How to Rob a Bank
It took more than the evil genius of Nirav Modi to pull off the massive Rs 11,400 crore swindle perpetrated on PNB. It took conniving bank officials and a deeply compromised banking system. Is there a way to put an end to this recurring highprofile loot a
Rs 11,400 crore and counting: a fraud allegedly engineered by diamantaire Nirav Modi shocks the nation and spells Big Trouble for PSU banks
In early January this year, days after officials of the Punjab National Bank (PNB) detected what they initially surmised was a Rs 280 crore fraud perpetrated by fugitive diamantaire Nirav Modi, 47, they summoned Modi’s brother Nishal to their Brady House branch in Mumbai’s Fort area. Nirav was known to be soft-spoken and suave, and the officials possibly expected a family resemblance of character in his younger brother. However, after the usual pleasantries, when the officials insisted Nirav had swindled money, which would have to be paid back, Nishal turned aggressive. “Do what you want,” a combative Nishal is reported to have told the officials. For the first time in years, bank officials were confronted with the dark side of a glitzy business. PNB approached the Central Bureau of Investigation (CBI) with a complaint on January 29, but in a regulatory filing on February 14, that figure of fraudulent transactions had ballooned to $1.77 billion (over Rs 11,000 crore), setting off a wave of panic in the stock markets and casting a long shadow on the operations of India’s public sector banks (PSBs) already struggling with over Rs 8 lakh crore in unrecovered loans.
Worse still, the scam itself could be much bigger, with fresh reports suggesting that Rs 20,000 crore could have been swindled, if one also takes into account bona fide credit extended to related firms owned by Nirav, his wife Ami, Nishal and uncle Mehul Choksi, chairman of Gitanjali Gems, all of whom are absconding and believed to be in the US. The scam has again brought to the fore
some of the worst-kept secrets in public sector banking in India—huge lapses in operations, poor management scrutiny, lack of accountability and transparency and an unholy nexus of unscrupulous and influential businessmen who artfully bend rules to suit their requirements, flaunting their ties with those in power. It has dealt a body blow to the government’s and the central bank’s massive effort to clean up the banking system through the new Insolvency and Bankruptcy Code (IBC), and could spur them to frame even more painful new policies and regulations, including a fresh push towards the privatisation of PSBs.
Meanwhile, more skeletons could well tumble out of the closet, causing more nuisance for the Reserve Bank of India (RBI) and the government over the next several months, as fresh revelations are made and new cases come to light. Already, the media is abuzz with another case involving pen maker Rotomac’s promoter Vikram Kothari, who the CBI alleges has defaulted on loans worth Rs 3,695 crore to PSBs. With fugitive businessman Vijay Mallya still sitting pretty in London despite owing Indian banks close to Rs 9,000 crore, the Modi and Kothari cases have become yet another embarrassment for the government as the public at large assumes the worst of an administrative and regulatory framework that lets fraudulent businessmen cock a snook at the system and make good with their hard-earned money. The fraud has also placed the government’s ambitious move to put in more taxpayers’ money into PSBs under greater scrutiny (it had announced a Rs 2.11 lakh crore recapitalisation drive of state-owned banks in October last year), with the public likely to question why the government should continue to throw good money after bad, only to lose it again to some fraudster. Ironically, the scam has also put the RBI, which has been making a big push to address the ballooning non-performing assets (NPAs) in the banking sector, on the back foot, with the central government asking why the scam went undetected right under its nose (the RBI head office happens to be just a stone’s throw away from Brady House).
How did Nirav Modi manage to swindle such a large sum of money and keep it under wraps all these years since 2011? The modus operandi went thus (see graphic). Firms promoted by Modi—Diamond R US, Solar Exports and Stellar Diamonds—approached PNB officials asking them to issue letters of undertaking (LoUs) that would allow them to raise overseas capital for importing pearls and diamonds to make jewellery. Raising capital overseas is much cheaper (interest rates in India can be as high as 10 per cent, while a foreign loan can carry interest of around 3.5 per cent). An LoU, usu-
ally issued for 90 days, would mean the issuing bank (PNB in this case) guarantees to pay the full amount to the paying bank, in case the client (Nirav & Co.) defaults. However, as a standard practice, this is done on the basis of a collateral, which normally amounts to 100 per cent of the value of the loan. In the case of PNB, its officials—Gokulnath Shetty, who retired as a deputy manager, and Manoj Hanument Kharat, among others—connived with officials of Modi’s firms to issue LoUs without seeking any collateral, and that too, for a year, disregarding RBI stipulations. Shetty had been in the bank’s foreign exchange department overseeing import payments for over six years from 2011 till he retired last year—which in itself has raised eyebrows, since banks keep transferring officials, especially those in sensitive positions, every three years. PNB sent messages on SWIFT (Society for Worldwide Interbank Financial Telecommunication, a global provider for secure financial messaging services) to the overseas branches of a host of banks, including Axis Bank and Allahabad Bank, side-stepping PNB’s core banking system (CBS) which would have, in the normal course, reflected these transactions. The overseas branches of Indian banks transfer the money to PNB’s ‘nostro’ account (meant to park overseas money for PNB’s customers), but even they overlooked the mandatory requirements.
