Indian banking sector is divided into two. There are public sector banks, and then there are private sector banks. The public sector banks, i.e., banks owned by the government are known as bureaucratic organizations where inefficiency is rampant. However, these banks are also known to be prone to corruption. This is because executives at state-owned banks are often under pressure to discard lending norms and guidelines. Politicians often ask these banks to give loans to their cronies even if they do not meet the required norms and standards.

There have been several scams that have taken place in the Indian banking system. However, the recent one has been the biggest in size. Punjab National Bank, i.e., a state-owned Indian bank is said to have lost more than Rs. 11,300 crore or $1.7 billion in this scam. This scam happened when an Indian businessman named Nirav Modi colluded with bank executives to swindle huge sums of money from the banking system.

In this article, we will have a closer look at the scam and how it was possible despite banks having systems, checks, and balances in place.

What is a Letter of Undertaking?

A letter of undertaking (LOU) is a mechanism to secure overseas credit for importing goods and services. When an importer buys goods, they need to make payment to an overseas bank on behalf of the exporter. Sometimes, they may not have the funds to do so. In such cases, they can ask a domestic bank to issue a letter of undertaking. This letter of undertaking is basically a guarantee from the domestic bank that they will pay the foreign bank in full, i.e., principal and interest.

On receipt of this letter of undertaking (LOU), foreign banks offer credit which can be used to pay the exporter. Usually, such letter of undertaking (LOU) is given only if the importer provides a significant amount of margin money to the domestic bank. The fraud done by Nirav Modi was that he had bribed bank officials to illegally obtain letters of undertaking (LOU) without paying and margin money. This basically amounted to an unsecured loan at very low-interest rates.

For instance, if Punjab National Bank issues a letter of undertaking (LOU) to Mr. Nirav Modi, he can then take it to the Hong Kong branch of HSBC bank and obtain credit. This credit can then be used to pay suppliers. Nirav Modi and exporter are no longer relevant to this transaction. In the end, Punjab National Bank now owes money to HSBC!

A letter of undertaking is a short-term credit which expires in 45 to 90 days. This scam has been going on for seven years! This is because each time these bills became due, they were rolled over. This means that new letters of undertaking (LOU) were issued and the money obtained from them was used to make payments for the old letters of undertaking (LOU).

Who Was Paid With These Letters of Undertaking (LOU)?

The nature of the fraud becomes even more bizarre when the transaction that Nirav Modi was entering came to light. A prima facie look at the details shows that Mr. Modi was paying off himself with these transactions. As a result, he was basically swindling money from Punjab National Bank to his own account.

Most of the companies that the payments were made to belonged to Dubai or Hong Kong. These countries are known to allow set up of companies without too many background checks. These companies which were party to millions of dollars of transactions are notoriously opaque. Most of them do not even have a website and very few of these entities held money in their own accounts. As soon as they received the payments, they used a complex web of entities to funnel money. The final beneficiary of these transactions has not been determined. However, it would be safe to assume that it would be Mr. Nirav Modi.

What Were the Governance Lapses at the Indian Bank?

This mega scam also brings in to question the strength of the systems being used by the banks. How could the banks not be aware of a scam which was happening in their backyard for seven long years? There are two major points to consider:

1. Firstly, Indian banks route all their transactions from Central Banking System. This is the sole system that is used to monitor the assets and liabilities of these banks. However, letters of undertaking (LOU’s) are contingent liabilities and are not monitored using the central banking system. Hence, while Punjab National Bank was monitoring the CBS system, the scam was taking place outside this system. Since the fraudulent employees and Nirav Modi skipped the CBS system altogether, they were never caught during these years.

2. Secondly, a low-level bank employee had the authorization to open letters of undertaking using the SWIFT messaging system. The bank should have ensured that this access is restricted by the dollar value of the transaction. A low-level executive should not have had the power to make the bank liable for $1.7 billion

To sum it up, this scam will make matters even worse for Indian banks who are already reeling under the pressure of non-performing assets. The public confidence has taken a beating and Punjab National Bank is almost facing a bank run.