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Banking

How was the Nirav Modi Scam Allowed to Build Up to its Breaking Point?

How did a bunch of rogue employees manage to subvert the banking system so fully, and continue to do so without being caught even once?

Diamond merchant Nirav Modi. Credit: facebook/Nirav Modi

The Nirav Modi controversy has captured the public imagination as very few developments have in recent months. Part of the fascination comes from the sheer size of the fraud, of course.

Also, the story has all the ingredients of a Bollywood blockbuster: a filthy rich protagonist, a pliant financial institution willing to bend every rule to please the ‘boss’, the supposed charms of a life lived in the twilight zone between legitimacy and downright thuggery and the high-octane drama of a vanishing act played to perfection. TV anchors have been breathlessly reporting on the ‘breaking news’ bits of this humongous tamasha. Some of them seem to be gushing over the finesse with which Modi worked the system. There have been endless ‘debates’ around how all this happened, who did what and when, who did not do what and when and why…

The only thing missing amidst all this sound and fury has been a simple recounting of what actually happened. This is partly understandable, because some of the ‘experts’ participating in the TV debates had an axe to grind here – their brief was to obfuscate, so that no harm came the current government’s way. There were, of course, some others whose mission was to pin it all down to one government or the other.

But as one looked on hour after hour, now at this channel and now at another, one was also dismayed. A lot of jargon and technicalese have been swirling around. It may not, therefore, be a bad idea to piggy-back the jargon as we go along. The smokescreen around the fiasco may be easier to dispel then.

Let’s start with the beginning. The errant Punjab National Bank (PNB) officers issued LoUs (letters of undertaking) that enabled Nirav Modi to borrow in overseas markets.

An LoU is a letter or note issued by an originating bank (or OB, in this case the PNB) assuring another bank (the counterparty bank, or CB) that, in the event the CB agrees to lend an agreed sum of money to a client identified by the OB for a pre-determined period (between 60 to 360 days), then the OB will make good that loan to the CB on the specified date.

The LoU also mentions the rate of interest (normally linked to LIBOR, or the London Inter-bank Offered Rate) and any other charges that the CB may choose to levy for the transaction.

Effectively, then, the OB guarantees the repayment of the loan along with interest and other charges on the due date, and, based on this guarantee, the CB makes out the loan to the client identified by the OB. In this case, the CB’s exposure is on the OB (in this case, the PNB), and not on the client. The CB, therefore, does not run a due diligence on the client and gives him the money on the basis of the CB’s ability and willingness to assume the exposure on the OB. (Let us note in passing here that no LOC, or Letter of Comfort, or SLC, or Standby Letter of Credit, or even an LC, or a Letter of Credit is at issue here – as some commentators and ‘experts’ have been suggesting. Sometimes, of course, it is an LC that is eventually followed by an LOU, but that point need not retain us here.)

Typically, where does an LOU come into the picture? Well, when Nirav Modi imports diamond roughs from an overseas supplier, he needs to pay for his purchase on a mutually agreed date in an agreed currency ( say, the US dollar or the euro). But Modi requests his bank (PNB) to lend him the dollars for a while (60/90/…. days) so that he can process the roughs, sell or export them, and then pay PNB back from out of the sale proceeds.

Now, PNB’s branch in Mumbai does not deal in dollars/euros but only in rupees. So, to help Modi out, PNB contracts with a bank operating in an overseas centre (with access to the required currency) for a short-term loan so that Modi’s supplier can be paid off and Modi has the leverage to pay back the money to PNB at that future date when he comes into money.


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Thus it is that the Hong Kong Branch of Allahabad Bank and Axis Bank then becomes the CB, passing on the money to the account designated by PNB for the purpose. On the due date, PNB authorises the CB to debit PNB’s account (called a Nostro account) with a bank at the overseas centre with the principal together with interest and other charges. The CB makes and receives its claim, and the transaction is squared off. PNB is supposed to recover the money, plus its own mark-up for the loan it had facilitated, from Modi’s account with itself. Almost always, the importer (in this case, Modi) enjoys regular, approved credit lines from the bank (PNB) which are utilised for settling such transactions. The approved loan line pre-supposes due diligence on PNB’s part on Modi’s credit-worthiness, cash flow adequacy, and the genuineness of his trade. In the event of Modi not having an approved credit line, PNB wants fall-back by way either of a 100% cash margin, or a combination of cash and other collaterals considered adequate to meet the liability. The payout as well as the payback of the overseas loan are routed through the Nostro account which, then, captures the transaction trail fully.

In this case, the LoUs were allegedly issued without or outside of any approved credit line by a few rogue operatives at PNB. They did not seek or obtain any collateral, cash or otherwise, worth the name either. That is where the fraud comes in. Modi apparently went on borrowing liberally on the basis of LoUs which neither led back to any ‘official’ liability owed by him to PNB, nor even to any realisable collateral that could be set off against the actual liability.

