WIRC 24 March, 2012

th

Bank Branch Statutory Audit

VERIFICATION OF ADVANCES
Paper Presented by :

CA Ismail B. Sonawalla

200, Ashoka Shopping Centre, 2 floor, L. T. Marg Next to G. T. Hospital, Mumbai 400 001. Tele: 022-2269 0070

nd

RBIs site www.rbi.org.in - Check for various circulars

A. Various Laws Applicable or Whose Knowledge is Essential

2 sets of Laws Applicable to the Lender Applicable to the Borrower 1) 2) 3) 4) 5) 6) 7) The Companies Act, 1956 or any other statute under which the Bank is registered. (applicable to the Bank and the Borrower registration of charge, resolutions, borrowing powers etc.) The Banking Regulation Act, 1949 (B. R. Act) The Reserve Bank of India Act, 1934 The Foreign Exchange Management Act & FEDAI rules The Income Tax Act, 1961 and its rules (TDS, Tax audit, Income tax) Service Tax rules The Stamp Act applicable to the respective State and / or The Indian Stamp Act The Indian Contract Act, 1872 Transfer of Property Act, 1882 Sale of Goods Act, 1930 Negotiable Instruments Act Law of Limitation (3 years limitation for documents) Memarts / Byelaws / Annual Closing Guidelines of the Bank Accounting Standards - Policies & Guidelines

8) 9) 10) 11) 12) 13) 14)

Certain features of these laws which need to be considered are follows:

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Banking Regulation Act Sec.5A of B.R. Act - The provisions of the Banking Regulation Act override the ones in any other Act or the Rules or Byelaws including the Companies Act, 1956. Sec. 14-A of B. R. Act - A Bank cannot create a floating charge on its assets. Sec.20 of B.R. Act Bank cannot give loan against its own shares. Sec.20 of B.R. Act - Loans are not allowed to be given to directors (including members of any committee) or firms or companies in which directors are directly or indirectly interested. Further, under Sec 20A of B.R. Act Remission of loans given to the above persons can be done only with the prior approval of RBI. For further details, refer RBIs Master Circular Loans & Advances Statutory & Other Restrictions dated 1st July, 2011. Sec.21 of B.R. Act RBI has power to control advances being given by a banking company. The maximum amount that can be advanced to one borrower is prescribed by RBI and the byelaws - Prudential norms state that the total exposure (funded & non-funded) should not exceed 15% of the banks Capital Fund for individuals and 40% for groups. Sec.29 of B.R. Act - Banks have to prepare Balance Sheet and Profit & Loss Account in Form A and Form B respectively as given in Third Schedule to the B.R. Act.

Stamp Acts For purpose of stamping of documents, Branch to follow law of the place where document is executed and not where registered office of bank is situated. Eg., for stamping of documents executed by a branch of Bank of India in Gujarat, The Bombay Stamp Act (as applicable to the State of Gujarat) to be followed and not the Bombay Stamp Act (as applicable to the State of Maharashtra), which is applicable to its registered office in Mumbai. If certain provisions not available in States Stamp Act, provisions of the Indian Stamp Act, which is a central act, to be followed. eg. provision for revenue stamp

Annual Closing Guidelines Major policies and rules that the Bank follows are given in the Annual Closing Guidelines. Hence, very essential that the same is read before the audit of Advances is commenced. If some of these guidelines are not in line with the Accounting Standards or other statutory guidelines prescribed, the guidelines, as given by the Bank should be followed and the fact about its deviation from the statutory guidelines to be given in the report.

B. Major Master Circulars issued by RBI during the financial year 2011-12
During the year, RBI has issued a number of circulars concerning advances and other topics. On certain topics, they have consolidated all the previous circulars and issued what is called Master Circular. The auditor should acquaint himself with the contents of all such circulars, before commencing the audit. More than 70 Master Circulars have been issued, details of some of which is given in Annexure-1
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C. Audit of Advances
General Before commencing, desirable to study accounting system followed by Branch, especially if it is computerized, since a large number of details required by the Auditor for verification as well as LFAR reporting, can be generated from the system itself no need to prepare one manually. Some of the statements that could be generated by the system as on 31st March, are as follows: Facilitywise / partywise list of accounts outstanding, alongwith the outstanding balance. The aggregate total of these lists should first be tallied with the figure of total advances in the Trial Balance to ensure that none of such statements have been missed out. Sanctioning powers of the branch officials and the higher authorities List of accounts where the regular facility or the adhoc facility is due for renewal, but has not been renewed List of accounts where stock / book debt statements are in arrears List of accounts where no insurance or inadequate insurance has been taken. List of accounts overdrawn beyond the sanction / DP limit. List of accounts where stock audit is due, but has not been done List of accounts where inspection has not been carried out in the last 3 / 6 months. For CC / OD accounts, monthwise details of debit and credit transactions NPA statements, as prepared by the Branch Discussion with Credit Officer may reveal information about further such statements which are generated from the computer.

