UNFOLDING PNB FRAUD: A CASE STUDY

There’s a huge “fraud” at Punjab National Bank, which involves lot of people in the net. Let us try to view the entire happening through our thoughts.

Few important notes:

1. There is panic amongst public as to what would happen to their deposits to PNB. There is no reason to pull your deposits or money out of Punjab National Bank. The bank may have to take a loss, but the government has a stated policy that no public sector bank will fail, so your deposits remain protected.
2. The fraud is not 11,000 crore. In this case the actual blow on PNB would probably be lesser in size. But it appears that this is a “STANDARD PRACTICE” among all public sector banks, which means it is probably much more in size if you do a research into the practice. Also remember that if everyone is doing it, it is easy to pretend that it is not a fraud.
3. The main culprits here are the top management of the bank and the auditors. How they could NOT have caught this is simply beyond rational imagination – and therefore points to people knowing it but letting it continue.

The Scam, and How It Stands

• Punjab National Bank announced a big fraud of Rs. 11,000 cr.+ in a surprise letter to the stock exchanges.
• And then, it apparently sent a message to several banks, blaming a now retired employee for raising fraudulent Letters of Undertaking for over six years.
• And simultaneously they blamed the people who received the funds, companies owned by a jeweller named Nirav Modi, and in another case, those owned by Mehul Choksi, such as the publicly listed Gitanjali Gems. Nirav Modi is Choksi’s nephew. (As trivia: Nirav Modi’s brother, Nishal, is married to Ishita Salgaokar, who’s Dhirubhai Ambani’s grand-daughter through his daughter Dipti)

So what actually happened?  Here is the entire story in brief.

THE CONCEPT AND ITS WORKING

1. An Importer named Nirav Modi or NM, wants to import pearls or diamonds and then sell them. He requires money and hence approaches a bank, say Punjab National Bank (PNB).
2. PNB says look, I’ll give you a loan but it will be like at 10%.
3. NM thinks tough and says, no, that is too much. He adds, wait, why don’t I take a foreign currency loan instead, after all I’m buying in dollars?  Much lower interest rates.  I can get at LIBOR+2% and LIBOR is like 1.5%, so I’ll have the money at 3.5%!
4. 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?
5. SO NM goes to PNB and says, boss, you are my banker, so please help some foreign bank give me some money to buy diamonds. Please assure that you will guarantee my loan by giving me a “Letter of Undertaking” (LOU).
6. PNB now should be saying “Look, if you want me to give Rs. 100 cr. guarantee, you give me stuff worth atleast 110 crore as collateral.
7. But PNB, for some strange reason, does not ask for collateral.  
8. So now the foreign bank is ready to lend NM the money, because PNB will guarantee it. And the foreign bank trusts PNB.  Why does it trust PNB? Because PNB sends a message on SWIFT – the banking message service – that PNB guarantees Rs. 100 cr. of money for 180 days for Mr. NM at an interest rate of, say, LIBOR + 2%.  It’s like a message – written in stone, effectively – that says PNB will pay if NM fails to pay. In fact the foreign bank trusts only PNB.  So it gives the money to PNBs account with it, called by PNB as a “NOSTRO ACCOUNT”.  This is an account that PNB maintains with banks abroad, where the other bank will send money meant for PNB customers.
9. PNB’s nostro account gets the money.
10. PNB then gives NM the money from the Nostro account, which is in turn is paid off to those from whom NM is buying his diamonds. This payment is to someone outside India which in turn is usually utilized, to fund a purchase of diamonds or other materials.

IMPORTANT NOTES:

1. The other bank gives money to PNB’s Nostro account and not to NM. They donot believe NM.  They only know that PNB has given a guarantee through the SWIFT channel.
2. The other banks involved in most of the cases, are foreign branches of Indian banks.
3. The bank in the foreign country does not care about whether NM was buying diamonds or bitcoin, for they believe that PNB would pay back even if NM becomes a bankrupt.

REPAYMENT:

Now the next question is -Why does PNB give a guarantee?  Does it attract any charges/Fees?  Yes. Each year, a bank may charge up to 2% to issue the LoU.  Here comes the question as to what happens when it is time to pay back?

• NM has to get the pearls in India
• Sell them and receive the money and pay PNB on the due date mentioned in the LoU.
• Then PNB will pay back the foreign bank with interest and other charges if any.

WHAT HAPPENED IN REALITY?

What could NM do with the bank money?  There are three options.

