Frauds, crises and the financial-stability framework

Detail

A. Bank frauds: what the data shows

• Bank fraud means someone deliberately cheats a bank or its customers to get money or assets. It can be a borrower, an employee or an outsider.
• RBI Annual Report pattern:
• Loan frauds (advances) are the biggest by value. A few large corporate loan frauds make up most of the rupee amount.
• Card and digital frauds are the biggest by number. There are very many cases, but each one is small.

• Exam trap: "most frauds are digital" is true by count. By amount, loan frauds lead.

• The RBI Annual Report 2024-25 publishes fraud tables in three ways: by area of banking operation (advances, cards/internet, deposits and so on), by bank group (public, private, foreign banks) and by date of reporting [5].

• Why the reported amounts rose again in FY25:
• In SBI v. Rajesh Agarwal (SC, 27 March 2023, Civil Appeal No. 7300 of 2022), the Supreme Court said banks must follow natural justice before they call a borrower's account a fraud. Natural justice here means the borrower must get a fair hearing first [2].
• A later Supreme Court order of 12 May 2023 said the same safeguards apply [2].
• So banks had to re-examine old fraud declarations. They then declared and reported many old cases again. Much of the FY25 amount comes from old frauds reported again, not new ones.

B. Master Directions on Fraud Risk Management (July 2024)

• Master Direction means a single RBI rulebook that brings all rules on one subject together in one place.
• What the July 2024 Directions contain:
• Early Warning Signals (EWS): signs of trouble in an account, such as delayed payments, money moved to related firms, or stock statements that do not match. The bank must check these quickly.
• Red-Flagged Account (RFA): an account where EWS suggest possible fraud. The bank must investigate it, often through a forensic audit, within a fixed time.

• Reporting to RBI's Central Fraud Registry (CFR): an online database of reported frauds. Banks can search it before they lend, so a fraudster cannot simply move to another bank.

• Natural-justice steps added after Rajesh Agarwal [2]:

• The bank must serve a notice on the borrower.
• It must give the borrower a chance to reply (a representation).
• It must give full details of the transactions on which the fraud charge is based.
• It must pass a reasoned order, meaning a written decision that gives reasons.

• All of this must happen within a fixed time.

• Governance features [2]:

• The Directions are principle-based. They set goals and do not try to list every possible case.
• They give the Board of Directors a stronger role in overseeing fraud risk.
• They stress strong internal audit and controls.

C. PNB–Nirav Modi case (2018): how a paper gap became a mega-fraud

• Letter of Undertaking (LoU): a bank guarantee. The Indian bank promises an overseas branch of another Indian bank that it will repay if its customer, the importer, does not. On this promise, the overseas branch gives the customer short-term credit.
• The chain of failure:
• PNB employees issued LoUs through SWIFT, the global messaging system banks use to send payment instructions.
• These LoUs were never entered in the Core Banking System (CBS), so the bank's own books did not show the liability.

• New LoUs were issued to repay old ones. The fraud grew for years without anyone noticing.

• Policy responses:

• RBI discontinued LoUs and Letters of Comfort for trade credit (March 2018).
• Parliament passed the Fugitive Economic Offenders Act, 2018. It allows the property of offenders who run away from India to escape trial to be attached and confiscated.
• The main lesson is that SWIFT must be linked with CBS. Any message that is not recorded in the books becomes a hidden risk.

D. KYC and anti-money-laundering (AML)

• Know Your Customer (KYC): the checks a financial institution must do on a customer's identity and address, and the due diligence (a careful look at who the customer is and where their money comes from). The aim is to stop fraud and money laundering, which means making illegal money look legal.
• Legal base:
• Prevention of Money Laundering Act (PMLA), 2002: the parent law.

• RBI KYC Master Direction, 2016: the detailed rules for banks.

• Tools:

• Central KYC (CKYC) Registry, run by CERSAI (Central Registry of Securitisation Asset Reconstruction and Security Interest of India). You do KYC once and get a CKYC number, which you can reuse across banks, insurers and mutual funds.
• Video-KYC (V-CIP), allowed from 2020: a live, consent-based video call replaces the in-person visit.
• Legal Entity Identifier (LEI): a unique 20-character global code for each party in a financial transaction. It shows "who is who" and "who owns whom". It is mandatory for large borrowers and market participants.

E. Unregulated finance: Ponzi schemes and chit funds

• Ponzi scheme: pays "returns" to earlier investors out of money from new investors, not out of real profit. It collapses when new money stops coming in.

• Example: Saradha (2013), West Bengal. It collected deposits from lakhs of small savers.

• Chit fund: a savings-cum-borrowing group.

• Members pay a fixed amount every month.
• Each month, the pooled sum goes to one member by auction or lot.

