Consider the following semi-fictional scenario. There are two friends. One is a bank manager. The other is a stockbroker. The banker must report his branch’s transactions and cash positions to the regional office every second Friday.

On the Monday after the reporting Friday, he lends his friend, the stockbroker, some money. The broker returns that cash before the reporting Friday. He gets 10 working days to turn a profit by trading with that cash. He pays “interest” to the banker, not the bank. No collateral is required. There are no transaction records.

Now imagine the two friends are a banker with access to the bank’s Society for Worldwide Interbank Financial Telecommunications system, also known as SWIFT, and a jeweller. The jeweller needs cheap foreign exchange loans. The banker uses the SWIFT access to issue guarantees (called letters of undertaking) that his bank will backstop those loans. The jeweller gets the loans at favourable interest rates, and returns the money. No collateral, no transaction records.

The first scenario on a very large scale was roughly how the Harshad Mehta scam worked across 1991-1992. It was discovered only because of an unusual chain of events. The Bombay Stock Exchange and other regional exchanges had gone on strike to protest the installation of a new regulator, the Securities and Exchange Board of India. Meanwhile, there was a special audit at the State Bank of India. So Mehta could not sell his stocks to return the cash to the bank.

The second deal is supposedly how the Punjab National Bank-Nirav Modi scam happened. In this case, the scam is said to have been broken when a certain compliant bank official happened to be replaced by a less compliant one who wanted collateral for the letters of undertaking.

In both cases, the scams could have carried on indefinitely. In the 1992 case, nobody would have known about the off-books loans if the money had continued to be returned. In the Punjab National Bank case, it went on for seven years and so long as the letters of undertaking were not triggered by demands that the bank pay up for a defaulting loan, it could have carried on.

It is hard to imagine that nobody reconciled piles of unrecorded SWIFT transactions over seven years, with the money flowing through Punjab National Bank’s Nostro account (an account held by a bank in a foreign bank usually in the currency of that country). It is also hard to believe that a deputy manager had the level of clearances required to run up 12 digits worth of letters of undertaking. It is harder still to believe that a high-flying pair of billionaires, with strong political connections, dealt only with very junior bank officials.

But let all that go for the moment. The biggest concern should be with the health and future wellness of the banking sector.

A ripple effect

The details and dimensions of the Punjab National Bank scam are difficult to discern. These might be hard to figure out even over the next several months or years. India’s investigative agencies will struggle to make sense of this. It will require forensic audits and painstaking reconciliation of SWIFT entries and letters of undertaking across multiple banks.

It is quite possible that Punjab National Bank’s actual liabilities will be a fraction of the Rs 11,380 crores worth of letters of undertaking unearthed so far. Modi says he returned the earlier loans and he may well have done that. Otherwise, the letters of undertaking would have been invoked earlier and Punjab National Bank would have woken up earlier to the scam since it would have had to fork out cash instead of merely letters.

However, whatever the amounts at risk may be, those are likely to be stuck in the system for a while or are possibly unrecoverable. Probably, Punjab National Bank will eventually take the hit, but it is likely to travel through the courts. We are told that most of the loans to Nirav Modi and his uncle Mehul Choksi were taken from the overseas branches of other Indian public sector banks. So there will be a “negative network effect” rippling through the banking system as that money gets stuck. Other businesses in the gems and jewellery space may also be affected by this negative ripple.

The negative ripple caused by the Punjab National Bank-Nirav Modi scam could affect other businesses in the gems and jewellery space. (Photo credit: Nirav Modi / Facebook)
The negative ripple caused by the Punjab National Bank-Nirav Modi scam could affect other businesses in the gems and jewellery space. (Photo credit: Nirav Modi / Facebook)

Deepening public mistrust

Second, the Reserve Bank of India will have to plug this gap in the supervisory system that allows SWIFT-based frauds. Similar scams exploiting holes in SWIFT supervision and issuing letters of undertaking without collateral are then likely to surface across the public sector banking system. Off-the-record, there have been quite a few bankers and exporters going through the process of saying “everybody does it”. Modi-Choksi may even have been small-time scamsters – this is a frightening thought.

This adds additional stress to the banking system at a point when it is in pretty bad shape. In its last Financial Stability Report released in December, the Reserve Bank reckoned that about 11% of all advances would have turned into non-performing assets (loans for which the principal or interest payment is overdue for 90 days or more) by September. That is about Rs 11 trillion – about 100 times the size of the Punjab National Bank scam. In terms of gross domestic product, that is about 7.5%-8%.

That Reserve Bank assessment came before the Punjab National Bank scam was revealed. We know from the few cases that have gone through the Insolvency and Bankruptcy Code process so far that there could be massive haircuts in the loan recovery. On average, where the defaulting company has been seized and auctioned, the creditors have received less than 20% of their dues.

The recapitalisation of the banking system may, therefore, require considerably more than the Rs 2.2 trillion or so the government has allotted to this task. Where will that money come from? We are talking about 5% of gross domestic product or more in terms of recapitalisation. There will be huge public opposition to the “bail-ins” proposed in the yet-to-be-legislated Financial Resolution and Deposit Insurance Bill.

Beyond the numbers, the Punjab National Bank scam has led to further public mistrust of the banking system and doubts about the probity of the current political leadership. The first blow was demonetisation. The erosion of public confidence it caused has manifested in many ways, such as a refusal to accept Rs 10 coins and the flight of capital into cryptocurrency. The next stage could lead to depositors starting to pull cash out of public sector banks.