First, the Concept:
Let’s understand how things work.
Some importer, let’s call him Mr Nirav Modi, wants to import pearls or
diamonds and then sell them. The purchase required money, so MrNirav Modi
approached a bank and in that case, the bank was Punjab National Bank (PNB).
PNB said,“Look, I’ll give you a loan but it will be 10% interest."
Mr.Nirav Modi thought hard and
said, "No, that’s a bit too much.
Wait a sec, 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, the question is, who will
give Mr Nirav Modi a foreign currency loan? An abroad bank? They don’t know Mr Nirav Modi.
They don’t have any history of Mr Modi, so why should they give him money?
So, Mr Nirav Modi went to PNB and
said, "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 then should have said,“Look, if you want me to give Rs. 100 cr.
guarantee, you give me stuff worth 110 cr. at least, as collateral.”
However, PNB, for some strange
reason, did not ask for collateral.
More on that later.
So, now the foreign bank was
ready to lend Mr Nirav Modi the required amount. Because PNB will guarantee it
and the foreign bank trusts PNB. Why does it trust PNB?
Because PNB sent a message on SWIFT, the banking message service.
That readPNB guarantees Rs. 100 cr. of money for 180 days for Mr NiravModi@
interest rate said, LIBOR + 2%.
It’s like a message written in stone, effectively that says PNB will pay
if Mr Nirav Modi doesn’t pay.
In fact, the foreign bank trusts
only PNB. So it gives the money to PNB’s account with it, called by PNB as a “Nostro”. The account that PNB
maintained with banks abroad, where the other banks send money meant for PNB
customers.
PNB’s Nostro account got the
money.
PNB then gave Mr NiravModi the
money from the Nostro account, usually paid off to whoever Mr Nirav Modi was
buying his diamonds from. This payment is to someone outside India usually to
fund a purchase of diamonds.
Note this carefully: The
other bank gave money to PNB’s Nostro account. Not to Mr Nirav Modi. They don’t
care about Mr NiravModi. They only know that PNB has given a guarantee via
SWIFT.
Note: The other bank is 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 Mr Nirav Modi was buying diamonds or bitcoin. PNB would pay
back even if Mr Nirav Modi’sbitcoin wallet got stolen.
Why does PNB give a guarantee?
Fees. Each year, a bank may charge up to 2% to give the LOU.
So, what happens when it’s time
to pay back?
Mr Nirav Modi has to get the
pearls to India, sell them, receive the money and pay PNB on the date mentioned
on the LOU.
Then PNB will pay back the
foreign bank saying,“Okay, we got the
customer’s money. So we’re paying youback, with interest etc.”
That’s what is supposed to
happen. But in reality, things went a little berserk.
The Reality: A Bit of a Ponzi
Mr Nirav Modi might not pay back
at all. Mr Nirav Modi might use the money to speculate in the markets or do
something else.
What if Mr Nirav Modi simply
didn’t have the money to pay back? Instead, he asks a PNB official to open another LOU, for the loan amount 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. The 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:
Mr. 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(s) 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 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 “OMG!We have already lost Rs. 280 cr.
on the Jan LOUs.”
Then someone asked, “Is there more of these not-in-system LOUs?
Someone should check that.”
Then someone checked.
OMG. Rs. 11,400 CRORES!!!
That’s……. a lot of money.
Everyone in the bank panicked.
Why couldn’t Mr Nirav Modi just
pay it back? He must have the original money.
No. He doesn’t.
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 have been
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 off 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 Rs.11,000 cr. you would think they would ask for collateral.
Especially after the whole Mr Vijay
Mallya fiasco, where loans to Kingfisher were given on nearly no collateral (although,
even in this case, 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 Mr Nirav Modi and that PNB needed to
pay only in case Mr Nirav Modi defaulted. So, in the eyes of PNB, it was always a
“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 6x the amount. This is a real problem – 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 Rs.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 Rs.1860 cr.
Unfunded to the same sector:Rs. 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 an Rs.11,000 cr. credit pass unnoticed, without top management realizing
it?
Think of it.Your Nostro account
with these other banks keeps getting big credits that add up to Rs.11,000 cr. Will
you not reconcile it with the accounting? Then, “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 cases will come up 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 Rs. 11,000 cr.
worth LOUs being renewed each year and that’s almost 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 up to 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 an Rs. 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 has to be paid 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 NiravModi 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 NiravModi or Choksi. 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 Rs. 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 Rs.60,000 cr. of gross NPAs. Another Rs.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 going to 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.
But the 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? 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? Better
to answer that than to say they will, or they will not.
(And no, not buying PNB)
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 would you not reconcile the Nostro
accounts? Suspend the auditors. Fire top management. Fix it.
Closing the door behind Mr Nirav Modi,
who’s 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 to the Indian current
account. And 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’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.
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