RBI revises classification of frauds; 21-day respond window for loan defaulters

The Reserve Bank of India (RBI) has updated master directions to incorporate the Supreme Court's 2023 ruling on 'natural justice' for borrowers before fraud classification. Under the revised rules, regulated entities must issue detailed show cause notices (SCN) with transaction details to loan defaulters (individuals, entities or its promoters) under fraud investigation, providing recipients at least 21 days to respond.

The circular specified that the updated guidelines require regulated entities (REs) to ensure adherence to principles of natural justice promptly before categorising individuals or entities as frauds, considering the Supreme Court's March 27, 2023 judgement in the case of State Bank of India & Ors vs. Rajesh Agarwal & Ors.

In its March 2023 ruling, the Supreme Court held that the principles of "audi alteram partem," which ensure both sides are heard, should be incorporated into the RBI's circular on classifying bank accounts as fraudulent.

The new master circular mandates that banks establish a board-approved policy outlining the roles and responsibilities of the board and senior management in fraud risk management. It specifies the measures a bank's board must consider before classifying individuals or entities as fraudulent.

The new guidelines also require lenders to serve a reasoned order to entities, informing them of the bank's decision to classify their accounts as fraudulent. Additionally, banks must establish a 'Special Committee of the Board for Monitoring and Follow-up of cases of frauds,' (SCBMF) comprising at least three board members consisting of the Chief Executive Officer and two Independent Directors.

"The Committee shall be headed by one of the Independent Directors," the central bank adds.

As part of the revised master directions on fraud risk management, the RBI has enhanced the framework for early warning signals (EWS) and red-flagged accounts (RFA) to ensure early detection and prevention of fraud, as well as timely reporting to law enforcement agencies and supervisors. A red-flagged account is one where suspicions of fraudulent activity arise due to one or more EWS indicators, necessitating further investigation.

For credit facilities or loan accounts classified as red-flagged, banks must use either external or internal audits for further scrutiny.

"The EWS indicators identified for monitoring credit facilities / loan accounts and other banking transactions shall be approved by the Risk Management Committee of the Board (RMCB). Appropriate Turnaround Time (TAT), preferably not more than 30 days, for examination of EWS alerts / triggers shall be prescribed by the RMCB," RBI adds.

The central bank also emphasised the need for data analytics and a market intelligence (MI) unit to strengthen risk management systems. The updated directions will apply to regional rural banks, rural cooperative banks, and housing finance companies, aiming to enhance fraud risk management systems and frameworks across these entities.