India: Banking system failures and the open questions post PNB

In a regulatory filing on 16th February 2018, Punjab National Bank (PNB) reported a Rs. 11, 394 Cr ($1.77 billion) fraud. Companies owned by diamond merchants Nirav Modi and Mehul Choksi are alleged to have swindled such enormous amounts by conniving with PNB branch officials and issuing unauthorized letters of undertaking.

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Over and above the capital loss and other penalties / restrictions PNB will face, if one looks at the bigger picture, this significantly undermines the government’s effort to capitalize public sector banks for the last 2 years. Riddled with asset quality deterioration, public sector banks are being urged by the government to clean up their books and are also receiving fresh capital to continue operating in the market. The intention is to bolster credit growth and appreciate the government’s capital held up in the 51% or more stake in public banks. Now, in this scenario public banks are already sitting on a pile of Rs. 60,000 Cr worth of debt. An additional Rs. 11,000 Cr on a fraudulent system of transactions (currently being investigated at other public sector banks as well) is a huge dent to a government which is already sticking its neck out to finance 3.5% fiscal deficit instead of 3.2%.

Modus Operandi of the Case 

Nirav Modi’s firm is a maker of jewelry and needs to import raw material from a foreign supplier. Now the importing firm does not want to make an upfront payment / instant transfer of money. Its intention is to import the raw material, defer the payments due on its part, convert the raw material into finished products, sell the final product and use the proceeds to settle dues.

In order to carry out such a transaction, Nirav Modi’s firm approaches PNB and requests the generation of a Letter of Undertaking (LOU) which is then sent to a foreign bank (in this case the foreign branches of Axis Bank and Allahabad Bank). The LOU is a document that states that PNB is backing Nirav Modi’s firm and that it is eligible to get a foreign loan. This loan amount disbursed into PNB’s nostro account (foreign currency denominated account of a domestic institution) is used to pay off the supplier of raw material. Going ahead, Nirav Modi’s firm will convert the raw material into a final product, sell it in the market and settle the dues on its end.

In the above structure, the following illicit activities were carried out:

  1. The generation of an LOU is supposed to be authorized and reported in the Core Banking Solutions (CBS) system of a bank. This helps to keep record of the liabilities a bank is assuming for a defined period of time. However, in this case the LOU was generated off the books and simply communicated to the foreign bank via a SWIFT message (used to send overseas transaction requests and interpreted as “approved” from the bank raising the request). Thus PNB was taking a loan in its nostro account without the actual consent and knowledge of the management.
  2. When PNB was issuing an LOU for Nirav Modi’s firm, it is supposed to take margin money or collateral as security. Nirav Modi’s firm and the PNB branch officials (who issued the LOU on behalf of PNB) were hand in glove and issued an LOU without any underlying security.
  3. When Nirav Modi’s firm didn’t settle the first loan (in 2011), the foreign bank would ideally raise alarm on account of failure of repayment. To offset this, another unauthorized LOU was issued to refinance the existing loan. An initial loan of Rs. 280 Cr ballooned into a Rs. 11,394 Cr bad debt (in 2017)

    Following are some of the open ended questions which still remain a grey area in the case and we are most likely to find answers once the finer details of the case are revealed:

  1. If refinancing has indeed occurred, what led a Rs. 280 Cr loan to get refinanced to the extent of Rs. 11,394 Cr. On what grounds did the foreign bank agree to refinance such a large amount without any further correspondence with PNB?
  2. The LOU issued by PNB was a bank guarantee or letter of credit? If a Letter of Credit, then PNB itself was liable (primary liability) to pay the discounting bank (Allahabad/Axis Bank) on a defined maturity date. If a bank guarantee, then PNB was liable (secondary liability) to pay only if Nirav Modi’s firm defaulted on repayment. In any case, why didn’t the foreign bank enforce repayments with PNB or Nirav Modi’s firm in the last 6 years?
  3. SWIFT transactions are scrutinized in a concurrent audit of a bank and reconciled with the CBS transactions. How has this been looped around the internal processes check?

The facts of the case are still being probed and will pave way for greater clarity on how a scam of this    magnitude has been orchestrated. It also accentuates a regulatory gap in the form that linking of SWIFT transactions with CBS isn’t a mandate by the Reserve Bank of India (RBI).

Involvement of a Whistleblower 

Although the PNB case has surfaced now, the opposition political parties in India are claiming that a person by the name Hari Prasad (involved in running a franchise for Mehul Choksi) had apprised the Prime Minister’s Office, Director of Companies and CBI in July 2016 about such illicit activities.  In return, Hari Prasad also received an acknowledgement from the directorate of companies saying that his concerns have been noted and due action has been initiated. If this indeed is true, one needs to further investigate into similar matters that may have been subdued at other banks.

Debt Resolution 

In light of settling dues, there has been a scuffle between PNB and the foreign bank branches of Axis Bank and Allahabad Bank for the fact that who should claim what proportion of the bad debt. PNB officials have raised a query stating that a typical LOU should have a maturity date of 90 days but the foreign banks have accepted an LOU with a maturity date of 1 year. On grounds of this violation, the argument is that Axis Bank and Allahabad Bank should be held accountable as well. Taking into cognizance these matters, the following legal aspects may form the basis of judgment:

  1. The LOC issued is genuine; however the method of issue is fraudulent (without any credit limit sanctioned and absence of collateral). In this case the issuing bank (PNB) is liable to take the liability on its books.
  2. The discounting banks have violated norms by accepting LOC with a maturity date greater than 90 days. In this case it will have to deal with penalties imposed by the RBI. However, this doesn’t change / eliminate / exempt PNB’s liability.

With regards to the amount to be recovered, Nirav Modi has alleged that figure Rs. 11,394 Cr is erroneous and that the actual amount due is approximately Rs. 6000 Cr. He has agreed to sell one of his businesses (Firestar Diamond) to compensate for Rs. 6000 Cr.

Operational Risk vs Credit Risk

Over and above the unscrupulous behavior of the accomplices, the state of technology lies at the core of the problems in this case.  The consequences which may materialize on account of inefficient and obsolete systems gives rise to operational risk. Enhancement of technology can possibly solve this problem or at least trigger a red flag on Day 1 of the case at hand (when the SWIFT messages were circumvented past the CBS by the PNB branch officials). For example, with the presence of Blockchain technology, there would be a single ledger of transactions accessible to the PNB management as well as the foreign bank accepting the LOU. The transactions recorded on them would be automatically and continuously reconciled leaving no scope for a person to complete a transaction all by himself/herself.

From the policy maker’s standpoint and for the economy at large, the key lesson to be picked up from this case is that operational risk in systems (referring to this case) are as detrimental as credit risks. Putting checks and balances on compliances and systems are as imperative as being extremely vigilant on credit off take.

Ayush Banerjee

Ayush Banerjee

Policy Intern at InPRA
Ayush Banerjee has completed his bachelor's in economics from Narsee Monjee Institute of Management Studies. He has been associated with several NGO's (Round Table India, Make a Difference, Save the Children etc.) in the past and is committed to making a positive difference. An avid follower of activist investing and Buffetology, he aspires to become a successful value investor in the Indian equity markets.
Participating in debates and MUN's has motivated him to research on international law and change the public perception about the prevalent laws by conducting a deep dive analysis of policies and it's ramifications. He hopes to do the same by writing for InPRA.
Ayush Banerjee