Decoding the PNB fraud: Time to fix the rot in the banking system

Let us begin from the beginning. To understand how things work, we have to begin from the concept. Some importer, let’s call him Nirav Modi or NM, wants to import pearls or diamonds and then sell these. The purchase requires money, so NM approaches a bank, say Punjab National Bank (PNB). On its part the PNB says look, I’ll give you a loan but it will be at an interest rate of, say, 10 per cent.

nirav modi2NM thinks hard and says, no, that’s too much. Wait, why don’t I take a foreign currency loan instead, after all I’m buying in dollars? Much lower interest rates, no? I can get at LIBOR + 2 per cent and LIBOR (London Inter-bank Offered Rate) is 1.5 per cent so I’ll have the money at 3.5 per cent!

But who will give NM a foreign currency loan? A bank abroad? They don’t know NM. They don’t have any history of NM, so why will they give him money? So NM goes to the PNB and says, boss, you’re my banker, so please help some foreign bank give me some money to buy diamonds. Say that you will guarantee my loan by giving me a Letter of Undertaking (LoU).

The PNB now should be saying look, if you want me to give Rs 100 crore guarantee, you give me stuff worth at least Rs 110 crore as collateral. But the PNB, for some strange reason, doesn’t ask for collateral.  Now the foreign bank is ready to lend NM the money because the PNB will guarantee it and the foreign bank trusts the PNB. Why does it trust the PNB? Because PNB sends a message on SWIFT — the banking message service — that PNB guarantees Rs 100 crore of money for 180 days for NM at an interest rate of, say, LIBOR + 2 per cent. It’s like a message — written in stone, effectively — that says the PNB will pay if NM doesn’t pay.

As the foreign bank trusts the PNB, it gives the money to the PNBs account with it, called by the PNB as a “Nostro” — the account that PNB maintains with banks abroad, where the other bank will send money meant for the PNB customers. The PNB’s nostro account gets the money. The PNB then gives NM the money from the Nostro
account, usually paid off to whoever NM is buying his diamonds from. This payment is to someone outside India usually, to fund a purchase of diamonds or other goods.

Note this carefully: The other bank gives money to the PNB’s Nostro account. Not to NM. They don’t care about NM. They only know that the PNB has given a guarantee on the SWIFT channel. Significantly, the other bank is nowadays mostly the foreign branch of Indian banks. The foreign banks always smell something sinister in such deals. Resultantly, the foreign banks couldn’t care less about whether NM was buying diamonds or bitcoin – to them, the PNB would pay back even if NM’s wallet gets stolen.

Now the question is why should the PNB give a guarantee? Obviously for a fee because for each and every transaction, a bank may charge up to 2 per cent to issue the LoU. Now we come to the other part. What happens when it’s time to pay back? NM has to get the pearls and diamonds in India, sell them, receive the money and pay back to the PNB on the due date as per the LoU. On its part, the PNB will pay back the foreign bank saying okay we got the customer’s money so we’re giving it back to you with interest, etc. That is what is supposed to happen. But in reality, it seems that things went a little berserk.

The Reality: A Bit of a Ponzi

NM might not pay back at all. NM might use the money to speculate in the markets, or do something else. What if NM simply doesn’t have the money to pay back? Instead, he asks some PNB official to open another LoU for the amount owed plus interest. So if the first LoU is at USD 10 million, the second one is USD 11 million to cover the interest on the first. The money from the second LoU is used to repay the first. It’s just rolling over of credit. It exactly fits over and over into the standard definition of a ponzi scheme. This can easily balloon into a larger amount, so large that it’s too much. In effect many such arrangements have turned into semi-ponzi schemes, with one LoU being opened to repay another and so on. In such a scenario, this is what probably happened.  Nirav Modi took loans from foreign branches of Indian banks through a LoU issued by the PNB. This was done through a SWIFT-based LoU issued through a rogue employee (or many of them) at the PNB.

The orders never showed up in the core banking solutions (CBS) for monitoring. The LoUs were rolled over all the way and increased over time too. The rogue official retired in 2017, and the replacement refused to roll over the LoU, which came due in January 2018 because he couldn’t find the past transactions in the system. No rollover means a default, since there was no money to pay. So the PNB quickly filed an FIR saying the bank has lost 280 crore on the January 2018 LoUs. Further investigation by the PNB found that the fraud was massive — to the tune of Rs 11,400 crores.


Naturally, when the fraud unfolded, everyone in the bank panicked. Could Nirav Modi pay it back? If it was intended to be paid back, the rollovers wouldn’t have been required. At some point, things got so out of hand that rollovers were required in order to stay stable. Generally, this would not be a problem. If the PNB had done things right, they would have had collateral worth the amount of guarantee, and they would have sold that collateral and paid the foreign bank.

