Bank fraud and the regulator’s role | Sunday Observer

Bank fraud and the regulator’s role

Rumours are circulating of a fraud at Sampath Bank. The bank issued a short statement to the Colombo Stock Exchange on January 29, confirming that a financial irregularity had occurred, but that some of the published information was “misleading” and “inaccurate”.

The bank went stated that it was unable to provide any further information due to an ongoing investigation.

The bank said that the incident had occurred a few months back and that appropriate measures had been taken to prevent recurrence. The share price of the bank appears unaffected by the rumour and stock market punters do not seem to be unduly disturbed by the news. The regulator, the Central Bank has made no mention of the incident.

The gist of the story as per the published sources is that the branch manager in connivance with the regional manager made unauthorised transfers of funds from customer accounts to third parties.

The manager had apparently not restricted his transfers to the money lying in the account but had also fraudulently opened new accounts (in the name of family members of account holders), created overdrafts and transferred these monies as well. The fraud was apparently discovered after the manager was transferred and the customers started receiving letters from the branch requesting settlement of the loans.

The bank has stated that some of these reported facts are either incorrect or misleading-we do not know what we can be relied on and what cannot be relied on but what appears clear is a failure of internal controls within the bank. We cannot gauge the extent of the failure since we do not have access to all the facts.

Nevertheless, depositors and investors have little to fear-Sri Lanka’s banking sector is well capitalised and regulated. The failure of Pramuka Bank in 2002 and a large fraud at Seylan Bank a couple of years before that saw the Central Bank tightening regulations.

The local banking sector is also busy raising capital to comply with the (international) Basel III standard that was issued in the aftermath of the global financial crisis in 2008. This specifies tighter regulations and requirements around capital adequacy, leverage, liquidity and funding to ensure that banks maintain sufficient capital to meet financial obligations and absorb unexpected losses.

The irony is that the banks most short of capital to comply with Basel III are the State banks which accounted for 72% of the capital shortfall in Sri Lanka’s banking system, according to the ratings agency Fitch.

While there is no immediate risk to depositors, the fraud does raise important questions for customers and the banking regulator.

The dilemma with bank systems is that they depend largely on maintaining customer confidence. If customer confidence is broken and panic breaks out it can trigger a bank run - when many customers withdraw their money simultaneously for fear that the institution is, or might become, insolvent.

The problem is that once a run starts it can quickly turn into a self-fulfilling prophesy. The greater the number of customers who withdraw, the greater the likelihood of default. As rumours spread this will trigger ever more cycles of withdrawals to the point where the bank runs out of cash.

An uncontrolled bank run can lead to bankruptcy and if the insolvent bank is then unable to settle obligations to other banks it creates an industry-wide panic that can lead to further collapses and economic recession. This was the experience of several banks in Europe and the US during the financial crisis that broke out in 2009.

Apart from the obvious reason of embarrassment this is probably why the bank and the regulator are tight-lipped about the issue.

The public and customers would be anxious to know full details of what went on but the regulator and the bank would be anxious not to spread panic so how can a tricky situation like this be handled? If there is any danger of panic a joint statement by the bank and the regulator would help calm the situation. In the longer term tighter regulation and stricter systems of internal control will help but mere regulation alone will not work.

Governor Urjit Patel of the Reserve Bank of India recently stated that no banking regulator can catch or prevent all frauds, adding that it is infeasible for a banking regulator to be in every nook and corner of banking activity to rule out frauds by “being there”. What may help is further strengthening the Deposit Insurance Scheme. Sri Lanka launched a deposit insurance scheme in 2010 and in 2014 increased the level of cover to all deposits up to a maximum of Rs.300,000.

Deposit insurance schemes reimburse a limited amount of deposits to depositors of failed financial institutions. All financial institutions are required to be members make contributions based on their risk profile and other factors. The insurance scheme accumulates the contributions in a fund. It is the financial institutions themselves who finance the scheme, not the public, therefore in the event of failure the depositors have every right to receive whatever payment available under the scheme. In order to ensure that the insurance schemes fulfil their requirements, stress tests are performed at regular intervals.

As the Insurance Scheme is set up for the express purpose of repaying depositors, repayment can happen very quickly. In the EU the rule is that depositors must be able to access their funds within 20 working days after the determination of failure(which is eventually to be reduced to 7 working days). At a depositor’s request, an emergency amount may be made available even earlier. There is no need to wait for the long drawn out procedures of insolvency.

From the depositors’ point of view, this protects a part of their wealth from bank failures. From a financial stability perspective, this promise prevents depositors from making panic withdrawals from their bank,’. From a public perspective, the taxpayer will not be forced to bail out risky investment schemes.

The existing deposit insurance scheme needs to be expanded to cover larger deposits, perhaps up to about a million rupees. Managing the cost will be a problem, the banks, already burdened under heavy taxes may have to pass it on to their customers. The real risk to the financial system however is not from the banks-it comes from the non-bank financial sector; the finance companies and the micro-credit providers where asset quality is much poorer and risks of default are rising amidst a general slowdown.