CREDIT RISK MANAGEMENT

DR. K. SRINIVASA RAO

[email protected]

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 CREDIT RISK MANAGEMENT (CRM)–
ACCORDING TO BANK FOR INTERNATIONAL
SETTLEMENT(BIS)

• Credit
risk is most simply defined as the potential that a bank
borrower or counterparty will fail to meet its obligations in
accordance with the agreed terms.
• The goal of credit risk management is to maximize a bank’s
risk-adjusted rate of return by maintaining credit risk exposure
within acceptable parameters.
• Thereforebanks need to manage the credit risk inherent in the
entire portfolio as well as the risk in individual credits or
transactions.

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 BIGGEST SOURCE OF CREDIT RISK

• Loans are the largest source of credit risk.

• Entire concentration in credit origination process has to be
assessed from credit risk angle to prevent future default.
• Butequal care is needed in managing investment portfolio
wherever counter parties are involved.

• Banks need to identify, measure, monitor and control

credit risk as well as to determine that bank holds adequate
capital to meet credit risk, if it precipitates.

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 CRM AS PER BIS
• Banks need to manage the credit risk inherent in the entire portfolio
as well as the risk in individual credits or transactions.
• Banks should also consider the relationships between credit risk
and other interdependent risks.
• The effective management of credit risk is a critical component of a
comprehensive approach to risk management and essential to the
long-term success of any banking organization.

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 WHO SHOULD MANAGE CRM –
FIRST LEVEL - BY BRANCH/UNIT
• Credit risk refers to the
probability of loss due to a borrower’s failure to
make payments on any type of debt.
• Hence CRM begins with branch level action beginning with pre-sanction
scrutiny and maintaining rigor in the assessment.
• Credit risk management is the practice of mitigating losses by
understanding the adequacy of a bank’s capital and loan loss re serves
at any given time – a process that ha s long been a challenge for
financial institutions.
• Keeping in view the risk weights and implications of lending on the
capital adequacy of the bank

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 WHY CRM IS IN SPOTLIGHT
• The Sub Prime Crisis and global financial crisis – and the credit
crunch that followed – put credit risk management into greater
regulatory spotlight.
• As a result, regulators began to demand more transparency.
• They wanted to know that a bank has thorough knowledge of
customers and their associated credit risk.
• And new Basel III regulations will create an even bigger regulatory
burden for banks.

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 COMPLIANCE ORIENTATION
• To comply with the more stringent regulatory requirements
and absorb the higher capital costs for credit risk, many
banks are overhauling their approaches to credit risk.
• But banks who view this as strictly a compliance exercise
are being short-sighted.
• Better credit risk management also presents an opportunity
to greatly improve overall performance and secure a
competitive advantage.

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 KNOW YOUR BANK’S LOAN PORTFOLIO AND
YOUR BRANCH PORTFOLIO TO UNDERSTAND
LINKAGES
• Based on the Loan policy of the bank, the current exposure
norms – Single/group exposure norms – sectoral exposure to
avoid concentration of risk in single sector.
• Trends of Capital adequacy ratio of bank
• Trends of loan to deposit ratio – Statutory liquidity ratios
• Yield on advances
• NPA levels
• Yield net of NPAs - Stress portfolio

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 HOW TO MANAGE CRM – I
BY MANAGEMENT OF RISK WEIGHTS AND CAPITAL
• Risk weights and its impact of capital to risk weighted assets
ratio must be under the scanner.
• When handling a loan assets, branch should understand its
capital impact on the balance sheet of the bank.
• Good quality asset destresses capital and lessens risks
• Without a thorough risk assessment, banks have no way of
knowing if capital reserves accurately reflect risks or if loan
loss reserves adequately cover potential short-term credit
losses.

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 TOOLS OF CRM
1. Structure for CRM
2. Independence to risk assesses
2. Prudential exposure limits
3. Risk rating – Internal and external rating to assess risk of the
borrower. It is a grading system that serves as a single point reference
4.Risk Based Pricing
5. Portfolio based risk management strategies

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 MEASURING CREDIT RISK - I

• In order to assess the level of credit risk and profitability of loan

portfolios, banks use different credit risk measurement and
valuation methods including:
• Probability of default (PD),
• Expected loss (EL)
• Credit values at risk – Expected credit losses
• Effectiveness measures used in credit scoring methodologies.

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 QUIZ – I
• What is credit risk and why is it important to assess
and measure it ?

• What are the tools of CRM ?

