Nirav Modi Saga , what transpired

All the media in india is right now filled with #niravmodi saga so thought of Sharing this for your benefit. A tad bit long but worth a read to understand the Modus operandi. 

There are a lot of statement and political explanations etc . There must be a lot of political , bankers and other business man that might have been sucked by the choksi and modi duo . Because people with these type of tendencies tend to splurge on high and mighty and lead a very lavish lifestyle to give an impression to their investors as being loaded . #niravmodi #pnbmodiscam 

What actually happened in PNB scam? Let’s start from the concept.

First, The Concept

Let’s understand how things work at the bank.

Some importer, let’s call him Nirav Modi or NIMO, wants to import pearls or diamonds and then sell them. The purchase requires money, so NIMO approaches a bank, say Punjab National Bank (PNB).

PNB says look, I’ll give you a loan but it will be like at 10%.

NIMO thinks hard and says, no, that’s too much. Wait, why don’t I take a foreign currency loan instead, after all I’m buying in dollars? Much lower interest rates no? I can get at LIBOR+2% and LIBOR is like 1.5% so I’ll have the money at 3.5% !

But who will give NIMO a foreign currency loan?  
A bank abroad? They don’t know NIMO. They don’t have any history of NIMO, so why will they give him money?

SO NIMO goes to PNB and says, boss, you’re my banker, so please help some foreign bank give me some money to buy diamonds. Say ,that you will guarantee my loan by giving me a “Letter of Undertaking” (LOU).

PNB now should be saying look, if you want me to give Rs. 100 cr. guarantee, you give me stuff worth 110 cr. at least As collateral.

But PNB, for some strange reason, doesn’t ask for collateral, More on that later.

Now the foreign bank is ready to lend NIMO the money. Because PNB will guarantee it. And the foreign bank trusts PNB. 
Why does it trust PNB?

Because PNB sends a message on SWIFT – the banking message service – that PNB guarantees Rs. 100 cr. of money for 180 days for Mr. NIMO at an interest rate of, say, LIBOR + 2%.  It’s like a message – written in stone, effectively – that says PNB will pay if NIMO doesn’t pay , a Sort of Bank Guarantee  .

In fact the foreign bank trusts only PNB. So it gives the money to PNBs account with it, called by PNB as a “Nostro” – the account that PNB maintains with banks abroad, where the other bank will send money meant for PNB customers.

PNB’s nostro account gets the money.

PNB then gives NIMO the money from the Nostro account, usually paid off to whoever NIMO is buying his diamonds from. This payment is usually to someone outside India , to fund a purchase .

Note this carefully: The other bank gives money to PNB’s Nostro account. Not to NIMO. They still don’t care/trust NIMO. They only knows and trusts PNB and  only care that PNB has given a guarantee on the SWIFT channel.

The other bank is nowadays mostly the foreign branches of Indian banks. Because the foreign banks have somehow smelled a rat – that PNB’s guarantee is a strange beast that isn’t backed with much, but we’ll come to that 

The foreign bank couldn’t care less about whether NIMO was buying diamonds or bitcoin – to them, Its the PNB who would pay back .

Why does PNB give a guarantee?
 Fees. 

Each year, a bank may charge upto 2% to give the LoU.

So What Happens When It’s Time To Pay Back?

NIMO has to get the pearls in India, sell them, receive the money and pay PNB. On the due date written on the LoU.

Then PNB will pay back the foreign bank saying okay, we got the customer’s money so we’re giving it back to you. With interest etc.

That’s what is supposed to happen. But apparently things went a little berserk.

The Reality: A Bit of a Ponzi

NIMO might not pay back at all. NIMO might use the money to speculate in the markets. Or do something else.

What if NIMO in the above example simply didn’t have the money to pay back? Instead, he asks a PNB official to open ANOTHER LoU. For the amount owed plus interest. So if we had the first LoU at $10 million the second one is $11 million to cover the interest on the first.

The money from the second LoU is used to repay the first.  It’s just rolling over of credit. Over and over. Standard definition of a ponzi scheme.

