PNB Crisis – Gem of a Scam among Scams of Gem
On 14th
of February, the Punjab National Bank, India's second-largest state-run lender,
said it had detected "some fraudulent and unauthorized" transactions
amounting to around Rs 11,360 crore at a branch in Mumbai. The fraud involved
unsecured loans that were given to Nirav Modi, a diamond and jewellery merchant,
and his associates. This piece is an attempt to explain the issue in the
simplest possible way and is my personal interpretation.
What is a bank: A
bank as ‘a financial institution that accepts deposits from the public and
creates credit. Lending activities can be performed either directly or
indirectly through capital markets’ (Wikipedia, sic). Hence, in a banking
system a group or network of institutions provides financial services to people.
These institutions by managing deposits, operating payment systems, and providing
loans, enables trade and money management. It is evident from the fact that all
the major financial centers in world (like Tokyo, Hong Kong, Singapore, Shanghai,
Mumbai, New York) are also major global trade centers.
Why do we need banks in trade: To put it simple - ‘Lack of Trust’. Trust between human
beings have diminished especially when it comes to money. Hence, banks act as a
third party guarantor, who the people can associate with and trust. This ecosystem
has its own benefits also, since it has facilitated trades between two parties from
two different world.
Before getting into the fraud,
let me set the plot. Lallu Lal is an
India based businessperson who trades overseas as well, be it in terms of
imports or end-market. Lallu wants to import goods from Hong Kong. He places
the order with a manufacturer named Ryan. Lallu and Ryan do not know each
other. Ryan has no way of knowing if Lallu can (or will) pay for the goods
after they are produced and shipped. Ryan cannot trust an Indian for the timely
payment while Lallu cannot trust the quality of goods due to country of origin
(pun intended). Hence, this is where banks
come into play. To manage risk, the seller uses an agreement requiring the
buyer to pay with a letter of credit as soon as shipment is made. Let us say, Lallu
deals with Bank AB (in India) and Ryan deals with bank BB (in Hong Kong).
Lallu will go to his bank AB and
ask a Letter of Credit (LC) to be issued to BB bank. A letter
of credit is a document from a bank that guarantees payment. If you are
familiar with escrow services, the
concept is similar: Banks act as "disinterested" third parties (will
remain unbiased), and they release funds only after certain conditions are met.
Letters of credit are common in international trade, but they are also used in
domestic transactions like as construction projects. Hence, once the goods are
delivered and are judged correct, Ryan will get the payment and AB will pay to
BB. Or else Lallu’s bank will return his money back. The whole transaction is
based on the trust between both the banks.
LC is a very old instrument and is
frequently used in international trading. One can obtain the LC based on his
purchase contract along with other required documents. The concerned bank may
ask him to keep certain percentage of ‘margin
amount’ with bank. The margin amount might vary from 1% to 100% of the
credit limit depending upon the credit worthiness (Fixed assets, transaction
history etc.) and personal relationship of the borrower with the banker. Therefore,
the lender bank blocks the margin amount from borrower’s account to pay LC (guarantee)
amount to the overseas seller on maturity date. In simple terms, AB (Lallu’s)
bank is promising BB (Ryan’s) bank that case Lallu defaults on his loan, AB
bank will cover the loss to BB bank and will take Lallu’s deposit.
Now in the case of Punjab National Bank (PNB), ‘fake’ letters
of undertaking (LoU) were used against the import receipts from Nirav Modi and
his firms. In this case, the processes were flawed, cash reserve or collateral were
not secured and the transactions went unrecorded in the bank's core banking
software, the system on which the banks' financial transactions are run and
recorded. For PNB, it was more of a contingent
liability (A potential liability that may occur, depending on the outcome
of an uncertain future event). A contingent liability has to be recorded in the
accounting records if the contingency is probable and the amount of the liability
can be reasonably estimated. Moreover, all these were ignored for seven years. After
issuing the LoUs, the culprit bank officials even informed the overseas
branches via SWIFT (Society for
Worldwide Interbank Financial Telecommunication); the international cash
transfer service that connects all international banks worldwide. However,
exploiting the information gap and the fact that PNB had not integrated its
SWIFT network with the bank's core banking network- they chose not to record
these transactions in the bank's own system.