• What is the impact of CRM on CRAR of the bank

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 CREDIT APPRAISAL IS PART OF CREDIT RISK
ASSESSMENT
• Thefirst step in CRM is sourcing of credit that involves
assessment of credit worthiness.
• Banks have developed various tools to improve the quality of
credit by putting the lendable project/borrower to tests.
• Debtequity ratio, Debt service coverage ratio, assessment of
maximu m permissible bank finance depending upon the cycle of
enterprise operations.
• Understanding the needs of entrepreneurs – Term loans, working
capital, non-fund based products, cash credit and many other
diverse needs of borrower.

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WHAT WE LOOK AT SOURCING OF GOOD CREDIT
-PRE CHECKS
• The prospects and needs of such projects in the area, what is the
demand, market conditions
• The knowledge, experience, leadership flair, management
capability of the entrepreneurs and succession planning.
• The
industry trends – how the project is positioned, who are the
competitors and how are they doing
• What are the government policies
• Prospects of environmental clearances and many other
preliminary checks

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 TRADITIONAL APPROACHES –IN
CRM – 5 CS
• Character – reputation, repayment history
• Capital – equity contribution, leverage, economy in
augmenting equity, own funds
• Capacity, - Competency, knowhow, leadership, skill sets
• Conditions – appropriate terms of credit suiting to the
bank and borrower and nature of his operations.
• Collateral – what is the proportionality of collateral
value to cover the loan

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 TOOLS FOR ASSESSING VIABILITY OF THE CREDIT
PROPOSAL - INTERNAL FACTORS

• Bank’s product features, pricing, repayment schedule

• Borrower details – his financials, the project and its working,
financial statements – existing/projected
• Bank’s internal norms to assess credit needs of borrower
• Tools for assessment :
• Financial statements of the borrower
• Rating of the borrower
• Arriving at the amount of loan to be given

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TOOLS FOR CREDIT APPRAISAL -EXTERNAL FACTORS
• Industry profile to which the borrower belongs
• Prospects of the industry in next 5-10 years depending upon the
duration of loan.
• Credit rating of the borrower
• Market intelligence report on borrower – depending upon bank’s
prescribed norms.
• Exposure levels of the bank and other banks
• Peer bank practices
• An industry view of the proposed activity

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 QUALITATIVE TENETS OF CREDIT RISK
ASSESSMENT - I
• Review strategic credit positions:
• Any changes to largest exposures (net of collateral)?
• How about changes to counterparty ratings?
• Any significant credits to be approved by chief credit officer or board?
• Credit limits and provisions:
• Any limit excesses?
• Limits to be rev iewed?
• Prov isions still up to date?
• All concentrations within limits?

• Credit exposure:
• All exposures covered and correctly mapped?
• Any Wrong w ay position?

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 QUALITATIVE TENETS OF CREDIT RISK
ASSESSMENT – II
• Credit reporting:
• All significant risks covered in credit report?
• Report distributed to all relevant parties?
• Any significant credits that must be discussed at top management/board level?
• Stress and scenario analysis:
• Any surprises from stress and scenario analysis at portfolio or global level?
• Anything not covered by current set of scenarios?
• Provisions:
• Any past or anticipated changes in general loss provisions?
• Any changes to specific provisions?
• Documentation:
• Full documentation in place for all transactions?
• Break clauses and rating triggers fully recognized?
• Credit protection:
• Credit protection utilized and understood?
• Any further possibility to exploit credit protection?

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DOES IT FOLLOW THE PRINCIPLES OF CREDIT RISK
ASSESSMENT
• The sound practices identifies following areas:
• An effective pre-disbursement control is a very important element of credit risk
management
• Maintaining an appropriate credit risk environment;
• Operating under a sound credit granting process;
• Maintaining an appropriate credit administration, measurement and monitoring
process; and
• Ensuring adequate controls over credit risk.
Although specific credit risk management practices may differ among banks
depending upon the nature and complexity of their credit activities, a
comprehensive credit risk management program will address these four areas.

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 PRE-SANCTION – THE MOST CRITICAL
PHASE FOR CRM

• Banks can always fix their risk appetite in terms of their current
exposure and its credit policy.
• The entire ability of CRM lies at this stage
• Beyond this line, recovery is the only way.
• The entire rigor of sanction has to be ensured here.
• Once sanction is accorded, there is no way for banks to manage
CRM except enforcing recovery.
• The acid test of CRM therefore is at pre-sanction stage.

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 TERMS OF SANCTION OF LOAN

• Each condition in credit sanction is a risk mitigant.

• The branch should be tactful to ensure that various conditions and
terms of sanction are so aligned that the ultimate delivery of
product should be risk proof as far as possible.
• Till the loan is sanctioned and conveyed, branch has freedom to
recheck the terms.
• Be meticulous in looking at the terms of sanction and visualize
what happens when credit is disbursed.