This can easily balloon into a larger amount, so large that it’s too much. In effect many such arrangements have turned into semi-ponzi schemes, with one LoU being opened to repay another and so on.

Which is what is likely to have happened.

don’t know the details, but it looks like:

Nirav Modi took loans from foreign branches of Indian banks through an LoU issued by PNB

This was done through a SWIFT based LoU issued through a rogue employee (or many of them) at PNB

The orders never showed up in the core banking system for monitoring

LoUs were rolled over all the way since 2011, and possibly increased over time .

The rogue official retired in 2017, and the replacement refused to roll over the LoU which came due in Jan 2018 because he couldn’t find the past transactions in the system

No rollover means a default, since there was no money to pay. So PNB quickly files an FIR saying oh goodness we have lost 280 cr. on the Jan LoUs

Then someone said, “Abe yaar, is there more of these not-in-system LoUs? Someone check no?”

Then someone checked.

Oh gawd. 11,400 crores.

That’s a lot of crores.

Everyone in the bank panicked.

Why couldn’t Nirav Modi just pay it back? He must have the original money no?

Because if it was ever intended to be paid back, the rollovers wouldn’t have been required. At some point, things got so out of hand that rollovers were required in order to stay current.

Typically this would not be a problem. If PNB had done things right, they would have had collateral worth the amount of guarantee, and they would have sold that collateral and paid the foreign bank.

But, and here’s the real issue:  PNB didn’t have any collateral.

Why did PNB give a guarantee without collateral?

If you and I go for a loan to a bank, they’ll ask us for income proof, and collateral. Only small tiny personal loans and credit card loans come backed without collateral. For something of the order of 11,000 cr. you would think they would ask for collateral.

Especially after the scene with Mallya where loans to Kingfisher were given on nearly no collateral (though even there they had a house and some promoter shares pledged)

Why did PNB give this guarantee then? 

It’s typical – banks give guarantees for more the amount you give as collateral. Because business relationships etc. 

And then: Because nearly every bank is doing it.

The loan was not a “fund based limit”. In a fund based limit like a term loan, the bank pays out money. In non-fund-based limits, the bank will only pay if someone else defaults or an event happens – like a Bank Guarantee or an LC or an LoU.

Meaning, PNB assumed that the foreign bank was giving a loan directly to Nirav Modi and that PNB needed to pay only in case Nirav Modi defaulted. So in the eyes of PNB it was always an “non-fund-based” loan.

But this is how a significant part of import financing works. They all rollover credit, and they all use LoUs for much higher than they can offer as collateral.

From my sources, the scale is huge. For every Rs. 100 that a bank has collateral, they will easily provide LOUs for upto 5x the amount. This is a real problem – that most PSB  do not keep much collateral against non-fund-based limits given to importing customers.

So even if a bank has collateral, it’s not enough. And moreover , such unfunded liabilities are usually not reported to RBI !

Basel Reporting: No Disclosure

PNB says that it has “unfunded” exposure of 11,000 cr. But they haven't  revealed  the same in their latest Basel III disclosure:

The funded exposure to “Gems and Jewellery” is shown at 1860 cr.

Unfunded to the same sector: 842 cr.

Basically PNB didn’t reveal that it was funding massive quantities of “unfunded, contingent exposure”. They will of course pretend that they didn’t know, because the transactions weren’t in the core banking system.

Did Employees Hide it? Was PNB Responsible or was it a fraud?

Can employees be responsible? Could they have hidden the credit and the rolling over of LoUs? 
But honestly, how does a 11,000 cr. credit pass muster without top management realizing it?
Moreover how will the fees ,if paid is accounted for ? 

Think of it – your nostro account with these other banks keeps getting big credits that add up to 11,000 cr. 

• Will you not reconcile it in the accounting? 
• “why is this money even here?” 
• question should have been asked by someone who audits accounts, one thinks?

And the SWIFT messages. It’s a specific kind of message. 

• Why wouldn’t PNB audit the SWIFT trail? 
• Reconcile it with the core banking system? 
• How many more such skeletons will tumble if they do?

