EXPLAINER ON WHAT WE KNOW ABOUT THE CASE SO FAR

On February 14, state-owned Punjab National Bank (PNB) disclosed that it had discovered $1.77-billion (around ₹11,400 crore) worth of fraudulent transactions at one of its Mumbai branches. In a complaint to the CBI, the lender named firms and people associated with billionaire jeweller Nirav Modi who connived with some of its officials to defraud the bank using bank guarantees. For those who came late, here is a primer based on CBI’s FIRs and public information available so far:

What is the fraud about?

Two PNB employees sent unauthorised letters of undertakings (LoUs), essentially bank guarantees, to foreign branches of Indian lenders, on behalf of firms related to Nirav Modi and the Gitanjali Group. The LoUs basically told these other lenders: Lend money to Nirav Modi firms so that they can pay for their imports. If they don’t pay up, we will make good this payment.

What’s irregular about this?

In the normal course, when an importer goes to a bank to ask for such a guarantee, one of two things happens. One, the bank asks him for collateral before it gives a guarantee. This collateral could be property in his name, or a fixed deposit with the bank. Second, the bank sanctions a credit limit. That means it will evaluate the importer (just like a lender asks for your income proof and address proof before giving you a home loan) and says he is good to be given a loan for a certain amount; but no money actually changes hands.

In the PNB fraud case, the bank employees had sent these guarantees in the absence of credit limits and collateral security (in Modi’s case). Secondly, they didn’t make an entry in the bank’s core banking system – the software used to support a bank’s most common transactions, which also acts as a record keeper. In some cases, they made a corresponding entry in the core banking system, but for lower amounts

Why would an importer use this convoluted method to raise money?

There are multiple reasons. For one, he has to raise money in foreign currency to pay for goods bought abroad. Second, the cost of such foreign currency borrowings abroad is typically lower.

What happens when the foreign bank or branch receives this guarantee?

When the foreign bank or branch receives the guarantee, for example from PNB, it will give a loan to the importer. That means it will deposit money either in the account of the supplier who’s selling goods to the importer, or in PNB’s account held with it. The tenure of this loan varies from 90 days up to even five years for capital goods. The money gets used to settle the payment for imports. Then, when the term of the loan is up

and the importer makes money from reselling the goods he imported, he will pay this sum to PNB with interest. PNB in turn will settle with the other banks.

What happened in this case?

According to the CBI FIR, in many transactions, the money raised through this guarantees was not used to make payments for imports. But it was used to settle earlier loans taken. In effect, every time a Nirav Modi related firm asked for a bank guarantee, it was to settle an older loan taken through a previous bank guarantee. Thus, the amounts piled up to around ₹11,400 crore.

How was this detected?

According to the FIR, two junior employees of PNB had been sending these unauthorised guarantees for seven years. Then, one of them retired. In January, when representatives of Modi firms asked for a fresh guarantee, the new PNB employee in that position asked for collateral security. On being told that this was never asked for in the past, the bank started investigating and found hundreds of guarantees relating to these firms.

Does this mean no one thought to check this earlier?

PNB’s defence is that the SWIFT messaging system used to send these guarantees was not linked to its core banking system. SWIFT stands for the Society for Worldwide Interbank Financial Telecommunication. Experts also said that a concurrent audit — an audit of transactions done as they happen by internal or external auditors — should have caught this. Won’t someone look at the money deposited in PNB’s overseas accounts? Won’t someone reconcile SWIFT messages with the money that was transmitted through PNB’s systems?

The jury is out on how many people at different executive levels are involved – either directly or because of negligence.

What happens now for PNB?

PNB is left holding bank guarantees worth ₹11,400 crore, which it has to pay to, among others, State Bank of India, Allahabad Bank and Union Bank. These payments are due over the next few months. The bank has tried to shift some of the blame to these banks. In a caution notice to the chiefs of other banks it essentially said this: You should have done more due diligence before giving out loans. Didn’t you notice that these guarantees are for one year, much above the RBI allowance of 90 days for the diamond industry? Other banks aren’t buying these arguments. They say: We took an exposure on PNB, a state-owned bank (and an implicit bet on the Indian Union) not on a diamond merchant. It is still a grey area on who will actually pay up and how the burden will shared

So, the banking system will take another ₹11,400 crore on top of its huge bad loans problem of ₹10 trillion?

Not necessarily. There will be some recoveries. For instance, the Enforcement Directorate has claimed it has already recovered gold, precious stones and diamonds worth around ₹5,500 crore (although that valuation is debatable for an asset like diamonds). In any case, the entire ₹11,400 crore which was raised for loans would either be in the form of diamonds (in case of genuine imports) or stashed away somewhere in other assets (if it had been diverted). It remains to be seen how much can be recovered.