So, how did this come about? How did a bunch of rogue employees manage to subvert the system so fully, and continue to do so  extensively and persistently without being caught even once?

The LoUs and the related payment authorisations are communicated by SWIFT ( acronym for Society for World-wide Interbank Financial Telecommunications) messages, structured, coded communications which use an internationally established protocol for such messaging.

A SWIFT message from PNB’s Mumbai branch is clearly and universally identifiable by any branch of any bank anywhere in the world as having come out of that branch alone. SWIFT messages are supposed to be fully secure communications, requiring as they do an elaborate, three-tier making/checking/authorisation  structure at the issuing bank branch. This also means, though, that if all these three levels are complicit in a criminal enterprise – or wholly negligent – then the SWIFT route can be easily abused, as appears to have happened in this case. Axis/Allahabad Bank’s Hong Kong Branch would normally have no reason to question the authenticity of a SWIFT message embodying an LOU or a payment authorisation received from the PNB branch.

Are there then no safeguards here other than the professional and personal integrity of the persons with access to the SWIFT apparatus? Yes and no. Thereby hangs another tale.

Every bank works on a business-cum-accounting platform – often called the CBS, or Core Banking Solution – which is programmed to accurately capture all customer-related transactions, deposits as well as loans, besides all the many other services rendered by a bank plus the recoveries of interest and all other bank charges.

So, if the PNB branch was carrying on normal banking business, it would have created the liabilities relating to the LoUs in Modi’s name, adding to the liability when a fresh LoU is issued, and marking it down once a liability is paid off. Here, though, is a catch: the SWIFT system operates on a stand-alone platform distinct from the CBS, and unless an active interface is created and used by a bank, the SWIFT messaging system will continue to exist on an autonomous plane.

Scandal-in-waiting

Many banks, including very many Indian banks, have put such an interface in place at their branches. Incredible as it may seem, however, PNB has not done that yet, leaving its inter-bank operations open to a humongous operational risk. In truth, this was a disaster waiting to happen. The rogue employees had the luxury of sending out appropriately constructed messages of whatever description/value to wherever they liked – and nobody would be the wiser for it. No liability was apparently owed by Modi to PNB even as he was free to continue helping himself to outrageously large sums of money – using the cash for setting up jazzy, glitzy boutique stores, or acquiring any asset he happened to fancy at the moment, or simply to blow it on a bash for his friends and admirers. There is also a possibility, although not proven yet, that he used it to launder dirty money that he could not otherwise account for, in sum, in any which way he pleased.

People stand in front of the logo of Punjab National Bank outside a branch of the bank in New Delhi, India February 15, 2018. REUTERS/Adnan Abidi

Was there no possible check on such outlandish gerrymandering? There was – only nobody in PNB seemed to bother, unless the whole bank was complicit in, or at least connived actively at, the crime, which appears unlikely.  The payouts and receipts in foreign currencies are necessarily routed through the bank’s Nostro accounts, where every debit is typically matched, often with a time-lag, either by a matching credit that flows into the same account to square off the transaction, or by a credit in the bank’s domestic (Indian) books by way of a recovery/ repayment from/by a client.

PNB authorised Axis/Allahabad Bank to debit its Nostro account in settlement of the LoU-related funds disbursement, but nobody anywhere in the bank seemed to keep a tab on these gargantuan NOSTRO debits and link them to any recovery/squaring-off anywhere in the system. Simply put, PNB’S Nostro accounts were neither reconciled nor even monitored, and the gigantic fraud built up merrily at one branch of this large bank, even as the bank’s inspection and audit and Forex departments – why, even the CEO, his top management team, the audit committee of the bank’s board and the board of directors itself – went about their ‘normal business’ as though no danger lurked anywhere. It may not be out of place to mention here that directors from both the RBI and the central government sit on the bank’s board and are jointly liable for the board’s lapses.

With such extravagant risk management skills/capabilities, how can a bank keep its head above the water except by sheer good luck? And plainly, PNB has been less than lucky.

There is also an outside chance that the whole game played out without the bank actually being out of pocket at any point in time, but that as one LoU was due to be redeemed, a fresh LOU was concocted by preying on another bank/branch, and the cash made out of the fresh LOU was used to pay off the earlier liability. Theoretically, it is even possible that none of the LoUs issued by PNB had fallen due for redemption up until now. Eventually, of course, all these liabilities would mature one by one — which seems to be happening now – and PNB would be left holding the baby.

At any rate, the scam is a withering commentary on the bank’s risk management functions. It was small comfort to find the bank’s CEO take pride in the fact at a press conference last week that it was the PNB, after all, that ‘unearthed’ the fraud.

Anjan Basu worked for a large public sector bank for over three decades, inside the country as well as outside it, on overseas assignments.