Now the counterparty bank at Hong
Kong (Primarily the local branches of Allahabad bank, Union bank, SBI, Axis
bank in this case) accepted the fake LoU to give credit to the seller party. Interesting
point to notice is that in such businesses sellers are usually from the same
family (or close relative). Since the LoUs were of 1-year validity, they were
not reported in PNB’s books. In short, PNB had a contingent liability without any
security and no paper work. In addition, soon before the 1-year period ended,
all the parties vanished. Over 150 such LoUs were issued since the first one
was fraudulently issued in 2011. Interestingly, while an LoU expires in 90-180
days, the fraudulent bank officials are believed to have rolled them over after
each expiry, as a result the fraud laid undetected for over 7 years. The
fraudulent LoUs were discovered when Modi's companies Solar Exports, Stellar
Diamonds and Diamonds R US asked PNB for buyers' credit in mid-January. When the bank asked for the margin amount, they claimed
they had been obtaining LoUs without co-laterals for a long time now. This is
when the case was dug deeper that rung the alarm bells and the fraud was
unearthed.
What is happening now?
-
The fraud is equivalent to 8 times the profits
declared by PNB in 2016-17
-
There are counter parties on the other side of
these LoUs who want their money back
-
The PNB chairman have written letters to 30 odd banks
and have told them about this issue
-
PNB has said that it will not service any such LoU because they did not originate through proper channel
-
The case is lodged with CBI and ED now
-
Legal actions has been initiated against Nirav Modi and associates
-
Police has attached Modi’s assets of worth approximately
6000 Cr to recover the loan amount
Probable Outcomes: There could be four scenarios now. First,
one could be a partial settlement between the banks, and each one of them reflect
their respective losses in their balance sheets. Second scenario could be that
PNB is made to honour the entire LoU amount and the loss is shown completely in
PNB’s balance sheet. In this case, PNB will face a serious financial blow. Third
option will be that government comes up with a bailout plan. This could hurt
the sentiments of the public. The last option, which is least likely to happen,
is that Nirav Modi repays the dues. Time will tell what is there in the cards.
What could a Government do to prevent this situation: Well,
the surname Modi is enough to create controversy in the social media fraternity
that is very mischievous. Although many people will link this with Modi
government, but there is, hardly anything a government can do in this case.
This is a gap and few good men outsmarted in the game.
Banking crisis on the cards: This is highly unlikely to happen.
PNB is self-sufficient (will have) to repay the amount. All that is required is
a strict supervision from RBI. This was a case of systemic failure and could
have only discovered by concurrent and internal auditors and not the RBI. Hence,
it has to be the sole liability of PNB.
There are numerous (in trillions)
LoUs in the market. It will create a havoc in case PNB does not honour the LC. Moreover,
all those LCs will come under the scanner.
Impact on Businesses: Banks will clampdown on credit
limits and insurance companies will turn cautious. Moreover, American insurance
company alerted all its offices not to take any exposure to two companies
linked to Nirav Modi and his associates (Source
- ET). In the short term, this will also badly affect the Indian imports
and exports.
Safety of the public deposits: Indian banking system is robust
and RBI has tough capital rules as a guardian. Banks will suffer a bit but it is
as one more scam added to the numerous others. So keep calm, and buy stocks
(risk intended). Do not listen to Twitter and Facebook qualified economists.
Corporate Governance: Corporate governance is the
system of rules, practices and processes by which a company is directed and
controlled. It was a bolt from the blue in this aspect. This reflects how high the
operational risks in Indian banking industry is.
Time for introspection:
- While international banks have tightened
supervision and corporate governance after the subprime credit crisis in 2008,
most Indian banks appear to have remained laggards.
- Time to reconsider the long-term solution to such
crisis - privatization of banks
- Despite close relationships with the customers, there
have to be mechanisms in place that would scrutinize such businesses and their
transactions precisely and carefully
- Increase accountability of the auditors
- Frequent resource mobilization (transfers) and
peer review in the case of critical positions. In this case, the culprit was in
the same position for 7 years.
- PNB had failed to learn from the experiences of the
Winsome group, a well-known diamond
house, who failed to repay a dozen lenders. PNB was hurt the most here as well.
(Pic courtesy: https://www.businesstoday.in/sectors/banks/live-updates-rs-11300-crore-fraud-at-pnb-cbi-begins-probe-nirav-modi-jewellery/story/270707.html )
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