Type of Facilities Based on Funds Funded where actual money is given by the Bank and Non-Funded where only a guarantee or commitment or co-acceptance is given that a certain amount would be paid on the occurrence of certain unknown events, or an accepted bill would be honoured on presentation (Letter of Credit) Based on Geography Inland and Export (Packing/Pre-shipment credit, Post-shipment credit) Based on Security Secured and Unsecured Secured - one granted against some security, while unsecured - one given against personal surety only. Secured can be further divided into hypothecation, pledge, mortgage, assignment etc. The security could be tangible (goods) or intangible (bank / government guarantees). Based on Sector Priority sector (40% by RBI) and Non-Priority sector Priority sector is one in which persons with small means are engaged or which needs to be supported / encouraged by the government.

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Type of Advances Demand / Term loan - such advance, though called demand loan generally repayable in predetermined instalments. If repayment period exceeds 36 months, called Term loan. Cash Credit this advance generally granted without any stipulation for repayment, but is required to be renewed every year. Such advance, granted generally against security of stock and book debts is called Cash Credit. When a borrower is allowed to draw beyond his sanctioned limit or drawing power limit, the said amount is called Temporary Overlimit TOL. TOL secured by existing securities against which the Cash Credit sanctioned. Overdraft - advance similar to Cash Credit, except that either no security is taken (termed as Unsecured Overdraft) or security is other than stock and book debts eg. FD receipts, NSC receipts, shares, LIC policies, etc. When such secured or unsecured overdraft granted to borrower to tide over temporary financial crisis, it is called Temporary Overdraft TOD. Unlike TOL, which is generally secured, TOD is generally unsecured. Bills Purchased / Discounted when advance against sale bill is granted to seller with the condition that the same should be repaid before the physical possession of the goods passes on to the buyer, it is called Bills Purchased facility; when an advance is granted against a sale bill, wherein the buyer has received the goods and has agreed to pay the amount therein within a stipulated period, such a facility is called Bills Discounted.

Extent of Verification Based on existence and efficacy of internal control procedures (including concurrent audit) Auditor to verify all large advances constituting more than 5% of the outstanding advance or Rs.2 crore, whichever is lower If NPAs are high or extensive problem is identified, percentage of check to be increased. During FY 2008-09, RBI had announced a revised restructuring scheme for all the advances and it quite a few borrowers have taken advantage of it. All such accounts, as well as all accounts which have heavy NPAs should be selected for verification.

Reporting of Verification Statutory Auditors have to report about discrepancies noted in the Advances in two separate reports one is the Statutory Audit Report for Major / Critical Discrepancies and the other is a detailed report in the Long Form Audit Report (LFAR) under para I-5 Advances. Before commencing verification of Advances, Auditor to devise query noting format, so that requirements of above two reports are also complied with simultaneously.

Stages of Verification (COMMON SENSE IS THE MOST IMPORTANT INGREDIENT) It is suggested that for verification of Advances especially the big ones, all the stages of verification should be done by the same person to enable him to get a birds eye view of the account. A suggested format for the same is enclosed herewith (Annexure-2).

