India’s Big Bank Heist

A record fraud prompts more insistent calls for improvements in an industry grappling with ongoing loan problems.

This article was first published by Global Association of Risk Professionals, Risk Intelligence, on August 03, 2018. Co-author: Anisha Sircar; https://www.garp.org/#!/risk-intelligence/culture-governance/conduct-ethics/a1Z1W000004AsL3UAK

In an article last year, India Confronts Its Non-Performing-Asset Crisis, we wrote about the rise of NPAs in India and how banks and the government had been managing the concomitant stress on its crisis-ridden banking sector. 

Failure to take decisive action regarding mounting NPAs was seen as perilous for the overall economy. Stronger auditing systems and punitive measures have been proving increasingly necessary to curb the festering of bad loans and wilful defaults across the country's public and private banks.

Since 2017, a lot has happened. Nirav Modi and Mehul Choksi have emerged as poster boys for credit-related fraud involving Punjab National Bank, Axis Bank, and Allahabad Bank, with implications for the general stability of the banking system.

Here, we deconstruct the mechanisms that enabled these crimes to occur and look at lessons that can be gleaned from what has been billed as the biggest fraud in the history of India’s banking sector.

The Fraud Is Revealed

In March 2018, Finance Minister Arun Jaitley told Parliament that 1,213 fraudulent letters of undertakings (LoUs, which are letters from one bank to another assuring that a loan will come through by a specified date) had been issued on behalf of companies belonging to Nirav Modi and Mehul Choksi over the previous seven years. 

As it turned out, Modi had acquired these LoUs with the involvement of two employees from Punjab National Bank (PNB) and conducted fraudulent transactions worth Rs. 114 billion, according to initial reports.

Basically, a number of partnerships owned by Modi and Choksi – Diamonds R Us, Solar Exports, and Stellar Diamonds – approached PNB with requests for buyer's credit, to make payments to overseas suppliers.

PNB's letter to the National Stock Exchange and Bombay Stock Exchange, informing them about the fraud a day after it came to light, stated, "Based on these [fraudulent] transactions, other banks appear to have advanced money to . . . customers abroad.”
In other words, based on fraudulent guarantees, banks in India were requested to advance funds to international clients and suppliers through unapproved sanctions issued by certain employees at PNB.

While shares of other banks such as Union Bank of India and Allahabad Bank fell immediately after the fraud was revealed, PNB suffered the most, having lost at least 10% of its market capitalization immediately following the news. Most public-sector bank stocks have been in free fall since February, but PNB has witnessed the largest decline.

(Prices in Rupees)

Source: Bombay Stock Exchange

As shown in the graph, PNB’s shares fell by about 55%, from a closing price of Rs. 171.25 in January when the fraud was revealed, to Rs. 78.7 in July. The scam, a reported swindle of Rs. 143 billion at a time when public-sector banks were already ailing, began highlighted an immediate need to implement more effective practices in the Indian banking system.

How Did They Get Away with It?

Firstly, staff at PNB were hand-in-glove with Nirav Modi. PNB employees.

Gokulnath Shetty and Manoj Kharat approved loans for Modi’s companies to buy and import diamonds for little or no collateral over a reported seven-year period. The fraud came to light when representatives from diamond-importing companies owned by Modi came to PNB’s Brady House branch in Mumbai to ask for LoUs and insisted that they had secured LoUs previously without providing collateral.

Ordinarily, when one of Modi’s companies was borrowing U.S. dollars to fund American diamond purchases, PNB would send a letter in the name of one of Modi’s import companies to the New York branch of another Indian bank, from which Modi was borrowing the dollars. The second bank would then deposit the money into PNB’s nostro account in a U.S. institution, and PNB would release the money to Modi’s company. PNB would repay the lending bank with interest in dollars, while Modi’s company would repay the amount to PNB in India.

But, on the day in mid-January when Modi’s companies applied for new LoUs, the official in charge asked for collateral, and Modi’s executives demurred, stating that they had acquired many letters in the past without being asked to provide collateral. 

