Everything you need to know about the $1.8 billion PNB-Nirav Modi fraud

Quartz india
Quartz india

India is currently dealing with what likely is its biggest bank fraud so far.

Companies owned by diamond merchants Nirav Modi and Mehul Choksi are alleged to have swindled Punjab National Bank (PNB) of over Rs11,000 crore ($1.77 billion). Amid speculation and a flurry of reports on the nature and magnitude of the scandal, here’s a basic list of questions and answers on the alleged crime.

When did the fraud take place?

Between 2011 and at least 2017. It was detected in the third week of January 2018, according to the PNB management which approached the Central Bureau of Investigation on Jan. 29.

How was it carried out?

In 2011, ​i​t began with a a much smaller amount with a single letter of undertaking (LoU)​ worth around Rs800 crore.

What is a letter of undertaking?

It is a guarantee that a bank is obliged to repay the loan if the actual borrower—Nirav Modi in this case—fails.

So, were the loans approved by PNB?

The first LoU was issued by two PNB employees on behalf of the bank via SWIFT, sanctioning loans to be disbursed abroad.

What is SWIFT?

Society of Worldwide Interbank Financial Telecommunication, or SWIFT, is a system to send instant messages. Once a foreign bank or a foreign branch of a bank gets the LoU via the SWIFT message, it disburses the loan to the borrower.

Where did it go wrong?

When the credit due was not paid in time, more LoUs were issued on behalf of PNB to offset the payment​.

What is “offsetting the payment”?

When the borrower did not repay the first Rs800 crore, the bank ought to have stepped in and booked a default by the group company. Instead, the two PNB employees, who were allegedly party to the fraud, issued more LoUs on behalf of PNB, asking other banks to give out fresh loans to the firms. This continued until two weeks before the whole operation came to light after some of Modi’s employees visited the bank on Jan. 05. The management was caught napping and the overdue loans exceeded Rs11,000 crore.

Are we sure the fraud did not exceed Rs11,000 crore?

“I don’t think so, but we will know after the investigation,” PNB managing director and CEO Sunil Mehta said on Feb. 15. If the probe reveals that the amount exceeded the current estimate, the bank’s liability may increase. “Gross exposure is significantly higher at $1.8 billion, though, at this juncture, it will be difficult to ascertain the financial impact across the banking system as investigations are on,” Edelweiss Research said in a note on Feb.15.

How did the management miss a colossal fraud like this for so many years?

PNB sources say the bank isn’t fully integrated on a ​​Core Banking System (CBS) which could have immediately detected the discrepancy.

What is a CBS?

Gartner defines CBS as a back-end system that processes daily banking transactions, posting updates to accounts and other financial records. It is a centralised software that keeps all records across branches and is capable of generating alerts over any undue activity.

So, India’s second-largest government bank didn’t buy good software?

According to sources, PNB’s integration to a CBS was initiated in 2002. The technology took a decade to become developed. It should have been upgraded by 2012, but wasn’t. It is getting updated now.

Is PNB the only bank without proper CBS?

“Public sector banks continue to grapple with weak systems, raising questions on why the processes are not centralised, unlike most private banks where bypassing CBS is not easy,” Edelweiss said. It added that “the liability on respective banks depends on the investigation’s outcome. Even Bank of India, in the third quarter of financial year 2018, reported stress of Rs9,400 crore pertaining to stand-by letter of credits discounted by its overseas branches.”

So, without good software, the two employees were able to game the system?

Yes, the two individuals apparently colluded with the borrower to wrongfully sanction fresh loans via SWIFT. ​

Shouldn’t banks have other ways of keeping track?

SWIFT transactions are supposed to be regularly reviewed. PNB sources say there is a system to check SWIFT transactions daily by the manager and a concurrent auditor within the branch,​ a norm that was not followed. “We have an internal rule wherein officials are rotated within departments, ideally every few months. But the two accused were in the same role in the same branch for seven years. ​The moot point is, we are at a loss to find out now. So many managers changed, so many auditors and inspectors came and went. How did they bypass everybody?” a PNB official said, requesting anonymity.

Is it the first time that such a fraud had occurred?

No. A bunch of Indian banks faced massive losses due to unpaid loans from Winsome Diamonds, which defaulted for the first time in 2013. The loans given to Winsome, and its associate entity Forever Diamonds, were through similar SWIFT route. However, both Winsome and Forever failed to repay, citing default by customers. The Serious Fraud Investigation Office is probing the case.

Is it possible there were more PNB employees involved?

It is too soon to say. The management has assured investors that it will undertake a forensic audit and look into loans approved under earlier managements, if needed.

Which are the other banks that lent money to Nirav Modi and Mehul Choksi’s firms?

According to sources, Allahabad Bank has the largest exposure—of ​over Rs4,000 crore. Union Bank has anywhere between Rs1,000 crore and Rs2,000 crore, and the State Bank of India about Rs1,000 crore. Axis Bank has over Rs2,000 crore, though it has already sold off those loans.

What will be the impact of the Rs11,000 crore (or bigger) fraud?

Loss of public faith in PNB and other state-owned banks will be the biggest risk. According to RBI regulations, PNB will have to repay other banks the money owed by the firms. PNB sharesholders may see their wealth eroding further as the Rs11,300 crore liability is more than a third of the bank’s market value. The pain will only increase if the probe reveals a bigger scam. This is besides the taxpayer money that will be lost in litigation and getting Modi and Choksi extradited.

Who will pay for the losses?

Reports say that RBI has instructed PNB to pay other banks for the loans disbursed to Modi and Choksi. Other banks will have to set aside money from their profits till the time PNB coughs up the money, and when it does pay up, PNB’s books will then have to show the amount as loss.

Have Modi and Choksi offered to repay?

The PNB CEO said Modi sent an email seeking time to repay, and the management, in turn, has sought a detailed repayment plan.

Where are Modi and Choksi?

We don’t know for certain but reports suggest that Modi may be in New York.

Correction: This post earlier mentioned that the alleged fraud had taken place between 2011 and 2014. In fact, it went on till at least 2017.

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