Who Is Liable To Pay For Rs 11,000-Crore Fraud At PNB?
Punjab National Bank building in Mumbai (Photograph: Brent Lewin/Bloomberg)

Who Is Liable To Pay For Rs 11,000-Crore Fraud At PNB?

A day after Punjab National Bank disclosed that its staff had issued fraudulent ‘Letters of Undertaking’, based on which more than Rs 11,000 crore has been loaned out, a scuffle has broken out among lenders over who will make good on the money.

The LoUs allowed at least three companies linked to designer and jeweller Nirav Modi to raise short-term buyer’s credit from international branches of a host of Indian banks. PNB, in its notice to stock exchanges, said the quantum of such transactions is $1.77 billion (about Rs 11,400 crore).

In the best-case scenario, the client, in this case Modi or his companies, would repay PNB which in turn would pay the banks that loaned out the funds. On Wednesday, BloombergQuint reported, citing bank officials who didn’t want to be identified, that Modi had offered to repay at least Rs 6,000 crore by selling assets. Modi’s communication team has not responded to queries seeking confirmation of such an offer.

But what if Modi can’t pay on time? Whose liability is it? PNB’s? Or the banks that loaned the money based on PNB LoUs?

“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,” said PNB in its release to stock exchanges.

In a ‘cautionary notice’ sent to banks on Monday, PNB brought up the possibility that employees at overseas branches of other Indian banks had been involved in the foul play.

“There is clear criminal connivance of group companies of Nirav Modi and Gitanjali Gems with our branch officials and also apparently, with the officials of other overseas branches of Indian banks,” PNB wrote in a letter signed by a general manager. The letter was sourced by BloombergQuint from officials in the banking industry.

PNB added that overseas branches of other banks overlooked certain RBI guidelines, specially the stipulation that payment must be received within 90 days of the shipment.

PNB’s attempt to spread the blame, and perhaps the liability, has other bankers worried.

Two bankers privy to the discussions, but speaking on conditions of anonymity, said there was no ambiguity on the fact that the final liability lies with PNB. The money was loaned based on PNB’s guarantee, said one of the bankers. This banker added that the money loaned had also been routed to PNB’s nostro account and not directly to the client.

The second banker had a similar view and said that PNB was only trying to deflect the blame by alleging that employees of other banks were at fault too.

Both bankers said that complaints have been filed with the Hong Kong Monetary Authority, the RBI and the Finance Ministry. The transactions were routed through the Hong Kong branches of Indian banks.

PNB has not responded to calls and queries since Wednesday. A spokesperson told BloombergQuint that it is yet to decide on whether it will address the press later in the day.

How Does An LoU Work?

An LoU is essentially a commitment offered by a domestic bank on behalf of its client to conduct an international transaction. It’s a commonly used trade finance instrument.

A borrower with verified credentials approaches a local bank for a LoU issued in favour of a foreign bank or the overseas branch of an Indian bank. The foreign bank then approves buyer's credit for the borrower, which is received in the nostro account of the local bank. A nostro account is a foreign currency bank account usually held in another bank for cross-border transactions.

The borrower then receives the money and proceeds with his operations for which the funds were sought. In most cases in the jewellery industry, the short-term credit is to secure raw materials such as uncut diamonds. Once the final product is complete, the borrower exports it and uses the funds to repay the international bank.

In case the borrower is unable to repay the foreign bank, the local bank that issued the LoU is liable to pay. According to a senior former banker, who spoke on the condition of anonymity, in most cases an LoU is backed by a 100 percent cash margin held in a fixed deposit account. If the client fails to pay, the local bank uses these funds to make the payment.

Who Slipped Up?

The main fraud appears to have occurred at PNB but there may be some negligence on the part of other banks too, according to former bankers and experts that BloombergQuint spoke to.

PNB should have been matching SWIFT messages with the contingent liabilities on their books and the cash margin maintained, according to the former banker quoted above. If they had done so, they would have detected the mismatch. SWIFT is a messaging service which allows banks to communicate with each other in a secure manner. It is used to issue instructions to other banks in the event of a multi-bank transaction. The activation of LoUs would have been transmitted over SWIFT to the overseas bank.

RK Bakshi, a former executive director at Bank of Baroda, said the fraud would have been detected had the SWIFT messages been reconciled with the core banking system at PNB. That way, the bank would have known of any transaction being conducted on its behalf, Bakshi told BloombergQuint in an interview.

“This fraud is a combination of complicity and lack of alertness. Simple practice of checking SWIFT messages could have averted it,” Bakshi said.

So Who Pays?

If it is indeed proven that transactions were being carried out on PNB's SWIFT network without the bank knowing, the bank would be liable to make good on the payments, Abizer Diwanji, partner and head of financial services at EY, said in an interview with BloombergQuint.

“If there is a SWIFT-tested coded message that is received then it means the counterparty bank has done its diligence... A SWIFT message is kind of taken as an effective contract,” Diwanji said.

One of the two bankers quoted above said that banks which had outstanding dues against PNB LoUs in this case have started making claims, though they would become due at different points in time.

If Modi pays the Rs 6,000 crore that he has promised banks he will, PNB may have the funds to make the payments. If not, PNB would be eventually liable to pay.

In the interim, lenders are also awaiting the results of an investigation initiated by the Central Bureau of Investigation to take further action against those who perpetrated the fraud.

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