Where forgery wins

What will never get highlighted with desired corrective measures, are the systemic ailments. Few will understand the glaring loopholes in the systems and procedures, even fewer will try to understand—leaving the next scamster to surface down the line. If the enterprising swindler manages to defraud bigger amounts, the headlines and discussions will match, and might even surpass the present level. In order to save the curious ones the trouble of studying the modus operandi, let us dissect it in simple terms here.

For that, one needs to differentiate between fund based and non-fund based exposures of a bank. When a bank lends money to a company for buying say raw material, it sanctions a line of credit to facilitate such purchases, this is fund based lending. This requires the lender to assess the need for such funds, the end use of it with a view to ensuring that the company will be in a position to generate the surplus from business to repay the debt. The other type of exposure a lender takes on a corporation is issuing guarantee – that the lender certifies the creditworthiness of the corporation and undertakes to pay the money on its behalf in case of an exigency like a default. In the case of Nirav Modi, the PNB branch had issued such a guarantee – the nomenclature for that is "Letter of Undertaking" (LOU). Such LOUs were issued to foreign banks through a system called SWIFT. SWIFT or the Society for Worldwide Interbank Financial Telecommunication provides a network that enables financial institutions worldwide to send and receive information about financial transactions in a secure, standardised and reliable environment. Once a message is received through SWIFT with the proper business identifier codes or SWIFT codes, the recipient bank acts on it without any further verification. In case of PNB, such LOUs were issued through the SWIFT network.

The standard norm for issuing a guarantee is to ensure that the client has the ability to repay the guaranteed amount in case the issuing bank has to meet the obligation. In other words, this is a non-fund based facility provided to a client. As per the capital adequacy norms of banks: any exposure must have an adequate capital (as stipulated by the regulator – Central Bank in the case of banks) to fund in case of default.

Capital Adequacy Ratio is the ratio of a bank's capital to its risk. It is a measure of a bank's capital. It is expressed as a percentage of a bank's risk-weighted to credit exposures. A national regulator (RBI in our case) tracks a bank's capital adequacy to ensure that it can absorb a reasonable amount of loss and complies with statutory capital requirements. A guarantee is a non-fund based exposure and requires to be fully protected with adequate capital (as rules specify). In case of PNB, the LOU – guarantee in layman's term – did not reflect in the bank's books. Officials just issued the LOU over SWIFT which was honoured by the recipient bank branch. For the receiving bank, which actually paid the money against the LOU since the exposure was fully guaranteed by a creditworthy bank, the money lent did not trigger any capital adequacy norm.

There were two glaring omissions on the part of the PNB branch issuing the LOU. First unauthorised, even fraudulent, use of SWIFT without there being a matching entry in the bank's books. This indicates the lackadaisical manner of bank supervision – first, on the part of the bank management and second, but no less, on the part of the much-revered regulator, the Reserve Bank of India. The regulator did not even have a proper auditing facility to detect such intransigence. It is doubtful if even after such frauds being unearthed the same will be initiated. One reason for the doubt is the case of Zoom Developers where its promoter, Vijay Chowdhury, was arrested by the Enforcement Directorate in May 2017. It was a similar case of defrauding Punjab National Bank but no systemic correction is known to have been adopted by either the PNB or the RBI. This provides the option for future Niravs to hog the limelight. SWIFT will continue to be used by enterprising bank men for certain enterprising transactions.

Second and no less critical is the fact that, neither the RBI nor the bank management has any clue of non-fund based exposures which could hit the banking system, like the present case. One can simply issue guarantee and not record the same in the books of the bank. Only in case of invoking such guarantee – that is only in the rare instance of the bank being asked to pay – will the management know of the exposure. In other words, neither the bank nor the RBI, the regulator, has any system which can prevent bank men from defrauding the system in concert with enterprising corporations.

Take a look at the bank which accepts the LOUs and funds the corporation. There is a limit for how long such exposure can remain in the books. Depending on the rules, it is safe to assume that in about a year, the corporation must repay the money so lent or else the bank funding it will go to the LOU issuing bank for payment. In that case, the forgery will be exposed. So, the next step is to obtain another LOU from the collaborative bankers and approach the bank which lent the money to issue a fresh advance backed by the LOU. With the money so lent, the previous loan could be paid. In each such round, the amount of LOU and therefore, fund lent, will increase to account for commissions—official or under the table – and also meet the bigger appetite arising out of the first round of success. The trend can continue as long as the collaboration lasts. In the case of PNB, the thread broke due to the retirement of a collaborating bank official. Had the bank, which is actually lending with the backing of LOU, been a little conscientious, it would have checked the business model of the LOU carrying client. The chain could have stopped then. Since in the Nirav case, all remained nirav (quiet) it gives the uncomfortable feeling of complicity at the lending end as well. Since in this case, these were branches of Indian banks the suspicion only increases.

What could be the outcome of such a glaring loophole in India's banking system? The global financial market regulators, if they are sincere, should downgrade Indian regulator RBI and banish it to share the table with countries like Nigeria. None of its past, present or future Governors must be seen delivering sermons on finance or economics. Any guarantee issued by any Indian bank must be compulsorily reverified with the appropriate authorities of the bank management. Third and also necessary is multiple checks on any Indian entity seeking any trading facility from a banking unit located in the jurisdiction of well-run financial markets.

The frequent exposures of scams indicate that ours is a country of crooks. Our systems can be easily violated. People in authority are either incompetent or complicit. In sum, they have neither the ability nor the willingness to clean the Augean stable. Nirav has zoomed before someone else comes in the headline. We the people will look from one set of the super-rich to another set of aspiring ones and in the end, we will not recognise who is who.