Public Sector Banks (PSBs) in India had for long been the poster boys of steady growth in the country. The customers seemed happy with the healthy returns they got on their deposits, stashed away safely – largely insulated from market risk. The bankers were content with the stability, esteem and relative autonomy associated with their job. The government too was satisfied – conveniently piggy-backing on the banks for financial integration of the rural population, tax collection on fixed deposits and what not. The regulators didn’t have much to worry about either, with their capital adequacy ratio norms (stricter than the global Basel norms) being comfortably complied with by Indian PSBs.
But then, things started going wrong. The PSBs had avoided putting the depositors’ money at risk by staying away from the risky investments that mutual funds and the like are typically known for. They had instead lent it out to corporates (going concerns believed to have robust payback capabilities) and aam junta (with collateral and/or human guarantee sufficient to enforce recovery), hoping to get it back with interest on time. What had skipped everyone’s attention was that market risk wasn’t the only type of risk at play – credit risk (manifesting itself in defaults) and operational risk (resulting in frauds) were equally dangerous adversaries.
No other case brought credit risk to the fore like that of Kingfisher Airlines, which was found to owe over 9000 crore in loans to 17 banks – a large majority being PSBs. Given the glamorous reputation of the accused owner and the colossal sum of money involved, the case stoked interest among the media houses and was readily lapped up by them. The common man – with the willingness to pay (WTP) but often devoid of the requisite ability to pay (ATP) – was found hard-pressed, while the affluent – often possessing the ATP but lacking the WTP – seemed to get away scot-free. This realization enraged the aam junta, who felt marginalized.
Still smarting from the Kingfisher revelation, the people of the country were in for another rude shock less than 2 years later – this time inflicted by the other nemesis called operational risk. On 13th February 2018, Punjab National Bank filed complaints with the CBI and the Enforcement Directorate (ED) alleging that 3 Mumbai-based private companies (including Gitanjali Gems) had connived with PNB officials to fraudulently obtain unauthorized Letters of Undertaking (LoUs) and Foreign Letters of Credit (FLCs) that were subsequently used to acquire funds from foreign branches of other Indian banks. Since LoUs and FLCs practically serve as guarantees, PNB claimed it was liable to pay back an outstanding amount of almost USD 750 million between February and July 2018 if the beneficiaries defaulted.
Unfortunately for PNB, the event of a default however wasn’t as stochastic in this case as it usually is. It was a foregone conclusion the moment the fraud came to light, given the modus operandi employed by the perpetrators – as explained in the FIR registered by the CBI. To understand it, let’s take a simple example. Imagine you take a loan of INR 10,000 from a bank to buy yourself a phone. When it’s time to repay the loan, you borrow another INR 12,000 from the same bank and use most of that amount to settle the previous debt. Again, when you need to repay the second loan, you take a third one and use it to settle the second. This ensures that you never default on a loan, even though you never set aside your own funds to repay it either. Things fall apart the moment your bank refuses to issue a fresh loan, thereby breaking the cycle.
The above serves as a layman’s explanation of what’s believed to have secretly gone on for almost 8 years in PNB before being discovered in 2018 to everyone’s horror. A couple of PNB insiders are alleged to have exploited a glaring loophole in the book-keeping mechanism of the bank to facilitate this swindling. The loophole involves 2 of the most important systems at the disposal of any PSB – CBS (Core Banking Solution) and SWIFT (Society for Worldwide Interbank Financial Telecommunications). The CBS works on an intranet within a bank and is, among other things, used to record all financial activities involving the bank. SWIFT works on the internet and is used to send electronic messages from one bank to another for, among other things, intimations about issuance of LoUs and FLCs. Traditionally, the 2 systems operate independent of each other – partly to ensure the safety of the data on CBS and partly due to lack of will for a tedious upgrade. Within a branch, even the computers used to operate the two are often different. This lack of linkage between CBS and SWIFT means that a manual entry (eg. – for the issuance of an FLC/LoU) first needs to be made on CBS, and only then a message intimating the other bank is to be sent through SWIFT. Performing only the latter step would essentially intimate a foreign bank of the LoU/FLC without ever recording its issuance at the issuer’s end. This is exactly how the fraud is understood to have been carried out.
In addition to the glaring transgression of not recording LoUs and FLCs on the CBS as described, there are several finer rules that were flouted in this entire charade. A cash deposit of 100% or more (i.e. to get a loan of $1000 from a foreign bank branch in the US, you need to deposit its INR equivalent or more – as per the rules of the issuing bank branch – back in India at prevailing exchange rates) is needed to obtain an LoU/FLC, unless the credit has been especially sanctioned by the bank. There was no sanction by or
Figure 1: Simple schematic explanation of an LoU
Figure 2: Simple schematic explanation of an FLC
cash deposit at PNB in this case. Import documents (with supplier details) too are typically required to be submitted as proof for what the funds sought are needed for. Such documents were never asked for either. Also, the RBI had stipulated that LoUs/FLCs issued for the import of rough, cut and polished diamonds could have a maximum credit period of 90 days (only ‘clean credit’ for import, i.e. one obtained without guarantees in the form of FLCs, LoUs etc., could be for a maximum period of 360 days – that too in special cases). However, all the FLCs and LoUs issued in this case were for a period of almost 1 year, thereby violating the norm. This has also brought under the scanner the foreign branches that acted on the FLCs/LoUs to release funds, since it’s strange even they didn’t notice that the FLCs/LoUs weren’t as per norms. The fault is not restricted to just the accused PNB officials and the foreign banks, though, as the rest of this paragraph may seem to suggest – the borrowers too have obviously been identified as culprits. In addition to being complicit in getting the fraudulent LoUs/LCs issued, they are also accused of not using the funds for the purposes they were issued for and instead utilizing them to settle old debt among other things.
The case has had plenty of repercussions, unsurprisingly. CRISIL has added the negative remark of ‘rating watch with developing implications’ to its outlook on the creditworthiness of various types of bonds issued by PNB. Taking cognizance of the modus operandi of the fraud, the RBI has instructed all PSBs to link their CBS with SWIFT by the end of April and has also banned the issuance of LoUs altogether. PNB now runs the risk of being taken under RBI’s Prompt Corrective Action (PCA), which will restrict the bank’s lending capacity, infrastructural expansion and workforce growth. As for the share market, it seems to have been caught completely off guard. In fact, just before the first maturation (since the fraud began emerging) of fraudulent LoUs happened on 25th January, the PNB share seemed to be in great demand – the traded volume increased almost 350% and the share price went up 11% all in a matter of just 2 BSE sessions. The market continued to carry on blissfully unaware till PNB officially provided it with price-sensitive information under Regulation 30(6) of SEBI’s Listing Obligations and Disclosure Requirements (LODR). The intimation on 14th February about the fraud’s magnitude being almost 11000 crore sent shockwaves across the market. It led to the traded volume going up about 1150% and the share price falling almost 21% in as few as 2 BSE sessions. The next intimation on 26th February (about the possibility of an additional 1300 crore getting added to the fraud’s monetary value) led to similar panic, with the traded volume increasing 370% and the share price going down 12% in a single BSE session. Overall, the share price has plummeted from a high of 194.55 on 24th January to almost half that number, and will be closely watched going ahead pending further developments.
(Any opinions expressed in this piece are personal and may or may not be endorsed by any of the bodies/organizations I’m associated with.)