Why fraudsters prefer to use letters of credit
What is an LoU?
The Punjab National Bank (PNB) fraud has brought forward an instrument used widely in international trade finance, in Asia and other developing countries in Africa and South America. Termed a Letter of Undertaking (LoU), also called a Letter of Credit (LC), it essentially is a guarantee undertaken by a bank. Assuring that irrespective of who carries the negotiable instrument and what happens in between, it would be repaid. The importer takes an LoU, and arranges to pay a client in a currency of choice, typically one of four major ones — dollar, euro, pound or yen.
Why are LoUs or LCs needed?
Why cannot an importer buy dollars from the market and directly pay to the client? The reason is that in most developing countries, full convertibility of the local currency is not allowed. Meaning you cannot simply buy as many dollars as you want from the local market and send it abroad to fulfill your payment obligation to a client. This is the case for our rupee — there is a limit on how much a citizen may send in a year. Currently, $250,000 per person. For a business, this is tiny.
The cap is termed partial convertibility. One may bring as much foreign currency as one wants into the country but you may remit only so much. The Indian rupee is partially convertible because its regulators fear massive volatility in local markets and the economy if the rupee becomes freely available for two-way movement. That would also mean any investor can build a huge position on a rupee-dollar movement and wreck havoc in the exchange rate. The economy is judged as not resilient enough to take those shocks.
And so, to aid businesses to carry on their usual work, the regulators in these countries have allowed the LoU/LC route.
How do LoUs/LC work?
Essentially, an importer — in this case, Nirav Modi — walks down to PNB’s Brady House branch and says he would need to pay his foreign clients $1 million to buy pearls. He can’t do it as the rupee is partially convertible. Assuming everything goes by the rulebook, the PNB personnel will ask Nirav Modi to choose between one of two methods, as described here.
One, Nirav Modi may borrow from PNB in rupees, convert the loan through the bank into dollars, pay the exchange rate and necessary taxes, fill a form of declaration, fill a loan agreement with an interest rate of, say, 13.5 per cent annually, and pay the pearl merchant through loans processed through a foreign branch of PNB. Alternatively, PNB can write a guarantee for Nirav Modi, valid up to a year, which Nirav Modi can deposit at any branch abroad. For convenience, PNB would do that for him from the local branch itself, by instructing the foreign branch through the SWIFT financial messaging system. The other branch will immediately pay the $1 million to PNB’s overseas account with the payee bank (not directly to Nirav Modi). This account abroad is called a Nostro account. The account will be debited in favour of whoever or whichever Nirav Modi wishes to pay. The fee for this would be an international benchmark rate (typically the London Interbank Offered Rate or Libor) plus two per cent.
Nirav Modi, or any other importer, would naturally choose the guarantee route, as it is cheaper and far more convenient. Here comes the catch. If the bank had given Nirav Modi a fund-based limit (based on his relationship with the bank and money deposited, mortgages in excess of loans, etc), the bank may or may not insist on 100 per cent assets pledged for the guarantees raised. This is because even if the foreign bank is sure PNB will pay, PNB itself wants to be sure Nirav Modi would pay back or at least ensure they can take the pledged amount. Nirav Modi then gets the pearls and sells these in the local market. And, pays back PNB, with interest. PNB pays back the payee bank abroad the dues.
What, then, is the scam?
The scam is essentially that Nirav Modi did not pay the security deposit needed to raise an LoU. By PNB’s First Information Report (FIR) with the CBI, the amount hanging at first worked out to be ~2.8 billion. On further investigation, it turned out that Nirav Modi had not been putting in enough of securities since at least 2011; the value is now ~114 billion. One deputy manager of the branch in question aided Nirav Modi in raising the guarantees without adequate securities, bypassing the bank’s core banking system (CBS). The deputy manager, Gokulnath Shetty, accessed the bank’s SWIFT — it seems this was not integrated with the bank’s CBS. Note that SWIFT is essentially like a telex machine; many banks don’t have their SWIFT integrated to CBS. However, routine audit of SWIFT is necessary and is to be done by all banks; apparently, not at PNB. This raises questions of collusion among many more employees; quite a few have been arrested already.
How did the amount build up to so much?
Details are sketchy at this point but it appears to have essentially been a ponzi scheme, the term for a form of fraud in which belief in the success of a non-existent enterprise is fostered by the payment of quick returns to the first investors from money invested by later investors.
The maximum validity of an LC is one year. After that, NM probably raised fresh LoUs to retire the older ones. With the bank staff in his pocket, he probably kept increasing the amount of the LoUs till it reached an unmanageable proportion and there was no way for PNB to hide it anymore. Especially when the Reserve Bank of India started demanding mandatory reporting of such guarantees in a format that could be fed into a computer, the analysis done in a click.
Is this is the first time an LC fraud has happened?
No! Most frauds in Indian banking have been due to use of LCs. And, PNB seems to be a favourite with such fraudsters. In the 1990s, its London branches fell for such massive LC fraud that those branches had to be merged with State Bank of India for depositor protection and to keep the country’s prestige. The bank’s chairman at the time had lost his job for letting the fraud go unchecked, even as he might not have been involved in the scam. None wiser, in recent times we have had Zoom Developers (~35 billion), Winsome Diamonds (~70 bn) and now NM (at least 114 bn) all having used the banking sector’s LC route to scam the system. In all these cases, PNB was the centre.
Is India alone in this?
Again, no! In 2015, China was hit by a massive LC scam. Countries in Latin America routinely get scammed by LC operators. There is also no way determined fraudsters can be prevented entirely; however, such frauds can be minimised to a great extent. Effective audit is one such route. And, of course, the need for LCs would disappear completely if the Indian rupee is made fully convertible, or becomes an internationally accepted major currency. Both are probably decades away.