Commercial Banking Scams

In the previous articles, we have already seen why commercial banking is considered to be very risky. We have also seen some of the errors which led to huge banking losses for related commercial banks. However, those cases involved negligent mistakes.

It is possible that in some cases, the mistakes may not be caused due to negligence. It is completely possible for a group of people to collude and deliberately pull off scams on commercial banks.

These commercial bank scams have happened on a small scale in various parts of the world. However, these same scams happened on a very large scale in India. Within the past decade, the Indian commercial banking system was rocked by two very different commercial banking scams.

It is important for a student of commercial banking to have a basic understanding of how these scams were perpetrated so that systems can be built which prevent the reoccurrence of such scams in the future. In this article, we will have a look at the two biggest scams which were executed using different methods.

1. Nirav Modi Scam

The Nirav Modi scam is named after Nirav Modi, the billionaire jeweller who is believed to be the mastermind of this scam.

Nirav Modi colluded with junior-level bank employees and used a loophole in the technological system of the bank to siphon off more than $1.7 billion from commercial banks. The biggest loser was Punjab National Bank (PNB) which was the second largest public sector commercial bank in India.

1. Collusion with Employees: The Nirav Modi fraud was an inside job. It could not have been executed without the support of junior-level bank employees.

   Nirav Modi bribed the junior-level bank employees so that they create a letter of undertaking (LoU) in his favour without taking any collateral. This meant that when Nirav Modi was transacting, the payments were being made by Punjab National Bank without having any recourse to collateral or guarantee from Nirav Modi. As a result, when these transactions failed, the bank had no collateral which they could seize to make good their losses. The end result was that the bank was left holding non-performing assets with no way to recover them.

2. Technological Cause: The Nirav Modi fraud could have been prevented by the use of technology. One of the main reasons for the fraud is that the SWIFT system i.e. the system which banks used to interact with other banks was not integrated with the bank’s internal systems.

   Hence, bank officers were able to instruct external parties to honor the LOUs issued on behalf of the bank without having any approvals to issue the LOUs on the bank’s internal system. If the internal and external systems were fully integrated, this fraud would not have been possible.

2. ABG Shipyard Scam

The Nirav Modi scam was the biggest commercial banking scam in India for a small period of two to three years. Soon it was overshadowed by the ABG shipyard scam which was almost double in its magnitude. The ABG shipyard led to a loss of $3.5 billion to a consortium of banks in India. This fraud was perpetrated in a different manner compared to the Nirav Modi scam.

Also, ABG shipyard scam led to losses for a lot of private sector banks which was different as compared to the Nirav Modi scam.

1. Diversion of Funds: The ABG shipyard scam was not an inside job. Instead, it was a corporation that was using complicated accounting techniques and taking advantage of lax regulatory procedures to siphon off huge amounts of money.

   The ABG shipyard scam happened as commercial banks lent money to the borrower for one purpose. However, it was siphoned off and used for a completely different purpose. Forensic accounting has revealed that ABG Shipyard created more than 98 different companies for the purpose of siphoning money to offshore locations.

2. Related Party Transactions: The ABG Shipyard scam was executed by creating a huge web of complicated transactions. ABG shipyard lent out the money to various shell companies from where it siphoned off to several related party companies. The end result was that the owners of ABG Shipyard ended up misappropriating the money which was used to buy personal properties. These properties never showed up on the accounting books of the main company. Hence, this was a clear case of embezzlement of funds and criminal breach of trust.

3. Evergreening of Loans: The magnitude of the fraud became so big because of the fact that ABG shipyard was able to pressurize the commercial banks to issue more loans. The financial situation of ABG shipyard had started to go bad a few years before the scam broke out.

   However, banks were compelled to issue more loans in order to be able to serve their earlier investments. This was done intentionally by ABG Shipyard and is commonly known as the evergreening of loans. The end result was that a wide variety of banks had lost a lot of money before the scam came to light.

From this article, it is clear that commercial banking is fraught with a very high risk of scams.

The business processes, as well as the technological systems, are complicated and there is always a chance that even a small loophole will cost the commercial bank billions of dollars. These two case studies can be considered to be a benchmark while building technological systems as well as regulatory systems in order to prevent such frauds.

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