• It is legal and state-regulated under the Chit Funds Act, 1982 (a central law that State governments enforce).

• Worked example: a chit fund versus a Ponzi scheme

• Chit: 20 members pay ₹5,000 a month, so the pool is ₹1,00,000. Suppose the winning bid in month 1 is a 20% discount (₹20,000). The winner gets ₹80,000, less the foreman's commission. The discount is shared among members as a dividend. No money is created out of thin air.

• Ponzi: the scheme promises 5% a month. It needs ever-larger new inflows to pay old investors, so it must fail.

• Banning of Unregulated Deposit Schemes Act, 2019: it bans any deposit scheme that is not registered with a named regulator (RBI, SEBI, IRDAI, State governments and others). Offenders face jail, attachment of property and repayment to depositors.

F. Cooperative-bank failures and the problem of dual control

• PMC Bank (2019): it hid large exposure to one real-estate group (HDIL) using dummy accounts. RBI put curbs on withdrawals.
• New India Co-operative Bank (2025): RBI put curbs on the bank after money went missing, reportedly through embezzlement (insiders stealing money placed in their care).
• Lessons:
• Dual control: RBI regulates the banking work. The State or Central Registrar of Cooperatives controls management, elections and audit. So no one regulator has full power.
• Boards are weak or captured by insiders, and professional oversight is thin.
• Response: Banking Regulation (Amendment) Act, 2020, which brought cooperative banks further under RBI supervision.

G. NCERT hook: consumer protection (Class 7, Banks and the Magic of Finance)

• Never share your OTP, PIN, CVV or bank details. A real bank never asks for them.
• Do not click unknown links. They can lead to phishing (fake sites that steal your passwords).
• Report fraud at once on helpline 1930 or on the National Cybercrime Reporting Portal. Reporting fast can help freeze the stolen money.
• For more detail, see the payment-systems-digital-finance note.

H. Systemic risk: why one failure can spread

• Systemic risk: when one institution or market fails, it can set off a chain of failures across the whole financial system.
• How it spreads:
• Interconnectedness. Banks, NBFCs and mutual funds lend to one another, so when one defaults, the others lose money.
• Common exposures. Many institutions hold the same assets, for example real-estate loans, so one shock hits all of them together.

• Fire sales. A troubled firm must sell assets fast. Prices fall, and every holder's balance sheet shrinks.

• Indian example: the IL&FS default (2018), where an NBFC default spread to mutual funds and other NBFCs. This is why the FSR tracks bank-NBFC links closely.

I. The 2008 global financial crisis (GFC): the chain

• Step 1: subprime lending. US banks gave home loans to borrowers with weak credit histories, often at "teaser" rates that later rose.
• Step 2: securitisation. Many loans were pooled and turned into tradable securities.
• MBS (Mortgage-Backed Securities): securities that pay investors out of home-loan repayments.
• CDOs (Collateralised Debt Obligations): MBS repackaged again into slices (tranches) with different risk, many of them wrongly rated AAA.

• These were sold to investors worldwide, so the risk spread across countries.

• Step 3: insurance on the risk. Credit Default Swaps (CDS) worked like insurance that pays out if a borrower defaults. AIG sold huge amounts of CDS without keeping enough capital.

• Step 4: collapse.
• US house prices fell and defaults rose.
• MBS and CDO values crashed.

• Lehman Brothers failed on 15 September 2008. AIG needed a government rescue, and credit markets froze worldwide.

• Lessons and reforms:

• Basel III: more and better-quality capital, plus liquidity ratios (LCR and NSFR) and a leverage ratio.
• Macroprudential policy: rules that look at the whole system, not just one bank, such as the countercyclical capital buffer. Details are in banking-monetary-policy.
• Financial Stability Board (FSB), 2009: a G20 body that coordinates global financial regulation.
• G-SIB regime: Global Systemically Important Banks must hold extra capital because they are "too big to fail". India's own version is the D-SIB list (Domestic Systemically Important Banks, such as SBI, HDFC Bank and ICICI Bank).

J. India's financial-stability architecture

• Financial Stability and Development Council (FSDC), 2010:
• It is chaired by the Union Finance Minister.
• Members include the heads of RBI, SEBI, IRDAI, PFRDA and IBBI.
• It coordinates regulators, watches large risks across sectors and handles inter-regulatory issues.

• It is a non-statutory body, set up by executive decision.

• RBI's Financial Stability Report (FSR):

• It is published every six months (June and December).
• It carries the Systemic Risk Survey (SRS), which asks market experts which risks they think are highest.
• The December 2025 FSR found that banks had strong capital and liquidity buffers, good earnings and better asset quality. Its stress tests confirmed that both banks and NBFCs are resilient (able to absorb shocks) [3].