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RBI has issued a letter dt. August 7, 2004 outlining Deficiency found in sanctioning of loans and monitoring of borrowal accounts by banks / financial institutions (Annexure-3) RBI has also issued a Master Circular LOANS & ADVANCES STATUTORY & OTHER RESTRICTIONS dated 1st July, 2011. The same also needs to be read. (i) Credit Appraisal & Sanction Documents required documents required vary based on the profile of the borrower; however, certain documents that need to be checked are: Statement of accounts, debtors, creditors and stock, projected balance sheet and profit and loss account, visit report by the branch, valuation report or proforma invoice for plant and machinery, vehicle, etc., credit appraisal report of the bank, papers showing net worth of the borrower and guarantors, confidential report from other banks, ratio analysis, etc., various licences as required by that business, proforma invoice for purchase of machinery / equipments, financial papers of guarantors, confidential report from previous bankers, if any; for partnership firms partnership deed; for companies - memarts, resolution, etc. Sanction Letter authority to sanction / terms of sanction whether complied Conditions by RBI - Prudential norms (individuals and group), etc In its Master Circular on Exposure Norms dated 1nd July, 2011, RBI has prescribed norms for banks exposure to various sectors. It includes norms as to the maximum amount that can be advanced to a borrower individually and all sister concerns (having commonality of management and effective control) taken together as a group. Presently, the norms say that the total exposure (funded & non-funded) should not exceed 15% (for individuals) / 40% (for group) of the capital fund of the bank. Loans against security of shares, bonds, etc. to an individual not to exceed Rs.10/20 lacs, if the securities are held in physical / demat form respectively. Uniform margin of 50 per cent to be applied on all advances / financing of IPOs / issue of guarantees on behalf of stockbrokers and market markers. A minimum cash margin of 25 per cent (within the margin of 50%) to be maintained in respect of guarantees issued by banks for capital market operations Previous adverse comments - Any adverse comments on the account in previous statutory audit, internal inspection, concurrent audit etc.

(ii)

Disbursement Documents by the Bank A-DP Note, B-Hypothecation / Pledge / Mortgage documents, C-Letter of Guarantee etc. No tick marks on documents Stamping (as per the law applicable) Documents to be obtained Charge Noting with ROC / RTA / Co-op. Housing Society, Assignment of Policies, Transfer of shares, NSC, FDR, Insurance etc. Insurance all immovable and movable properties assignment in favour of Bank Special Conditions Mode of disbursement (direct payment), clearing of dues, processing charges etc.
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(iii)

Review of Operations MOST IMPORTANT RBI Any transaction susceptible to fraudulent transaction to be directly reported to RBI by the Auditors. Intelligent scrutiny of the bank statement (debit / credit entries, cash / cheque, transfer from / transfer to accounts, frequent return of cheques, excessive withdrawals / deposit in cash, no / inadequate payments by cheque for purchases, no / inadequate deposits by cheque for sale proceeds, turnover in the account disproportionate to the sale / turnover of business, payment to persons or for items not related to this business or transfer of funds to personal accounts of owner or sister concerns etc. (diversion of funds) Drawing power (DP) limits based on the stock and book debts of the borrower, monthly / quarterly drawing power limits are fixed, which are equal to or less than the sanctioned limits; the auditor has to verify whether the account is frequently / continuously overdrawn over the DP limits; at times, DP limits are enhanced for temporary period by sanction of adhoc limits. Incidently, this verification is also necessary for NPA classification of the borrower. Verification of stock / book debt statements - compare movement of stock / book debts from month to month with turnover in account and purchase and sale declared by the borrower in the stock statements; the stock and book debts declared in the statement for March of the previous year to be compared with similar figures given in the audited or unaudited financial statements of the concern; book debts statement to be certified by a chartered accountant on a quarterly basis; for non-submission of these statements, penalty is charged; necessary to verify whether the stock includes unpaid stock (represented by Sundry Creditors), stock under L/C, stock under Packing Credit, etc., since all these stocks being unpaid stock have to be deducted from the total stock considered for DP limit. Specifically verify the genuineness of stock-in-transit. Account with other banks is it permitted, purpose, details of transactions etc. Audit and audit reports compulsory for non-corporate entities, with sanctioned limits above Rs.10 lacs, to get their accounts audited. Recovery of instalments & its source / turnover in accounts frequent overdrawings. Special conditions in case of advance against exports, the same has to be informed by the bank to Export Credit Guarantee Corporation (ECGC) to cover the said advance under its insurance scheme. Further, concessional rate of interest is charged to the borrower, provided certain conditions are fulfilled and the advance is liquidated within a specified time limit out of the export proceeds. If the same does not happen, the benefit of concessional rate of interest is withdrawn. Balancing of books (General ledger with Subsidiary ledgers) Major frauds take place
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(iv)

