What actually happened in PNB scam? Let’s start from the concept.
First, The Concept
Let’s understand how things work.
Some importer, let’s call him Nirav Modi or NM, wants to import pearls or diamonds and then sell them. The purchase requires money, so NM approaches a bank, say Punjab National Bank (PNB).
PNB says look, I’ll give you a loan but it will be like at 10%.
NM thinks hard and says, no, that’s too much. Wait, why don’t I take a foreign currency loan instead, after all I’m buying in dollars? Much lower interest rates no? I can get at LIBOR+2% and LIBOR is like 1.5% so I’ll have the money at 3.5%!
But who will give NM a foreign currency loan? A bank abroad? They don’t know NM. They don’t have any history of NM, so why will they give him money?
SO NM goes to PNB and says, boss, you’re my banker, so please help some foreign bank give me some money to buy diamonds. Say that you will guarantee my loan by giving me a “Letter of Undertaking” (LOU).
PNB now should be saying look, if you want me to give Rs. 100 cr. guarantee, you give me stuff worth 110 cr. at least. As collateral.
But PNB, for some strange reason, doesn’t ask for collateral. More on that later.
So now the foreign bank is ready to lend NM the money. Because PNB will guarantee it. And the foreign bank trusts PNB. Why does it trust PNB?
Because PNB sends a message on SWIFT – the banking message service – that PNB guarantees Rs. 100 cr. of money for 180 days for Mr. NM at an interest rate of, say, LIBOR + 2%. It’s like a message – written in stone, effectively – that says PNB will pay if NM doesn’t pay.
In fact the foreign bank trusts only PNB. So it gives the money to PNBs account with it, called by PNB as a “Nostro” – the account that PNB maintains with banks abroad, where the other bank will send money meant for PNB customers.
PNB’s nostro account gets the money.
PNB then gives NM the money from the Nostro account, usually paid off to whoever NM is buying his diamonds from. This payment is to someone outside India usually, to fund a purchase of diamonds or whatever.
Note this carefully: The other bank gives money to PNB’s Nostro account. Not to NM. They don’t care about NM. They only know that PNB has given a guarantee on the SWIFT channel.
Note: the other bank is nowadays mostly the foreign branches of Indian banks. Because the phoren banks have realized something sinister – that PNB’s guarantee is a strange beast that isn’t backed with much, but we’ll come to that
The foreign bank couldn’t care less about whether NM was buying diamonds or bitcoin – to them, PNB would pay back even if NM’s bitcoin wallet got stolen.
Why does PNB give a guarantee? Fees. Each year, a bank may charge upto 2% to give the LoU.
So What Happens When It’s Time To Pay Back?
NM has to get the pearls in India, sell them, receive the money and pay PNB. On the due date written on the LoU.
Then PNB will pay back the foreign bank saying okay, we got the customer’s money so we’re giving it back to you. With interest etc.
That’s what is supposed to happen. But in reality, things went a little berserk, it seems.
The Reality: A Bit of a Ponzi
NM might not pay back at all. NM might use the money to speculate in the markets. Or do something else.
What if NM in the above example simply didn’t have the money to pay back? Instead, he asks a PNB official to open ANOTHER LoU. For the amount owed plus interest. So if we had the first LoU at $10 million the second one is $11 million to cover the interest on the first.
The money from the second LoU is used to repay the first. It’s just rolling over of credit. Over and over. Standard definition of a ponzi scheme.
This can easily balloon into a larger amount, so large that it’s too much. In effect many such arrangements have turned into semi-ponzi schemes, with one LoU being opened to repay another and so on.
Which is what is likely to have happened.
We don’t know the details, but it looks like:
Nirav Modi took loans from foreign branches of Indian banks through an LoU issued by PNB
This was done through a SWIFT based LoU issued through a rogue employee (or many of them) at PNB
The orders never showed up in the core banking system for monitoring
LoUs were rolled over all the way since 2011, and possibly increased over time too.
The rogue official retired in 2017, and the replacement refused to roll over the LoU which came due in Jan 2018 because he couldn’t find the past transactions in the system
No rollover means a default, since there was no money to pay. So PNB quickly files an FIR saying oh goodness we have lost 280 cr. on the Jan LoUs
Then someone said, “Abeyaar, is there more of these not-in-system LoUs? Someone check no?”
