In­tegrity due dili­gence a must ex­er­cise

Ab­sence of a true sys­tem can lead to is­sues that banks face to­day, feels Deepak Bhaw­nani, CEO, Alea Con­sult­ing, which spe­cial­izes in rep­u­ta­tion risk and cor­po­rate in­ves­ti­ga­tions:

Banking Frontiers - - Highlights - mo­han@bank­ingfron­

Ab­sence of a true sys­tem can lead to is­sues that banks face to­day, feels Deepak Bhaw­nani, CEO, Alea Con­sult­ing, which spe­cial­izes in rep­u­ta­tion risk and cor­po­rate in­ves­ti­ga­tions

N. Mo­han: What is in­tegrity due dili­gence and its rel­e­vance in the bank­ing and fi­nan­cial ser­vices sec­tor?

Deepak Bhaw­nani: There are var­i­ous types of due dili­gence ex­er­cises con­ducted prior to a busi­ness as­so­ci­a­tion. The three key ones are le­gal, fi­nan­cial and in­tegrity. All three en­com­pass a com­pre­hen­sive as­sess­ment of the po­ten­tial busi­ness part­ner or lender. In­tegrity due dili­gence fo­cuses on rep­u­ta­tion risks and en­tails in­ves­ti­gat­ing in­for­ma­tion re­gard­ing reg­u­la­tory com­pli­ance, source of funds, cor­po­rate gov­er­nance, po­lit­i­cal ex­po­sure, sanc­tions and black­lists, i.e. is­sues that, by as­so­ci­a­tion, can ad­versely im­pact the fi­nan­cial in­sti­tu­tion’s brand in­tegrity. An in­tegrity due dili­gence is im­per­a­tive to the BFSI sec­tor. One main rea­son as­cribed to ac­cu­mu­la­tion of bad loans is lack of ad­e­quate due dili­gence.

Do you think the con­cept has caught the at­ten­tion of the In­dian bankers?

In pri­vate sec­tor banks, cer­tainly. I can­not, how­ever, say the same for pub­lic sec­tor banks.

Is cus­tomer due dili­gence a norm in good bank­ing prac­tices? Is not KYC suf­fi­cient?

A cookie-cut­ter ap­proach to KYC does not suf­fice to iden­tify risks of money laun­der­ing or ter­ror­ist fi­nanc­ing. While an en­hanced KYC may not be nec­es­sary for all clients, there should be a mech­a­nism to trig­ger such checks au­to­mat­i­cally for the high-ex­po­sure cus­tomers. Cur­rently, the process is seen as a one-time ex­er­cise, ie, dur­ing the client on-board­ing stage. Clients should be sub­ject to an en­hanced KYC each time the fi­nan­cial ex­po­sure rises above a thresh­old.

Other ar­eas where banks should un­der­take due dili­gence ex­er­cises to ward off pos­si­ble risks?

One ma­jor area to con­sider is a back­ground screen­ing of bank em­ploy­ees hold­ing sen­si­tive roles and man­agers with high limit ap­proval au­thor­ity. Val­i­da­tion and val­u­a­tion of col­lat­eral, ie, as­sets of the pro­mot­ers and guar­an­tors prior to dis­burse­ment of high-ticket loans should be a core part of the due dili­gence.

Ran­dom and fre­quent screen­ing is re­quired for red flag checks. Prior to dis­burse­ment of loans, there must be checks for re­lated par­ties, au­di­tor in­de­pen­dence and other con­flicts.

Could the ex­ist­ing NPA bur­den be avoided had the banks adopted sci­en­tific due dili­gence pro­grams?

In ad­di­tion to reg­u­la­tory for­bear­ance, the `10 tril­lion NPA stresses in In­dia can be at­trib­uted to la­cu­nae in the due dili­gence and ap­praisal process prior to loan dis­burse­ment. Lim­ited au­dit scope and re­la­tion­ship man­ager mon­i­tor­ing of an ac­count post-sanc­tion con­trib­utes to the losses. RBI has stip­u­lated a Cen­tral Fraud Registry (CFR) for banks for early de­tec­tion of frauds and mit­i­gate risks. How­ever, the bank scams in­di­cate that ei­ther the data­base was in­sub­stan­tial or not re­viewed prop­erly. Ro­bust risk man­age­ment prac­tices and au­dits to re­view im­ple­men­ta­tion would have cer­tainly mit­i­gated losses by pro­vid­ing an early warn­ing.

Do you think suc­cess­ful cor­po­rate en­ti­ties have for­mal­ized the due dili­gence pro­grams?

Most, if not all, pri­vate equity funds will con­duct some level of due dili­gence on a po­ten­tial in­vestor. Some fo­cus on the in­di­vid­u­als, while oth­ers on the or­ga­ni­za­tion. Banks have largely been re­ac­tive, ie, in­ves­ti­gate to re­cover - and this is what needs to change. A proac­tive ap­proach would have lim­ited ex­po­sure in the long run. The re­cent RBI no­ti­fi­ca­tion to banks, to weekly re­port iden­ti­fi­ca­tion of in­cip­i­ent stress of bor­row­ers (with ag­gre­gate ex­po­sure of `50 mil­lion and above), to the Cen­tral Repos­i­tory of In­for­ma­tion on Large Cred­its is laud­able.

In a bank or a fi­nan­cial ser­vices in­sti­tu­tion, ide­ally, who should have the re­spon­si­bil­ity for car­ry­ing out rep­u­ta­tional due dili­gence?

The struc­ture ex­ists, ie, the Chief Risk Of­fi­cer, Chief Se­cu­rity Of­fi­cer, or Chief Vig­i­lance Of­fi­cer as­so­ci­ated with the fi­nan­cial in­sti­tu­tion. Any of these of­fi­cers can be given the man­date and bud­get to ini­ti­ate rep­u­ta­tional due dili­gence process. The re­port should then be re­viewed by an in­ter­nal ‘Green Light Com­mit­tee’ be­fore mak­ing the fi­nal de­ci­sion.

Fi­nally, what is the fu­ture of due dili­gence in the bank­ing in­dus­try?

What needs to be made clear across the bank­ing in­dus­try is that fill­ing a com­pli­ance form does not con­sti­tute a due dili­gence. In­de­pen­dent pro­fil­ing and check­ing against a whole host of reg­u­la­tory com­pli­ance, en­force­ment, PEP, lit­i­ga­tion and other data­bases – of the en­tity and its direc­tors and share­hold­ers – is what should be a manda­tory part of the ap­proval process. Don’t lend to the un­known. Trust, but Ver­ify!

Deepak Bhaw­nani

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