Renewal / Enhancement / Reschedulement / Balance Confirmation Generally at the end of one year, unless it is an adhoc advance or it is otherwise specified in the sanction letter; non-renewal can make the account a non-performing asset (NPA). For limits re-aligned or enhanced, necessary documents to be executed. Even if the limit is sanctioned for a temporary period, proper stamping and execution of the necessary documents is mandatory. Where a project gets delayed or temporary crisis arise in the business of the borrower, the loan repayment amount and its time is rescheduled. Reschedulement is permitted, but sanction for the same from the appropriate authority is necessary. To avoid documents becoming time-barred, Letter of Acknowledgement of Debt (LAD) to be obtained, preferably every year; applicability of Law of Limitation.

(v)

Physical Inspection of Securities (Visit to office / factory & verification of accounts) Stock / Machinery (obsolete stock, non-working machinery) generally Statutory Auditors do not go for inspection, but rely on report of stock / concurrent / internal auditors adverse comments to be looked into. Stock audit mandatory above a certain limit of advance prescribed by bank. Further, if account is NPA, mandatory for bank to obtain stock audit report from an external agency every year in cases, with o/s balance of Rs.5 crores and above. Auditor to examine these reports to see if there are any adverse comments and its rectification. Special attention to non-moving stock & obsolete machinery included in stock statements on the basis of which DP limit is determined. Demat or physical shares / TDR / Other Scrips with Branch Valuation of securities in case of loan against shares, bank to prepare periodical statement of valuation of shares pledged to check whether margin is still maintained. In case of NPA accounts, it is mandatory for the bank to obtain valuation report for all immovable properties / machinery mortgaged / hypothecated to the bank atleast once in 3 years.

(vi)

Verification of charges due on the advances Following charges recoverable at rates prescribed. Auditor to test check recovery. Charges for processing of loan, stamping, insurance etc. Interest / charges on the advance, including withdrawals against effects (WAE), temporary overlimit etc. Charges for late / non-submission of stock / QIS statements, nonrenewal of limits, inspection, valuation, etc.

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Certain Indicators which could lead to identify Irregular Accounts / Frauds While verifying loans and advances, the auditor has to take cognisance of certain indicators, which may lead to irregular accounts / frauds. The branch has 1 or 2 major borrowers constituting more than 50% to 75% of the total advances of the branch, to whom the branch goes out of its way to give continuous overlimits or withdrawals against uncleared effects or does not pursue recovery of overdue bills or stock statements are not received in time and yet drawing power limit is continued or account is not renewed on due date or adhoc limits are not cleared and yet facility is continued, etc. etc. While verifying CC a/c, OD a/c and bills a/c, the following observations are made account remains continuously overdrawn; a number of cheques are bounced due to insufficient funds; cheques deposited are not honoured and returned unpaid; the account has been granted continuous TOL by the branch for 20 to 25 days every month moreover, such TOLs have been granted by the Branch Manager, at times, without having the power to do so; the 12 months turnover in the account does not commensurate with the sale and purchase shown in 12 monthly stock statements or the statement of accounts submitted; the realisation of bills purchased / bills discounted is not received on the due date and subsequently the same are cleared by debit to the borrowers CC / OD a/c; as soon as the above bills are cleared, fresh bills are purchased / discounted; the facility has not been renewed on the due date and the reason given is that the borrower has not submitted the necessary papers; all overdue CC limits, OD limits, unrealised bills, unrealised interest are bundled together and the borrower is granted WCTL Working Capital Term Loan to avoid the account becoming NPA. Such bullet loan is an indicator that the account is having problems; for certain accounts, when papers are asked for, the branch is unduly slow in producing the same or makes a plea that the same have been sent to some authority and hence is unavailable at the branch; in case of certain accounts, the Branch Manager pleads not to put any adverse remark in the report and that he shall get it rectified after the audit is over; in certain cases, the branch just does not produce the papers, pleading that the same are not traceable; While verifying monthly / quarterly stock statements submitted, the following observations are made generally stock statements are not submitted on time;