Then someone checked.
Oh gawd. 11,400 crores.
That’s a lot of crores.
Everyone in the bank panicked.
Why couldn’t Nirav Modi just pay it back? He must have the original money no?
Because if it was ever intended to be paid back, the rollovers wouldn’t have been required. At some point, things got so out of hand that rollovers were required in order to stay current.
Typically this would not be a problem. If PNB had done things right, they would have had collateral worth the amount of guarantee, and they would have sold that collateral and paid the foreign bank.
But, and here’s the real issue: PNB didn’t have any collateral.
Why did PNB give a guarantee without collateral?
If you and I go for a loan to a bank, they’ll ask us for income proof, and collateral. Only small tiny personal loans and credit card loans come backed without collateral. For something of the order of 11,000 cr. you would think they would ask for collateral.
Especially after the scene with Mallya where loans to Kingfisher were given on nearly no collateral (though even there they had a house and some promoter shares pledged)
Why did PNB give this guarantee then? It’s typical – banks give guarantees for more the amount you give as collateral. Because business relationships etc. And then:
Because nearly every bank is doing it.
The loan was not a “fund based limit”. In a fund based limit like a term loan, the bank pays out money. In non-fund-based limits, the bank will only pay if someone else defaults or an event happens – like a Bank Guarantee or an LC or an LoU.
Meaning, PNB assumed that the foreign bank was giving a loan directly to Nirav Modi and that PNB needed to pay only in case Nirav Modi defaulted. So in the eyes of PNB it was always an “non-fund-based” loan.
But this is how a significant part of import financing works. They all rollover credit, and they all use LoUs for much higher than they can offer as collateral.
From my sources, the scale is huge. For every Rs. 100 that a bank has collateral, they will easily provide LOUs for upto 6x the amount. This is a real problem – that most public sector banks do not keep much collateral against non-fund-based limits given to importing customers.
So even if a bank has collateral, it’s nowhere near enough. And then, such unfunded liabilities are not even reported to RBI!
Basel Reporting: No Disclosure
Continue in next post
First, The Concept
Let’s understand how things work.
Some importer, let’s call him Nirav Modi or NM, wants to import pearls or diamonds and then sell them. The purchase requires money, so NM approaches a bank, say Punjab National Bank (PNB).
PNB says look, I’ll give you a loan but it will be like at 10%.
NM thinks hard and says, no, that’s too much. Wait, why don’t I take a foreign currency loan instead, after all I’m buying in dollars? Much lower interest rates no? I can get at LIBOR+2% and LIBOR is like 1.5% so I’ll have the money at 3.5%!
But who will give NM a foreign currency loan? A bank abroad? They don’t know NM. They don’t have any history of NM, so why will they give him money?
SO NM goes to PNB and says, boss, you’re my banker, so please help some foreign bank give me some money to buy diamonds. Say that you will guarantee my loan by giving me a “Letter of Undertaking” (LOU).
PNB now should be saying look, if you want me to give Rs. 100 cr. guarantee, you give me stuff worth 110 cr. at least. As collateral.
But PNB, for some strange reason, doesn’t ask for collateral. More on that later.
So now the foreign bank is ready to lend NM the money. Because PNB will guarantee it. And the foreign bank trusts PNB. Why does it trust PNB?
Because PNB sends a message on SWIFT – the banking message service – that PNB guarantees Rs. 100 cr. of money for 180 days for Mr. NM at an interest rate of, say, LIBOR + 2%. It’s like a message – written in stone, effectively – that says PNB will pay if NM doesn’t pay.
In fact the foreign bank trusts only PNB. So it gives the money to PNBs account with it, called by PNB as a “Nostro” – the account that PNB maintains with banks abroad, where the other bank will send money meant for PNB customers.
PNB’s nostro account gets the money.
PNB then gives NM the money from the Nostro account, usually paid off to whoever NM is buying his diamonds from. This payment is to someone outside India usually, to fund a purchase of diamonds or whatever.
Note this carefully: The other bank gives money to PNB’s Nostro account. Not to NM. They don’t care about NM. They only know that PNB has given a guarantee on the SWIFT channel.