PNB paid this money to Modi and his firms purportedly to finance business-related purchases. However, the money was used only to “retire import bills or replenish the maturing buyer’s credit of some other banks”, PNB said in a caution note to 30 banks on February 12. It was a Ponzi scheme of sorts. Modi firms ask for fresh LoUs, extending earlier ones, this time covering the interest to be paid too, ultimately leading to an ‘evergreening’ of loans, which finally balloons to a huge sum. The scam came to light only when there was a change of guard at the operational level. When Modi’s firms approached PNB for fresh LoUs, they were asked to submit adequate collaterals amounting to 110 per cent of the value of the goods. Modi’s firms protested, saying such letters had been issued in the past too, without much fuss. Internal investigations following this opened a can of worms, with PNB discovering it had been cheated of Rs 280 crore. Subsequently, the CBI filed an FIR on January 31 against Modi, Ami, Nishal, Choksi and the PNB officials on charges of criminal conspiracy, cheating and abuse of official position by public servants. PNB then revised the fraud numbers. Both Shetty and Kharat were arrested on February 17, and along with Hemant Bhatt, the authorised signatory of companies run by Modi and his close relatives, sent to CBI custody till March 14. Three more PNB officials were arrested on February 17, while Vipul Ambani, CFO of Nirav’s Firestar Diamond, was arrested three days later.
But to say that the entire scam was the handiwork of just a few junior officers would be to miss the wood for the trees. They were not operating in isolation but in a banking network that is supposed to have several layers of checks and balances. How deep then did the rot run? Were there systemic failures too? And is there a fail-safe way to prevent repeats of this kind of fraud?
FAILURE 1 PSU BANKS: THE UNHOLY NEXUS
Why did the transactions made in its nostro account not get reflected in the core banking system of PNB, India’s second largest PSB after the State Bank of India? That alone shows the extent of the rot in the bank, whose gross NPAs amounted to Rs 57,519 crore on December 31, 2017. Ironically, PNB was showing signs of a turnaround, posting a net profit of Rs 1,325 crore in 2016-17 as against a net loss of Rs 3,974 crore the previous fiscal. But the present episode will take a heavy toll on the bank, whose shares have already fallen 28 per cent (as on February 19) since the scam was reported, eroding nearly Rs 10,976 crore of its market cap. Experts feel there is more to the scam than meets the eye. “A scam of this magnitude cannot take place without the connivance of several top officials in the bank,” says J.N. Gupta, managing director, Stakeholders Empowerment Services, a proxy firm, and a former banker. “When customers were asking for LoUs for raising such huge amounts, it should have rung alarm bells then and there.” He also questions the flouting of established norms. “How can an officer be posted in such a sensitive position (handling the overseas loan window) for seven years?” Gupta asks. The scam remained undetected by the bank’s operational risk team, its internal and external auditors, as well as the RBI for many years, which points to the deep malaise in the banking system, he adds.
Also questionable is how the counterparty banks, which transferred money into PSB’s nostro account, continued to discount LoUs without checking if there was movement of goods, or shipping documents. “It seems everyone was doing blind banking,” says an expert. Fundamental to banking is the need to know what the lending is for, which was overlooked in
Former Allahabad Bank director Dinesh Dubey says his dissent note against a loan to Gitanjali Gems in 2013 went unheeded. He even wrote to the RBI deputy governor
this case. Also, from a regulatory perspective, any letter of comfort for a loan of over $20 million of non-capital goods has to be reported to the RBI. This wasn’t done either.