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the itemwise details of stock is not given and instead lumpsum figures are shown without quantitative details; if itemwise details are given, a comparison of statements submitted over a period of time shows that the same stock is repeated over and over again with the same quantity and value; there is heavy sundry creditors indicating unpaid stock, but the said amount has not been deducted from the stock value, before determining the DP drawing power limit of the borrower; the stock statement contains details of stock, which have actually financed by the branch under LC limit or Packing Credit limit or some other limits; there is a huge difference in the closing stock shown in the stock statement of 31st March, 2011 and the audited / unaudited accounts submitted subsequently or better still, the borrower does not submit the stock statement of March or the same is untraceable in the branch; the stock statement reflects an unusually high amount of stock in transit every month, which does not commensurate with the monthly purchases or the monthly turnover in the accounts; though mandated, the Branch has not obtained the stock audit report; the stock audit report has adverse comments, but the Branch has not taken any corrective steps; OR the Branch Manager states that subsequently he has visited the unit and everything is rectified and regularised; the stock inspection done by the branch is superfluous and does not record the details of the stock verified a few direct indepth questions to the branch staff, who went for the concerned stock inspection would reveal the quality of the inspection done; While verifying monthly / quarterly book debts statements submitted, the following observations are made book debts due for more than 90 days are not segregated, though the same is mandated in the Sanction letter; a comparison of last 10-12 months statement reveals that there are a number of book debts, which probably are being shown for more than 8-10 months and may be bad debts or recovered, but not deducted from the statement; A comprehensive 10-12 months analysis of monthly sales, purchase and stock as shown in the stock statements, the book debts, the turnover in the accounts and the audited financial statements may reveal that the stock statements submitted every month are highly inflated. Verification of other records at the branch verification of immovable property documents under ultra violet rays can reveal whether the document is genuine or a xerox copy;
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in immovable property loans, the branch has not obtained search report of the property from the Registrars office, or the adverse comments in such report have been ignored; the branch has not obtained NOC from the builder / society or such NOC has been personally brought by the borrower to the branch instead of the same being directly obtained by the branch from the builder / society; in case of loans to limited companies, details of previous charges have not been obtained or if any adverse observations have been made, the same are ignored for eg. the report shows that the borrower has borrowed from other banks without the knowledge / permission of the existing banker, old charges which were supposed to have been cleared have not been done indicating that old loans are still outstanding; there is correspondence on record, which states that on the same immovable property, the borrower has obtained loans from more than one bank; the branch has filed a suit against the borrower to recover the amount;

D. Verification of Non-Funded Advances

Generally, verification of funded and non-funded advances done simultaneously; certain components of non-funded advances need to be looked into. Reserve Bank of India has issued a Master Cicular dated 1st July, 2011 under the heading Guarantees and Co-acceptances Non-funded advances called Off Balance Sheet items, as their value not reflected in Balance Sheet. They form Contingent Liability. However, for purpose of keeping a control over these items, banks pass contra entries in its books of accounts at branch level & hence these items get reflected on liability as well as asset side of Trial Balance. However, while preparing Balance Sheet of the bank as a whole, value of these items reflected in Notes to Accounts. RBI has mandated banks not to do non-fund business (guarantees, co-acceptances, LCs) with persons, who do not enjoy credit facilities with the bank. (i) Guarantees Two types financial guarantee, wherein guarantor (bank) promises to pay stated amount to beneficiary, if person for whom guarantee is given, fails to pay the same (invoking the guarantee); performance guarantee, wherein guarantor promises to pay beneficiary a stated sum, if the person for whom guarantee is given, fails to perform, as expected, in a given period of time. Banks generally discouraged from issuing Performance guarantees. Comprises of two independent, but related components one guarantee issued by banker (of buyer) to beneficiary (i.e. seller) and other is counter guarantee given by buyer to his banker. Since invoked Guarantees become funded advance, banks not to encourage borrowers to over extend their commitments solely on the basis of guarantees. Guarantees for specific transaction (specific guarantee) or for multiple transactions within a specific time frame (continuing guarantees); should be for short durations maximum maturity period - 10 years. Unsecured Guarantees to a particular borrower not to exceed 10% of total exposure
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Banks not to concentrate its unsecured Guarantees to a particular borrower or a group. Ghosh Committee recommended precautions to be taken by banks while issuing Guarantees. Guarantees issued by keeping margins, either as cash / term deposit or some other security. Guarantees issued on behalf of share and stock brokers - RBI has advised banks to obtain minimum margin of 50% (with 25% being cash margin) RBI restrictions on guarantees of inter-company deposits / loans and inter-institutional guarantees. RBI - extensive guidelines on issue of guarantees on behalf of exporters and importers. Letter of Credit (LC)