• The FSR stress-tests a sample of scheduled commercial banks that together hold about 98% of total banking-sector assets [3].

• Asset-quality trend: a PIB release reports that the Gross NPA ratio fell from 9.11% (March 2021) to 2.58% (March 2025) [4]. A Gross NPA (non-performing asset) is a loan whose interest or principal has been unpaid for more than 90 days.

K. Stress testing: how it works

• Stress test: a "what-if" simulation. It checks whether banks would still have enough capital under severe but plausible shocks, such as a deep recession, a sharp rise in interest rates or a jump in bad loans.
• Scenarios in the FSR: baseline (expected path), medium stress and severe stress.
• Formula:
• CRAR (Capital to Risk-weighted Assets Ratio) = (Tier 1 capital + Tier 2 capital) ÷ Risk-Weighted Assets (RWA) × 100

• Risk-Weighted Assets: loans and other assets, each multiplied by a risk weight. For example, a government bond is about 0%, while an unsecured personal loan carries a higher weight.

• Worked example (illustrative figures):

• A bank has capital of ₹12,000 crore and RWA of ₹1,00,000 crore, so CRAR = 12%.
• In the severe scenario, extra bad loans wipe out ₹3,000 crore of capital. The new CRAR is 9,000 ÷ 1,00,000 × 100 = 9%.

• The RBI minimum total CRAR is 9%, or 11.5% with the capital conservation buffer. So this bank just meets the base minimum but has used up its buffer. It would have to limit dividends and raise capital.

• Scaffold result: the system-level CRAR stays above the regulatory minimum even under severe stress (verify against the latest FSR).

L. Emerging risks flagged in FSR December 2025

• Unsecured retail credit: personal loans and credit cards without collateral are growing fast. Defaults rise quickly when the economy slows.
• Bank-NBFC interlinkage: banks lend heavily to NBFCs, so stress at NBFCs can pass back to banks.
• Climate risk: floods, heat and carbon rules can hurt borrowers' ability to repay. This is both a physical risk and a transition risk.
• Private credit: lending by non-bank funds outside bank rules. It is hard to see and hard to value.
• Stablecoins: crypto tokens pegged to a currency such as the US dollar. They could drain deposits, weaken monetary control and help money slip across borders unseen.

Prelims Hooks

• By value, most bank frauds are in advances (loans). By number, most are in card and digital payments.
• SBI v. Rajesh Agarwal (27 March 2023): the borrower must get notice, a hearing and a reasoned order before the account is classified as fraud. This comes from the principle of natural justice (audi alteram partem, "hear the other side").
• Master Directions on Fraud Risk Management: July 2024. Key tools are EWS, Red-Flagged Accounts and reporting to the Central Fraud Registry.
• LoUs were discontinued by RBI in March 2018, after the PNB-Nirav Modi fraud, where SWIFT messages were not recorded in CBS.
• CKYC registry is run by CERSAI, not by RBI or SEBI. LEI is a 20-character code.
• Chit funds fall under the Chit Funds Act, 1982 and are enforced by State governments. They are not regulated by RBI or SEBI.
• FSDC (2010) is chaired by the Finance Minister, not the RBI Governor. The FSR is half-yearly (June and December) and published by RBI.
• Lehman Brothers failed on 15 September 2008. FSB was created in 2009. CDS worked as insurance against default (AIG).
• CRAR = Capital ÷ Risk-Weighted Assets × 100. The stress tests use baseline, medium and severe scenarios.

Mains Points

• Due process vs speed in fraud control: Rajesh Agarwal and the 2024 Directions protect borrowers' rights. But they slow fraud classification and cause old cases to be reported again. Banks must balance natural justice with quick recovery, and doing it on a fixed timetable is the middle path.
• Frauds, NPAs and trust: large loan frauds add to NPAs, eat into public-sector bank capital and make bankers afraid to lend. Better tools help, such as EWS and analytics, linking SWIFT with CBS, CFR data-sharing, and strong internal audit. So do laws like the FEOA and the unregulated-deposits ban. Together they strengthen India's financial safety net.
• Dual control in cooperative banks: PMC (2019) and New India Co-operative Bank (2025) show how split regulation between RBI and the Registrar leaves gaps. The 2020 amendment helped, but governance reform and professional boards are still unfinished. This links to GS-II themes of federalism and cooperatives.
• Lessons from the 2008 crisis for India: macroprudential rules, D-SIB surcharges, FSDC coordination and FSR stress tests help catch risk early. New risks like unsecured retail credit, bank-NBFC links, private credit, climate and stablecoins show that regulators must keep updating these tools.