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 QUIZ – II

• What are the essentials of credit appraisal system

• What are factors to be considered in working out terms
of sanction of loans to mitigate risks ?
• It is said that calibrating terms of sanction is critical in
CRM – if so why ?

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LOAN LOSS PREVENTION – PREVENTING
SLIPPAGE OF ASSET QUALITY
• Having understood credit risk management and how to source
qualitative credit to aid mitigation of credit risk, we now come to the
stage of monitoring to ensure early detection of weaknesses, if any.
• It begins with end use verification as a tool of credit risk management
• Post disbursement monitoring including the watch on the operation of
the account is the first tool to keep a tab on the quality of loans.
• By collaborating with the borrowers, we should ensure that the funds
are used for the purpose for which it is sanctioned.
• Any sign of diversion of funds is the start of weakness

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POST SANCTION ACTIVITIES TO PROVIDE SIGNAL
OF EARLY SIGN OF WEAKNESSES

• Early signs could be Instances of Cheque bouncing, cheques

issued to unconnected people and transfer of funds to other
accounts is to be carefully watched even if the account is
operated within the limits.
• Non compliance to the terms of sanction of loan – stock
statement, inventory details, book debt details and so on

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 CONDUCT OF THE LOAN ACCOUNT –
PULSE OF CRM
• Operations in the account – Credit/debit in the account
• Compare transactions with turnover to ensure that all
transactions are routed through bank account.
• You can identify if he is discreetly banking with others
• Diversion of funds, if any
• Conduct test check on beneficiaries to whom cheques are
issued.
• Check if any cheque is returned for financial reasons
• From where funds are getting into the account

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 STOCK STATEMENTS/ ASSET DETAILS
• Undertake regular site inspection to see that all machinery/stocks
financed by the banks are properly functioning
• See their usage – is there any under utilization of assets
• Are they kept safe
• Is there maintenance of proper record of stores
• Is there proper inflow/usage of material in the site
• Is excess stock piling up
• Is the warehouse/store is well organized to retrieve stocks in time

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INSPECTION OF ASSETS OF BORROWERS/MORTGAGED
PROPERTY

• Similarly
collateral property mortgaged to bank
should be checked
• Reports of inspections to be preserved
• Discuss with the borrower about state of the
property
• Ensure that their title deeds are preserved
properly

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PERIODICAL FINANCIAL STATEMENTS
• Call for stock statements regularly
• Check them and arrive at the drawingpower to determine how
much working capital can be allowed known as setting drawing
power
• Check financial statements and di scuss about the variance in
sales in relation to projections
• See if profits are reasonable
• Any abnormal deviations need to be discussed with the borrower
• Course correction to be discussed with management

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REGULARITY IN PAYMENT OF STATUTORY DUES
• Satisfy that all dues are paid in time
• Capture data from early alerts – classification of loans into
different stages as per the central bank norms.
• All statutory dues are listed and paid without default
• Insurance is sufficient and record keeping is intact
• Check if salary/wages of employees are paid in time
• Bonus/OT, if any is honored.

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 ADEQUACY OF INSURANCE OF ASSETS IN THE
SITE
• Allmovable and immovable property of the unit must be
adequately insured.
• Due date diary of insurance is to be checked
• Premium details/ extent of coverage is to checked
• Negotiation of terms of insurance should be understood by the
unit
• Claims, if any are followed up
• Fire protection is provided and rescue/eviction map is in place
• Disaster management systems are in place

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 MANAGEMENT SYSTEMS – HUMAN RESOURCE
MANAGEMENT – CONFLICTS AND RESOLUTION
• Management control systems – Internal inspection of the laid down
policies and procedures must be in place.
• Management audit must be got done
• Concurrent audit is to be institutionalized
• Statutory audit/customer service audit
• Industrial relations at the unit
• Training and HR policies to be in place

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REGULARITY IN PAYMENT OF DUES TO
VENDORS AND EMPLOYEES
• Therecord of purchase of accessories/raw material and vendor
payments record must be prompt.
• The
average period of bills payable and book debts must be kept
under watch.
• An y rise in average duration is a sign of stress in the fund flows
of the borrower which can be monitored.
• Similar is the control on out sourced activities and their
payments

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REGULARITY IN THE COMPLIANCE WITH
LOCAL LAWS
• License renewal/lease rent renewal/industrial allotments
• Environmental clearances
• Taxes and cess to be paid to local authorities
• Fire preparedness/compliance to such laws
• Municipal clearances, if any
• Permissions for business, if any

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 CREDIT RATING PATTERN OF THE BORROWER

