What is the Nirav Modi scandal?

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Hardik Lashkari

It is textbook banking fraud.

Let's start with a brief overview of how trade in diamonds is settled.

Rough diamonds are very expensive, easy to transport, and cutting – polishing them adds little value to the final product. This makes rough diamonds an excellent tool for round-tripping funds into India via fake invoices. Diamond firms raise credit abroad in USD at low interest rates (called buyers credit or BC), deploy a small part of it as working capital (it's a low-value added industry) and use the rest to speculate in India's high interest-rate formal and informal financial markets. In a few months the USD loan is paid off and the firm pockets the interest differential. Surat traders have been doing it for decades. That's why they are so rich in such a low value added industry. Nirav Modi is just one such trader.

The instrument through which such firms raise credit abroad is usually called a Letter of Undertaking (LoU). It is a guarantee given by a bank branch located in India to a bank overseas that it would meet the liability if the borrowing firm defaults. LoUs are almost always collateralized. LoU to foreign banks are sent through SWIFT – a secure messaging platform for banks. Once a foreign bank receives a LoU through SWIFT, it issues the BC to the borrower.

Punjab National Bank (PNB) has alleged that two of its employees at a Mumbai branch fraudulently issued LoUs to three of Nirav Modi's firms without them having any existing line of credit or collateral to cover them. The two employees transmitted the LoUs to Hong Kong branch of Allahabad Bank, Axis Bank, and State Bank of India etc., through SWIFT without recording them in PNB's core-banking system (CBS). This is essentially the modern day equivalent of forging a signature.

HK branches of the banks then lent USD to Modi's firms based on the terms of the SWIFT message. Modi's firms used the BC to settle import bills and roll-over maturing BC. It's likely a large portion of it was just laundered away. Now that the firms have defaulted – no ready supply of fake LoUs – PNB has a contingent liability of USD 1.8 billion on its balance sheet. They found out about the scam when two junior employees who were rolling-over matured LoUs finally retired.

PNBs narrative is that Nirav Modi with the help of two insiders essentially fooled and bypassed its internal controls from 2011 to 2018 to get cheap loans abroad.

Anyone who has formal training on how internal bank controls and SWIFT works would know that PNBs current narrative is bollocks.

For starters, why wasn't PNB's CBS linked to SWIFT? It is common practice for banks to do so.

SWIFT recommends that bank branches manually reconcile SWIFT messages with their general ledger at least once every year. This is done at the branch level. Banks in the US reconcile theirs twice per year while Chinese banks do it every quarter. Did the PNB branch in question didn't do it once between 2011 to 2018?

Allahabad Bank has stated that it credited BC worth INR 22 billion into PNBs nostro account – PNBs foreign currency bank account in Allahabad Bank. I accept that PNBs SWIFT isn't linked with its CBS but a nostro account is an integral part of CBS. INR 22 billion credited to the nostro without an accompanying SWIFT message should have raised automatic alarm bells not only at PNBs department of risk management but also at the Reserve Bank of India – nostro accounts come under FEMA.

At the very least this is indicative of an almost complete breakdown of internal controls at PNB.

There are too many unknowns here to establish any liability but I believe PNB should be indicted for financial fraud borne out of negligence. PNB is facing a possible trial in Hong Kong as well for breaking Hong Kong Monetary Authority (HKMA) regulations. This is nothing short of an existential crisis for PNB.

Nirav Modi isn't an Indian citizen. I am not sure if the Enforcement Directorate will be able to get him extradited.

It's a multi-regime fraud. I expect this to be heavily politicised. PM Modi will blame Indira Gandhi's bank nationalisation for weak internal controls at PNB while Congress will portray it as BJP's 2G Scam all the while bipartisan effort will be to put the blame squarely on PNB (and its auditors).

Also Read-

Steps initiated by ICAI on Punjab National Bank Matter

No instructed PNB to meet its commitments under LOU: RBI

PNB clarifies on alleged Scam by Nirav Modi and Gitanjali group

The Punjab National Bank (PNB) Fraud

PNB issue Caution Notice in Suspected Fraud case