PNB scam: ‘This is what we call kite flying’, say senior bankers aghast at reckless rule breaking on LoUs, margin money, credit limits

What about the forex guys? How did they miss this every single time over five long years? It's impossible that the blame can be pinned down to just those with access to the SWIFT code. How come there was never any margin money paid for every loan in the Nirav Modi-PNB case? Those are astonished eye rolls coming from senior bankers who spoke on background about the trail of recklessness that points to other shocks that possibly await as the investigation into India’s biggest banking fraud - the Rs 11,300 crore PNB scam - unravels in the coming weeks.

India’s top investigating agency has arrested 11 so far with the latest 5 round ups coming late Tuesday.

The red meat at the heart of the PNB scam is a scaffolding of banking instruments called Letters of Undertaking (LoU) which allowed Nirav Modi to clean out $1.8 bn in borrowings with no sign of repayments for five long years. Bankers with long years of experience explain how they would analyse this heist. Here’s what they said.

The latest arrests in the PNB fraud case Tuesday night/ AP

The latest arrests in the PNB fraud case Tuesday night/ AP

“Letters of Undertaking must be backed by margin money”
A letter of undertaking is a sort of a bank guarantee under which a bank can allow its customer to raise money from another Indian bank’s foreign branch in the form of a short term credit. For example, Punjab National Bank Mumbai can authorise Axis Bank, Antwerp to give money on behalf of a PNB customer - that is to a supplier of Punjab National Bank. The LoU serves the purpose of a bank guarantee for a bank’s customer. LoUs must be backed by margin money. For raising the LoU, the customer or the importer at Mumbai is supposed to pay margin money to the bank. But in Modi’s case neither was there a credit limit nor was there any margin money given, from reports that have emerged so far. The margin money can vary from 10% to 100% which proves both solvency and earnestness. Once an LoU is acknowledged and accepted, the foreign bank transfers money to the Master Account of PNB in foreign currency and PNB pays the supplier from this account.

Why did a short term credit roll over beyond 90 days?
Ideally the credit on the basis of an LoU is extended only for a short term but in the Modi-Choksi case, it was extended beyond what the rule book prescribes - even for a whole year. Even PNB and other lenders are slugging over over the term of loan which PNB says should not have been extended for longer than 90 days. For example, let’s say Modi wants to import Rs 10 crore worth of diamonds in India. His people go to a bank and say we’ll give you a margin, give us an LoU. Normally an LoU is established at another branch of an Indian bank abroad. Other (foreign) banks are not going to do this, only Indian banks which have ongoing business with other Indian banks will do these LoUs with each other. Let’s say Modi pays the 1 crore margin, PNB sends the LoU to Axis Bank branch. Axis Bank branch is supposed to extend a 90 day credit based on the LoU. They will credit PNBs Master Account with forex. Two days before the 90 days limit, the customer says we have another order here, so we need Rs 20 crore and the bank also extends. This is what we call kite flying. Given how the Antwerp diamond business has been overtaken by a virtual nexus, there could be a much larger pattern of LoUs that unfolds as the investigators move forward.

At least 3 officials must independently authorise SWIFT payments
At least three officials have to independently authorise any payment via the highly protected SWIFT system. Normally, in a typical workday, each of the three may not independently vet the payment. They may authorise one person with the secret commands. In the worst case, this may be shared with the customer itself. That is a blow to the integrity to the security of the banking system especially in such cases where the checks should be far tighter because of the nature of the business. Export of diamonds is a highly risk rated business. A lot of black money and illegal money that finance anti social activities can be inferred from the way in which money moves.

Scale of the fraud indicates that crores of receivables may surface too
That investigators have been able to garner Rs 6,000 crore worth of assets means there is a substantial business. PNB will extend this LoU facility only to its customers, not to anybody. For example, you can’t go and have a free cup of coffee in a 5 star hotel, even if you have a letter from someone with these instructions for free coffee. Clearly, there is a sustained relationship here. These are all people who have regular export accounts and carrying on business. The very fact that they have been able to round up Rs 6,000 crore worth of assets from the Rs. 11,300 crore means it is not an insubstantial business. This also suggests there may also be a lot of receivables. It is entirely possible that there’s at least a couple of thousand crores due from others to Modi’s companies. It seems be a case of overshooting and grossing up much more than what was possible. The toxic cycle has been cut only because a new person came into the picture who quoted the rule book and asked the questions that should have been asked when Modi defaulted on the very first LoU. This set off a chain reaction. Modi could not raise any further money so the supply chain stopped and the whole operation came to a screeching halt.

How did the forex department miss this?
When a SWIFT message is sent and Axis Bank Antwerp credits PNB’s Master Account, some other department which in this case is the forex department, will get to know that this money has come in. What this money has been credited for is something the forex department must know. Then, when it is paid to the supplier, where is the authority from the Indian branch of PNB for which we now have a debit? How the forex department missed this is a mystery. The entire process cannot be centralised in the person sending the SWIFT message. It is the foreign exchange department’s responsibility to maintain the Master Account. Devolution of funds and use of funds must have happened at least in 60- 90 cycles - how come this escaped PNB’s notice every single time? We don’t yet know the arrangement specific to PNB but it is safe to say that this is certainly not the way it would be handled if things were done right. PNB has hinted in a letter that other banks involved did not raise this issue earlier. But each LoU, each bill is an independent transaction. Why didn’t those monitoring PNB’s Master Account raise it each time the 90 day period rolled over? Whoever did not raise the issue acted that way because it suited them at the time. What is the quality of your checks and controls that this was missed for so many years? When there is collusion, there can't be any controls.

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Updated Date: Feb 22, 2018 20:10:29 IST

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