The basic principles of operating a system in a computerised environment have been compromised. “Usually, the SWIFT system would have multiple passwords (two or three), depending on the bank and size of transaction. In large amounts as in the Modi case, there would be at least three, but in this case, a single person was handling all the three passwords,” says the former chairman of a PSB, preferring not to be named. It could be that the person fraudulently acquired the passwords, or they were given to him by conniving officials. Second, the SWIFT system has to be mandatorily reconciled with the bank’s CBS, which was not done. There could be cases where integration between the two systems in a bank may not have happened in toto, but in such cases, they should have been manually reconciled.
PSBs in India lost at least Rs 22,743 crore between 2012 and 2016, according to an IIM-Bangalore study, due to lax supervisory control and lack of other checks and balances. In the 2013 Winsome Diamonds scam, where promoters swindled Rs 6,800 crore from a consortium of banks led by Standard Chartered, PNB has the highest exposure of Rs 1,800 crore.
HOW TO FIX IT
According to Mohit Bahl, partner & head of forensic services at auditors KPMG, three sets of activities need to be undertaken to prevent such frauds. One set includes measures that a bank (such as PNB, in this case) needs to undertake immediately—assess its current exposure and capture fraud risks under trade-based lending activities. The second is a transformation of the internal audit function of the bank while the third involves making a fraud risk assessment framework integral to the bank’s control framework. This can be done with the help of an internal as well as an external team. In the first case, it is essential to assess all transactions across the bank’s network that may have used the same modus operandi as in the Modi case. Then, identify all overseas branches/ regions that are impacted, and review the internal documentation and process followed to process these transactions. Next, assess the existing internal controls deployed by the bank to monitor trade transactions (including reconciliation procedures between CBS and SWIFT, nostro entries, periodic confirmations). Also, assess the role of the staff and investigate any collusion or negligence, including assessment of compliance to job rotation guidelines. Last but not the least, conduct fraud risk assessment of trade-based lending activities (domestic and overseas) and identify exposure to the bank.
FAILURE 2 NPAs: THE ROBBER BARONS
The significance of PSBs in the country is underlined by the fact that these 21 banks form 70 per cent of the country’s deposits and advances in the banking industry. The PNB fraud comes on the back of a massive problem of NPAs in the banking system. RBI data put PSB bad loans at Rs 7.34 lakh crore at the end of the second quarter of 201718. On the other hand, NPAs in the private sector were considerably lower at around Rs 1 lakh crore. The PNB case, however, is not one of NPAs. In NPAs, loans turned bad when entire businesses, especially in infrastructure, power and steel, got stuck partly due to the downturn following the collapse of Lehman Brothers in 2008 and partly due to inept promoters entering businesses that they had absolutely no experience in. In the PNB case, borrowed money was used to retire old loans, until the loan became too big to be repaid.
Similarly, in the Vikram Kothari case, which is also making headlines, the Rotomac promoter allegedly raised foreign letters of credit from seven PSBs, allegedly to procure wheat and export of goods for various other purposes, and round-tripped the money to his company and sister firms. Kothari was declared a wilful defaulter in February 2017, and banks auctioned various properties he and his family owned to recover dues. Kothari was being questioned by the CBI at the time of going to press. In 2014, the United Bank of India declared liquor baron Vijay Mallya a wilful defaulter, following which other banks such as SBI
and PNB followed suit. Mallya, who subsequently fled the country to the United Kingdom, owes Indian banks nearly Rs 9,000 crore. Efforts to bring him back haven’t succeeded yet, nor have any other promoters or bank officials been brought to book. In the Kingfisher loan case, Yogesh Agarwal, former CMD of IDBI Bank, was arrested along with another former bank executive in January 2017 but granted bail later. According to the CBI, both these officials showed “undue favours” to the now-defunct Kingfisher Airlines, sanctioning a loan of Rs 1,000 crore despite its “weak financial record”. In 2014, S.K. Jain, ex-chairman and MD of Syndicate Bank, was arrested for accepting bribes to sanction Rs 8,000 crore worth of loans. He was subsequently removed from office. In 2013, Shyamal Acharya, a deputy MD of SBI, was charged by the CBI in connection with a case of bribery, but an internal enquiry by the bank exonerated him of the charge later that year. A year later, he was reinstated by the SBI as a deputy MD in the bank’s inspection and management audit department, based in Hyderabad!
HOW TO FIX IT
By putting IBC in place, the government and the RBI are in the process of cleaning up the NPA mess by enabling faster sell-offs of companies through the National Company Law Tribunal (NCLT), which is a work in progress. The government is also planning to infuse Rs 2.11 lakh crore in PSBs to recapitalise them.
