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In view of the recent Nirav Modi-led Punjab National Bank (PNB) fraud case, Reserve Bank of India (RBI) Governor Urjit Patel on Wednesday said that it is not possible for any banking regulator to catch or prevent all frauds.
Delivering the inaugural lecture at National Law University, Gandhinagar, Patel said, "There has been a tendency in the pronouncements post revelation of the fraud that RBI supervision team should have caught it. While that can always be said ex post with any fraud, it is simply infeasible for a banking regulator to be in every nook and corner of banking activity to rule out frauds by 'being there'. If a regulator could achieve such perfect outcomes, it would effectively imply that the regulator can do anything that banks can do, and by implication, can simply perform the entire banking intermediation activity itself".
Patel added that the RBI had issued precise instructions via three circulars in 2016 to all banks to eliminate such hazards. But PNB failed to follow instructions.
"What is needed is that various mechanisms to deter frauds and other irregularities are in place so that fraud incidence is low and magnitudes contained. Indeed, frauds have happened at banks in regimes with varying levels of banking regulatory quality and in both public and private banks. In the specific case at hand, the Reserve Bank had identified, based on cyber risk considerations, the exact source of operational hazard -through which we understand how the fraud had been perpetrated. In particular, the RBI had issued precise instructions via three circulars in 2016 to enable banks to eliminate the hazard," he added.
He also said that it is essential for banking regulatory powers to be ownership neutral.
"Banks in most parts of the world, however, have a significant portion of deposit funding that is insured, and since banks serve critical payments and settlements function, they are often too big to fail or too many to fail. Hence, a part of the market discipline is weakened as a trade-off with financial stability and is substituted by a delegation of supervisory and regulatory powers to a banking regulator. Detection and punishment by the regulator then need to be effective to discipline fraud," he said.
"Investigative and formal enforcement process takes in our country, perhaps for the right reasons, a fair bit of time. Indeed, RBI data on banking frauds suggests that only a handful of cases over the past five years have had closure, and cases of substantive economic significance remain open. As a result, the overall enforcement mechanism - at least until now - is not perceived to be a major deterrent to frauds relative to economic gains from fraud," he added.
He believes that in the case of private sector banks, the real deterrence arises from the market and regulatory discipline.
"It is fair to say that in case of private sector banks, the real deterrence arises from the market and regulatory discipline, and their confluence. A private bank CEO's primary concern is whether s/he will be able to raise capital when the need arises or even whether s/he will still be running the bank the next day. The point is that they could be readily cautioned through their Boards and even replaced by the RBI in case of large or persistent irregularities. Further, a private bank failing to meet bank solvency standards and under RBI's "prompt corrective action" (PCA) would find it hard to raise capital, whereby it would need to put the house in order at swift notice so it can raise funding from markets and get back to a growth path. In turn, there are incentives to invest in governance, so as to limit frauds and regulatory violations, and to respond with alacrity when incidents do arise," Patel concluded.
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