The real issue

In this case, the PNB didn’t have any collateral. The question is why did the PNB give a guarantee without collateral? If a commoner goes for a loan to a bank, they’ll ask us for income proof and collateral. Only small personal loans and credit card loans come backed without collateral. For something of the order of 11,000 crore you would think they would definitely ask for collateral.

Ironically, it happened even after the experience with Vijay Mallya where loans to Kingfisher were given on nearly no collateral (though in that case a house and some promoter shares had been pledged). Why did the PNB give this guarantee then? It’s typical — more the amount you give as collateral, more the guarantee that banks give. Again, the loan was not a “fund-based limit”. In a fund-based limit like a term loan, the bank pays out money. In non-fund-based limits, the bank will only pay if someone else defaults or an event happens — like a Bank Guarantee or a LC (Letter of Credit) or an LoU. Meaning, the PNB assumed that the foreign bank was giving a loan directly to Nirav Modi and that PNB needed to pay only in case NM defaulted.

So, in the eyes of the PNB it was always a “non-fund-based” loan. But this is how a significant part of  import financing works. They all rollover credit, and they all use LoUs for much higher than they can offer as collateral.
The fraud may be even bigger because for every 100 that a bank has collateral, they will easily provide LoUs for up to six times the amount. This is a real problem — that most public sector banks do not keep much collateral against non-fund-based limits given to importing customers. So even if a bank has collateral, it’s nowhere near enough. And then, such unfunded liabilities are not even reported to the Reserve Bank of India!

Basel Reporting: No Disclosure

The PNB has “unfunded” exposure of 11,000 crore, they say. But they don’t even reveal it in their latest Basel III disclosure: The funded exposure to ‘Gems and Jewellery’ is shown at 1860 crore and unfunded to the same sector at 842 crore. So in effect, the PNB didn’t reveal that it was funding massive quantities of “unfunded, contingent exposure”. The Bank may pretend that it did not know because the transactions weren’t in the core banking system (CBS).

Did employees hide it? Was the PNB responsible or was it a fraud? Can employees be responsible? Could they have hidden the credit and the rolling over of LoUs? How does 11,000 crore credit pass muster without top management realizing it? Think of it — your nostro account with other banks keeps getting big credits that add up to 11,000 crore and you don’t reconcile it in the accounting? The “why is this money even here?” question should have been asked by someone who audits accounts? The SWIFT messages are a specific kind of message. Why wouldn’t the PNB audit the SWIFT trail? Reconcile it with the core banking system. How many more such skeletons will tumble if they do?

Data wasn’t entered into the core banking system. LoUs weren’t authorized. It appears hard to believe, because the amounts are very large. Surely someone on the top would know. The SWIFT system was illegally used. It is hard to believe that a bank like the PNB would not audit its SWIFT messages regularly, not even its auditors or even the RBI.
On the face of it, it looks like the ex-employee is being used as a scapegoat. It’s likely that a lot of people were in on this thing. And that it generated massive, fat fees for the PNB all these years. Imagine 11,000 crore worth LoUs being
renewed each year — that’s upto 200 crore in fees that was all hitting the PNB’s top line. When you hit numbers like 11,000 crore, this is surely something the top management would know.

Scale of fraud?

While the PNB reported it as a 11,000 crore fraud, they filed an FIR with the CBI for only 280 crore. All of it will now have to be borne by the PNB. Whether someone abused their SWIFT usage is not relevant, if the PNB’s SWIFT message said they will pay, they have to pay if there is a default. Think about the fallout. The problem was that some liabilities were not in the system. There could be more such LoUs from the same branch or others. Other banks could have such LoUs too. It’s imperative to start looking — we know that Nirav Modi will not be an isolated case.

Also, the issue was that the limits had no collateral behind them. If all banks were told to verify their non-fund-based limits and demand collateral against them (say at least 25 per cent) then the scale would be absolutely massive. It’s not that this is happening only with Nirav Modi or Mehul Choksi. A very large number of importers of commodities have been doing this, and rotating credit. A change in regulation here can change the game dramatically for every other bank in the system.

Fixing the malady

How can you have transactions on SWIFT outside CBS? The only alternative left is to fix it. Why would you not reconcile the nostro accounts? Suspend the auditors and fire top management. The General Secretary of All India PNB Officers Federation, Krishna Kumar, who is very vocal has often been raising issues plaguing the banking system.

Closing the door behind Modi, who has already left the country, is probably useless. Invoke their personal guarantees, and file cases to attach their personal properties. After that, file in National Company Law Tribunal to make these companies insolvent. Take the hit, and try to recover. Find out more such cases where collateral cover is too low. Find out if the LoUs or LCs are just getting rolled over or is the customer actually paying back through the Indian current account. And if not, demand more collateral to avoid further spread of the fraud. It is horrible that our banks have been this lax and they have been allowed to, with no bankers being investigated. The rot inside the banks has been ignored and instead industrialists have been the targets of outrage. It’s time to fix the rot in the banking system.

The views expressed are the author’s own.