(ii)

LC a promise by banker to honour payments to be made by its customer (buyer or importer) to seller or exporter. Generally used in international trade. At request of buyer, his banker opens an LC, which is sent to seller. Based on such LC, seller despatches goods and sends bills through his banker to the buyers banker to make payment of the bill. Buyer makes payment and routes it through his banker to sellers banker. In case buyer fails to make payment (devolvement of LC), buyers banker, who has opened the LC, liable to make payment to seller. RBI has mandated banks not to discount bills drawn under LCs or otherwise for beneficiaries, who are not their regular clients. Co-acceptance of bills Seller despatches goods and raises bill on buyer. Buyer accepts the bill and then it is coaccepted by buyers banker. The sellers banker then discounts this bill. Facility often used by customers to float accommodation bills (i.e. bills which are not supported by genuine sale and purchase of goods) and hence auditors should be careful while examining such bills.

(iii)

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Annexure-1 List of some Important Master Circulars issued by RBI

S.No. Date Particulars

Advances 1 1/7/2011 2 1/7/2011 3 1/7/2011 4 1/7/2011 5 1/7/2011 6 1/7/2011 7 5/7/2011 8 1/7/2011 9 1/7/2011 10 11 12 13 14 1/7/2011 1/7/2011 1/7/2011 1/7/2011 1/7/2011

Master Circular Export Credit Refinance Facility Master Circular Guarantees and Co-acceptances Master Circular Guidelines for Advances during Natural Calamity Master Circular Housing Finance Master Circular Interest rates on Advances Master Circular Lending to MSME Sector Master Circular Lending to Priority Sector Master Circular Micro Credit Master Circular Prudential Norms on Income Recognition, Asset Classification and Provisioning of Advances Master Circular Exposure Norms Master Circular Rupee / Foreign Currency Export Credit Master Circular Wilful Defaulters Master Circular Loans and Advances Statutory and Other Restrictions Master Circular Self-Help Groups Bank linkages

Deposits 1 1/7/2011 2 1/7/2011 3 1/7/2011 Foreign Exchange 1 1/7/2011 2 1/7/2011 3 1/7/2011 4 1/7/2011 5 1/7/2011 6 1/7/2011 7 1/7/2011 8 1/7/2011 9 5/7/2011 10 1/7/2011 11 1/7/2011 Special Programmes 1 1/7/2011 2 1/7/2011 3 1/7/2011 4 1/7/2011 5 1/7/2011 Miscellaneous 1 1/7/2011 2 1/7/2011 3 1/7/2011 4 1/7/2011 5 1/7/2011 6 1/7/2011 7 1/7/2011 8 1/7/2011 9 1/7/2011 10 1/7/2011 11 1/7/2011 12 1/7/2011 13 1/7/2011 14 1/7/2011 Bank Branch Advances.docx

Master Circular FCNR (B) Deposits Master Circular Interest rates on NRO and NRE Accounts Master Circular KYC Norms & AML Standards

Master Circular Direct Investment by Residents in JV Master Circular Export of Goods and Services Master Circular ECB and Trade Credits Master Circular Foreign Investments in India Master Circular Import of Goods and Services Master Circular Remittance from India Facilities for Residents Master Circular NRO Accounts Master Circular Remittance Facilities for NRI / PIO / FN Master Circular Risk Management & Inter Bank Dealings Master Circular FCRA Obligations Master Circular Acquisition & transfer of immovable property in India by NRI/PIO/FN

Master CircularPriority Sector - Credit Facilities to Minority Communities Master CircularPriority Sector - Credit Facilities to SC and ST Master Circular New SRMS Scheme Master Circular Swarna Jayanti Shahari Rozgar Yojana (SJSRY) Master Circular Swarna Jayanti Gram Swarozgar Yojana (SGSY)

