PNB Fraud - what happened and what went wrong

It has been almost three weeks since Punjab National Bank (PNB) went public with the Nirav Modi / Geetanjali Gems (Mehul Choksi) issue. Reams have been written about various facets of the entire episode and may continue in days to come. There has been an intense debate in media and public domain, and the whole episode has been variously classified as fraud, open loot of public money, misdemeanor and Niravgate etc , but there are many core process issues which are still not clear.  

For the uninitiated, let’s try to decipher what has happened and what is yet unanswered.  

On February 14, 2018 PNB informed Bombay stock exchange that it had detected fraudulent transactions worth around Rs 11,380 crore (USD 1.77 billion) put through its Mid Corporate branch at Brady House, Mumbai. It further said that the Bank has already lodged a complaint with Central Bureau of Investigation (CBI) and Enforcement Directorate (ED) implicating celebrity Jewelers and Diamantaires Nirav Modi (NM) and Geetanjali Gems run by his Uncle Mehul Choksi (MC) for alleged embezzlement of Rs 280.70 crore. Subsequently on 27^th February,2018 PNB added Rs. 1,323 crore to the heist, thus taking the  aggregate of fraudulent transactions to Rs. 12,703 crore ie. USD 2 billion approximately.

PNB has alleged that two of its officials connived with NM and MC group companies to issue letters of Undertaking (LOU) to Overseas branches of several Indian Banks. These LOUs or guarantees were issued in two tranches of Rs. 6,500 crore between 2011 and February 2017 and another Rs. 4,900 crore between March and May 2017. One of the officials Gokulnath Shetty retired from service in May 2017.

LOUs are basically short term guarantee letters issued by a Bank on behalf of its prime customers engaged in import of goods/ capital equipment. These LOUs enable the importer customer to borrow in overseas centres at interest rates prevailing at that centre, which are generally in the range of 3 % to 4 % per annum ie much cheaper than interest rates in India. Reserve Bank of India (RBI) from time to time, specifies the duration for which a LOU can be issued ranging from 90 days to 360 days in case of raw material / goods (depending on the commodity) and upto 3 years for import of capital goods. For import of rough diamonds ( as was the case with NM/MC) RBI had notified a period of 90 days.  

A LOU guarantees payment by Issuer Bank to the Overseas Bank in case of default by the customer. So the local Issuer Bank, wishing to protect itself against any future default, builds a margin of safety through cash deposit or charge over immovable property. Quantum of margin may wary depending on Issuer Bank’s risk perception. Generally Banks build this margin through blocking a part of the customer’s existing credit limits, so LOUs are generally issued within Credit limits sanctioned by the Bank.

Issuance of LOUs is considered profitable business by Banks, as a commission between 2 % and 3 % of the LOU amount is charged from the customer.

What appears to have happened in PNB

The rogue employees at PNB’s Brady House branch, started issuing LOUs to NM and MC group companies in 2010 without authorization. Banks have a system whereby different types of loan /credit facilities are sanctioned by different categories of officials. In this case the rogue employees were not authorized by the Bank to issue any sort of LOUs. Still the LOUs were issued and no security was taken from the borrowers (NM/MC) thus exposing the Bank to a grave risk. The said LOUs for import of rough diamonds and pearls should have been issued for 90 days (as per RBI guidelines) but were issued for one year. The LOUs were presented to overseas branches of Indian Banks (mainly in Hong Kong) who extended loans against the same, considering them as fool proof security ( having been issued by a Public sector Bank). It is alleged that the said overseas loans were routed back to associate companies of NM/MC.

Main elements of fraudulent transactions

(i)   LOUs were provided by rogue PNB employees without any authority and without obtaining any  security, thus exposing Bank to a potential financial loss (which has in fact happened now)

(ii) LOUs were issued for a period of one year instead of 90 days as permitted;

(iii) Overseas branches of Indian Banks overlooked the fact that the LOUs should have been issued for 90 days only (instead of 1 year) and blindly permitted loans against the LOUs ;

(iv)  Loans drawn against the said LOUs were paid to suppliers of rough diamonds, which are suspected to be companies of NM/MC groups only.

(v)   It has been alleged that when the LOUs fell due for payment , the rogue employees again helped NM/MC by issuing fresh LOUs which were encashed at an overseas centre, and the proceeds were used to settle the earlier LOU. Thus there was an “ever greening” of the LOU transactions so that there is no default.

What could have prevented the fraud

PNB fraud has opened a Pandora’s box and has raised questions about compliance with usual system of checks and balances which is the backbone of Banking industry. The fraud or resultant loss to the Bank could have been prevented if the laid down operational systems and procedures were followed. What processes seem to have been ignored, which resulted in the system failing to detect the fraud in time ?

Supervisory Checks and Balances at Brady House

It is clear that the LOUs were issued illegally and without authorization. The LOUs were transmitted to overseas Bank branches through coded messages, so that the overseas recipients accept them without suspicion. This was done through a system of communication prevalent amongst Bankers worldwide known as SWIFT (Society for Worldwide Interbank Financial Telecommunication). As PNB had not linked their SWIFT system with their Centralised Accounting system (Core Banking system - CBS), SWIFT transactions went through as plain correspondence without getting reflected in the accounting system.

