Cover Story

A mega bank scam

Print edition : March 16, 2018

Nirav Modi, the alleged mastermind in the Punjab National Bank scam.

Mehul Choksi, Nirav Modi's uncle and business partner. Photo: AFP

Central Bureau of Investigation officials escort Vikram Kothari (centre), owner of Rotomac Global Pvt. Ltd., to a court in New Delhi on February 23. Photo: REUTERS

Vipul Ambani, one of the accused in the PNB scam, after his appearance in the special CBI court in Mumbai on February 21. Photo: AFP

Prime Minister Narendra Modi in a group photograph with the Indian CEOs in Davos on January 23. That Nirav Modi (second row, third from left, without necktie) was caught on camera in a group photograph with the Prime Minister in Davos, after his antics were made aware to the Prime Minister's Office, cast the Prime Minister in a poor light. Photo: PTI

The scandal at Punjab National Bank reveals dangerous cracks in the Indian financial system. The Reserve Bank of India, the Finance Ministry and bank managements have much to answer for the lessons not learnt from the great Indian securities scam of 1992, which is immortalised in the name of Harshad Mehta.

The latest scandal to rock Indian banking has all the ingredients of a sensational potboiler: two international diamond dealers who rob a bank with the help of an insider—not once, not twice, but repeatedly, over seven years. And, the embellishments in the plot come by way of bumbling enforcers of banking regulations and of the law in general arriving late at the crime scene, long after the criminal has fled the country. But there is only one problem with this plot: it lacks credibility. Questions abound. And, there are many that have been asked about how Punjab National Bank (PNB), India’s second biggest public sector bank, has been brought to its knees.

The scam could not have been more embarrassing for Prime Minister Narendra Modi. His tenure, marked by the government’s policy of aggressive promotion of big business’ agenda, has proved to be a high-risk option. Hobnobbing with the rich and the shady—as evident from his entourage on foreign tours—has encouraged the popular perception that there is a coincidence of interests between what big business wants and what is on the government’s agenda. Disturbingly for Modi, the fact that Nirav Modi, the alleged mastermind in the PNB scam, was caught on camera in a group photograph with the Prime Minister in Davos, after his antics were made aware to the Prime Minister’s Office, cast the Prime Minister in poor light. Soon, videos from the past were unearthed (from 2015) that showed Prime Minister Modi referring to Nirav Modi’s chief accomplice, Mehul Choksi (also business partner and maternal uncle), endearingly as “Mehul bhai”, causing even more embarrassment.

Anatomy of a scandal

On January 29, Avneesh Nepalia, Deputy General Manager at the Zonal Office of PNB in Mumbai, filed a police complaint alleging that Nirav Modi and Mehul Chinubhai Choksi, partners in Diamonds R Us, Solar Exports and Stellar Exports, colluded with bank officials to fraudulently siphon off $44.22 million (Rs.280.70 crore) from the bank. Just over two weeks later, on February 13, Nepalia filed another complaint, this time complaining of a loss of $754.92 million (Rs.4,886.72 crore) through an identical modus operandi. The second complaint was primarily against Choksi and his three companies—Gitanjali Gems, Nakshatra Brands and Gili India. Both cases were taken up by the Central Bureau of Investigation (CBI).

Between these two dates, on February 12, the General Manager at the International Division of PNB wrote a “confidential” letter to the top leadership of all Indian banks explaining the modus operandi that was used to issue false letters of undertaking (LoUs) in favour of Nirav Modi, Choksi and their associate companies. The General Manager’s “caution notice” pointed out that “none of the India-based banks have shared with us any document/information made available to them by these Indian companies at the time of availing buyers’ credit from them”. Two days later, PNB informed the stock exchanges that the losses arising from such “unauthorised transactions” amounted to $1,771.69 million (about Rs.11,394.02 crore).

The instrument that was used fraudulently by Nirav Modi and Choksi was the LoU. In the Indian case, an LoU is in the nature of an undertaking given by a bank here to one based overseas (it could be an Indian bank’s branch overseas) to extend buyers’ credit to the bearer of the LoU. It is typically a short-term facility, usually of 90 days, meant for Indian exporters to source raw materials (in this case pearls and diamonds) from overseas in foreign exchange. When the LoU is presented to a bank overseas, it releases, after confirmation, the equivalent foreign exchange into the bank’s nostro account (a nostro account of an Indian bank is a foreign currency account in a bank overseas) from which the importer draws (in this case Nirav Modi and Choksi). The bank issuing an LoU earns a fee, which is usually a percentage of the value of the LoU, and the foreign entity earns interest on the payment it makes on the strength of the LoU. The Reserve Bank of India (RBI) considers the facility in the nature of a short-term borrowing and one that is not eligible for a rollover (extension of tenure).