Master Circular Branch Authorisation Master Circular Para-Banking Activities Master Circular Prudential Guidelines on Capital Adequacy (NCAF) Master Circular Prudential Guidelines on Capital Adequacy-Basel I Master Circular Frauds Classification and Reporting Master Circular Prudential Norms on Investments Master Circular Detection & Impounding of Counterfeit Notes Master Circular Levy of Penalty for Delayed Reporting, etc. Master Circular Facility for Exchange of Notes & Coins Master Circular Customer Service in banks Master Circular Exemption from provisions of RBI Act Master Circular Credit Card Operations of Banks Master Circular Disclosure in Financial Statements - Notes to Accounts Master Circular -- CRR and SLR 12 of 15

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Annexure - 2

_____________ BANK Loan Verification Name : ____________________________________________________________________ Facility Type Limit (Rs. in lacs) O/s

Sanctioning Authority

Documents Verified

Insurance

Other Sanction terms / Expiry date

Lien/Mortgage/ROC reg. etc.

Stock/Book Debt Statements

Stock Audit

Inspection/ Physical verification/Valuation

Operations/Overdrawings

Audited Statements

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Annexure-3 August 7, 2004 Deficiency found in sanctioning of loans and monitoring of borrowal accounts by banks / financial institutions I. Deficiencies at the stage of sanction (i) There were deficiencies in the appraisal of credit proposals. High projections of the borrowing company were not critically analysed by the sanctioning authorities. With the result, the borrowers credit requirements were not properly assessed. In some cases, the credit limits were sanctioned on the basis of appraisal made by the Merchant Banking Division for the purpose of public issue. In such cases, the existence of a conflict of interest was not always appreciated, as the arranging of finance was one of the services, which the Merchant Banker was rendering to the borrower. The bank relied on such appraisal and no separate assessment for credit risk was done. There were instances where term loans were sanctioned without insisting on the project report, cost of project and means of finance. At the time of mid-term review of the projects, additional loans were sanctioned without proper appreciation of the market conditions and the factors which led to time and cost overruns in the projects by the sanctioning authorities. The sanctioning authorities had overlooked the irregularities pointed out by the lower level functionaries in the borrowal accounts or in the accounts of the group companies based on stock verification reports, audit reports, etc. and sanctioned the facilities. They had not taken into account the fact that the existing accounts of the borrower were irregular, audit objections not cleared, estimates inordinately inflated and the vital issues either not commented upon or wrongly commented in the inspection / audit report itself. The sanctioning authorities were not given full facts about the borrowers and the projects by the officials in controlling office / branch. This was mainly because the branch did not make proper scrutiny of the borrowing companys antecedents and verify the claims of achievements by them. Contrary to the above, the sanctioning authorities had adequate facts about the unsatisfactory position of the borrowal accounts and yet facilities were sanctioned overlooking the deficiencies. There were instances where the sanction itself was not justified on the basis of projections made by the borrowers and valuation of securities offered by them. Sanctions were made deviating from the laid down policy on extending finance for capital expenditure / long term working capital. In one case, facilities were sanctioned by the banks board in violation of its own internal norms. Sanctioning authorities overlooked the fact at the time of take over of accounts that the borrowing company had irregular accounts with the previous bank/s. Adhoc limits were sanctioned frequently even if the company had regular limits and its accounts were running irregularly. At times, such limits were sanctioned by branch / Zonal Office / Central Office level functionaries in excess of their delegated powers. Revival packages were also sanctioned by the Regional authorities in respect of credit limits originally sanctioned by the banks Head Office Committee. The terms and conditions prescribed at the time of sanction of loan facilities were subsequently relaxed by the sanctioning authorities themselves while disbursing funds without any justification for such relaxation. In some cases, it appears that the sanctioning authorities had acted on extraneous influences, rather than deciding on the merits of the case. The borrowal account finally turned into a non-performing asset.

