February 23rd, 2018 | Updated on March 6th, 2018
India is currently dealing with what likely is its biggest bank fraud so far. However, instances of financial fraud have regularly been reported in India in recent years. Companies owned by diamond merchants Nirav Modi and Mehul Choksi are alleged to have swindled Punjab National Bank (PNB) of over Rs11,000 crore ($1.77 billion).
The Nirav Modi-PNB fraud came to light when on January 29, a PNB official from Mumbai filed a criminal complaint with Central Bureau of Investigation (CBI) against 3 companies, Solar Exports, Stellar Diamonds and Diamond R US, and four people, including diamantaire Nirav Modi and Mehul Choksi, the managing director of Gitanjali Gems, saying they had defrauded the bank.
The bank alleged two junior employees at the Mumbai branch had helped the companies and people managing them get letters of credit or “letters of undertaking” (LoUs) from it without having a sanctioned credit limit or maintaining funds “on margin”.
Let’s cut through the jargon and look at them in greater detail.
Amid speculation and a flurry of reports on the nature and magnitude of the scandal, here’s a basic list of questions and answers on the alleged crime.
So, what are LOUs?
LOU is an undertaking provided by one bank to another bank, in favour of or on behalf of a customer. The LOU serves the purpose of a bank guarantee for a bank’s customer for making payment to its offshore suppliers in the foreign currency. It is a guarantee that a bank is obliged to repay the loan if the actual borrower—Nirav Modi in this case—fails.
How does it work?
As a matter of fact, letter of undertaking is a letter of credit issued by one bank (let’s call it Punjab National Bank) that paves way for another bank (let’s call it Allahabad Bank-AB) to give money to supplier of Punjab National Bank’s customer. As mentioned earlier, the money is transferred by AB to supplier of PNB’s customer via a nostro account that PNB holds in AB in abroad.
When did the fraud take place?
Between 2011 and at least 2017. It was detected in the third week of January 2018, according to the PNB management which approached the Central Bureau of Investigation on Jan. 29.
How was it carried out?
In 2011, it began with a a much smaller amount with a single letter of undertaking (LOU)worth around Rs800 crore.
How did the Punjab National Bank (PNB) scam work?
A key element of the scam is the Society for Worldwide Interbank Financial Telecommunication (SWIFT), a messaging network that connects banks and other financial institutions across the world.
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Among other things, a bank that is part of SWIFT can use the system to convey credit instruments called letters of undertaking (LOUs) to other banks located overseas.
An LOU is simply a request made to another bank in the SWIFT network to loan money to a client. The bank that issues the LOU essentially guarantees the bank that receives the LOU request that it stands by the creditworthiness of the borrower. That is, in case of a default, the bank that issued the LOU stands liable to compensate the bank that made the loan to the borrower.
PNB alleges that employees at one of its branches in Mumbai issued fraudulent LOUs that were not authorised by its management. This allegedly allowed Mr. Modi’s companies to obtain loans from the overseas branches of various Indian banks.
How did the management miss a colossal fraud like this for so many years?
PNB sources say the bank isn’t fully integrated on a Core Banking System (CBS) which could have immediately detected the discrepancy.
What is a CBS?
Gartner defines CBS as a back-end system that processes daily banking transactions, posting updates to accounts and other financial records. It is a centralised software that keeps all records across branches and is capable of generating alerts over any undue activity.
Is it the first time that such a fraud had occurred?
No. A bunch of Indian banks faced massive losses due to unpaid loans from Winsome Diamonds, which defaulted for the first time in 2013. The loans given to Winsome, and its associate entity Forever Diamonds, were through similar SWIFT route. However, both Winsome and Forever failed to repay, citing default by customers. The Serious Fraud Investigation Office is probing the case.
Which are the other banks that lent money to Nirav Modi and Mehul Choksi’s firms?
According to sources, Allahabad Bank has the largest exposure—of over Rs4,000 crore. Union Bank has anywhere between Rs1,000 crore and Rs2,000 crore, and the State Bank of India about Rs1,000 crore. Axis Bank has over Rs2,000 crore, though it has already sold off those loans.
What will be the impact of the Rs11,000 crore (or bigger) fraud?
Loss of public faith in PNB and other state-owned banks will be the biggest risk. According to RBI regulations, PNB will have to repay other banks the money owed by the firms. PNB shares holders may see their wealth eroding further as the Rs11,300 crore liability is more than a third of the bank’s market value.
The pain will only increase if the probe reveals a bigger scam. This is besides the taxpayer money that will be lost in litigation and getting Modi and Choksi extradited.
Who will pay for the losses?
Reports say that RBI has instructed PNB to pay other banks for the loans disbursed to Modi and Choksi. Other banks will have to set aside money from their profits till the time PNB coughs up the money, and when it does pay up, PNB’s books will then have to show the amount as loss.