PNB-Nirav Modi Scam, Modus operandii, its Implications and the Way Forward

PNB-Nirav Modi Scam, Modus operandii, its Implications and the Way Forward

By:

Vijay Sardana[1]

1.    What is the PNB scam all about?

One of the biggest scams in the country’s corporate history, Delhi-based Punjab National Bank (PNB), country’s second-largest public-sector bank (PSB), said on Wednesday it had been defrauded of about Rs 114 billion by jeweller Nirav Modi, his maternal uncle Mehul Chinubhai Choksi, and other relatives through a clutch of companies they own. Bank said two of its employees were involved in the scam, where the bank’s core banking system was bypassed to raise payment notes to overseas branches of other Indian banks, including Allahabad Bank, Axis Bank, and Union Bank of India, using the international financial communication system, SWIFT.

Case Details:

The scam surfaced when companies of Modi and Choksi approached PNB's Brady Road branch, Mumbai, in January this year seeking Letter of Understanding (LoU) for payments to suppliers.

The official handling the case sought 100 per cent cash guarantee before any such letter could be issued to which the company officials said no such guarantee was sought in the past.

The official checked the records which did not show such an LoU to Modi or Choksi's company which led to suspicion.

It is alleged that Shetty, for the last seven years, was bypassing PNB's core banking system and issuing LoUs fraudulently.

An LoU is a guarantee which is given by an issuing bank to Indian banks having branches abroad to grant a short-term credit to the applicant. In case of default, the bank issuing the LoU has to pay the liability to credit giving bank along with accruing interest.

Shetty and Kharat allegedly sent messages of these LoUs using an international messaging system for banking systems called SWIFT (Society for Worldwide Interbank Financial Telecommunication) which is used to pass instructions among banks globally to transfer funds.

It is estimated that millions of messages are sent daily using the SWIFT technology globally wherein every member bank can send or receive messages of financial transactions to another bank worldwide.

The PNB officials allegedly sent these messages to Indian banks — Canara Bank, State Bank of India, Bank of India, Axis Bank, Allahabad bank — located in Antwerp, Hong Kong, Bahrain, Mauritius, Frankfurt without making entries in the banking software about the LoUs.

These LoUs and Letters of Credits (LC) worth Rs 11,384 crore were getting renewed or issued afresh during last six years without coming in the notice of the bank.

The Indian banks abroad did not mind as their money was safe (under guarantee from PNB) and increasing because of the accruing interest.

The party was spoiled in January this year when first renewal arose after the retirement of Shetty, the officials said.

An alarmed bank dug out all such LoUs and LCs showing a mammoth liability towards other banks.

The conniving officer also issued Foreign Letters of Credit by entering a smaller amount in trade finance module of Core Banking Solutions (CBS) system and generating the reference number and a SWIFT message was sent for the amount, the bank alleged.

It said subsequently without making any changes in the module of the CBS, the conniving officer sent modified SWIFT messages for enhanced amount under the same reference to the beneficiary bank.

Upon receiving messages from PNB under SWIFT, the banks abroad transferred these amounts into PNB's NOSTRO account with them.

A Nostro account means is an account that a bank holds in a foreign currency in another bank to enable foreign trade by its clients.

2.    What caused it - The unauthorized issuance on LoU was the basis of fraud:

This latest fraud uses an age-old method employed to defraud the banking system. It involved LoUs raised at the PNB’s Mumbai office by firms owned by Modi and his family. A LoU is issued by a bank to an importer (in this case Modi). It works like a bank guarantee, which the importer can sell to other banks at a discount. The importer receives the money, or letter of credit, and pays his client. The issuer bank messages overseas branches of other banks through the SWIFT network and that bank immediately pays the client against the LoU. The bank that holds the LoU then goes back to the issuer bank (PNB in this case) and gets its due.

The issuer bank (PNB) recovers its due to the LoU from its client (Modi). Since the LoUs are used for importing goods and involve foreign currency, a vostro account (client’s overseas account) is used to deposit the credit by the bank accepting the LoU. However, issuance of the LoU involves a lot of processes and to mitigate the risks of fraud, banks insist the client deposit an equivalent amount of assets, mainly cash, in the local branch, to avail of the overseas facility. All these safeguards were ignored in this case.

