A year after PNB fraud: Lessons learnt from Nirav Modi episode, but some questions still elude answers

Last year, in February, India’s second largest government-owned lender, Punjab National Bank (PNB) disclosed that it has been badly hit by Rs 14,000 crore financial fraud orchestrated by diamond merchant Nirav Modi and his uncle Mehul Choksi.

A year after this shocker, the key perpetrators of the case—Modi and Choksi—are still on the run. Just like in the Vijay Mallya-Kingfisher case--the government and investigators are engaged in a cross-border legal battle that has not yet made any meaningful progress.

As far as PNB is concerned, the bank is mostly past the initial pain of the mega fraud, having made the provisions to cover the losses, and is revisiting the processes and safety infrastructure. But the damage on the bank’s reputation won’t be healed quite easily.

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The PNB fraud episode has offered a few important lessons to the banking sector and has also left some key unanswered questions.

One: The software wasn't to blame, but the human beings in charge of it

The PNB fraud is often blamed on technology—the lack of integration between the SWIFT software and core banking. Post-the fraud, the Reserve Bank of India (RBI) made the rules stricter and asked banks to address this problem. But top bankers have opined that failure to ensure adherence to laid-out processes and rules have played a bigger role in the fraud remaining undetected for years. The PNB failed to monitor transactions involving Letter of Undertaking--LoUs (the instrument used by Modi to design the scam) from the very beginning. The fraud began in 2011. The bank kept honoring the instrument all these years till the scam came out in public in February 2018.

Two: The bank’s auditors, too, either failed or became party to the crime

In the PNB episode, the SWIFT messaging platform that was used by the corrupt bank officials and Modi is subjected to a daily check by the branch manager, which is compulsory in any bank. Even if one imagines that this part failed, the branch manager has to do a daily tally of income and expenditure in the branch while one of the officers (not involved in the transactions) combs through the books to look for suspicious transactions, the official said. That apart, the bank conducts a concurrent audit through the year. Such a fraud should have reflected there. The PNB miserably failed to follow the rule book that could have prevented the fraud.

File photos of Nirav Modi (left) and Mehul Choksi. Pic courtesy: YouTube

Three: The case was initially looked at in isolation—this was a major mistake

After failing in its duty, paving way for one of the biggest-ever bank frauds since nationalisation, the PNB kept defending itself by passing the blame to the SWIFT software, its disconnect with the CBS system and Nirav Modi’s criminality, to claim innocence .

From day one, the PNB should have been the trigger to overhaul the manner in which risk management systems function within the banking system. The problem here was that the system failed to function with respect to basic checks and balances. In one of the interviews, former RBI deputy governor and PNB chairman K C Chakrabarty had told Firstpost that Indian banks have zero-risk management capacities. The RBI shouldn’t treat this as a one-off case and should start working on overhauling the risk management framework for Indian banks.

Four: RBI initially acted in panic by banning LOUs outright

The RBI committed another blunder by terminating LoUs altogether in a knee-jerk reaction post-the PNB fraud. To begin with, the RBI couldn’t detect a banking fraud right under its nose, perpetrated by a smart jeweler in collusion with certain low-rank bank officials; that too for a good six to seven years. When the fraud surfaced and questions were raised about the regulator’s efficacy to do its job properly, it decided to kill a legitimate trade instrument outright, something traders have been using for long. Both importers and exporters use LoUs extensively as this is one of the cheapest instruments available to them. The RBI banned it without giving much thought to the larger impact on the country’s importers and exporters. This was a big mistake from the RBI.

Five: Dual regulation is an issue in banking system

Dual regulation is a major problem for Indian banks. The PNB fraud pushed some skeletons out of the closet when both the central bank and the government locked horns over the regulation of government-owned banks. Former RBI Governor Urjit Patel had argued that the apex bank doesn’t have strong regulatory control over PSBs, as it does with private banks. He cited seven areas or instances where the RBI cannot initiate actions on state-run banks, which control 70 percent of the assets of the banking industry including provisions such as inability of the RBI to remove directors and management at PSBs even if it wants to, to force a merger like it does in private banks, to revoke a banking licence or to trigger liquidation of PSBs among others.

The government countered the RBI citing clauses within the Banking Regulation Act that gives powers to the RBI over banks. In hindsight, it is apparent that there is an issue of dual regulation of PSBs that is triggering larger problems. The banking crisis gives an opportunity to policymakers to rethink the issue of dual regulation, which doesn’t augur well for the industry, 70 percent of which is dominated by PSBs.

Six: All officials responsible for failure in risk-managment should be accountable 

In this context, the Central Bureau of Investigation (CBI) charge sheet on the Rs 13,000 crore Nirav Modi-scam at PNB, which picks the name one of the former CEOs of the bank who served during the scam-period, looks strange. It could be true that the continuance of the fraud was facilitated by Usha Ananthasubramanian, but what about the original perpetrators of the crime? Ananthasubramanian was PNB’s CEO between August 2015 and May 2017 while the scam began in 2011 as admitted by the bank management at the first press conference where it announced the scam. Between 2011 and 2015 there were two other CEOs for PNB—K R Kamath and Gauri Shankar. Were they asked about the Letter of Understanding (LoU) transactions by the RBI or CBI? If the charge is of ignoring banking rules, i.e., prudential norms governing the LoU transactions, shouldn’t it apply to all?

To sum up, the PNB fraud wasn’t a financial crime orchestrated by two greedy businessmen alone. This incident epitomized the sheer absence of basic risk management systems in India’s banking system dangerously dominated by government-owned banks and the deplorable governance standards followed by even the top financial institutions in our country.

(Parts of this article have been published earlier on Firstpost)