• What is the credit rating – is there any change – Up-

gradation/down-gradation – reasons
• What action the borrower is taking to restore rating
status
• How the portfolio rating mix – is it on improvement trail
• Is he transparent in his communication

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LOAN REVIEW MECHANISM (LRM)
• It is an effective tool for constantly evaluating the
quality of the loan book and bringing about qualitative
improvements in credit administration.
• In this regard, banks formulate a loan review policy
under the review of BOD, annually. The policy should,
inter alia, address:

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 STRESS TEST FOR CREDIT RISK ASSESSMENT
• Stress test for
credit risk assesses the impact of increase in
the level of nonperforming loans of the bank on Capital
Adequacy Ratio (CAR).
• This involves three types of shocks, namely;
• Type One deals with the increase in the Non-Performing
Loans (NPLs) and the respective provisioning.
• TypeTwo deals with the negative shift in the NPL categories
and hence the increase in respective provisioning.
• TypeThree deals with the fall in the Forced Sale Value (FSV)
of mortgaged collateral.

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 QUIZ – III
• Even when the loan account is running well what are
those signages that provides an inkling of manifesting
credit risk
• Operations in the loan account is considered as the
heart line of monitoring of the account - why ?
• Why site visit is important ? What factors can come to
light during the visits ?

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WHAT IS FRAUD IN A BANK

• The criminal offense of bank fraud is deliberately engaging in a secret

scheme or deception intended to defraud a bank or financial institution, to
obtain money or property owned by the bank or financial institution. Bank
fraud is considered to be a white collar crime.
• By cyber attacks funds can be diverted which need equal attention
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WHAT IS LOAN FRAUD – LOAN FRAUDS/CYBER
ATTACKS TO SIPHON FUNDS
• Loan fraud simp ly means when someone uses wrongful identity to illegally
obtain a loan. The crime has many variations. In the US, for example,
mortgage fraud is the most common.
• Catching loan thieves can be challenging.
• The fraud can go unnoticed for quite some time, and gradually the debt
starts piling up in your name.
• If technology is used to divert funds, it is necessary to trace and track the
flow of funds to find the culprit

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INTENTIONAL FRAUD BY BORROWERS
• Simply put, when someone provides false information on their
loan application, it is loan fraud.
• This can be during the time of filling in the application or when
receiving the loan.
• In many cases, the banks suffer a loss for providing loan to
someone who is not entitled.

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LOAN ACCOUNTS TURNING FRAUDULENT LATER
• While fraudulent loans to people with impersonation or based on forged
documents are quite common but in many cases a going loan account,
initially good turns fraudulent due to circumstances.
• When the borrower is unable to cope with the business challenges, he may
sell property with forged documents that are already mortgaged to bank
• Diversify the loan amount to purposes other than for which it is granted.
• Goes out of the country without informing the bank and loan becoming
irrecoverable

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UNREALISTIC DATA OF PERFORMANCE CAN BE A SIGN
OF IMPENDING FRAUD.
• Normally, businesses would inflate their earnings in order to score a
bigger loan from banks. To spot this in time, a detailed evaluation of
the business is necessary. Yes, it can be challenging.
• The lender might have to hire a seasoned financial analyst to help
with accepting or rejecting a loan application.
• Cases of companies manipulating their books of accounts to impress
investors and analysts are not uncommon.

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HOW TO DETECT LOAN FRAUDS
• Loan Fraud Detection can be tricky. Loan thieves frequently change banks
or states, making it difficu lt to spot patterns or a business trail. Ho wever,
there are red flags that the banks can look out for;
• It’s a red flag when a person owns several businesses in under one name,
especially when there isn’t much income to back up that claim.
• This scheme is prevalent among money launderers.
• Changing location of business quite often
• No Physical Location or Address of Business. KYC is essential

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FRAUDS IN CREDIT RISK MANAGEMENT
• A variety of factors are leading to an increase in NPAs.
• A key factor, is increased incidence of frauds and fraudulent diversion of
funds by the borrowers.
• In the recent past, various banks, on the directive of central bank, have
conducted forensic audits.
• However, the spate of financial frauds is not showing signs of abating.
This coupled with delays in detection and reporting is making matters
worse as information is not shared with other banks on a timely basis to
nip matters in the bud.

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FRAUD DUE TO STAFF COLLUSION AND NEXUS
• In an anxiety to make quick big gains, staff collusions with fraudsters
are on the rise.
• In India, Major frauds were unearthed in PNB, PMC Bank, Yes Bank and
Global trust banks where the internal bank staff have enabled the
frauds to take place involving huge losses to the banks.
• Even corporate sector frauds are not un common – Globally Enron
scandal, collapse of Arthur Anderson and Barings Bank collapse are
classic examples of nexus of internal staff in perpetrating frauds.
• Similarly
in India, Satyam computer is engineered by the owners
themselves.

