Legal audits hold the key to address loan write-offs by Indian banks

Legal audits act as a comprehensive check on the assets backing loans. (Pixabay)
Legal audits act as a comprehensive check on the assets backing loans. (Pixabay)

Summary

  • These provide banks with a cost-effective tool to improve collateral management, secure their lending base and shield themselves from future financial and legal challenges. A legal audit is a safeguard that promotes the sustainability of the banking industry.

Banks have written off loans worth 9.90 trillion in the last five financial years, with 1.70 trillion written off in 2023-24 alone. 

This statistic highlights a significant financial challenge facing the banking sector. In the face of loan write-offs and non-performing assets (NPAs), effective collateral management stands out as the only remedy.

In this context, the importance of a thorough legal audit of guarantees becomes crucial for banks, helping them protect against costly legal and financial setbacks in the future.

Also Read: What loan write-offs are, and what they are not

Why is a legal audit necessary? 

Legal audits act as a comprehensive check on the assets backing loans, ensuring they are genuinely owned by the borrower, free from competing claims, and aligned with the loan terms.

With fraud cases on the rise, banks have encountered instances where borrowers lacked legitimate authority over the assets they offered as security. 

This oversight has led some financial institutions into costly legal disputes as they vie to enforce claims on the same collateral.

The increasing levels of fraud and loan irregularities have attracted the attention of the Reserve Bank of India (RBI), which recently directed banks to conduct rigorous legal audits to ensure that assets pledged against loans are authentic and have clear titles. 

Also Read: PAN 2.0 sounds good but will it end fraud through impersonation?

A proper legal audit not only verifies the validity of such assets but also strengthens the foundation of lending practices.

The role of legal audits in effective collateral management: Collateral is the cornerstone of sound lending. 

For banks, the primary purpose of holding security is to mitigate credit risk and secure priority in the event of a borrower’s default or liquidation. 

However, poorly documented or disputed collateral can quickly undermine this security, leaving banks exposed.

In recent legal cases, courts ruled that banks could not pursue borrowers for unpaid amounts once the security was sold, leading to potential financial losses. 

However, the court of appeal has since clarified that banks can pursue borrowers for any outstanding balances provided due diligence was observed in the realization process.

This underscores the necessity of a thorough legal audit to safeguard banks’ rights to recover their dues. 

By accurately identifying, documenting and regularly auditing these securities, banks can ensure they meet all necessary legal standards and are correctly valued, mitigating risks before they escalate.

The technology advantage—Declining costs and greater efficiency: Traditionally, legal audits were both costly and time-consuming. 

Today, advancements in legal tech have made the process quicker, more affordable, and more accessible.

Through artificial intelligence (AI), machine learning and data analytics, banks can efficiently review large volumes of legal documents, property records and other critical information. 

These innovations not only reduce the costs of conducting legal audits but also enhance accuracy by automating data verification and identifying potential red flags.

For instance, software can now cross-reference public records and title deeds instantly, ensuring that any liens or claims on securities are identified upfront.

This reduction in cost and time has made regular legal audits a practical option even for smaller loans. 

By leveraging technology, banks can perform more frequent audits, transforming security management from a reactive to a proactive strategy.

Preventing losses and avoiding legal pitfalls: A legal audit today is an investment in a bank’s financial security tomorrow. 

Poorly verified or inadequately documented securities can lead to significant losses—not only from unrecovered loans but also from legal disputes over asset claims.

Also Read: Microfinance risk: Small loans can spell big trouble for Indian banks

The legal audit process ensures that these securities are enforceable and liquid enough to cover outstanding liabilities in case of borrower default, saving banks from the expense and uncertainty of protracted legal battles.

RBI’s recent push for legal audits is a strategic move to protect the banking sector from NPAs and to encourage greater accountability.

With technology making legal audits more feasible, banks now have the tools to improve collateral management, secure their lending base and shield themselves from future financial and legal challenges.

Ultimately, investing in legal audits is a cost-effective safeguard that promotes the sustainability of the banking industry.

The author is co-founder and CEO of AdvaRisk. 

Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint. Download The Mint News App to get Daily Market Updates.
more

topics

MINT SPECIALS