Instances of loan fraud seem to be increasing in recent days. These kinds of fraud make it difficult for financial institutions such as banks, finance companies and other micro-lending agencies to maintain their financial security. There are several common psychological and environmental conditions that result in fraud at lending institutions.These can include an individual’s propensity towards addictive behaviour, family problems, romantic entanglements and financial hardships. The involvement of top officials is not necessary to commit fraud. Lax management and weak internal controls can lead to fraudulent activities in lending institutions. Similarly, a lack of early investigation and inadequate audit programmes present unscrupulous insiders with opportunities to engage in improper behaviour.

Fraud causes

Loan fraud can be of various types in financial institutions. For example, ‘nominee loans’ are used, where the loan document is prepared in the name of a borrower but the borrower is not the real party. To put it another way, a loan is documented in the name of borrower but the use and benefit of the loan is enjoyed by a hidden party. This type of transaction is used to circumvent laws, regulations and the internal policies of institutions. In Nepali financial institutions, nominee loans were used massively in the past, jeopardising the financial health of a number of banks and financial institutions.

Furthermore, conflicts-of-interest among officials can also foster fraudulent activities. In some cases, loans are tied to favoursfor friends, family and relatives. Similarly, non-monetary assets are also considered while providing loans to kith and kin. And sometimes loans arranged inappropriately and in a fraudulent manner to purchase capital stock. Similarly, manipulation is done in the purchase and sale of loan pools.

Preventing fraud

To protect the financial system from fraud, early examinations of the institution’s operations become vital. This can be done through audits and on-site investigations by accredited examiners. After the investigation, strict action must be taken against offenders, if any, found to be involved in fraudulent activities. In case of high-level officials found to be involved in financial fraud, criminal prosecution as well as disciplinary action should be pursued by the concerned institution. Other actions against such offenders include assessing and reimbursing the loss amounts; making restitution or compensating the loss; and making certain the offender does not work for financial institutions in the future.   

Measures such as the adoption of a code of conduct, proper employment practices, a loan review system, independent audits and internal controls can also work as strong tools for controlling loan fraud. The code of conduct should address the issue of conflict-of-interest and self-dealing; clearly define acceptable behaviour; encourage ethical conduct; institute a compliance system;establish monitoring mechanisms; provide for proper disclosure of all related interests; and institute a whistleblower policy to encourage the reporting of any suspicious activity. Furthermore, the board of directors of any financial institution must be required to make a statement about their ethical position as a preventive essential code of business principles against loan fraud, thereby providing a clear message to the public that the institution does its business fairly and honestly.

Proactive employment practices can also deter fraudulent activities. Such procedures are required to incorporate proper criteria for a comprehensive background check of employees, including those of the directors; employment references with respect to the prospective employee’s eligibility and reliability; and sudden changes in lifestyle andbehaviour of employees and directors.

Additionally, there should be an effective loan review system in place.This system can contribute to exposing insider loan fraud and self-dealings at an early stage. Loan reviews should be conducted periodically and thoroughly. The review must be independent of the credit administration and loan approval processes. Procedures should be put in place so that fictitious and fraudulent activities on loan fraud are promptly identified and the adherence to established lending practices and conflict of interest policies assessed. Personnel involved in loan review activities should have the knowledge and confidence to challenge suspicious transactions executed by whosoever (either by executive officer or board member).

Strengthening inner workings

Moreover, institutions should institute a comprehensive, reliable and independent audit system to deter fraudulent lending practices. The audit report should be submitted directly to the board of directors for prompt and effective implementation. There should be specific audit procedures targeted at controlling insider loan fraud.Auditors too should dare to challenge suspicious transactions, especially when an executive officer or a board member is involved.

The potential for insider loan fraud is high in an environment where internal controls are slack, arbitrary or non-existent. Hence, institutions should have stern internal control systems which provide no room for anybody to be exempted from the institution’s policy and procedures. Anti-fraud policies and procedures should be implemented effectively. The institution should pursue control environments and organisational structures which do not allow lending officials to undermine lending procedures and decisions. Potential consequences of violatingthe lending policy should be stipulated clearly and implemented accordingly. The board should play a proactive role in monitoring and supervising the loan officers to see whether they are executing their duties and loan authority in accordance with the loan policy and the delegation of authority.

Finally, preventing loan fraud in the first place is far more cost effective than investigating and prosecuting offenders. It is a herculean task to control all insider loan fraud activities in financial institutions. However, financial institutions that create a proper control environment and have an open and ethical corporate environment are better suited to address such concerns.

Burlakoti holds a PhD in law and is former Chairperson of the Debt Recovery Tribunal