Due Diligence Reports on Banks

Soniya Khanna

06 Jul, 2023

Bank executives around the world have discerned the value of having adequate KYC controls in place to know their customers. A potent aspect of these controls is due diligence on the existing and prospective customers. The banks can become subject to operational, legal and reputational risks, without sufficient due diligence. In general terms, due diligence is a process of analysis and research that is initiated before a business partnership, acquisition, bank loan, or investment to evaluate the worthiness of the subject or identify the major issues involved. This write-up accentuates the importance of due diligence for banks.

Due Diligence mechanism in Banks

Often, when the company wants to get the credit facilities from the Banks, they are asked to provide a due diligence report, or the bank may itself get it prepared from professionals. The Notification issued by the Reserve Bank of India dated 2nd February 2009 via Notification no. DBOD. NO. BP.BC.110/08.12.001/2008-09 prescribes about the due diligence reports from the professionals, specifically the Company Secretaries. The Notification has mandated the due diligence for lending under Multiple Banking arrangements or Consortium arrangements.

In paragraph 2(iii) of the above circular, RBI has stated the purpose of strengthening the information sharing system amidst banks in regards to the borrowers leveraging credit facilities from multiple banks. Thus, the banks are required to attain certification from a professional, preferably a Company Secretary concerning the compliances of numerous statutory prescriptions that are in vogue, as given in Annex III to the circular.

In addition to the Company Secretaries, the banks can also obtain the certification by a Cost Accountant or Chartered Accountant. The rapid pace in developments has called for a robust due diligence mechanism for Banks.

Why is there a need for Due Diligence for Banks?

The motive of the due diligence report for banks is to scrutinize the records of a borrowing company and assess its conduct as a corporate entity from the legal perspective. Here are the ways in which the due diligence for banks is an efficient tool to truly determine the borrower entity:

• To verify and check the details of the company’s directors and assess their relationship with the promoters of the company.
•  For assessing the previous and existing lending of the company.
• To discern the defaulting status of the company and its Directors in the past.
• To ascertain whether the company has complied with the stringent provisions of the Companies Act, 2013 or not.
• Also, due diligence enables the bank to determine the compliance of certain statutory and procedural requisites by the company.
• The banks also get an insight into the overseas borrowings and foreign exchange exposure of the company.
• With diligence reports, the banks confirm whether the company’s assets are insured or not. Thereby, safeguards from dealing with any mishappening that can cause a burden on the funding.

Approach of Due Diligence Reports for Banks

Documentation plays an essential role in the process of due diligence. Banks must incorporate the approach of due diligence with professional assistance to identify and ascertain the status of compliance and governance with provisions, thus gain a fair idea of the borrower’s functions. It will not only help to evaluate the financial position of the borrower, but also know the standard of business being conducted by the borrower. If there is a lack of proper diligence, some potential risks may incur like the company not using the funds for the purpose it was borrowed, diversion of funds, legal and regulatory risks, etc.

The importance of due diligence for banks is beyond measurement, so let’s look at the right approach to make due diligence report:

• Banks can do the company’s assessment from records accessible such as risk committee, minutes of the audit committee, stakeholder committee, whistleblower committee, or other executive committees which have been constituted by the board. Also, review board minutes and explanatory notes for resolutions.
• Additionally, banks can conduct due diligence by cross-inspecting with the correspondence ROC, Stock exchanges (in case the company is listed), reviewing legal notices in the name of the company and license authorised to the borrower company, etc. Moreover, it is indispensable for the banks to check the cash flow statements, statutory and internal audit reposts of the company.
• A financial institute or bank must analyze the recent loan history of the borrower before lending any credit facility. An increase in capital or significant change in cash inflow during the period covered by the due diligence report needs to be closely examined. The professional pursuing the due diligence must have a core focus on the borrower’s financial discipline and status of compliances and governance.

Impact on Banks for lack of proper Due Diligence

As mentioned earlier, the inadequacy of due diligence for banks and other financial institutions can be a massive threat in operational, legal, and reputational terms. Bank shall have to face the following risks.

• Reputational Risk- A banking business model requires a continual maintenance of goodwill to gain the confidence of creditors & depositors so it can be more prone to reputational risk. It refers to the potential adverse publicity concerning a bank’s practices and associations (irrespective of being accurate) that degrades its integrity in the marketplace. Banks are more vulnerable to the reputational risk since they can become easy prey of illegal/illicit activities carried by their customers. Assets held by the bank on a fiduciary basis or under management, can pose several reputational dangers. Thus, banks must safeguard themselves using consistent vigilance through a powerful KYC and due diligence mechanism.