Significantly, in this case, PNB did not seek a margin, which is typically 100 per cent or even more of the value of the LoU. Even this margin is not a loss for the importer because the margin that is deployed with the LoU-issuing bank earns an interest rate that is much higher than what the importer would get if he had deposited overseas where interest rates are much lower. According to some reports, the investigating agencies have detected nearly 300 such LoUs issued to the two jewellers since 2011. They simply got more LoUs issued when the old ones lapsed, ensuring an endless access to funding without having to deposit any collateral. PNB’s complaints allege that the money mobilised by the entities did not even go towards the purposes they were meant for.

The SWIFT (Society for Worldwide Interbank Financial Telecommunications) system, akin to a closed group using an instant messaging platform, is used by banks worldwide to securely transmit coded information and instructions on financial transactions. In order to ensure integrity of transactions, four different persons enter the information in the system. The “maker” keys in the message; the “checker” does what the word means; and a third person, the “verifier”, ensures the bona fide credentials of the transaction. The confirmation, usually from an overseas bank/branch, is received by a fourth person in the bank in a secure environment, usually a separate printer in a separate room. In its complaints, PNB alleged that the SWIFT system that was used to authorise the illicit transactions bypassed its internal systems (core banking solution, or CBS), which was why these evaded early detection. In essence, the bank and later Finance Minister Arun Jaitley and the RBI have attempted to portray the scandal as a one-off event caused by a “rogue insider” acting in collusion with the bank’s clients.

The myth of a lone rogue

But this narrative of a lone rogue raises more questions than providing answers to what has happened. Both the LoU issuer (PNB) and the counterparty bank overseas (Axis Bank, Allahabad Bank, State Bank of India and others) ought to have records of first the SWIFT confirmation acknowledging the relevant transaction and later the evidence of deposits and withdrawals from the nostro accounts. How can PNB deny either of these even if its initial SWIFT messages initiating the LoU were issued by compromised employees? Moreover, it ought to have documents that support the transactions in its nostro accounts with other banks. Or, is it PNB’s case that banks at the other end of the transaction were also compromised? It is clear that over a seven-year period PNB issued LoUs in ever-increasing value, and that too without any supporting collateral from Nirav Modi, Choksi and their associates. How was this allowed? Even if PNB’s innocent claim that the scam happened because the SWIFT system and its CBS were running on parallel tracks is accepted, how did the fees/commissions it earned on the LoUs periodically over seven years that would have entered its CBS system escape scrutiny? After all, these earnings would have been tagged to particular transactions (issuing LoUs), so how did these transactions not come to light?

At the counterparty (banks that issued buyers’ credit to Nirav Modi and Choksi and their companies) end too there are questions that suggest negligence. First, did these banks send confirmation acknowledging the LoUs? If so, where are the records for these? Immediately after the scandal came out in the open, the counterparty banks demanded that PNB ought to pay them for having “honoured” the fake LoUs. Although PNB’s Managing Director and Chief Executive Officer Sunil Mehta assured banks that his bank would meet all outstanding obligations, he added the important caveat of meeting all “bona fide” claims.

Long legal haul ahead

Tellingly, PNB, in the second first information report (FIR) dated February 15, 2018, pointed out that RBI norms for extending credit (LoU) for the import of raw materials for the jewellery industry (precious and semi-precious stones, including pearls) prescribe a maximum limit of 90 days. It pointed out that in many cases the credit for buyers’ credit, facilitated by these LoUs, extended for 360 days “ab initio”. It pointedly observed that “this should have evoked suspicion in the minds of overseas branches [sic] of Indian banks extending buyers credit”. “These banks never raised any alarm on violation of RBI guidelines and continued to provide funding against fraudulent LoUs,” PNB stated in its complaint to the CBI. Clearly, although PNB may appear to be on the defensive now, when it comes up for challenge in the courts it may have a point that the counterparty banks had not exercised due diligence while dealing with its delinquent clients.