1. NM might not pay back at all.
2. NM might use the money to speculate in the markets. Or
3. NM may do something else with the money.

Let us see as to what happens,  if NM in the above example did not have money to pay back to the Foreign Bank?

• He asks a PNB official to open ANOTHER LoU , for the amount owed plus interest. So if we had the first LoU at $10 million the second one is $11 million to cover the interest on the first.
• The money from the second LoU is used to repay the first. Thus, it is just rolling over of credit which otherwise is a PONZI scheme.
• This can easily balloon into a larger amount, so large that it is very high.
• In effect many such arrangements have turned into semi-ponzi schemes, with one LoU being opened to repay another and so on.

WHAT COULD HAVE HAPPENED IN THIS CASE?

Though we do not have the details, possibly followed would have happened:

• Nirav Modi took loans from foreign branches of Indian banks through an LoU issued by PNB
• This was done through a SWIFT based LoU issued through PNB employees
• The entries were never reflected in the core banking system for monitoring
• LoUs were rolled over all the way since 2011, and possibly increased over a time too.
• The Bank official said to have issued these LoUs, retired in 2017, and the one who replaced him refused to roll over the LoU which became due in Jan 2018 since he was unable to find the past transactions in the system
• No rollover means, obviously A DEFAULT, since there was no money to pay. So PNB quickly files an FIR claiming that they have lost 280 crore on the Jan LoUs
• Then internally some one finds that more of the LoUs are not found in the system which is checked by seniors to find out that the total of such entries is around Rs. 11,400 crores.
• Everyone in the bank panicked.
• Bank people think as to why Nirav Modi could not pay back the dues since he must be having the original money of these exports?

REALITY:

• If the amount was ever intended to be paid back, the rollovers would not have been required. At some point, things got so out of hand that rollovers were required in order to stay current.
• Typically this would not be a problem if PNB had donne things right. That is the bank would have had collateral worth the amount of guarantee, and they would have sold that collateral and paid the foreign bank when there was a claim on the LoUs.
• But, unfortunately, PNB DID NOT HAVE ANY COLLATERAL.

ISSUES:

1. Why did PNB give a guarantee without collateral?
2. If a normal person goes to a bank and requests for a loan, the bank will ask for income proof, and collateral. Only small tiny personal loans and credit card loans are made available, without collateral.  For something of the order of 11,000 cr. you would think they would ask for collateral.
3. Incidentally, we might recall that in the case of Vijay Mallya, loans to King Fisher were given on nearly no collateral (though there was some collateral in the form of a house mortgaged and few of the promoter shares pledged)
4. Why did PNB give this guarantee then? It is typical – banks give guarantees for more the amount you give as collateral, because of the business relationships and every bank is doing it.
5. One more important thing is Banks extend facility of two type – Fund Bases and the other Non-fund based.  This loan was not a “fund based limit”. In a fund based limit like a term loan, the bank pays out money. In a non-fund-based limit, the bank will only pay if someone defaults or an event happens – like a Bank Guarantee or an LC or an LoU which is otherwise invoked or claimed.
6. Here it is therefore clear, that PNB assumed that the foreign bank was giving a loan directly to Nirav Modi and that PNB needed to pay only in case Nirav Modi defaulted. So in the eyes of PNB it was always a “non-fund-based” loan.
7. Typically, 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.
8. One can practically find that with any Public Sector Bank, normally, for every Rs. 100 that the bank holds collateral, they will easily provide LoUs upto six times the amount of collateral. This is a typical problem with most of the PSU Banks, where adequate collateral is not held on any Non fund based limits, especially extended to the importers.   Even if a bank has collateral, it will normally not cover the entire facility, and neither such unfunded liabilities are eported to RBI!

BASEL Reporting: No Disclosure:

• PNB has “unfunded” exposure of 11,000 crores as per their claim. However, this is not revealed in their latest Basel III disclosure:
• The funded exposure to “Gems and Jewellery” is shown at 1860 crores.
• Unfunded to the same sector is shown as: 842 crores.
• So, in effect, PNB did not reveal, that it was funding massive quantities of “unfunded, contingent exposure”. The bank however takes shelter, under the fact that the transactions were not found in the core banking system.

QUESTIONS RAISED:

• Did Employees hide the details?
• Was PNB Responsible or was it a fraud?
• Can employees be responsible?
• Could they have hidden the credit and the rolling over of LoUs?
• But honestly, how does a 11,000 cr. credit pass muster, without the top management realizing it?

