How state-owned banks function: An explainer of PNB financial fraud

The following explainer and points have been pieced together after conversations with employees of public sector banks. They are lifers who started young with these banks, rose up the ranks, raised families and built homes with PSB salaries and pensions. They know the ins and outs of how these banks work, never in a vaccum, but under pressure from the government which owns them, and intense competition from private banks. This part is on how a fraud regarding Letters of Undertaking (LoUs) could have occurred, not necessarily how Nirav Modi and Mehul Choksi carried it out.

You are a jeweler. You have a supplier in South Africa who provides you diamonds and gemstones to make your jewelry with. Say you have to pay him Rs 1 billion, but you don’t have that kind of money or assets. So you approach Bank A, with whom you have an account. You tell Bank A to issue an LoU which you will then take to Bank B’s Cape Town Branch. That branch, upon receiving the LoU, pays your supplier Rs 1 billion. Remember that the LoU is not backed by any collateral, simply because nothing you own is worth that much.

Now Bank A tells you to keep Rs 1 billion in your account, which it will withdraw before the 90-day expiration period of the LoU is over and use that to pay Bank B in a Nostro Account. You admit to Bank A that you don’t have that kind of money. However, you inform Bank A that you have another account in Bank C, and that if another LoU were to be issued (again without collateral), the Bank C’s Hong Kong branch could pay Bank B the required Rs 1 billion. So another LoU is issued, and Bank C pays Bank B. Again, Bank A tells you to keep Rs 1 billion which it will then pay Bank C.

Of course you don’t have that much money. So you tell Bank A to issue another LoU (without collateral, unsurprisingly), which you will then take to Band D, whose Dubai branch will pay Bank C.

And hence this goes on and on, LoUs being issued to pay for previous LoUs. Imagine this happening for a number of pending payments and transactions, and not just a single Rs 1 billion payment. That is when the scope and scale of the LoU fraud in Punjab National Bank really comes to the fore.

The problem with collateral security

There are no clear regulations and guidelines on how much collateral should be guaranteed as against a loan. Guidelines differ from sector to sector. They are more established for micro, small and medium enterprises. Bankers say this lack of clarity is a huge hindarance.

“When you approach us the first time for a loan, we will ask for collateral. However, if you take further loans from us, we won’t anymore. Also, if you are a known corporate house or a big brand, we will not ask for LoUs. You have to understand; we need the business. If they don’t come to us, they will go to another PSB, or a private bank,” said a former employee of a state-owned bank. There have been cases were loans in excess of Rs 5 billion were issued with zero collateral.