(ii)

(iii)

(iv)

(v) (vi) (vii)

(viii) (ix)

(x) (xi)

II. Deficiencies at the monitoring stage (i) (ii) Loans / advances were released by the branch officials in blatant violation of the terms and conditions of the sanction laid down by the Central Office. No proper monitoring of the end-use of the funds by the borrowers was noticed in a few cases. Cases of such diversion of funds in larger accounts were not reported to the banks Board for their information and providing required direction in the matter. Monitoring of the companys financial standing especially with reference to the financial indicators was not carried out effectively. Undue reliance on the certificates given by the Chartered Accountants / Valuers without co-relating them with other relevant procedures was noticed. For example, in the case of projects under implementation, reliance was placed on the certificates without adequate monitoring of the progress of construction through site visits. Similarly, in respect of certificates for verification of inventories, there was inadequate correlation of the figures with audited financial statements and also inadequate follow-up on deficiencies reported. In one case, it came to light subsequently that the borrower company had produced forged expenditure certificates from the Chartered Accountants.

(iii) (iv)

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(v)

(vi) (vii) (viii) (ix) (x)

(xi) (xii)

There was also lack of proper monitoring even with regard to very important terms and conditions of the term loan sanction such as, tie up of funds, stipulation of promoters contribution, etc leading to disproportionate lending by the banks / FIs. As regards working capital limits, failure to detect disappearance of stocks given as security had resulted in misappropriation of funds / sale of stock and realization of receivables without the knowledge of banks/FIs. Failure to ensure adequacy of the security offered by the borrowers, especially failure to verify whether the same asset was mortgaged to another bank / FI was also noticed. Periodical reviews of accounts were not undertaken after the funds were lent by the banks / FIs. Proper assessment of the financial standing of the projects was not carried out when the bank / FI took over an account from another bank. Excess drawings permitted by the branch / Regional Office level functionaries, in the borrowal accounts were ratified by the Head Office in a routine manner without examining the need for such permissions, at times, frequently. Limits sanctioned were allowed to be interchanged indiscriminately by the branch officials without proper authority. In cases pertaining to term loans for financing projects, important terms and conditions of the sanction stipulated by the Board of Directors such as induction of technical directors, constitution of Audit Committees and independent project monitoring committees are not taken seriously. Many a times, non-compliance even at the stage of the release of the final instalment of the loan sanctioned is not taken seriously. This is a very serious lacuna which cuts at the root of the principles of project management and project financing.

III. Suggestions to improve the system The following suggestions are made with a view to improving the system. (i) In many cases diversion of funds is facilitated by opening of accounts with other banks wherein the sale proceeds / proceeds of realized book debts are credited, without the knowledge of the lending bank. With a view to prevent such malpractices, the lending bank should obtain a certificate from the borrowers on a quarterly basis furnishing details of accounts opened with other banks. (ii) It is noticed that the banks rely on the certificates of valuation given by the external valuers which in some cases were subsequently found to have shown grossly inflated values. It is, therefore, suggested that the setting up of independent cells for valuation within banks themselves, which are manned by technical personnel with the right expertise is considered seriously. (iii) Immediate action should be taken where the malafides / gross negligence on the part of dealing officials are noticed. The Advisory Board finds that in the large majority of cases, administrative action is either not initiated well in time or not initiated at all. (iv) Wherever there is a prima-facie case against the dealing officials, appropriate action in terms of CVC guidelines for their inclusion in the list of officers with doubtful integrity should be initiated by banks / FIs in consultation with the CBI. (v) While processing loan applications, there is no scientific application of mind by the bank officials in observance of compliance with the stipulated terms and conditions by the borrowers and as a result, certain serious defaults had occurred causing systemic failure of the financial sector. It is, therefore, suggested that banks/FIs should evolve a process of check listing which would enable them to take note of any deficiencies while releasing the funds to the borrowers or monitoring the end use of funds. (vi) There is a need for building up a cadre of officials with proper educational background and training to take care of at least larger projects being financed by the banks / FIs. (vii) Perhaps the single largest cause of financial loss to the lending institutions is the fact that in respect of project finance, disbursements are not made by the lending institution in proportion to the funds disbursed by the promoter / borrower. In several cases, the promoter / borrower is unable to bring in or raise the funds which he is required to provide in terms of the sanction and consequently, in order to protect the investment already made, the lending institution has to provide additional funds not envisaged in the original proposal. The same situation persists when there are cost over-runs, whereby the exposure of the lending institution gets increased. This problem can be avoided if the promoter / borrower is required to bring in up-front his contribution (other than funds to be provided through internal generation) and the lending institution commences its disbursement only after the stipulated funds are brought in by the promoter / borrower.

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