PNB Scam Simplified

Many must have been looking for clarity on recent PNB scam and what exactly is this PNB scam? Who all are involved in this scam? How come this scam was not identified since many years? What was the modus operandi used in PNB scam? Why was the PNB scam unearthed only now? Find answers to all those questions here.

Article published here is purely personal understanding and a copy of various public information sources. Content here is a mixture of general process followed and a bit of hypothesis on what could have happened. So, facts may turnout to be different as time and investigation progress from the time i publish (18-Feb-2018) this article.

I have simplified the whole scam in simple terms for common readers who can't go through various sources and understand it. Few banking technical terms are intentionally used as those terms are good to know for one's better banking knowledge. Pay patience while reading to understand the whole scam. After all, it is 11,000+ crores scam.

If you join CBI, you are more likely to work on these kind of scams as CBI is full of such big cases and there is hardly sufficient staff in CBI when compared with number of cases. As i told in another articles, once you are made IO of the case, you are the owner of the case and you need to investigate the case completely. No one else is the boss of the case. Sufficient time (some times even a year or more) will be given as per complexity of the case. If you have decided to join CBI, be prepared to work on such high impact cases and get All India reputation to the level of the case.

Enough of introduction!! Tell us what could have happened in PNB scam?

Let's understand few basic concepts on how things work.

Some importer, let's call him Nirma Moody (😎) or NM, wants to import pearls or diamonds and then sell them. The purchase requires money, so NM approaches a bank, say PNB.

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

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

So NM goes to PNB and says, boss, you’re my banker, so please help me to get some money from foreign bank 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 NM 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. NM at an interest rate of, say, LIBOR + 2%.  It’s like a message – written on stone, effectively – that says PNB will pay if NM doesn’t pay.

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 NM the money from the Nostro account, usually paid off to whoever NM is buying his diamonds from. This payment is to someone outside India usually, to fund a purchase of diamonds or whatever.

Note1: The other bank gives money to PNB's Nostro account. Not to NM. They don’t care about NM. They only know that PNB has given a guarantee on the SWIFT channel.

Note2: Other banks are nowadays mostly the foreign branches of Indian banks. Because the foreign banks have realized something sinister – 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 NM was buying diamonds or bitcoin – to them, PNB would pay back even if NM’s bitcoin wallet got stolen. 

Why does PNB give a guarantee? 

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

What happens when it is Time To Pay Back? 

NM 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 in reality, things went a little berserk, it seems.

The Reality: A Bit of a Ponzi

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

What if NM 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. 

We don't know the details, but it looks like:

Nirma Moody 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 (CBS) for monitoring.

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

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, "Abeyaar, is there more of these not-in-system LoUs? Someone check no?"

Then someone checked.

Oh god!! 11,400 crores. That's a lot of crores. Everyone in the bank panicked. 

Why couldn't Nirma Moody 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, here is 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 will 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 and competition among the banks to do better business.

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 Nirma Moody and that PNB needed to pay only in case Nirma Moody 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 up to 6x the amount. This is the real problem – that most public sector banks do not keep much collateral against non-fund-based limits given to importing customers.

So even if a bank has collateral, it's nowhere near enough. And then, such unfunded liabilities are not even reported to RBI!

Basel Reporting: No Disclosure

PNB has "unfunded" exposure of 11,000 cr. they say. But they don’t even reveal it 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.

This doesn't even add up. So, in effect, 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?

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? The "why is this money even here?" question should have been asked by someone who audits accounts, one thinks?

And the SWIFT messages. It is 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. (Of course, otherwise you would have had to report it)

LOUs weren't authorized. (Hard to believe, because the amounts are very large. Surely someone on the top would know?)

The SWIFT system was illegally used. (Again, hard to believe that a bank like PNB would not audit its SWIFT messages regularly. Or its auditors. Or RBI.)

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 that it generated massive, fat fees for PNB all these years.

Fees wise: Imagine 11,000 cr. worth LoUs being renewed each year – that’s up to 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 is 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.

But think about the fallout. The problem was that some liabilities were not in the system. There could be more such LoUs. From the same branch or others. Other banks could have such LoUs too. It's trivial to start looking – and we know that Nirma Moody will not be an isolated case.

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 Nirma Moody or Cheeksi. A very 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% in the last one month. But note that PNB already has 60,000 cr. of gross NPAs. Another 11,000 cr. can only hurt but not kill. Shareholders might suffer. As a shareholder of a public sector bank, you’re used to suffer.

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? 

Have you been living under a rock? Nothing will ever bring the market down, nowadays. One thing that brings 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? If RBI tightens up, liquidity will pull money out of stocks, and 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 be.

But overall, we wouldn't worry too much. Just react, don't predict. What would you do if stocks fell? We better answer that question than to say they will, or they will not.

Our 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 not reconcile the nostro accounts? Suspend the auditors. Fire top management. Fix it.

Closing the door behind Moody, who has already left the country, is probably useless. If you find fraud,  invoke their personal guarantees and file cases to attach their personal properties. After that, file in NCLT to make these companies 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. If not, demand more collateral to avoid further spread of the ponzi.

But this is quite unlikely to happen because the banking system is going to take massive hits now and we are going to have to deal with the fallout of really horrible systems. It is 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 is time to look at banks as malicious players too, and to fix that rot.

Final Kick: 

      Though the scam has been happening since 2011, it was not identified until 2018. However, PNB was awarded Vigilance Excellence award way back in 2017 for the year 2016-17.

-----------------------
-----------------------
Before you ask relevant questions in the comments section, i request you to go through all other posts of this blog here or use the search feature available at top of this blog with your keyword which will give you all the relevant articles with those key words. Open each article one-by-one and try searching again with your keyword with "Ctrl+F" if you are using desktop or "Find in Page" feature if you are using mobile to land at exact spot in that article. I am sure those posts would cover all your other doubts. I am also waiting for a useful and unanswered question.

If you have gone through majority of the blog articles, you can share your emotion/feedback here which will be considered as per relevancy. Only one feedback by a blog reader. You can give feedback only if you are a signed in google user. This is made to avoid junk/spam feedback. However, nothing stops you in asking a question in comments section of each article.

If you find articles in this blog answered most of your doubts and worth sharing with your friends and co-aspirants who are also looking for precise information like what i have presented here, Pls do so until it reaches an honest officer(s) for whom the department looks forward. The blog is for the benefit of every passionate aspirant.