The Great Indian Bank Robbery

The Rs 11,400 crore scandal featuring the high-flying diamond dealer Nirav Modi brings out in stark detail the country’s broken banking system. Internal checks and surveillance systems remain too weak to spot abuse of financial authority, while a variety of institutions designed to act as external regulators have been caught napping.

On the first day of the New Year, a jeweller quietly left India. Within days, his uncle followed him. No one paid any attention. After all, Nirav Modi, creator of fine jewellery, had extensive interests abroad straddling the world’s hotspots of diamond sourcing and haute glitter fashion. Nor would anyone have bothered, but for a peculiar occurrence in Mumbai.

A fortnight after Modi’s departure, an employee of his firm walked into the Brady House branch of Punjab National Bank (PNB) in Mumbai, requesting buyer’s credit for making payments to suppliers overseas. The bank declined. In banker parlance, Modi’s firm had no sanctioned limit for the issuance of a Letter of Undertaking (LoU), a bank guarantee that would enable the firm to borrow money from another bank abroad. The PNB branch in Mumbai insisted on a 100 per cent cash margin before an LoU could be given. This was a prudential measure, as an LoU amounts to the bank lending money to the extent of the sum mentioned. The representative of Modi’s firm responded by saying it had availed of this facility in the past. Officials of this government-owned bank found no records of the firm having been given such LoUs.

But when PNB carried out an internal investigation, it was found that a number of firms associated with Modi and Mehul Choksi, his uncle, had scandalously been issued LoUs over a long period without the approval of senior managers. The first LoU, the bank discovered, had been issued way back in 2010, when Gokulnath Shetty, the official now alleged to have connived with Modi’s concerns, was posted at the Brady House branch. A massive fraud had been unearthed.

Another fortnight passed before the bank approached the Central Bureau of Investigation (CBI) in Mumbai with a complaint. The FIR in this case was lodged on January 31st, a month after Modi left India. The blow to the bank: a tidy Rs 280.7 crore.

The next fortnight was chaotic for PNB. The timing of the scam’s revelation was particularly bad. The bank had just been promised an infusion of Rs 5,473 crore by the Government in the form of bonds, part of a programme necessitated by the weak financial position of several public sector banks, PNB included. The bank has had a large number of wilful defaulters. In 2013, the sum of such outstandings stood at Rs 843 crore. By September 2017, it had jumped to Rs 12,232 crore.

It soon became clear that the amount that PNB stood to lose was much bigger. The sum being mentioned by the second week of February was Rs 11,343 crore, more than double the money the Government planned to pump into the bank, effectively nullifying its effort to shore up PNB’s finances.

The real scandal, however, was the manner in which the fraud was pulled off by a clutch of low-level officials operating from a single branch of the bank. The method was simple. The LoUs were issued through the global Swift messaging system, named after the Society for Worldwide Interbank Financial Telecommunication. In a well-run bank, the sums transmitted via this mechanism are matched routinely with the Core Banking System (CBS) accounts of the bank, which records all transactions. At PNB, the two systems were running in parallel without anyone bothering to check if the numbers of one could be reconciled with the other. Preliminary enquiries of its operations reveal worse. The bank’s Swift access password had allegedly been given away by Shetty to Modi’s employees.

All this has sent shockwaves through India’s financial sector. But the problem is hardly unique to PNB. “In general, [banking] processes are not robust. In private sector banks, you cannot do Swift transactions unless you enter a CBS. [At PNB], there was no communication between the Swift and CBS systems,” says Krishnamurthy Subramanian, an economist at Indian School of Business, Hyderabad, who was a member of the PJ Nayak Committee that reviewed the governance of bank boards. “In private sector banks, Swift is centralised, but in public sector banks, this is decentralised,” he adds. “When you have branches being authorised to carry out Swift transactions, given the level of exposure of these banks… it is a ticking time bomb.”

The PNB episode speaks of a near total breakdown of the risk assessment and management practices of public sector banks. The missing oversight of Swift LoU messages is part of a broader problem that has gone unaddressed for too long, a problem that has largely to do with working out the chances of loans not being repaid and turning into losses. The galloping non-performing assets (NPAs), advances which have stopped giving money back, over the past five years point to a failure in the main job of banks: getting the right payback for risks borne in lending money. At the end of March 2017, PNB had gross NPAs of Rs 55,300 crore. These numbers are the highest among all public sector banks, barring the State Bank group. Add the numbers of the latest scam, and the picture looks bleaker.

In the period after Modi fled the country, investigative agencies such as the Enforcement Directorate (ED) and Income Tax Department have conducted raids on the premises of his companies, seizing diamonds and other valuables. So far, the total worth of the seizures made is estimated at Rs 5,671 crore. The IT Department has also attached seven properties owned by Choksi’s Gitanjali Group.

On February 19th, three days after the first raids, the absconding jeweller— whose whereabouts are not known—reacted to the charges against him, protesting that PNB had acted ‘in haste’. In a letter to the bank, Modi said, ‘In the anxiety to recover your dues immediately, despite my offer, your actions have destroyed my brand and the business and have now restricted your ability to recover all the dues leaving a trail of unpaid debts.’ Brazen as these words sound, this is not the first time that a defaulting businessman has blamed the banks for wrecking his chance to recover the money due to them; a similar claim was made by the fugitive Vijay Mallya, who is currently fighting an extradition case in a London court. Modi, though, has alleged that the multi-agency probe on his companies, Firestar International Pvt Ltd and Firestar Diamond International Pvt Ltd, had effectively put an end to their operations, asking the bank to pay the 2,200 employees their salaries.

So far, the investigation has resulted in several arrests of middle- level PNB officials, including Shetty and his alleged accomplice Manoj Hanumant Kharat. Shetty has retired from his job, as have a number of managers who were posted at the branch when the irregularities took place. In addition, some officials of the bank have been suspended and a few others have been transferred, including a general manager responsible for human resources.

