20 Feb 2018 19:54 IST

The PNB scam: India’s Lehman Brothers moment?

Punjab National Bank PNB Nirav Modi LoU Fraud

When the business class has no qualms defrauding banks, it’s unfair to only pull up the latter

Is the ₹11,400-crore PNB-Nirav Modi scam the Indian banking sector’s Lehman Brothers moment? The letter of understanding scam (LoU) unearthed last week has shaken people’s faith in the country’s banking and financial sector.

Even before this scam unfolded, the banking industry was in the grip of a crippling bad loans (NPA) crisis which has been slowly creeping up on it over the last few years. The NPA bubble, which was at 27 per cent when the NDA government came to power in 2014, has now gone up to over 40 per cent. This means that more than 40 per cent of the loans extended by PSU banks are of doubtful quality; in other words, for every ₹100 banks loan out ₹40 is unlikely to return to them.

According to a Times of India report, over the last 11 years, the government has injected ₹2.6 lakh-crore into PSU banks to shore up their capital (commonly known as bank recapitalisation). To put things in perspective, the ToI report says this sum is more than the CAG’s figure of notional loss arising from the 2G scam and more than twice the Centre’s allocation for rural development this year.

What happened at PNB

The PNB scam has only compounded the woes of the banking sector. A lot has been written so far on the ‘nuts and bolts’ of the scam, but a brief account may be in order. Some employees of PNB’s Brady House branch in Mumbai extended letters of understanding (LoUs) to diamantaire Nirav Modi.

An LoU is basically a letter that allows a person to get funds from foreign branches of Indian banks. These foreign branches of Indian banks extended credit to Modi with the assurance that PNB stands guarantee to the funds. So even if Modi defaulted, these branches assumed that they would recover their money from PNB as it was the original issuer of the LoU and acted as guarantor.

The fraud was perpetrated when some employees in the Brady House branch wilfully ignored the rules and procedures regarding issuance of LoUs. One, these LoUs are issued only for 90 days, but in this case they were issued for 365 days. Two, crucially, these LoUs are issued only against strict collateral and security norms, often with margins of 110 per cent. Which means if you want an LoU of ₹100 you have to show the bank that you have funds worth ₹110 as back-up. But Nirav Modi and his associates managed to get LoUs without showing any security, which is where the ‘house of cards’ started building.

This also reveals the shocking lapse in the internal audit mechanism of PNB, where relatively junior level staff could bypass senior management and put through LoUs for such vast sums through the SWIFT system.

Unfortunately, the other banks that gave credit to Nirav Modi — known as counterparty banks, that include Allahabad Bank, State Bank of India, Union Bank of India and others — are also involved in this, as they have to account for the sums extended on their balance sheet. Now if PNB refuses to honour its commitments to these banks, which is what it has been hinting, then there is a real risk of this scam becoming a ‘contagion’ — a systemic risk spreading across the banking sector. This is where the chilling similarity to the Lehman Brothers case begins.

Contagion spreading

As of now there is pressure building on PNB to limit the risk to itself by honouring its commitments to counterparty banks — to make good the amounts they extended — and prevent this from becoming a contagion.

Predictably, there have been calls for a greater push towards privatisation of PSU banks to prevent such scams from occurring in future. Chief Economic Adviser Arvind Subramanian has led this call at a recent public event in Chennai — though he clarified that these were his personal views and not that of the government. Ironically, industry body Assocham, on February 19, put out a press release calling for speeding up privatisation of nationalised banks.

There are two issues here — one, there is no guarantee that such scams would not occur if banks were under private control. The Satyam scam in the private sector and the US sub-prime banking crisis (where all the banks were in the private sector) are proof of this.

Two, though the errant PNB staff, who had a major role in this scam, must be brought to book, we seem to be in a tearing hurry to blame only the banking sector for this mess. Shouldn’t we be demanding answers from our business class, which seems to have no qualms in defrauding banks in this manner? Shouldn’t the industry bodies, instead of blithely asking for PSU bank privatisation, be urging its members to conform to higher ethical standards?

Though the Finance Minister and Prime Minister have so far been unusually silent, how the government deals with this issue will be of crucial significance. Though the political fallout of the PNB scam is hard to predict, there is little doubt that, if this issue is not resolved quickly, it will seriously impact the economy. The ratings agencies, both domestic and global, would have started sharpening their ‘analytical’ pencils by now.