But it is not clear as to what happened to the commission which Bank was supposed to charge for issuance of LOUs. For example, if the Bank issued LOUs of Rs. 4,900 crore between March and May 2017, the same should have resulted in commission of  Rs. 147 crores (@ 3 % Per annum which is the usual PNB charge for LOUs).Similar amounts or thereabouts ( say Rs 100 crore plus) should have been the commission income in earlier years also. For any Bank branch office, such amount of income under “Commission “ head is huge, and should have been noticed by the Branch Management / Controlling authority. The very fact that this amount was not questioned all these years by any authority, shows the utter casualness with which business of banking was being conducted. Unless the rogue employees did not deposit the commission amount in Bank’s income account, but pocketed it themselves. In that case also, such huge inflow ( or even a fraction of that as bribes) would have impacted the lifestyles of the rogue employees and should have been noticed by their colleagues in the Bank.

As the transactions fall under the category of Operational Risk, it is clear that PNB has failed in instilling the culture of Risk Management and Risk detection amongst its cadres. With increase in business volumes, it is not possible to depend on manual risk detection mechanisms and systems will have to be automated to generate periodical “red transaction” reports which look suspect and need investigation.

Dereliction by Auditors

Brady House branch had its own Internal Auditor ( a Senior PNB officer permanently posted there to monitor day to day operations) and was also subjected to various periodical external audits by firms of Chartered Accountants hired by the Bank  / RBI team as mandated by regulations. All these auditors failed to detect the suspicious transactions which could have been done through examination of record of SWIFT messages or verifying the genesis of huge commission income flows. If they had performed their jobs scrupulously, then the fraud could have been detected at the initial stages itself. Question is how these were not detected over a period of 7 years ?

Finance Minister Arun Jaitley has rightly pointed out “Auditing is beyond balancing the Profit & Loss account and the Balance Sheet. Auditors need to have a thorough understanding of the businesses they are auditing and the loopholes that are exploited by management.” Clearly there was absence of required skill sets.

Dereliction at Apex level

In February 2016, hackers got access to Bangladesh Bank’s SWIFT system and made off with USD 81 million. In August 2016, RBI issued a circular to all Banks advising them to integrate SWIFT system with their respective Core Banking Systems (CBS). This was followed with another strongly worded missive in November 2016, citing "decentralized" operations that hinder compliance and a "high number" of Swift user IDs at banks that increased the risk of misuse. RBI further instructed the Banks to verify all Swift messages to ensure all are "supported by genuine underlying transactions" by 28^th February 2017 and file a compliance report with RBI by 15^th March 2017. PNB’s apex management clearly ignored these instructions to their own peril. Even if the Bank had verified Swift messages for FY 2016-17 by March 2017 as mandated by RBI, the fraud could have been detected earlier and Bank could have saved Rs.4,900 crores ie amount of LOUs issued between March and May 2017.  

A Bank which does not take timely steps to minimize its risks is bound to suffer. Just imagine the magnitude of damage, if the new officer at Brady House branch had not raised the red flag in January 2018.

Dereliction at Overseas centres

Overseas branches of Indian Banks were expected to be aware of RBI guidelines that a LOU supporting import of rough diamonds / pearls can be issued only for a period of 90 days and not one year. The said branches overlooked this vital stipulation. It seems the said LOUs were never checked, leave apart cross verification with the issuer,  If the LOUs had been checked at any stage for compliance with extant guidelines, the fraud could have been busted then and there , cutting down future losses.

Balancing of Nostro accounts

In International banking, Nostro account is an account held by any Bank with a foreign Bank, usually in the currency of that country. PNB maintains a account with a Bank in United States (in US Dollars) for its international transactions. Overseas branches extending loans against LOUs credited the proceeds to PNB’s Nostro account , from where funds were siphoned off to “Sellers” suspected to be NM/MC companies. It appears that Nostro accounts of various Banks are not scrutinized on a regular basis as mandated. A “balancing” or matching exercise of the two transactions ie credit by overseas branches and then debit for payment to seller may have thrown some signals or may have led to some inquiry to the issuer ie. Brady house branch. But there were no leading questions, simply because there was no regular scrutiny.

What next

Enforcement agencies shall probe what actually happened, and try to bring the culprits to book. Banks and Reserve Bank of India shall try to retrieve lost ground and plug loopholes wherever found. Regarding losses, it shall be a matter of detailed accounting exercise to finally understand and conclude that out of the aggregate outstanding amount of Rs.12,703 crores quoted by PNB, how much was channelized to NM/MC accounts and how much was used for ever greening. The actual default amount may be lower than the quoted figure of Rs 12.,703 crores.

Is privatization the answer ?

Industry body Assocham as well as some other worthies like Adi Godrej and Uday Kotak have asked for privatization of Public sector Banks (PSBs). Their take is that Privatization will make the management accountable to shareholders and free them from government interference. It will also save lacs of crores of taxpayer’s money which PSBs are presently guzzling as Govt infused capital. According to them Private sector banks have lower toxic assets. But is Privatization the answer?

As pointed out by Rajnish Kumar, Chairman of State Bank of India, several Public sector companies have a better governance track record compared to their Private sector peers exemplified by the fact that huge bad debts in Banking industry are mainly on account of Private sector units. If there had been a better culture of accountability and governance in Private sector, then contribution to toxic assets should have been lower. Therefore it can be safely concluded that improved governance and monitoring combined with inculcation of better risk management and detection skills amongst all staff members are the only answer to prevent Nirav Modi / Mehul Choksi like situations in future.