In its first formal reaction to the scandal, on February 20th, the Union Finance Ministry drew the RBI’s attention to its role as banking regulator. In a letter to the central bank, the Ministry directed it to Sections 35, 35A and 36 of the Banking Regulation Act of 1949, which empower the RBI to oversee bank operations. Section 35 gives RBI the right to inspect any bank’s records. Section 36 lets it prohibit any bank from carrying out certain transactions. Similarly, Section 12 of the Foreign Exchange Management Act of 1999 allows RBI to obtain information, verify it and ensure compliance with the Act. While the violations by Choksi and Modi are under the examination of various authorities, the nature of its transactions could mean that foreign exchange rules were also flouted. The Ministry reportedly asked the RBI about this possibility as well.

Later on February 20th, the central bank issued this statement: ‘RBI had, therefore, confidentially cautioned and alerted banks of such possible misuse, at least on three occasions since August 2016, advising them to implement the safeguards detailed in the RBI’s communications, for pre-empting such occurrences. Banks have, however, been at varying levels in implementation of such measures.’ The RBI also appointed an expert committee led by YH Malegam, a former member of its board of directors, to identify why there was such a wide gap between its own and various banks’ estimation of what their loans were worth and what money was needed to cover defaults. The committee is also expected to pinpoint factors behind the increasing number of frauds and recommend what should be done about it.

The hole blown in PNB’s finances and the uncertain spread of the LoU ‘contagion’ across the banking system—the extent of all claims that other banks could make on PNB is unclear—has caught the RBI and Government off guard. Initial reports suggested the RBI had told PNB to honour its commitments for the LoUs it had issued. But within days, the central bank denied this. On February 16th, it said that, ‘There have been reports in the media that in the wake of fraud involving a sum of USD 1.77 billion that has surfaced in [PNB], the [RBI] has directed PNB to meet its commitments under the [LoU] to other banks. RBI denies having given any such instructions. The fraud in PNB is a case of operational risk arising on account of delinquent behaviour by one or more employees of the bank and failure of internal controls. RBI has already undertaken a supervisory assessment of control systems in PNB and will take appropriate supervisory action.’ This was in contrast to what RBI had said in its guidelines on the subject issued in July 2015. In case such instruments are not honoured, it had stated then, it would adversely affect their character as an accepted means of payment; ‘This could also affect the credibility of the entire payment mechanism through banks and affect the image of the banks.’

WHAT IS ALARMING about the current case is the regu- latory failure at multiple levels. Take the Banks Board Bureau, the newly minted institution that was supposed to help the Government formulate a code of conduct for banks along with improving the quality of manpower at the senior level. Its first chairman, Vinod Rai, a former Comptroller and Auditor General of India (CAG), came with a formidable reputation. The poor quality of manpower, subject to blandishments offered by fraudsters to do their bidding, is considered a major problem in clamping down on fraudulent practices.

Then comes the Central Vigilance Commission (CVC), which is supposed to keep an eye on public institutions and spot signs of corruption. But as Shetty’s instance shows, even agreed-upon measures to prevent any misuse of authority are not being followed. Banks, for example, have guidelines that place limits on the tenure of officials in sensitive positions, such as those handling foreign transactions. Shetty’s posting was to last three years. Yet, he ended up staying there for almost seven. Orders to move him out were first issued in 2013, but were not issued to him and then cancelled in 2015. He stayed there till his retirement. It was only after PNB’s top brass noticed this that the CVC woke up and demanded a report.

The bulk of the blame, however, lies with the RBI. At one time, its officers used to carry out rigorous inspection of banks. “But over time, the practice fell into disuse for various reasons,” says an observer of the central bank’s regulatory practices. The claim made after the PNB scam emerged that the RBI had warned banks of the misuse of Swift appears rather lame.

The ultimate cause of India’s dysfunctional banking system is the peculiar division of labour between the ownership, day-to-day management and regulation of public sector banks. As their majority owner, the Government, irrespective of the party in power, has been extremely reluctant to cede control over them. The RBI does issue elaborate instructions on what banks can and cannot do, but for the most part, its approach is hands-off; otherwise it is inconceivable that such a large-scale abuse of the Swift system could go on for so long right under its nose. For their part, banks like PNB regularly decry government interference as a cause of their woes. To an extent, this is true and it is not just about individuals and businesses getting special treatment at the behest of politicians. There is an elaborate system of pushing credit towards particular sectors that ignores the risks associated with it. Apart from impairing the country’s credit culture, it also destroys the incentive of bankers to tackle the problem of poor risk analysis. “Individual chairmen do not have a sufficiently long tenure to understand the big problems and fix them. The mismatch between incentives and the time horizon of leaders in public sector banks does not allow solutions to emerge,” says Subramanian. “The lack of processes, as seen in the PNB case, is not accidental but a result of skewed incentives in the banking system,” he adds.

One solution would be to privatise public sector banks. The NPA burden of private banks is much lower than that of government- owned lenders. The former’s risk assessment practices are far more robust, as they have to compete in a market not only to lend but also source money. Such banks are subject to another kind of discipline and their search for profits, control of costs and management of risks display a close correlation.

Privatisation as a solution, though, would run into another hurdle at this juncture. The weakness of public sector banks is so serious, that governments periodically have to dish out taxpayer money to bail them out. If these banks were to be sold off at current valuations, it would be akin to selling off the family silver at throwaway prices. “The first thing to do is fix governance. That is the key step in improving valuation. Once the market-to-book ratio is brought to one—at the moment, it is half—that will be the time to consider the possibility of privatising banks,” says Subramanian. That time is clearly distant.

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