PNB fraud: Five major lessons from India's biggest banking scam

The quantum of money involved in bank frauds that the various state-run banks have reported so far, to the Central Bureau of Investigation (CBI), stands at over Rs 20,000 crore. Of the at least seven cases reported so far, the big ones are the Punjab National Bank (PNB) scam (Rs 14,000 crore), the Rotomac scam (Rs 3700 crore), and the Totem Infrastructure scam (Rs 1394 crore). Of course, these are approximate figures since the quantum of fraud in each case is getting bigger, from the originally reported number, as investigators dig deeper into the mess.

State-owned banks, which have been blissfully unaware about these fraudulent transactions taking place at their offices, started running to the CBI’s offices after the PNB fraud surfaced. At the heart of the Rs 14,000 crore PNB scam is a widely used credit instrument used by importers called the letter of undertaking (LoU). In simple terms, this is a guarantee given by a bank to an importer who can draw money from foreign offices of other banks to pay the counter party in that country. These instruments carry a maturity period ranging from 90 days to 365 days. The originator bank can renew/reissue the instrument after the expiry.

Representational image. Reuters.

To Nirav Modi, his uncle Mehul Choksi and their associates, PNB issued 1590 LoUs since 2011, the finance ministry informed the Parliament in a written reply.  On the whole, PNB issued 41,178 letters of undertaking (LoUs) since 2011, the ministry said. The Reserve Bank of India (RBI) has banned LoUs altogether post the PNB fraud.

In hindsight, there are five major lessons for the banking system from the Nirav Modi LoU fraud:

Lesson 1: Follow the rule books -  Clearly, the PNB failed to monitor transactions involving LoUs 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.  If the customer fails to repay dues within the specified period, the bank is obliged to pay the counterparty bank. PNB could have stopped the fraud in 24 hours if it had followed the checks and controls in place. The bank’s auditors too either failed or became a party to the crime. In the PNB episode, the SWIFT messaging platform that was used by the corrupt bank official 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 fraud should have reflected there. PNB miserably failed to follow the rule book that could have prevented the fraud.

Lesson  2: Don't examine cases of fraud in isolation - Looking at the PNB case in isolation was a mistake. After failing in its duty, paving way for one of the biggest-ever bank frauds since nationalisation, 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 . The government and investigators repeatedly suggested PNB is an isolated case. This was a cardinal mistake. PNB should be the trigger to overhaul the manner in which risk management systems function within the banking system. The basic problem here is that the system failed to function with respect to basic checks and balances. Former RBI deputy governor and PNB chairman K C Chakrabarty 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.

Lesson 3: Avoid blanket bans in the immediate aftermath - 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 about the larger impact on the country’s importers and exporters. This is a big mistake from the RBI.

Lesson 4:  Dual regulation doesn't bode well for the 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. RBI Governor Urjit Patel 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 license or to trigger liquidation of PSBs among others. The government countered the RBI’s asserting, 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 for the policymakers to rethink the issue of dual regulation, which doesn’t augur well for the industry, 70 percent of which is dominated by PSBs.

Lesson 5: Recognise systemic problems and fix them - It's time to resolve banking sector imbalance. Ruchir Sharma, the head of emerging markets and the chief global strategist at Morgan Stanley Investment Management, rightly pointed out, an imbalance is choking the financial system. The imbalance Sharma is talking about isn’t hard to understand. Public sector banks control two-thirds of the assets of the industry but are largely confined to conventional lending, a significant part of which is directed lending. This includes, compulsory lending to the agriculture sector and an obligation to fund long-term infra projects. But PSBs are not really capable to meet the long-term infrastructure funding demand on account of high asset-liability mismatch. Private banks, on the contrary, are aggressively involved in most transactions despite holding only a third of the total assets. In most developed countries, infra financing is left to long-term funds such as pension and insurance and to the bond market. In India there is a problem with this burden falling on the banking sector. It is time to address this imbalance by urgently rethinking the privatisation agenda.

It is unproductive for the RBI and the government to engage in a blame game post the PNB fraud and accuse each other for laxity. That doesn’t take the debate any far. The Nirav Modi episode only highlights a larger malaise. There are important lessons to be learned.