Although law enforcement agencies have attached properties of the two jewellers, their associates and their companies, this itself may not mean much, as is indicated by the Vijay Mallya case. Instead, there is likely to be a three-way contest among the three sets of actors—PNB, its counterparty banks and the accused. This only means one thing for certain: that the size of the scam could escalate to more than Rs.20,000 crore if PNB contests the claims made by the counterparty banks by claiming that they did not exercise due diligence or that they themselves violated RBI regulations while “honouring” the dubious LoUs presented by the accused jewellers and their entities.

Dodgy world of diamond dealers

The rogue employee-jeweller nexus argument appears even more dodgy when the nature of the underlying business for which funds were being made available is considered. The jewellery business in general, and diamonds in particular, is known to be a shady affair, not just for being a refuge of illicit wealth but even more dangerously for acting as a vehicle for round-tripping and the generation and laundering of black money.

An officer in State Bank of India told Frontline that lending to the diamond trade is risky because diamonds are difficult to value, the key being their lack of fungibility.

“No two diamonds are identical in either their physical characteristics or their value. Valuations are thus tricky in this business,” he said. Banks ought not to lend to the diamond trade without a much higher margin than in other lines of business, he said. This was because without a proper understanding of the value of the precious stone, it was impossible to gauge the extent of risk the bank was exposing itself to, he pointed out. The fact that PNB let Nirav Modi get away without having to provide any margin at all upfront is why it has come to much grief now.

The Indian diamond and precious stones industry in particular is the main player only in the relatively low-value end of the global business. While a handful of cartels control the global business, the Indian expertise is confined to the lower end, that of polishing rough diamonds, which is a labour-intensive process. The difficulty of estimating value in the diamond business, coupled with the low level of value addition in India relative to the value of the imported raw material, makes the commodity a lucrative option for money laundering and round-tripping (which is basically disguised capital flight that comes back into the country masquerading as foreign investment).

The nature of the Indian diamond trade, especially its significance as a vehicle for money laundering, raises several other questions that the RBI and the Finance Ministry ought to answer. Nothing in the ongoing investigations so far by the CBI, the Enforcement Directorate and the Directorate of Revenue Intelligence indicates that the fraudulent use of the SWIFT platform for fake LoUs started as soon as the first LoU to the jewellers were issued in 2011. Instead, the evidence available indicates that the value of the LoUs kept escalating over time and that the actual fraud is of a more recent vintage. The fact that the RBI, which was entrusted with the task of monitoring and supervising bank credit to the sector that was offered special export incentives, repeatedly issued several circulars to banks starting in August 2016 about the possible abuse of SWIFT and its non-integration with their general banking systems raises a key question, was the RBI particularly worried about the abuse of systems for money laundering? In fact, according to a recent Bloomberg report, the RBI again issued a more detailed and focussed circular to banks in November 2016. Specifically, the RBI referred to the “high number” of SWIFT users in banks, indicating its worry about possible abuse. This same circular asked banks to check whether SWIFT messages for their transactions reflected “genuine underlying transactions”. It set a deadline of February 28, 2017, for verification by banks and asked them to send reports by March 15, 2017.

Diamonds and demonetisation

These dates are highly significant because they happened in the context of demonetisation, which was announced on November 8, 2016. In fact, as soon as Narendra Modi finished his speech that evening, long queues were reported at jewellery stores across the country, especially in the large metropolises. Another significant indicator of how the wealthy were reacting to demonetisation was revealed in the happenings in the foreign exchange markets; the value of the dollar began to climb as rupees were being converted; there were also reports of unusual activity in the hawala trade.

Recent reports indicate that the imports of rough diamonds increased by almost 300 per cent in the April-November 2017 period compared with the same period of the previous year (from Rs.10,672 crore to Rs.40,809 crore). Since Indian companies in the gems and jewellery business mainly do only cutting and polishing, what is exported is automatically valued at more than what they were imported for. Reports indicate that the surge in the volume of imports reflects a thriving practice of over-invoicing, one of the key avenues for whitewashing black money. One estimate suggests that about $4 billion was sent abroad through the diamond trade as a result of over-invoiced imports. Clearly, diamonds were the black money holders’ best friend after demonetisation, which was unleashed by Narendra Modi on hapless millions in the name of wiping out black money.

