like discounting of bogus export bills,
availment of pre-shipment credit from banks on the basis of bogus
contracts, opening of import letter of credit without necessary safety
clauses / without checking the credentials of the overseas suppliers.

5. GENERAL SAFEGUARDS/PRECAUTIONS

Frauds can not be prevented merely by laying down well conceived and well
defined procedural instructions. What is more important is the strict adherence
to the implementation of such instructions at the various levels. The need for
the banks to be on their guard all the time and to make available suitable
machinery for ensuring proper checks and counter checks at various stages need
hardly be emphasized. Some general precautions which may help early
detection of frauds are listed below:

1. Balancing of books of accounts with the general ledger balances should

be done every month and this should be checked by a responsible officer.
An element of rotation should also be introduced in the balancing of
books of accounts. Differences in balancing should be got reconciled
promptly.
2. Prompt reconciliation of bank accounts and inter branch transactions
should be done atleast every month and this should be checked by a
responsible officer. Unreconciled entries especially which are old, large
value and having debit balances need to be reconciled as quickly as
possible.
3. All debit and credit vouchers pertaining to a day's transactions should be
serially numbered and the totals of the same recorded in the main cash
book. The vouchers should be in the custody of passing officials who
should hand them over to another Officer for independent checking the
next day.
4. Number of accounts as per the monthly balancing books should be tallied
with accounts opened closed register and account opening forms.
5. Inoperative accounts should be transferred to a separate register and all
precautions taken while allowing operations in such accounts.
6. The blank passbooks, cheque books, deposit receipts, specimen signature
cards and other important documents should be done in the custody of a
responsible officer.
 7. Specimen signature cards should be in the custody of passing officials
only and withdrawal slips should be serially numbered and the stocks
accounted. The slips should be issued to account holders over the counter
against acknowledgement and passing officials should verify the balances
in the accounts before passing cheques for payment.
8. Balance confirmation should be obtained from depositors periodically.
9. For remittance by borrowers, supervisory officials should issue serially
numbered chalans after posting the number of the chalanas in the loan
accounts. At the end of the day it should be ensured that all the chalans
have been tendered to the bank.
10.Pledged jewels and other valuables should be verified independently by
officials unconnected with their custody. Surprise element for such
verification should be introduced.
11.Periodic rotation of duties among staff should be introduced.
12.Books of accounts of the bank should be periodically checked up by the
Chief Executive and other Senior Executives to ensure that unauthorized
entries and unauthenticated corrections do not exist.
13.After yearly closing of accounts, verification should be done to ensure
that inflated credit balances are not carried forward and differences, if
any, are reconciled immediately.
14.Banks should introduce a sound system of internal audit. The report of
the auditor and the action taken to rectify the defects should be placed
before the Board of Directors.
15.Banks should prescribe suitable periodical returns for branches and
submission of the same should be watched at Head Office.

Note: Students may also refer to the chapter No. 27 Preventive Vigilance
in Banks A Textbook of Fundamental of Modern Banking N.C. Majumdar