Lessons from PNB scam: keep an eye on the little things

"It has long been an axiom of mine that the little things are infinitely the most important," says Sherlock Holmes in Arthur Conan Doyle's A Case of Identity.

Nirav Modi and his men either did not know what Holmes thought or seem to have forgotten this when they systematically skimmed Rs 11,500 crore off Punjab National Bank. The fraud came to light to a "little thing" that Modi and his men appear to have ignored - the key PNB official who was their co-conspirator had to retire someday. Unfortunately, for them, the man who replaced him not only refused to issue fresh LoUs (Letter of Undertaking) without collateral, he also went looking into the previous ones that had been issued. Many skeletons came tumbling out of the cupboard.

Amidst all the hullaballoo surrounding l'affaire PNB, the most common question that crops up is, "Can such events be prevented in the future?" The most appropriate answer to the question is, " It depends" - because if there is no connivance with the bank officials, robust internal processes can prevent such episodes, but if bank officials become co-conspirators, they will always find a way around their own systems. As the PNB affair plays out, regulators will put in new regulations and investigating agencies will go about their arrests.

The modus operandi in the PNB affair had all the elements required for a fictional novel - the importer approaches a bank for an import loan, the bank quotes an 'Indian' rate of interest hovering around 10%, the importer decides to take a loan abroad at a 'foreign' rate of interest, but asks the bank to stand guarantee for him.

The bank gives the guarantee since they stand to get a reasonable commission and the amount borrowed is supposed to be repaid by the importer in some time. Since the bank located abroad knows only PNB and not the importer, it deposits the loan amount into PNB's 'Nostro' account. Up to this point, it is a perfectly normal banking transaction.

When the date for repayment comes, though, either the importer does not have the money to repay the loan or he does not have the intention to (the latter appears to be applicable in this case). When bank officials insist on repayment, the importer takes out another LoU to pay off for the first one. And this repeats itself every time repayment becomes due, eventually becoming hundreds of LoUs. Nobody else is apparently aware of what's going on except only the official issuing the LoUs and Modi and his associates.

The bank guarantee or undertaking is conveyed to the foreign branch of the Indian bank which is actually giving out the money through a SWIFT message. At the core of the PNB scam is the fact that the SWIFT message itself was fraudulent- issued bypassing PNB's core banking system and whatever internal rules and processes it may have had.

Who is to blame for it? Normally, in incidents of such magnitude, the full facts are never out. Apart from Modi and his associates, the bank official, the co-conspirator, has to be blamed along with the management and the concurrent auditors. Whatever the bank may say, it is impossible to believe that such a large exposure did not raise a red flag for anyone for seven years.

A reconciliation of the Nostro account would have revealed old balances that were outstanding - this should have been done by any of the teams of auditors that banks have. The management should have kept an eye on the unusual transactions in Nostro accounts. Typically, Nostro accounts are an ocean of debits and credits and a reconciliation would not have been attempted either due to the enormity of the task or due to the mistaken impression that nothing can go wrong in a Nostro account.

It has been reported that Modi's co-conspirator in the bank had held the same crucial position for more than five years - an unpardonable lapse of internal controls. The SWIFT messages are said to have bypassed the core banking system -- one can perhaps now expect changes in the core banking systems to ensure that some sort of cross-referencing data is available for off-balance sheet exposures.

Lessons to learn

To minimise PNB-type incidents in the future, it is important to change the way we look at our banks. Presently, there is a feeling amongst many that Indian banks are soft on defaulting or fraudulent borrowers and, irrespective of what happens, the banking relationship can be "managed". Schemes such as debt restructuring and loan waivers only strengthen this view. Banks can help change the way we look at them by imposing strict penalties on the conspirators and by not bending the rules to grant political favours.

The RBI should also send out a strong statement empowering banks to take whatever action they deem fit the moment they come across a fraudulent transaction, instead of having to fill in lengthy reports before taking any action, by which time the fraudster would have done the vanishing act, as in the present case. Where necessary, the regulator and the banker should walk the talk and publicise action taken against recalcitrant borrowers.

Considering the facts that are floating around, it is difficult to believe that the PNB instance is an isolated one. There are likely many PNB-type LoUs that have been discovered in the wake of the Nirav Modi affair and banks must be taking steps to ensure their collection or getting ready to write-off the monies. The PNB scam is a lesson for everyone - the regulator, bank employees, investigators and auditors. We can only hope that as the learning continues, such incidents become exceptions rather than a regular occurrence.  

(The writer is a Bengaluru-based tax expert)