Stocks of Indian jewelers and state-run banks have been sinking since Friday, when the full extent of what's now understood to be the largest bank fraud case in Indian history was unveiled in a complaint to Indian federal banking regulators filed by the the Punjab National Bank, a state-owned bank based in New Delhi.
The bank discovered the first bread-crumbs in January, but the full extent of the fraud - which was carried out over seven years and involved the theft of nearly $1.8 billion - wasn't known until very recently. And before today, when Reuters published a report fleshing out some newly uncovered details, little was known about the mechanics behind it.
The pressure has dragged the S&P BSE SENSEX - an index of some of India's most established companies - lower.
Last week, we learned that the fraud involved Nirav Modi, one of India's 100 richest men and a well-known jeweler who has dressed both Hollywood and Bollywood stars, was at the center of the conspiracy. He was aided by Mehul Choksi, whose Gitanjali Group of companies was intimately involved in the fraud. Finally, the third key conspirator was PNB branch deputy manager Gokulnath Shetty, who oversaw the circulation of fake "letters of undertaking" - essentially one bank vouching that a certain client is credit-worthy and should qualify for a loan from another bank.
From the broadest possible perspective, the fraud unfolded as follows: Modi and Choksi controlled a group of fraudulent jewelry companies. Shetty would circulate "letters of undertaking" vouching for collateral that didn't really exist. Based on these letters, the shell companies secured loans from foreign branches of India-based banks. This money then disappeared.
A fourth individual - a junior employee who worked for Shetty - is also being held but his or her involvement is still unclear.
But in the first major review of the case by an English-language media organization, Reuters said the details available overwhelmingly point to a shocking failure of oversight by both India's banking regulators and the state-owned bank's internal controls. As a result, criminals were able to steal early $2 billion from PNB largely because nobody was watching.
A review of bank and government documents related to the case - and interviews with current and former PNB executives, bank auditors and experts - points to a lack of accountability and standards in the country’s public banking system.
As of last September, those banks held about 87 percent of the Indian banking system’s 9.46 trillion rupees (about $147 billion) of soured loans that are non-performing, restructured or rolled over.
A preliminary investigation by the nation’s tax authority said of the PNB fraud that “the hit Indian banks would take in the end may well exceed” $3 billion, according to an internal note seen by Reuters.
“Yes, there is a problem. We have recognized it,” bank Chief Executive Officer Sunil Mehta said during an investor call on Friday. “We are in the process of fixing it up. We’ll see wherever the loopholes are there. The people-related risk, we are going to mitigate.”
But despite that promise of action, one current senior executive at the bank’s headquarters in New Delhi said further problems could not be ruled out.
“In Indian banks, we don’t work under ideal situation,” the executive, who declined to be identified, said during an interview at his office. “We are in the business of risk, you can’t say there won’t be road accidents.”
Reuters also provided the most detailed account yet of how Shetty was able to circulate the fraudulent letters to other Indian banks...
According to court documents filed on Saturday by the CBI, branch deputy manager Gokulnath Shetty issued a series of fraudulent Letters of Undertaking – essentially guarantees sent to other banks so that they would provide loans to a customer, in this case a group of Indian jewelry companies.
These letters were sent to overseas branches of banks, thought to be almost all Indian, that would then lend money to the jewelry firms.
Shetty did so using the bank’s SWIFT system to log in with passwords that allowed him, and in at least some instances a more junior official, to serve as both the person who sent messages and as the person who reviewed them for approval, according to court documents and interviews with bank executives.
“The involvement and connivance of more staff members and outsiders at this stage cannot be ruled out,” said a CBI document submitted to the court in Mumbai.
After entering the transactions on SWIFT, the CBI documents said, Shetty – who worked at the same branch from 2010 to 2017 despite normal bank practices of regular rotations - did not record them on the bank’s internal system.
Because PNB’s internal software system was not linked with SWIFT, employees were expected to manually log SWIFT activity. If that was not done, the transactions did not show up on the bank’s books.
A SWIFT spokeswoman said in a statement last week that the company does not comment on individual customers.
All together, there were at least 150 such fraudulent Letters of Undertaking during a seven-year period, according to a CBI official who spoke on the condition of anonymity.
As one of the bank's auditors' said, the fraudulent transactions was "off books".
The mechanics of how the fraud happened, and what it says about the underlying industry culture, are worrying, said Abizer Diwanji, national leader for financial services in India at accounting firm Ernst & Young.
“Checks and balances are there in public banks as well but they are not followed earnestly,” said Diwanji, who has tracked India’s financial services industry for more than two decades.
“This is where the discipline, the culture is not there. I always believe that we don’t have the culture to manage risks, even operational risks. PNB is not an outlier in this.”
To control such risks, most private sector banks require branches to route SWIFT messages through their central offices, Diwanji said. They also usually integrate their own software systems and SWIFT, meaning that activity such as a Letter of Undertaking being sent would get automatically recorded.
Neither is the case at PNB or most state-run banks in India, Diwanji said.
Representatives of two of the external audit firms listed on PNB’s annual report for the 2016-17 fiscal year said they could not have known what happened.
“It was off-books, so auditors will not be in a position to detect it,” said Sudesh Punhani, a partner at Chhajed & Doshi.
The question now is: Will Indian banking regulators make the hard but necessary decision to force banks to integrate their systems with SWIFT while strengthening other oversight tools? Even if it risks uncovering other embarrassing fraud cases?
Remember, it was just October, when we discussed Indian Prime Minister, Narendra Modi’s, decision to hand over $32bn to recapitalize India’s state banks. The motivation was India’s slowing growth rate and the need to add one million Indians to the workforce every month. India has the second highest bad debt ratio of the world’s largest economies – possibly third since China’s official figure is patently incorrect.
Crippled by massive bad debts, the state-owned banks were struggling to extend more credit to the economy. The announcement caused a surge in India’s Sensex equity index, led by the banks.
So much for that? Time for another bailout!!