Tamal Bandyopadhyay: Crime and punishment

The RBI has acted strictly in penalising banks for violating established norms. But do these banks run a reputation risk? Hardly

On Monday, the Reserve Bank of India (RBI) imposed financial penalties on Industrial Development Bank of India (IDBI), ING Vysya Bank and HDFC Bank for violating the know-your-customer (KYC) norms, breaching prudent banking practices, and the failure to adhere to the established norms for granting loans against shares and initial public offerings (IPOs). For HDFC Bank, this is the second instance of being penalised in an IPO allotment-related incident since January 23, when the central bank published its first list of banks involved in such incidents. In the first instance, the RBI was relatively lenient on this bank and imposed a fine of Rs 5 lakh. This time, the amount has increased five times, to Rs 25 lakh.

This time, the total number of banks penalised by the RBI for their role in such incidents has increased to nine. And these are banks of all hues. For instance, HDFC Bank and ICICI Bank represent new generation private banks. Indian Overseas Bank, Vijaya Bank and IDBI Ltd are from the public sector. Two foreign banks penalised are Citibank and Standard Chartered Bank. Then, there is an old private bank, Bharat Overseas Bank. Another old private bank, which also features in the list, has for all practical purposes been converted into a foreign bank "" ING Vysya Bank.

This time, HDFC Bank has been fined for showing lack of prudence in opening 271 savings accounts with one common name and multiple unconnected names. These accounts were used by the IPO allotment process manipulators for opening 1,142 demat and 24 loan- against-share accounts. In January, this bank was fined for violating the guidelines on opening of deposit accounts and failure in monitoring the transactions in conformity with KYC norms. The demat accounts opened with HDFC Bank were used for making multiple applications in IPOs. The bank had even issued around 4,000 cheque books with one lakh leaves to one person who effectively controlled operations in 24 loan-against-share accounts.

The irregularities were detected when the RBI inspection team found that the proceeds of individual account payee refund orders were credited into the accounts of brokers instead of the individual accounts on the requests of the associates of the depository participants.

Apart from imposing penalty, the RBI also prohibited banks from crediting "account payee" cheques to the account of any person other than the payee named in the cheque.

Banks crediting the proceeds of individual account payee refund orders into the accounts of brokers instead of the individual accounts on the request of the associates of DP providers amounts to manipulation of the payment system.

Unlike the Harshad Mehta and Ketan Parekh episodes in the past, this has not been a case of a stock market scam spilling over the banking system. The origination point are certain branches of certain banks that have aggressively been pushing for capital market-related business. It is entirely possible that these are cases of frauds involving certain employees who have connived with brokers. However, the banks involved should not have been totally unaware of the developments as most of them are covered by the "hub and spoke" technology architecture whereby branches are spokes linked to a common back-office which issues all cheques. This means, the issuance of thousands and lakhs of cheque leaves to customers cannot go unnoticed by the central processing system of the banks concerned. Bank managements possibly cannot afford to look the other way and pass the buck to some branch managers.

Also under the glare is the concurrent audit system of banks. According to RBI rules, 50 per cent of a bank's business requires to be covered by concurrent auditors. For most of the banks, less than 10 per cent of the total branch network can cover 50 per cent of the business. Even then, the standard of concurrent audit is not always of high quality. Most of the banks do not have in-house resources to conduct concurrent audits and hence a large chunk of it is outsourced. Since the money paid for this job is modest, normally a junior staff of an audit firm visits a few bank branches a day and the focus is on his presence at the branches and not the books of the branch.

Globally, banks are penalised by regulators for irregularities. More than the monetary loss, banks run reputation risk when they get pulled up by regulators. For instance, these banks will have to publish the penalties imposed on them in their 2005-06 annual reports. They will also be required to make this information public as and when they enter the capital market in future. Moreover, the punishment does not end here. Indeed, it could just be the beginning. The regulator can raise their cash reserve ratio (CRR) requirement, clamp down on branch licences and even issue "cease and desist" orders, forcing them to stay away from growing their businesses. A few years ago, the US Federal Reserve had issued a cease and desist order on State Bank of India for its alleged failure in adhering to the KYC norms.

However, the banks penalised by the RBI haven't seen any adverse impact on the movement of their stocks on the bourses. This means, they do not run much of a reputation risk.