BRAIN STORMING ISSUES:

Think of it –

1. Let us say your Nostro account with these other banks keeps getting big credits that add up to 11,000 crores.
2. Will you not reconcile it in the accounting?
3. A question “WHY IS THIS MONEY LYING HERE?” should have been asked by someone who audits account. Is it not?
4. What is a SWIFT message? It is a specific kind of message.  Why could not PNB audit the SWIFT trail?  Reconcile it with the core banking system? How many more such skeletons will tumble if they do?

Here are the excuses given by PNB

• Data was not entered into the core banking system. (Of course, otherwise one should obviously report it)
• LOUs were not authorized. (Hard to believe, since the amounts are very high. Definitely, someone at the top level must be aware of it)
• Above all, it is said that the SWIFT system was illegally used. (Again, hard to believe that a bank like PNB or its Auditors or RBI would not audit its SWIFT messages regularly).
• An ex-employee is named as the main accused in the case. It is likely that lot of people were involved.  And that it generated massive, fat fees for PNB all these years.

FEES COLLECTED:
Imagine 11,000 crores, worth LoUs being renewed each year – that is up to Rs. 200 crore in fees that was all hitting PNB’s top line.  You could bribe an employee to the tune of say 10-20 crore,  but when you hit numbers like 11,000 crore, this is surely something the top management would know.

What’s the Scale of this scam?

All of it will be borne by PNB right now. Whether someone abused their SWIFT usage is not relevant, if PNB’s SWIFT message said they will pay, they have to pay if there is a default.   Punjab National Bank (PNB) has told the police that it has uncovered additional exposure of about Rs 942.18 crore (USD 145.27 million) to Asmi Jewellery of Gitanjali Group in connection with a massive alleged fraud, according to a court filing by the Central Bureau of Investigation.  This takes the Delhi-based lender’s total exposure to one of country’s biggest banking frauds up to Rs 13,640 crore from the earlier estimate of Rs 12,700 crore.

OTHER ISSUES COMING UP

But 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 trivial to start looking – and 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 are told to verify their non-fund-based limits and demand collateral against them (say at least 25%) then the scale would be absolutely massive.
• It is not that this is happening only with Nirav Modi or 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 (and import account) in the system.

The simple point:

This particular transaction will result in a lower loss than 11,000 cr. for PNB if recoveries are made.  Meanwhile RBI stopped issuing LoUs as of now.

PNB stock prices?

It has fallen to 17%.  But it may be noted that PNB is already piled up with 60,000 crore of gross NPAs.  Another 11,000 crore will obviously hurt it but not kill it. It won’t die – the government will take it over. Shareholders might suffer, but come on as a shareholder of a public sector bank , since you are used to suffering.

Real Problem:

• There is never just one cockroach. When you go deeper, you are likely to find more dirty, dark secrets, and none of them will be any good.
• PNB is going to be hurt for a while, but so are others who will find their books similarly tarnished, once they investigate.

Will This Bring The Market Down?

If RBI tightens up, liquidity will pull money out of stocks, and that will hurt.

Of course, this hurts the fiscal deficit since PNB has to be rescued.  So bond yields are up to 7.6% and therefore we would avoid any long term funds or bonds.  Short term it will have to be.

But overall, we would not worry too much.  Just react, don’t predict. What would you do if stocks fell? Better to answer that than to say they will, or they will not.

CONCLUSION:

1. This is the Indian public sector banking system. Fix it.
2. How can you have transactions on SWIFT outside CBS? Fix it.
3. Why would you not reconcile the nostro accounts? Suspend the auditors. Fire top management. Fix it.
4. Closing the door behind Nirav Modi, who has already left the country, is probably useless. If you find fraud,  invoke their personal guarantees,  and file cases to attach their personal properties. After that, file in NCLT to make these companies insolvent. Take the hit, and try to recover.  Ofcourse action has been taken on this.
5. Find out more such instances where collateral cover is too low.
6. 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 collateral to avoid further spread of the ponzi.

But this is quite unlikely to happen because the banking system is going to take massive hits now, and we are going to have to deal with the fallout of really horrible systems.  It is amazing that our banks have been this lax, but they have been allowed to;  with no bankers being investigated, the rot inside the banks has been ignored and instead, industrialists have been the target of outrage.  Therefore it is time to look at banks as malicious players too, and to fix that rot.  Let us do it now….