Given these developments, it is quite plausible that the RBI was worried. But it did little apart from issuing circulars. It failed to rein in the banks indulging in practices that violated the rules it had laid down as a supervisor and regulator of banking in the country. Or, is it just as plausible that the central bank, stretched to its limit by the massive strike that was demonetisation, was simply unable to handle this responsibility?

This is not all. As early as 2013, the RBI was referring to the large and mounting balances in nostro accounts overseas. In fact, the banks themselves had complained that the burgeoning numbers as well as values in such accounts were hindering early reconciliation of balances in such accounts. The RBI merely asked banks to deploy technology to address the issue and left it that. It did not ensure that a solution was actually implemented mandatorily by the banks. In the process it failed to prevent early detection of wrongdoing. Moreover, how did these transactions at PNB and its counterparty banks escape the periodic hawk-eyed audits of the central bank?

At the banks too there were several rounds of audits—internal audits, branch audits, concurrent audits and statutory audits. Thomas Franco, general secretary of the All India Confederation of Bank Officers’ Associations, told Frontline that the quality of periodic audits—internal as well as external—had deteriorated over time. He pointed to the demands and pressures on staff and officers arising from bank “activities” that are completely extraneous to their main role as bank employees. The attitude of the government towards unions in general and to those in the banking industry in particular has ensured the elimination of those who could have performed a watchdog function in banks, said Franco. “There is not a single public sector bank that has filled long-pending vacancies for representatives of bank employees and officers,” he said.

Banks’ negligent owner

In the aftermath of the PNB fiasco, which has exposed systemic weaknesses in Indian banking, the government, more particularly the Finance Ministry, has reacted like any other Indian citizen—with surprise and consternation. Clearly, Indians deserve better because the Finance Ministry, which represents the government’s status as the owner of Indian public sector banks, is expected to act as the custodian and guardian of these institutions. Jaitley’s pretence that this is a one-off act of a few rogues is clearly inadequate and does not reflect well on his responsibilities. The government’s ownership of these banks is manifested by the fact that its representatives sit on the boards of these banks. Moreover, these representatives are also expected to act as a bridge between the RBI and the banks, fundamentally by ensuring that the central bank’s guidelines and regulations are adhered to. What were these representatives doing when the scale of the violations was building up?

Instead, agents of the government, most notably Chief Economic Adviser Arvind Subramanian, have obliquely suggested privatisation of these banks recently. Ironically, industry lobbies, which represent the interests of corporates that have caused the banks much grief, have joined in the chorus in an egregious expression of self-interest. In reality, as the accompanying story by C. Shiv Kumar highlights, the NPA imbroglio bears all the hallmarks of a scam in its own right.

It is evident that fudged LoUs are only one means of robbing a bank. The recent unearthing of a bank scam involving the Kanpur-based Rotomac Global Private Ltd, better known popularly for its pens, and its promoter Vikram Kothari highlights this. The CBI has alleged that Vikram Kothari and his associates have defaulted on loans aggregating Rs.3,695 crore to a seven-member consortium of public sector banks. The primary allegation in the FIR is that the company diverted the funds for purposes other than stipulated by the terms on which the credit was sanctioned. Last July, the Debt Recovery Tribunal in Allahabad recommended a forensic audit of the banks’ books for not detecting irregularities in multiple accounts of the group.

It is clear that no lessons have been learnt from the mega scam that has been immortalised in public consciousness as the Harshad Mehta scam. Frontline’s coverage of that scam of the 1990s revealed that contrary to public perception it was not perpetrated by a lone rogue acting in collusion with a few bank employees. As it unravelled, its wider tentacles became evident, encompassing top officials in banks, the policy mandarins in New Delhi and rogue brokers. Incidentally, the “PNB scam” is, strictly speaking, not the biggest in Indian banking. Recall that the scam of 1992 was valued at almost Rs.5,000 crore; in real terms, accounting for the value of the rupee then, relative to today’s rupee, the 1992 scandal would tower over what has happened now. That apart, one thing is clear: the actors in financial scams are the same, even though their faces may have changed. Technological advance and the general rise of the animal spirits may have changed their appearance, but at heart they remain as they were 26 years ago. So much for the onward march of liberalisation!

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