With 2013 and 2017 the Key Dates in Nirav Modi Scam, Congress and BJP Can't Pass the Buck

The gaping holes in Nostro account monitoring and the SWIFT messaging system were well-known. It just needed Nirav Modi to come along and exploit them.

Investigation agencies are saying that the size of the Nirav Modi scam may be bigger than Rs 11,000 crore. Credit: Reuters

Investigation agencies are saying that the size of the Nirav Modi scam may be bigger than Rs 11,000 crore. Credit: Reuters

In early 2013, a clutch of public sector banks formally made a representation to the RBI expressing a lot of difficulty in either eliminating or reconciling the proliferating number of entries in their accumulating ‘Nostro’ accounts after a lapse of time.

A Nostro account is typically opened by a domestic bank, in this case Punjab National Bank (PNB), with overseas banks and the account is used to make payment to overseas parties for imports, such as for rough diamonds in the present instance. A domestic bank typically facilitates creation of such Nostro accounts with overseas banks so that it is able to pay dollars from the overseas account for imports by its local client.

So, when banks told the RBI in 2013 that it was becoming difficult to eliminate or reconcile the burgeoning Nostro accounts, the central bank specifically advised that public sector banks should minimise the number of Nostro accounts to have a better control over reconciliation.

The RBI also instructed banks to put in place a system of “fast reconciliation and close monitoring by the top management at short intervals by leveraging technology,” says a Business Standard report from January 2013.

The reason why the RBI’s advice from five years ago is so important is that if a system of fast reconciliation and close monitoring of Nostro accounts – which Nirav Modi and his family associates used to fraudulently take out $1.8 billion – had been put in place, the PNB management would have detected this scam much earlier. It is precisely the lack of monitoring of the Nostro accounts that made this scam so big. It appears the banks did have a clear idea of the risk way back in 2013 when they went to RBI with the problem.

The RBI, on its part, gave the right advice but failed to follow up on it to ensure that banks had indeed put in place a technology driven mechanism to reconcile and eliminate Nostro entries at short intervals. Thus a systemic risk, clearly identified by the banks, was allowed to grow.

Another compliance failure that facilitated the Rs 11,000 crore scam was the unmonitored usage of the SWIFT financial messaging system. In this too, we find a cautionary tale from two years ago, when the Union Bank of India was hacked and lost (later recovering) $171 million. Most importantly, just like the Nirav Modi scandal, fraudulent payment instructions went out over SWIFT and bypassed the core banking system.

RBI deputy governor S.S. Mundra gave a speech in September 2016 that addressed this very issue. “Recently, in India too, a similar attempt was made on a commercial bank by generating fraudulent payment instructions on the Nostro accounts and transmitting them over SWIFT messaging system. Though monetary loss could be prevented with proactive follow-up with the concerned paying/intermediary banks, the incident has reinforced the fact that the various stakeholders have not learnt the lessons yet,” he said.

“Although, the latter incidents were mainly a result of failure of internal controls and non-adherence to “four eyes principles”, it is also on account of reliance on disparate systems whereby SWIFT transactions could be done without originating a corresponding transaction in the CBS,” he added.

LoU scam

As it turns out, it only needed the twisted business brain of Nirav Modi to exploit the loophole to keep drawing more and more funds from the Nostro accounts by issuing fake letters of undertaking (LoUs) to repay the money within a stipulated 90 days. It was based on these fraudulent LoUs that the overseas bank would transfer funds to the Nostro account.

But apparently the temporary credit would keep getting rolled over every 90 days to become perpetual unpaid credit for a long time. Since such short-term loans are traded among banks, the liability appears to have got shifted to a number of other banks. Investigations are still on but one estimate is that at least 20-plus banks are saddled with such Nostro account liabilities created by Nirav Modi and other diamond companies associated with him.

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The RBI will have no option but to step in and reconcile these liabilities among banks even as the CBI and ED attach properties of Nirav Modi to recover whatever it can. According to The Indian Express, investigation agencies are saying the size of the scam is bigger than Rs 11,000 crore and an additional liability of Rs 3,000 crore has been discovered in the Nostro accounts.

The CBI FIR says Nirav Modi issued eight LOUs between February 9, 2017 and February 14, 2017 and it appears the size of the fraud increased greatly over the past year. Though Nirav Modi’s companies have been using letters of credit from 2011, the investigation so far suggest the fraud multiplied in size over the past two years, and more specifically since January 2017.

One doesn’t know whether this has any connection with the economic situation that prevailed in the aftermath of demonetisation. After all, the diamond trade is known to work with a lot of cash. An elaborate report on black money generation submitted by NIPFP to finance ministry points to the diamond trade as a major source of money laundering. Is it possible that diamond merchants like Nirav Modi had to resort to substantially higher and fraudulent borrowings through Nostro accounts overseas to deal with the setbacks caused by sudden clampdown on the cash economy?

Or was it simply his overweening ambition to create branded jewelry stores in the most expensive locations around the world which might have forced him to resort to such illegalities? A deeper investigation will reveal the whole truth.

Finally, looking at the recent history of Nostro accounts and their abuse, the Reserve Bank of India will also have a lot to answer for. The regulator made the right prescriptions to the banks in regard to monitoring and reconciling these accounts very closely but failed to ensure that the banks strictly adhered to the due diligence process.

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