The major frauds in the banking industry during the last two decades were mainly because of the failure of the audit profession in identifying the signals in advance

The appointment of statutory central auditors for public sector banks (PSBs) was the prerogative of the Reserve Bank of India (RBI) till a few years back, and the banks had practically no say in this matter. This system ensured the independence of auditors, who were not obligated to the banks for their appointment and hence could report their findings without fear or favour. The independence of auditors is widely considered as the cornerstone of the public accounting profession.

However, from the year 2008-2009, the government in its wisdom granted managerial autonomy to the public sector banks to appoint their statutory auditors, by directly sourcing the names of auditors from the panel maintained by Controller & Auditor General of India (CAG) and getting it approved by the RBI, which in effect is a mere formality. However, the RBI has informed the banks that though the autonomy is given to PSBs, the norms for empanelment and remuneration of auditors shall continue to be as prescribed by it. Further, RBI has advised all PSBs to frame their own policy for appointment of statutory central/branch auditors.

This revised practice has been followed for the last four years and it is time for RBI to reflect on this practice. To pre-empt any misuse, it is desirable to make the following changes in the present system to make the auditors’ appointment above board. 

1. Transparency and professionalism while appointing statutory auditors: One of the apprehensions voiced both by the public and a few members of the CA profession was that there being no specific criteria for selection of auditors, all kinds of pulls and pressures could operate to ensure appointment of specific firms of auditors, which are aggressive in marketing themselves through fair and foul means. As one of the readers of Moneylife puts it, “audit firms are in an open field vying with each other in wooing bank managements to get the audits awarded to them and, in exchange, the banks are in a position to get the certificates from their auditors on dotted lines”. It is also said that that the auditors are tempted to compromise with audit independence because they are de-facto appointed by the management. Auditors are no doubt honourable men and women, who belong to the intelligentsia of the country. But there being no ground rules for selection; abuse of the system cannot be ruled out in the environment in which we function today. In order to minimize such situations the best course for the RBI is to introduce the method presently followed in the appointment of auditors in private banks, where banks are required to recommend double the number of vacancy available and the RBI can pick and choose the best amongst those recommended according to their judgment, thereby making the system more transparent and less prone to misuse. In effect, if there are six vacancies, the PSBs should recommend twelve names to the RBI, which in turn will select the best six among them, thereby considerably reducing the chances of favouritism in the appointment. This is an improvement over the present system of leaving the entire selection to the banks’ managements, which are prone to be influenced by even the political class in such selection. The proposed system of giving some discretion to the RBI has served the private sector banks well and there is no reason why it cannot be followed in PSBs also.
2. Evaluation of audits by RBI: At present there is no system of evaluating the auditing done in PSBs and the report of the auditors is final without any review. RBI being the regulator of banks can introduce the system of evaluating the audit so as to serve as an oversight over the audit work being done, and this will ensure that the auditors do their job with due diligence and with seriousness it deserves. This can be easily done by the RBI by introducing a system of review of audit also in their annual financial review (AFI) conducted by them every year in every bank and assess the level of performance of the statutory auditors in a systematic way. Normally it is observed in every bank that there is always short provisioning for NPAs (non-performing assets) resulting in inflation of profits and this is one of the important findings of the AFI by RBI every year.  If the variation is large, there is certainly a case for deciding whether the auditors have done their job properly or not and whether they deserve to be reappointed as auditors for the next year. There are many other critical areas like frauds, irregularities in reporting, etc, if not unearthed by the auditors but subsequently noticed by the RBI inspectors, is an indication of the failure of the audit profession and this could be a case for review for their reappointment. RBI could think of many other ways in which to review the audit and thus serve as the protector of banks if the auditors fail in discharging their duties honestly, diligently and fearlessly in the best interest of the banks concerned. 
3. Cooling off period requires to be changed: At present it is a game of musical chairs so far as appointment of auditors is concerned. A small coterie of audit firms monopolize the entire audit of public sector banks and they are rotated from one bank to another making the system of cooling off period a mockery of the whole exercise and gives rise to all sorts of abuses in the selection process. In order to widen the base of eligible audit firms it is necessary to increase the cooling off or rest period and provide opportunity to the new members of the audit profession, who can be groomed to take up audits of larger banks in due course. At present at the end of three-year period of continuous audit of a public sector bank, there is a cooling off period of two years during which period; the audit firm is not eligible to be considered for statutory audit of any other PSBs. This in effect means that there are only two sets of teams of audit firms who monopolize the audit of public sector banks, by alternating between themselves, virtually depriving all other audit firms from participating in the audit of public sector banks. Unless this system is changed, the monopoly of a few audit firms cannot be broken. The cooling off period should ideally be increased to minimum of four years, so that another set of teams of auditors get an opportunity to audit the PSBs. This increases the participation of audit firms by 50% from the present level, thereby broad-basing the system making more audit firms eligible to compete for audit of PSBs. Along with increasing the cooling off period to four years, there is a need to change the selection norms prescribed by the RBI to enable the new audit firms with slightly lesser experience to become eligible for being appointed as statutory auditors of banks, thereby extending the opportunity to many more audit firms who are waiting in the wings to take up this job. 
4. Change of partner of the audit firm every year: At present there is no system of changing the partner of the audit firm which is responsible for signing the balance sheet of the bank allotted to them and the same partner can continue for a period of three years in a bank. The drawback of this system is that it results in the audit partner going on the beaten track and deprives the bank the benefit of new thinking, which is essential to gear up the efficiency of audit in the interest of continuous improvement in the system of audit. The RBI should lay down guidelines to ensure that a different partner represents their firm and leads the audit team every year in the larger interest of making bank audits more independent and objective. 

If you analyze the reasons for the major frauds in the banking industry during the last two decades, it is evident that it is mainly because of the failure of the audit profession in identifying the signals in advance, many times relying too much on the statements made by the managements of banks. The Harshad Mehta scam, Ketan Mehta scam, the GTB scam, CRB scam,  Satyam Computers scam and many others have the auditors squarely to blame for their inability to smell a rat, even when the regulators have found something amiss in their operations with the banks. And in most of these cases, it is the media who finds out skeletons in the cupboards of banks, rather than the auditors, whose job it is to do.

Therefore, when you give autonomy to the banks, it should be coupled with checks and balances to ensure that such autonomy is not misused. As per the media reports, the credit rating of most of the large public sector banks has been recently downgraded, which calls for urgent steps to improve the functioning of banks and their corporate governance standards. As the saying goes “prevention is better than cure”. Hence it is advisable to continuously improve the systems when the going is good rather than take corrective steps after the happening of a scam. The steps suggested above will help in ensuring the independence of the auditors and will go a go a long way in strengthening both the banking institutions and the audit profession in our country.

 (The author is a banking analyst and he writes for Moneylife under a pen-name ‘Gurpur’.)