• Operational Risk– Another menace that occurs because of inefficient due diligence for banks is operational risk. It can be defined as the risk of direct/indirect losses, which are the outcome of a failed internal system or external events. Mostly the operational risk is due to ineffective control procedure, improper implementation of bank programs, or failure to rightfully practice due diligence. The operational risk creates a bad image of the bank in the public eye, thereby affects the bank’s business adversely.

• Legal Risk– Banks may get subject to a prospective danger due to the adverse judgments, lawsuits, or unenforceable contracts. It can disrupt the condition or hamper the operations of a bank. Banks are likely to become the victim of lawsuits, resulting from the failure to comply with the mandatory KYC standards or not deploying due diligence for banks. Consequently, banks are liable to pay fines, criminal liabilities, and penalties levied by the authorities. Undoubtedly, greater costs are imposed on the banks for any negligence in legal matters. Moreover, Banks cannot protect themselves from such legal risks unless they do not pursue due diligence activities and emphasize on identifying their customers and their business.
• Concentration Risk- As a common practice, the supervisors mandates banks to have a solid information system for identifying credit concentrations. Additionally, banks must set prudential limits that confine their exposures to a single borrower or group of related borrowers. However, without precisely knowing the customers and their relationship with others, it is impossible for the bank to measure its concentration risk. Hence, the banks must create due diligence reports of their borrowers and related counterparties.

Steps to be Taken to Minimize Risks

All the financial institutions and banks have to take exclusive measures to mitigate the risks mentioned above. Banks should pay special attention to all the large, complex, or unusual transactions or patterns of transactions that have no apparent lawful or economic purpose.

• The purpose of such transactions should be verified and examined with the assistance of auditors, supervisors, and law enforcement agencies. If a bank suspects the root of funds belongs to a criminal activity, then it should promptly report its suspicions to the legal authorities.
• All directors, employees, and officers of the bank should be protected by legal provisions from civil or criminal liability for breaching any restriction on disclosure of confidential information by any legislative, administrative or regulatory provision. If any member of a bank reports his/her suspicion in good faith to the bank, even without precisely underlying the criminal activity, the concerned authority must take the necessary actions.

• Any director, officer, or employee of the bank is prohibited from warning their customers when any information concerning them is being reported to the competent authority.
• Financial institutions and banks reporting their suspicions must comply with the prescribed instructions given by the competent authorities.
• Banks should build programs against money laundering. Such programs must include:
  • The development of internal procedure, controls and policies like the designation of compliance officers at a management level, and sufficient screening procedures to ascertain high standards when hiring staff;
  • Ongoing employee training programme;
  •  An audit function to test the system.

Checklist of Due Diligence Report for Banks

An ideal report of due diligence for banks must include the clauses stated below:

• General Information:
  • Organizational charts both by management reporting structure and legal entity;
  • Strategic plan;
  • A detailed list of employees, comprising the information about their date of employment, salary, bonus, and title;
  • A list of all current branches of banks along with their work locations and planned branches and locations (if any);
  •  Brief  of employment’s history and resumes of all bank officer positions;
  •  Common shares outstanding and dilutive shares, including options, warrants, etc.  
• Corporate Records:
  • Bank and Company’s Articles of Incorporation, Bylaws as amended;
  • Board of Directors Minutes of last 3 years;
  • Minutes of  Annual Shareholder Meeting of recent last 3 years;
  • Minutes of Board Committee Meeting, for instance, Audit, ALCO, Compensation; Executive of last 3 years;
  •  Complete list of investments and affiliations in partnerships, corporations or other entities;
  • Recent Board of Director’s monthly information package;
  • Shareholders’ Rights Plan (if any).
• Accountant or Internal Audit:
  • Loan Review, Compliance, and IRS reports;
  • Accountant management recommendation letters (Letter of Recommendations) and responses in the most recent 3 years;
  •  Status of any audits, examinations or reviews in progress for which reports have not been provided or received;
  •  Reports of any internal or external examinations, contracted audits, loan reviews, director exams, information systems of recent 2 years.
• Insurance  
  • A synopsis of insurance coverage for bank(s) and holding Company (Blanket Bond, Excess Employee Dishonesty Bond, Equipment and Facilities, Media reconstruction, electronic funds transfer, business interruptions insurance, errors and omissions, extra expense and backup site expense, items in transit, key man, other probable risk, etc.).
  • A listing of any insurance claims and pending claims in the last three years. 

Conclusion

Financial institutions and banks are most vulnerable to external threats, so it’s better to be vigilant and take necessary measures beforehand. Due diligence for banks is crucial to know their borrowers in a better way.

You can take the assistance of Enterslice experts to prepare a due diligence report as we have competent and experienced Chartered Accountants and lawyers.