Although protection mechanisms are required to prevent corruption, money-laundering and financial frauds and scams, it cannot be emphasised enough that the real solution lies in prevention rather than cure, observes Arshad Shaikh
Earlier this month, a massive banking fraud came to light. The Punjab National Bank (PNB) reported that it had been defrauded by one of its clients and it had suffered losses to the tune of $ 1.77 billion or Rs 11,700 crores. The news that threw memories of the Harshad Mehta Securities scam in the 90s, made immediate headlines with the PNB stocktaking a southward dive and the media whipping up frenzy as the principal accused in the scam was one of India’s Forbes billionaires – Nirav Modi. But the scam has thrown up more questions than answers and shaken the banking industry to its very core.
People wanted to know how a fraud of such magnitude and scale could take place without the wilful endorsement of those in the highest echelons of power. The answers came in the form of a blame-game with the politicians blaming the auditors and the central bank while the banking fraternity hinted at systemic problem and negative externalities of operational risks. In the end, the much flaunted resilience and reliability of the banking industry has taken a big hit and exposed the fault lines in the way our economy and financial systems are managed.
How did they do it?
Nirav Modi is an importer of diamonds. Importers prefer to take loans in foreign currencies as they come with lower interest rates. Nirav Modi’s firm approached the PNB for what is known as buyer’s credit. Buyer’s credit is a loan that is originally taken from an overseas bank but backed by a local or home bank, in this case the local bank being the PNB. The local bank has to issue a LOU (letter of understanding) to the overseas bank. LOU is essentially some kind of an assurance to the primary lender (overseas bank) that the client seeking the loan is genuine and having sound “credit-worthy” credentials. The overseas banks are again basically the foreign branches of Indian banks. This LOU is thus between the local or home bank and the overseas bank issuing loan to the client. This means that the loan is actually issued by the overseas bank to the local bank and not the end user (or the client seeking the loan). The home bank creates what is known as a Nostro account to which the funds are transferred by the overseas bank.
PNB is now accusing Nirav Modi of siphoning the funds meant for imports to some other financial activities and transactions for funding his business. There are various conjectures about how the LOUs were misused by Nirav. One supposition is that old LOUs were used up for different business activities and then new LOUs were issued to payback the old ones; like a “ponzi” scheme. Another theory is that the LOUs were continuously extended giving the client almost free access to unlimited funds for an extended period of time. But how can so much credit be issued and disappear without a trace or some kind of audit or supervision?
Gaping holes in technology?
In normal circumstances when credit is extended to a client in any form, the credit-worthiness is checked thoroughly and appropriate collateral is demanded to back the loan in case of default. In the case of PNB scam this basic and fundamental process was corrupted and completely bypassed, but how? Scamsters are experts in exploiting loopholes in technology for their own benefit. LOUs are issued using a system called SWIFT (Society of Worldwide Interbank Financial Telecommunication) that are encrypted messages wired across two transacting businesses. In India all banking transactions are recorded on CBS (Core Banking System). If SWIFT comes in the picture, it is mandatory for banks to have a common interface with CBS. PNB did not have this interface in place. Now RBI has issued a circular demanding all banks to link the SWIFT system with CBS by April 30. PNB claims that the LOUs were managed through SWIFT by some corrupt bank officials who are culprits and deserve punishment. But is it that simple?
Who else are the culprits?
The whole narrative of a few corrupt bank officials looking after SWIFT were responsible for this scam seems quite ludicrous as issuance of credit (asset creation in the balance sheet of the bank) at such a scale and for so long to escape the watchful eyes of the bank’s top brass is hard to believe. The role of PNB’s auditors is also very questionable. How could they allow this huge fund transfer go undetected and not being recorded in PNB’s balance sheet? The role of overseas banks in the case of PNB scam like Allahabad Bank, Union Bank of India and Axis bank is extremely suspicious and requires an in-depth examination. The nation’s central bank, the RBI too is receiving flak for not imposing stringent regulatory frameworks, fool-proof systems and tougher lending norms. Of course the government of India’s Ministry of Finance too cannot wash its hands of the whole affair as it is the biggest shareholder in any public sector bank and it won’t be incorrect to paraphrase the axiom – “the buck stops here”.
Damage control, too little too late?
PNB has suspended some managers and law enforcement agencies have arrested bank officials who are suspected to be complicit in the scam. The government has promptly divested itself of all responsibility by blaming the central bank, their auditors and systemic failures within the banking industry for the scam. The Reserve Bank of India (RBI) constituted an expert panel that will look at the divergence in asset classification and provisions reported by banks vis-à-vis those interpreted by the central bank’s auditors, and also to examine the rising incidence of fraud in the banking system. The panel will be headed by former RBI board member Y H Malegam, who had also earlier led several RBI committees on important reform measures.
In a statement RBI said: The panel will explore “factors leading to an increasing incidence of fraud in banks and the measures (including IT interventions) needed to curb and prevent it; and the role and effectiveness of various types of audits conducted in banks in mitigating the incidence of such divergence and fraud.”
Money grows and men decay
The Irish playwright and writer George Bernard Shaw once very aptly titled one of his writings – “How wealth accumulates and men decay.” The insatiable thirst for accumulating more and more wealth without any moral qualms has been the bane of many with many more paying a huge cost for this malaise. The PNB scam and many such similar frauds being unearthed show that unbridled greed can find its way through any amount of precaution and fool-proof system of checks and balances to prevent theft, fraud and perjury.
Although protection mechanisms are required to prevent corruption, money-laundering and financial frauds and scams, it cannot be emphasised enough that the real solution lies in prevention rather than cure. Islam promises success to its followers both in this world and the Hereafter. Islam inculcates in its followers that this world is an examination in which God has sent man for a limited period of time and the verdict about his future will depend on how well he utilises his powers and capabilities in this examination, how he utilises the resources entrusted to him by the Will of God and how he behaves with people which God has linked to his life.
With such a noble and pious attitude, there can never ever be misappropriation of power, money and resources. Accountability before the Creator, Master of the Day of Judgment, the Provider and Knower of the unseen, Who sees and knows all, becomes the driving force behind fair and honest trade, business and mercantile activity. We are in the midst of a crisis of confidence: confidence in our systems, our present and our future. But, as Roosevelt said, Confidence… thrives on honesty, on honour, on the sacredness of obligations, on faithful protection and on unselfish performance. Without them it cannot live.