The scale of the latest scam to hit the Indian banking system is staggering. Punjab National Bank revealed this week that it had detected fraudulent transactions worth more than Rs 11,380 crore in a Mumbai branch. That amount is nearly double the amount of money the government infused into the bank, India’s second-largest public lender, to help cover its non-performing assets problem. It was one-third of the bank’s entire market capitalisation at the time when it was reported. It is also equivalent to 8.5 times the bank’s profit for financial year 2016-17. By any measure, the magnitude of this alleged crime is massive.

And the alleged perpetrators are not faceless bank officials. The bank has alleged that the scam involved companies connected to famous jewellery designer Nirav Modi, who is a billionaire, and is known to have ultra-rich clients including Hollywood and Bollywood stars. Reports have now suggested Modi left India before Punjab National Bank filed a First Information Report. Meanwhile, raids are being conducted at properties connected to the companies across India. And the matter has turned political, with the Congress accusing the Bharatiya Janata Party of looking the other way as Modi fled the country.

But what exactly happened? Although much is yet to be revealed, a note circulated by Punjab National Bank to other banks provides some details of the scam so far.

What was the scam?

According to Punjab National Bank’s note, a junior level branch official “unauthorisedly and fraudulently” issued Letters of Undertakings on behalf of companies connected to the Nirav Modi group. These were Solar Exports, Seller Diamonds and Diamonds R Us. The LoUs allowed the companies to get buyer credit – essentially loans meant to be used to buy material that would be imported into India – from foreign branches of other Indian banks. In other words, Nirav Modi’s companies were allegedly able to get loans in foreign currencies, without offering any security. Moreover, the Punjab National Bank note claims that these loans, which are supposed to be used directly to pay for the imported goods, were instead used for other things like paying back other loans taken from other banks.

What are LoUs?

An LoU is essentially a letter of credit, where one bank tells another that it will meet a customer’s liability. For an above-board import transaction this would have worked in the following way:

  • One of Nirav Modi’s companies asks Punjab National Bank for an LoU to import jewels from Hong Kong.
  • Punjab National Bank gives the LoU in favour of, say, Allahabad Bank’s Hong Kong branch.
  • Because of the LoU, Allahabad Bank trusts that any money it extends to the Nirav Modi company will be paid back by Punjab National Bank. So it puts the money into a Nostro account – a kind of account held by one bank in foreign currency in another bank.
  • Nirav Modi’s company now has access to this money to pay for the imports.
  • Within a stipulated period, once the imports have actually been shipped into India, Nirav Modi has to pay back PNB, which will pay Allahabad Bank.

In effect, Punjab National Bank is lending money to Allahabad Bank, which is subsequently lending forex to Nirav Modi to import material.

The difference in this scam seems to be that Punjab National Bank did not know it was agreeing to lend money to Nirav Modi’s companies in the first place. The bank’s note claims that an official within the company fraudulently issued fake LoUs, which were then used by Modi’s companies to obtain forex credit from the overseas branches of other Indian banks.

Put simply, Allahabad Bank and others thought they were lending money to Nirav Modi for imports on behalf of Punjab National Bank – but the latter had no idea that this was happening at all. Now Punjab National Bank has to pay up for loans it claims it did not officially give out in the first place.

How could this go undetected?

This is where the allegedly crooked Punjab National Bank official comes in. According to the bank’s note, this “junior level branch official” sent instructions to the foreign branches of the other banks that Punjab National Bank had issued LoUs on behalf of these companies. These instructions were sent through the messaging system of the Society for Worldwide Interbank Financial Telecommunication, or SWIFT. This system is trusted by banks all over the world almost implicitly, because it needs to be endorsed by supervisors before instructions are issued.

Software comes into it as well. Although the instructions regarding the LoUs were sent through SWIFT, they were not logged on or tallied against Punjab National Bank’s core banking system, which uses Infosys’ Finacle software. This meant that the instructions, essentially promises to other banks that Punjab National Bank would pay them back for credit extended to Nirav Modi, were not noticed by the PNB management.

So how did the bank figure it out?

Punjab National Bank, in its note, claims that after the conniving official retired, the companies again approached the same branch asking for LoUs. This time they were asked to provide a 110% cash margin, since they only had current accounts with the bank with no built-in credit allowances. The companies told the branch they had been availing LoUs without providing cash margins for several years now, which is when the alarm bells were raised. The bank then went through the SWIFT trails to examine what actually had been going on in the branch, and that is when the scam emerged.

This, of course, cannot be the end of the story and there are several questions that this raises, starting with why the companies would go back to the branch and reveal their method of operation if they knew the allegedly conniving official had retired. Considering SWIFT instructions also require some further clearance, it is clear more than one official was involved and indeed the bank has suspended a total of 10 employees. The most pressing question is how these SWIFT instructions could bypass the bank’s core banking system altogether, in such a way that the transactions went unnoticed.

Are there more complications?

Of course. For one, the LoUs were not the only way the fraud was allegedly perpetrated. Gitanjali Gems, a company Punjab National Bank said is promoted by Mehul Choksi, Nirav Modi’s maternal uncle, also had accounts with the same branch. According to Punjab National Bank’s notes, these accounts did have credit allowances, so when LoUs or the similar Foreign Letters of Credit were provided to those companies they were officially logged in the bank’s core banking system. Later, when the actual instructions were sent to other banks through SWIFT, the amounts were “substantially enhanced” beyond what had been logged in the core banking system. Again, this meant Punjab National Bank was effectively guaranteeing loans that it did not know it had given out.

So who pays for all of this?

The answer here is also complicated. Technically, right now the exposure is on the books of other banks and not Punjab National Bank itself, since they were the one who lent the money. But those banks gave out the money based on SWIFT instructions, which are trusted across the banking system. Allahabad Bank, which is believed to have the largest exposure here, has said that its liabilities are with Punjab National Bank and not the individual companies, and so it expects the bank to pay up and does not have to worry about collecting money from Modi’s companies.

But Punjab National Bank does not seem to agree. In its official release to the Bombay Stock Exchange, Punjab National Bank said “in the bank, these transactions are contingent in nature and liabilities arising out of these on the bank shall be decided based on the law and genuineness of the underlying transactions.” In its note, the bank also claimed that the other banks involved not only overlooked certain stipulations regarding LoUs, it also says “there is clear criminal connivance of group companies of Sh. Nirav Modi and Gitanjali Gems with our branch official and also apparently, with officials of overseas branches of Indian banks.”

In other words, though Punjab National Bank has said it will pay back any liabilities that authorities say it is responsible for, it is making the argument that the LoUs themselves were fraudulent and that other bank officials were also responsible, and so it should not be liable for them. This has spooked the banking sector, with concerns that this could descend into arbitration and frozen assets at a time when banks are already dealing with a massive NPA situation. Meanwhile, investigation agencies will try to figure out the extent of the conspiracy and what assets Nirav Modi actually has.