Observers point to a systemic failure, which could have been addressed to some extent had the government chosen to implement some of the recommendations of the P.J. Nayak committee on governance issues in banking. The committee had submitted as many as 82 structural recommendations to the then RBI governor Raghuram Rajan in May 2014, but only six or seven of them have been implemented so far, according to banking consultant Ashvin Parekh. “On governance and change management, the Nayak committee report had warned of possible loopholes during the migration from the manual system to technology,” says Parekh. In both operational as well as interface technologies, the design elements raised questions. What was evident was that the changes effected were more like translating the system rather than re-engineering it, he says. “The system was not keeping up with the challenges in banking. Some of those questions raised are becoming pertinent in the present context. For instance, how could someone issue an LoU, without touching core banking?”
Second, the banking system in India is fairly elaborate, too dispersed with multiple touch points, unlike in the US or Europe. Controls in the system were designed keeping this kind of spread in mind, but in a different era. “Have we created controls that match the requirements of today? No. The system is leaking everywhere, as is evident both in the rising NPAs and the number of frauds,” says Parekh. The third element is the question of quality of supervision of internal audit, be it paying statutory auditors adequately or getting reputed firms to carry out audits.
FAILURE 3 AUDITORS: CRIMINAL NEGLECT
On the face of it, the bank’s auditing system looked foolproof. An official of the rank of assistant general manager is the manager of PNB’s Brady House branch. A concurrent auditor tracks all daily transactions and gives a report at the end of the day, which both the concurrent auditor and the manager sign. It’s then sent to the head office. Since the auditor reports to the bank HQ, he cannot be influenced. But in PNB’s case, the transactions sidestepped the bank’s core banking network.
Also, when the transactions took place in PNB’s nostro account, they should have been reconciled in the bank’s treasury branch, but weren’t. Even the overseas branches that lent the money turned a blind eye to the various lapses.
The third level of checking comes with the statutory or external auditors. However, in many cases, they rely on internal audit reports. As per PNB’s annual report for 2016-17, its auditors were Chhajed & Doshi, R. Devendra Kumar & Associates, Hem Sandeep & Co, Suri & Co and SPMG & Co. Then there are the RBI auditors, who deal with the head office but do not examine the bank’s day-to-day operations. “What are our auditors doing?” asked finance minister Arun Jaitley. “Both internal and external auditors have looked the other way.”
HOW TO FIX IT
To improve the bank’s internal audit function, says Bahl, it is crucial to reassess coverage and components (including execution methodology) of existing audits such as internal, IT, concurrent and management etc. to align them with dynamic risk assessment and regulation change. What is needed is a centralised transaction monitoring unit that triggers early warning for reconciliation bypasses, inadequate margins, breach of guidelines etc. The existing internal audit organisation structure and allocation of roles and responsibilities needs to be enhanced to improve the overall functioning of the unit and setting up a realtime management reporting framework.
FAILURE 4 RBI: MISSING IN ACTION
Critics say the central bank has been too busy fighting inflation to focus on other aspects of its mandate as regulator of the banking business and protector of the consumer. In the PNB fraud, many are baffled that even RBI’s auditors could not trace the scam.
HOW TO FIX IT
“There is an important challenge where the supervisory agencies now have to introspect what are the additional mechanisms they have to put in place to make sure that stray cases don’t become a pattern and it is nipped in the bud,” says Jaitley, in an obvious reference to the RBI’s responsibilities in preventing such frauds. In what is being seen as a fallout of the PNB scam, the RBI, on February 21, announced the setting up of a panel under the chairmanship of Y.H. Malegam, a former member of the central board of directors of the RBI, to study the rising cases of bank frauds and set out a blueprint to curb them.
FAILURE 5 GOVERNMENT: BUSINESS IS OUR BUSINESS
The government, being a majority owner in PSBs, cannot shirk its responsibility in this case. Although it cannot interfere in the day-to-day working of the banks, it can put in place systems for better detection and prevention. “We need PSBs to fulfil the government’s social and development objective. The government could consider a holding company for banks which is professionally managed to push PSBs to adopt better governance practices,” says a senior bureaucrat. The muchtouted Banks Board Bureau, set up in 2016 to bring about a holistic makeover of PSBs, under the leadership of former CAG Vinod Rai, hasn’t lived up to its expectations. With Rai set to retire in March, the bureau’s fate remains uncertain.