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FRAUD MANAGEMENT
• Though there are various methods institutionalized to prevent
frauds in the banking system – the most effective methods is
‘sensitivity and alertness’ of other employees who are not part of
the fraud.
• Relyingtoo much on colleagues or blind faith can be counter
productive where even the innocent people become victims to
someone else perpetrating fraud.
• While doubting integrity of people is to be avoided but a careful
observation of lifestyle and moment of people could help unearth
fraudulent activities before they cause harm.

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TOOLS FOR FRAUD MANAGEMENT
• Preventive vigilance
• Training is early detection of frauds
• Enhanced cyber security
• Whistle blower policy
• Surprise visits/inspection of branches
• Management audit
• Credit audit at the site of the borrower
• Regular inspection of loan documents
• Proper due diligence of valuers and legal experts to use their services

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ENHANCING SYSTEMIC CONTROLS
• Increasing priority of regular audit
• Classifying branches as fraud prone if the history says
so – be alert with them and be extra cautious.
• Classifying branches into fraud risk categories
• Maintaining fraud registry to alert other staff about
pattern of frauds.
• Occasional cross verification of documents/mortgages
provided by borrowers on test check basis.
• Circulation of modus operandi of frauds.

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FRAUD PREVENTION STRATEGIES
• Institutionalize a ROBUST Fraud risk identification, event
reporting, control, allocation and mitigation framework. ‘Four
eyes principle’ must be followed in all sensitive areas without
compromise.
• Follow the 5 ‘Cs” of CREDIT - Capacity, Capital, Collateral,
Conditions and Character.
• Bring in a CULTURE of eternal vigilance, strong internal control
and compliance . Please remember Fraud is criminal offence.
• Introduce effective checks and balances to calibrate PEOPLE
RISK.
• Insulate technology fire walls and conduct vulnerability tests

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 FRAUD RISK MANAGEMENT
• Concerned over the increasing incidence of frauds, central banks
have increased its focus on frauds committed on banks by
borrowers and has over a period of time set up various
mechanisms towards mitigating this risk.
• The new concept of ‘Red Flagged Account’ (RFA) has been
introduced in the existing fraud risk management framework to
deal with loan frauds.
• Enhancing capability within the credit monitoring team to
perform adequate and enhanced background checks and gather
market intelligence on prospective borrowers is necessary to
prevent frauds.

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 INVESTIGATION OF FRAUDS – ON THE LINES OF
FORENSIC AUDIT – I
1. Bank statement analysis:
• Promoter cash contribution analysis • Fund tracing - inward and
outward • Payment and credit history • Interest coverage and
payment • Multiple bank account operations • capture huge cash
withdrawal
2. Review of books and records:
• Financial statement analysis • Insurance and security coverage •
Project cost benchmarking • LC/BG structure and operations •
Debtors and creditors turnover • Complex entity structure •
Qualified internal and external audit reports

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INVESTIGATION OF FRAUDS – ON THE LINES OF
FORENSIC AUDIT – II
3. Public domain checks:
• Litigation and disputes analysis • Adverse media reports •
Related and associate entity identification • Validation of ROC
information with financials • Inadequate public discloures •
Regulatory/trade sanctions.
4. Market and intelligence field visit:
• Enforcement action on borrowers • Frequency project profile
change • Physical verification access not available • Frequent
management changes • Borrower and competition analysis • Inter-
connected entities and relationship identification

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FRAUD INVESTIGATION STRATEGIES
• Further, in addition to ramping up capability to perform
detailed financial and transaction reviews, banks may
be required to invest in building expertise to gather
market information and conduct regular intrusive public
domain checks to identify EWS

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ADDITIONAL READING MATERIAL
• https://home.kpmg/content/dam/kpmg/pdf/2015/06/Framework-Loan-
fraud.pdf
• https://www.bis.org/review/r170202d.pdf
• https://qed.qld.gov.au/our-
publications/managementandframeworks/Documents/corp-
governance/fraud-corruption-control-framework.pdf
• https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/press/pr/pre
ss_20210121_beware_of_online_financial_frauds_and_scams_e.pdf

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 RECAP TASK
• Each participant to summarize the take away from this
session in 300 words and submit to me by email to
[email protected] or to the program coordinator for
forwarding to me – Time line by end of Monday – 15/11/2021.
• This presentation will be shared by the coordinator which
you can flip through to recollect what we learnt.
• It will help
me to verify if the deliverables are in sync with
the design of the program.

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