3.    Why it remained undetected?

The fraud in PNB is a case of operational risk arising because of rogue behavior by one or more employees of the bank and failure of internal controls. This is due to the poor management system in the banks. Incompetent Auditors both internal and external and careless Board of Directors in all the banks associated with the fraud ensured that fraud not only remains undetected but flourish with time. Central bank failed in ensuring auditing of risk management system and enforcing sensible auditing system in banking system including foreign exchange tracking. People involved undertook unauthorized trades and there was a failure of SOP and failure of corporate governance to track it.

4.    After Vijay Mallya now Nirav Modi case – do these incidences break the international investor confidence in India

Yes, it does break the confidence. It indicates either system is managed by incompetent people or corrupt people. Including auditing systems is ineffective and governance is also week. This sends a very wrong message about the governance in the country.

5.    What are the remedies?

Remedies are simple. The government of India must issue clear directives to all authorities to enforce Global Best Practices and risk management in financial transactions across the spectrum of industries. These must be enforced ruthlessly in time bound manner. All auditing and rating agencies must be made accountable for the frauds if they remain undetected beyond the auditing frequencies and rating frequencies. Board of Directors and all Head of the departments must submit an undertaking to concerned authorities that they have evaluated the effective risk management. They must do dummy trials to test the effectiveness of the systems.

6.    Was Indian government seen on front foot on black money? Where are the fault lines?

In my view, there was a gap between what they were saying and what they were doing. For example – common citizen was told to adopt digital payment for day-to-day to petty transactions, but the same was not enforced for political donations.

The political donation was kept open for cash transfers. Corporates were asked to contribute for the political donation. Most of the unaccounted and black money goes into funding political activities. It is public knowledge that most licensing, inspection and enforcement authorities are considered corrupt and failed to deliver services to common citizens with ease, but till date, there is hardly visible action against these corrupt inspectors and authorities. These are a clear example that fight against black money and corruption is half-hearted. Common man still suffers due to poor delivery by an inefficient system. India’s ranking in Corruption Index is linked to black money. Affluent class does use speed only called bribe to get them. This is also responsible for the huge divide between the haves and has not.

7.    Advise to international investors?

India is a hugely attractive opportunity. One must invest to take the benefit of this market. My proposal does invest and you just stick to the Good management practices and risk management.

8.    What is the hit like? How much time banking sector will take to recover.

Difficult to say now. The losses may increase due to various factors.  After demonetization, there was a disruption in a normal business cycle which led to the creation of many NPAs. Before demonetisation, many corporates took excessive loans based on the inflated market projections based on poor research shared by many well-known consulting companies. This lead to capacity creation but a poor business realization. Banks also extended credits based on these ill-researched project reports. All these led to the serious banking crisis. This type of frauds also shakes confidence in the private sector.

Now, if it is up to the government what decision they will take to clean the banking system.

Suggestions:

Charity begins at home. Let political leadership and decision makers in India make political funding system transparent and accountable. No cash transfer to a political party so that donors can be asked to the source of funds and his business practices can be evaluated if required. Why political parties need this concession or loophole, when digital payment can be used to buy a cup of tea or an ice cream?

This will force everyone else in the system to become transparent and law abiding.

If the government is keen to clean the system from corruption and frauds they must ruthlessly enforce laws and fix accountability and remove all discretionary powers from individuals and shift it to the committees to make the system accountable and transparent.

Adopt Good Business Practices and code of conduct.

RBI and other regulators around the world must study all banking frauds happening worldwide and issue suitable advisory and checks and balances for banking system to prevent repeat.

Auditors, inspectors and rating agencies must be made answerable for every fraud. Unless people benefit from the frauds are made to pay more than the cumulative gain from the fraud, it will be difficult to make the system accountable.

Transparency must be part of all decision-making process.

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[1] Leading Business & Policy Risk Management Advisor for Commodity Markets, Member of Board of Directors & Economist