Nirav Modi financial fraud : All you need to know

Yesterday the Indian financial sector was rocked by a startling revelation of a fraud that took place in one branch of the State-owned lender Punjab National Bank. In the cacophony of accusations, both from the party in power and the opposition, the voice of reason is lost. Here is my attempt to explain the modus operandi and what could be done to avoid this in future.

But before that a simple explanation of certain terms used:

Basic Terminology and Usual procedure:

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In an import-export transaction, the parties involved generally do not meet face to face. Hence they involve their respective bankers to bring a level of trust and faith to the transaction. Banker solves the very basic issue that “what if Indian person sends money to the supplier and he doesn’t supply goods at all or what if the supplier sends the goods and the Indian person doesn’t pay up”? That’s where the Bankers come into the picture.

A Letter of Undertaking (LOU) is a confirmation issued by a local bank (in this case PNB) on behalf of its customer (in this case Nirav Modi and his entities) to another bank outside India (in this case branches of Axis Bank etc) for conducting an international transaction. The letter simply states that if the customer fails to pay for the goods then the Bank (read PNB) shall pay on its behalf. So once a banking entity confirms payments, the foreign supplier has nothing to worry about and they may supply the goods (in this case diamonds).

Once the foreign Bank/Branch receives the LOU they approve the “buyer’s credit” for the borrower (in this case Nirav Modi and his entities), which is then transferred to an account called the “Nostro account” of the bank which issued the LOU. In simple terms, the “Nostro account” is a foreign currency bank account held in another bank for cross-border transactions. To initiate this transfer the Banks don’t communicate via emails etc but use a very secure system called SWIFT to send messages. Once the SWIFT message is sent by Indian Bank and confirmed by the foreign banks the money transfer is initiated.

The Modus Operandi:

As per the reports, 2 of the bank staffers were involved in this fraudulent activity. Firstly they would issue the LOU’s from their branch but never made relevant entries in the Bank accounting systems. Moreover, it is alleged that Nirav Modi’s entities did not have credit facilities with PNB which entailed them access to LOU’s. So it can be said that these LOU’s were off balance sheet items.

After this, the Complaint filed by PNB with the Central Bureau of Investigation, also alleges that the staffers sent SWIFT messages to foreign bankers and completely bypassed the Core Banking System/software. Foreign bankers trusting the SWIFT instructions and LOU’s extended credit and transactions were happening all this while. As per further reports, the total value of such transactions is well over INR 11000 crores.

Systemic Failure:

As is clear from the above, that a gap in the process and system seems to have been unduly used by just two people which has caused a flurry in the Indian banking system. This is nothing but a clear case of systemic failure, audit failure on the part of internal auditors, risk managers and even the management as well as the RBI and Finance Ministry. Heavily depending on my corporate governance background, I can say that a simple reconciliation of SWIFT messages and outstanding liability could have detected this fraud long ago. That this reconciliation is not happening since 2011, is nothing short of shocking.

To dig further, it must also be probed if there was any gap in the software that is used by the Bank. How can a single person access, approve and complete a transaction by bypassing the system altogether that too over such a long period and for such high-value transactions? If one branch knew this loophole, is it ok to say many others could well be aware of this too? I shudder to think on those lines.

For now, we wait for further information to trickle in. The Enforcement Directorate has conducted raids and the main accused have apparently fled the country in the first week of January itself.


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