When bank officials proceeded to check their database and SWIFT (Society for Worldwide Interbank Financial Telecommunication) records, they found that unapproved LoUs for little or no collateral had indeed been issued to Modi’s and Choksi’s companies since 2011. As the probe deepened, it found that newer LoUs had been requested to pay debts incurred by earlier ones.

Because the bank’s database hadn’t been updated, and SWIFT messages weren’t integrated with customer records, the transfers hadn’t triggered any warnings, and the two diamantaires were able to get away with it for so long. This was the primary vulnerability that invited the attack. The slope might have continued if Gokulnath Shetty hadn’t retired in 2017.

Secondly, lapses in communication facilitated the fraud.

Concurrent auditors that validate transactions on a daily basis neglected to reveal the fraud, and the funds moving in and out of PNB’s nostro account should have raised a red flag when they didn’t square with the actual amount approved by the bank. Further, PNB stated that it did not receive a crucial directive sent out by the Reserve Bank of India (RBI) in November 2016 asking all commercial banks to strengthen their risk mechanism to avert frauds such as these.

After the scam broke out, the RBI sought a compliance report from all banks, including PNB, which could have prevented the fraud. But PNB denied ever having received it. With stronger control mechanisms monitored by the RBI to ensure security, more effective communication at every level, integration of the SWIFT and CBS (Core Banking Solution), and stronger auditing measures, the fraud could well have been prevented in any bank.

The Continuing NPA Crisis

Non-performing asset and loan frauds, which are cases where borrowers intentionally deceive lending banks by deferring the repayment of loans, continue to be a massive problem. World Bank data reveals that India is among the top 30 countries in the world in terms of non-performing loans to total gross loans. The RBI's statistical tables show that NPAs have been on an upward trend since 2012.

(Amount in Billion)

Source: Reserve Bank of India

Source: Reserve Bank of India

According to a Reuters report, bad loans surged to a record $149 billion last year. An RBI response to a right-to-information request showed that 8,670 loan fraud cases totaling Rs 612.6 billion occurred over the last five financial years, up to March 31, 2017.

Also, in February this year, the Rs. 36.95 billion Rotomac case involving wilful loan defaulting came to light, as did the mounting loans of Videocon, driving home the urgent need to plug every loophole that has been deepening the dilemma of loan defaulting. These cases expose the magnitude of the problem in a banking sector that is increasingly under the hammer for poor lending practices.

Stronger Regulation

As such, regulators have sought to strengthen measures to have banks fully disclose bad loans, speed up their recovery through recapitalization, and start actively highlighting cases of fraud, without concealing them as cases of NPAs.

Last year, the government said it would inject $32 billion this financial year and the next. In the wake of PNB and Rotomac, the RBI sent out a circular revising its Insolvency and Bankruptcy Code (IBC) and redefining some its “defaulting” taxonomy, stating that a company must be termed a defaulter if it fails to repay a loan within 91 days. 

Despite bankers and companies being unnerved by the new clauses, and lobbying with the center to reconsider, the RBI expressed strong objections to relaxing the new norms.

Regulatory steps such as these seem well-intended and capable of making an impact in the long run. But for real change to occur, the fundamentals need to be addressed. People need to start acting in a more moral manner, for which one might need to face a much stronger penalty. Financial crimes such as these could perhaps be avoided by borrowing from the conceptual predicament of ensuring everybody's skin is in the game.

While the extent of the fraud is unmatched, the case of Nirav Modi is not isolated in India and has been allowed to continue with frequency due to systemic issues such as corruption, poor lending practices, failing monitoring mechanisms, communication lapses, and technological issues.

Apart from regulatory reforms, ultimately, perhaps the only way to ensure that people don't take undue risks is by making sure they have to share in the risk-taking.

With one's personal liability at stake, it would be considerably more difficult to make less responsible choices and challenge the larger interests of society, and thereby arrive at a state of exponentially growing Naturally Performing Assets restoring India's banking sector.