Rope in psychologists to check fraud in financial entities

K Srinivasa Rao | Updated on November 11, 2019 Published on November 11, 2019

Data-driven regulation and risk-based supervision cannot identify malicious intent and collaborative crime inherent in business models. Using the services of psychologists in regulatory teams will help read the fraudulent pulse better

The RBI unveiled a new unified structure of supervision and regulations for banks, non-banks and cooperative banks for more effective control. Hitherto supervision and regulatory functions of the RBI was separate for banks, non-banks and cooperative banks, operating separately and independently with no unitary control.

Such organisational restructuring by merging the supervisory and regulatory functions of the three financial entities now brought under a unitary control should be able to bring more homogeneity with better clout on their functioning.

It has been observed that despite heightened regulation and enhanced surveillance, the financial system has been marred by repeated frauds and corrupt activities eroding the wealth of millions of innocent stakeholders.

Losses due to fraud

According to RBI data, the amount of losses on account of bank frauds in 3,766 cases amounted to ₹71,500 crore during 2018-19. In the last 11 years the total losses on account of bank frauds worked out to a whopping ₹2.05 trillion. In addition to the amount of loss to the banking system, the damage that it has caused to the interconnected business units is phenomenal.

Even the best written regulations, robust systemic controls, transparency and disclosure standards are unable to detect the frauds, more importantly the tacit connivance and nexus between top management and fraudsters in some of the financial entities. Most of the high-value frauds are due to insider collaboration with fraudsters.

The reason for this is obviously the flawed implementation of laid down laws, regulations, rules, procedures in letter and spirit that often escapes the regulatory scrutiny fomenting the rot. It exposes the inadequacy in capturing malicious intentions latent in business mix that remains successfully obfuscated by the management from regulatory glare.

Selective sharing of data

With markets maturing fast and technology empowering financial entities to selectively dissect data and share only that part of information with regulators which suit them instead of sharing the big picture restricts the scope of reach of regulators to the root of the deceit.

Another formidable challenge could be the ability of financial entities to set data access levels and share only limited part of the business information that can pass regulatory test creating a continued false oasis of compliance.

Such opaqueness in sharing information and obscuring business intelligence helps organisations or a part of disgruntled people in the organisation to continue fraudulent practices siphoning precious funds of stakeholders till such time that the whistle-blowers are able to break the barriers to expose the malady.

The series such wrong intentional doings by few ill-intentioned people in the organisation led to the collapse of mighty looking Infrastructure Leasing and Financial Services (IL&FS) along with its numerous subsidiaries that have been built like scaffoldings causing upheaval in financial markets.

Its collateral damage stretched to many other small and big non-bank financial companies (NBFCs) such as Dewan Housing Finance Corp Ltd (DHFL) and Altico to mention a few. Many other interconnected NBFCs are still suffering. The Finance Bill 2019 has given powers to the RBI to restructure NBFCs that may help restore semblance in due course.

Another recent notable failure, of Punjab and Maharashtra Cooperative Bank (PMCB), caused immense pain to the innocent small and marginal depositors who rely on bank savings for their day-to-day maintenance. The recurring saga of such frauds and failure of financial entities with its attendant risk to the financial sector clearly underlines the need to further strengthen regulatory controls and a better collaboration among regulators in the financial sector.

But going by the experience of irregularity that has surfaced in the financial sector, it clearly transpires that the collateral damage caused by the impact of the spread of fraud is more dangerous than the loss due to fraud per se — like what has happened in NBFCs and co-operative banks after the events.

Innovation needed

It is difficult to contain the spread of contagion. Hence, it might be the right time to introspect if the present standard of data-driven regulations and risk-based supervision is enough to cap bad intentions of perpetrators. Will it be able to unravel the mystery of thought process and malicious intentions and collaborative crime inherent in business models? It may be necessary to think beyond data shared by entities in interpreting the adequacy of regulations.

While the journey of progressive up-gradation of regulatory controls is good, it may not be enough to guard against protracted ill-willed governance. Business losses can be assessed with stress tests but not intentions to defraud stakeholders.

Hence there is a need to be innovative in regulating financial entities going much beyond the relationship between regulated and regulator exchanging data and information. Here comes the role of psychologists in regulatory teams to interact with regulated entities to be able to read fraudulent pulse.

A research-based report of the Advisory Committee on the Auditing Profession, United States Department of the Treasury, Washington, is interesting. It highlights the need to “develop a framework that identifies three psychological pathways to fraud, supported by multiple theories relating to moral intuition and disengagement, rationalisation, and the role played by negative effect. The purpose of developing such a framework is two-fold: (i) to draw attention to important yet under-researched aspects of ethical decision-making, and (ii) to increase our understanding of the psychology of committing fraud.”

The paper will be useful to regulators to create ‘psychological red flags’ that can predict fraudulent behaviour. When the autonomy in operations of regulated entities becomes complex, normal tools of regulations may not necessarily be able to capture incipient fraud.

In enhancing the rigour, use of trained professional psychologists may be able to add to the innovative methods of mining intentions, which may not be possible to capture with the given templates of regulatory tools. More interactive models of regulations and out of box irregularly regular interface with board members and top management by trained psychologists in supervisory teams may be better able to safeguard the financial system which is going to attain new scales with GDP targeted at $5 trillion by 2025.

The writer is is Director, National Institute of Banking Studies and Corporate Management . The views are personal.

Published on November 11, 2019
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