Their excuses are

• ·      Data wasn’t entered into the core banking system. 
• ·      LOUs weren’t authorized. (Difficult to swallow this because the amounts are very large)
• ·      The SWIFT system was illegally used. ( PNB would not auditing its SWIFT messages regularly. Or its auditors. Or RBI. for all this years ? Come on ,give me a break)

On the face of it, it looks like the ex-employee is being used as a scapegoat. It’s likely that a lot of people were in on this thing. And all these transactions generated massive fat fees for PNB all these years. so how can that bypass the audit .

Fees wise: Imagine 11,000 cr. worth LoUs being renewed each year – that’s upto Rs. 200 cr. in fees that was all hitting PNB’s top line. You could bribe an employee to maybe give you a small increase – say 10-20 cr. but when you hit numbers like 11,000 cr. this is surely something the top management would know.

What’s the Scale of this scam?

While PNB reported it as a 11,000 cr. scam, they filed an FIR with the CBI for only Rs. 280 cr. This has probably expanded since then but even if the total outstanding is as much as that, there’s a good chance that the actual loss amount will be lesser.

All of it will be borne by PNB right now. Whether someone abused their SWIFT usage is not relevant, if PNB’s SWIFT message said they will pay, they have to pay if there is a default.

the probable fallout.

The problem is that some liabilities were not in the system. There could be more such LoUs from the same branch or others. and similar modus operandi could have been carried out in other branches and other banks. We know that Nirav Modi will not be an isolated case and their will be several other players as well using this loophole to their advantage.

Also, the issue was that the limits had no collateral behind them. If all banks are told to verify their non-fund-based limits and demand collateral against them (say at least 25%) then the scale would be absolutely massive. It’s not like this is happening only with Nirav Modi or Choksi, A large number of importers of commodities have been doing this, and rotating credit. A change in regulation here can change the game dramatically for every other bank (and import account) in the system.

The simple point: this particular transaction will result in a lower loss than 11,000 cr. for PNB. Because of recoveries and such. But if RBI asks all banks to pull up collateral on such lending and stop such practices, the scale is many times larger.

What about the PNB stock?

• It’s fallen 17%. But note that it already has 60,000 cr. of gross NPAs. Another 11,000 cr. will hurt it but not kill it. It won’t die – the government will take it over. Shareholders might suffer, but come on as a shareholder of a public sector bank you’re used to suffering.
• The problem really is: There is never just one cockroach. When you go deeper, you are likely to find more dirty, dark secrets, and none of them will be any good.
• PNB is gonna hurt for a while, but so are others who will find their books similarly tarnished once they investigate.

Will This Bring The Market Down?

only one thing that does bring markets down is the outflow of liquidity. What if so much of the “ponzi” credit – essentially money that was rolled over very month – is being invested directly, or indirectly, into stocks?But If RBI tightens up, liquidity will pull money out of stocks, that will hurt.

Of course, this hurts the fiscal deficit since PNB has to be rescued. So bond yields are up to 7.6% and therefore we’d avoid any long term funds or bonds. Short term it will have to. But overall one shouldn't worry too much. 

My View: Fix it.

This is the Indian public sector banking system. Fix it.

How can you have transactions on SWIFT outside CBS? Fix it.

Why would you not reconcile the nostro accounts? Suspend the auditors. Fire top management. Fix it!

Closing the door behind Modi, who’s already left the country, is probably useless. If you find fraud

•  Invoke their personal guarantees
•  File cases to attach their personal properties.
• File in NCLT to make these companies ,promoters and their officials insolvent. 
• Take the hit, and try to recover.

•        Find out more such instances where collateral cover is too low.
•        Find out if the LoUs or LCs are just getting rolled over or is the customer actually paying back through the Indian current account.
•       And if not, demand more collateral to avoid further spread of the ponzi.

Having said that ,  this is quite unlikely to happen because the banking system is going to take massive hits now, and we’re going to have to deal with the fallout of really horrible systems. It’s amazing that our banks have been this lax, but they have been allowed to; with no bankers being investigated, the rot inside the banks has been ignored and instead, industrialists have been the target of outrage. It’s time to look at banks as malicious players too, and to fix that rot.