HOW TO FIX IT
The government has created several avenues to interact with top officials of banks and share ideas. One was the ‘Vichar Manthan’ where the FM would deliberate on key issues affecting the banking sector with the CMDs of these banks. This is on the lines of the ‘Gyan Sangam’ initiated immediately after the present government came to power.
Chief Economic Advisor Arvind Subramanian has made a case for privatisation of PSBs, but if that alone were the answer, no private bank would stand accused of malpractice. Also, bank appointments are based on years in service rather than expertise. PSB jobs are like quasi-government jobs. A senior bureaucrat believes it is time now for the Indian Banking Association to assess systemic failures that let lower level bank officials issue LoUs of such massive sums. Usually, every branch manager can sanction only a certain amount; large amounts require higher level approvals.
Meanwhile, a political slugfest is on with both the BJP and Congress blaming each other. Union law minister Ravi Shankar Prasad claimed a majority of the “loans” sanctioned to Nirav Modi were during Congress rule between 2011 and 2014. However, a CBI FIR filed on February 15 says Modi and his firms swindled Rs 4,886.72 crore in 2017-18 alone by getting 143 LoUs issued through PNB. Lawyer-activist Prashant Bhushan blames the politician-businessman nexus. “There has been complicity at higher levels, and a political signal to these banks to allow these to go on. Otherwise it is very, very unlikely,” he told a news channel. Whistleblower mails have been ignored, both in 2013 and in 2015. Dinesh Dubey, a former government-nominated director of Allahabad Bank, has come out in the open to say loans were granted to Gitanjali Gems despite his dissent note in 2013. He claims to have written to the then RBI Deputy Governor K.C. Chakrabarty. Similarly, Bengaluru-based businessman Hari Prasad has also come out to say he had registered a complaint with the city police against Choksi and his group companies in 2015, after he allegedly cheated him of Rs 13 crore. He claims to have written even to the Enforcement Directorate, CBI, SEBI and the Prime Minister’s Office. The PMO sent him a reply saying the complaint had been forwarded to the Registrar of Companies, but there was no progress thereafter. Santosh Shrivastav, former MD of Gitanjali Gems, on February 19 claimed there were severe issues of corporate governance violations at the firm, but these were suppressed by the influential Choksi.
WHO RECOVERS THE MONEY?
Nirav’s properties and goods worth Rs 5,000 crore have been confiscated, but the scam has eroded the brand and a subsequent selloff may not yield much
The process of litigation and recovery of money from Modi and his family will be a long drawn out one, and could take several years. Investigating agencies have reportedly sealed or confiscated goods or properties of Modi worth over Rs 5,000 crore across various locations. But that will also lead to a steep erosion in the value of the Nirav Modi brand; a subsequent selloff will not yield much. In a letter Modi wrote to the PNB management, he pegged the amount his companies owes the bank at under Rs 5,000 crore, and said it will be hard for him to pay up now that the issue has attracted so much media attention. “The erroneously cited liability resulted in a media frenzy which led to immediate search and seizure operations, which, in turn, resulted in Firestar International and Firestar Diamond International effectively ceasing to be going-concerns,” he reportedly said in his letter. “In the anxiety to recover your dues immediately, despite my offer (on February 13, a day before the public announcement, and two days later), your actions have destroyed my brand and the business and have now restricted your ability to recover all the dues.” (india today has not obtained this letter).
Finance minister Jaitley had announced in his budget speech last year an intent to introduce a law to confiscate assets of economic offenders who leave the country. “In the recent past, there have been instances of big-time offenders, including economic offenders, fleeing the country to escape the reach of the law. We have to ensure that the law is allowed to take its own course,” he had said. Perhaps the government can make the Modi saga a test case for effecting that law.
How much of the onus of the current fraud is on the PNB? “In this case, PNB is going to be responsible for paying up the entire money,” says a banker. Reports also say the RBI has directed the bank to pay the full amount to the counterparty banks. “We will honour all our bona fide commitments,” Sunil Mehta, PNB’s MD, told the media recently.
But the PNB scam could just be the tip of the iceberg. As more and more rigour is built into the system, more cases of unscrupulous misuse of public money may emerge. But this is a pain the Indian banking system will have to endure. Till then, it will remain mired in the muck of misgovernance, plunging further into inertia that could mark its collapse.