Note: the other bank is nowadays mostly the foreign branches of Indian banks. Because the phoren banks have realized something sinister – that PNB’s guarantee is a strange beast that isn’t backed with much, but we’ll come to that
The foreign bank couldn’t care less about whether NM was buying diamonds or bitcoin – to them, PNB would pay back even if NM’s bitcoin wallet got stolen.
Why does PNB give a guarantee? Fees. Each year, a bank may charge upto 2% to give the LoU.
So What Happens When It’s Time To Pay Back?
NM has to get the pearls in India, sell them, receive the money and pay PNB. On the due date written on the LoU.
Then PNB will pay back the foreign bank saying okay, we got the customer’s money so we’re giving it back to you. With interest etc.
That’s what is supposed to happen. But in reality, things went a little berserk, it seems.
The Reality: A Bit of a Ponzi
NM might not pay back at all. NM might use the money to speculate in the markets. Or do something else.
What if NM in the above example simply didn’t have the money to pay back? Instead, he asks a PNB official to open ANOTHER LoU. For the amount owed plus interest. So if we had the first LoU at $10 million the second one is $11 million to cover the interest on the first.
The money from the second LoU is used to repay the first. It’s just rolling over of credit. Over and over. Standard definition of a ponzi scheme.
This can easily balloon into a larger amount, so large that it’s too much. In effect many such arrangements have turned into semi-ponzi schemes, with one LoU being opened to repay another and so on.
Which is what is likely to have happened.
We don’t know the details, but it looks like:
Nirav Modi took loans from foreign branches of Indian banks through an LoU issued by PNB
This was done through a SWIFT based LoU issued through a rogue employee (or many of them) at PNB
The orders never showed up in the core banking system for monitoring
LoUs were rolled over all the way since 2011, and possibly increased over time too.
The rogue official retired in 2017, and the replacement refused to roll over the LoU which came due in Jan 2018 because he couldn’t find the past transactions in the system
No rollover means a default, since there was no money to pay. So PNB quickly files an FIR saying oh goodness we have lost 280 cr. on the Jan LoUs
Then someone said, “Abeyaar, is there more of these not-in-system LoUs? Someone check no?”
Then someone checked.
Oh gawd. 11,400 crores.
That’s a lot of crores.
Everyone in the bank panicked.
Why couldn’t Nirav Modi just pay it back? He must have the original money no?
Because if it was ever intended to be paid back, the rollovers wouldn’t have been required. At some point, things got so out of hand that rollovers were required in order to stay current.
Typically this would not be a problem. If PNB had done things right, they would have had collateral worth the amount of guarantee, and they would have sold that collateral and paid the foreign bank.
But, and here’s the real issue: PNB didn’t have any collateral.
Why did PNB give a guarantee without collateral?
If you and I go for a loan to a bank, they’ll ask us for income proof, and collateral. Only small tiny personal loans and credit card loans come backed without collateral. For something of the order of 11,000 cr. you would think they would ask for collateral.
Especially after the scene with Mallya where loans to Kingfisher were given on nearly no collateral (though even there they had a house and some promoter shares pledged)
Why did PNB give this guarantee then? It’s typical – banks give guarantees for more the amount you give as collateral. Because business relationships etc. And then:
Because nearly every bank is doing it.
The loan was not a “fund based limit”. In a fund based limit like a term loan, the bank pays out money. In non-fund-based limits, the bank will only pay if someone else defaults or an event happens – like a Bank Guarantee or an LC or an LoU.
Meaning, PNB assumed that the foreign bank was giving a loan directly to Nirav Modi and that PNB needed to pay only in case Nirav Modi defaulted. So in the eyes of PNB it was always an “non-fund-based” loan.
But this is how a significant part of import financing works. They all rollover credit, and they all use LoUs for much higher than they can offer as collateral.
From my sources, the scale is huge. For every Rs. 100 that a bank has collateral, they will easily provide LOUs for upto 6x the amount. This is a real problem – that most public sector banks do not keep much collateral against non-fund-based limits given to importing customers.
So even if a bank has collateral, it’s nowhere near enough. And then, such unfunded liabilities are not even reported to RBI!
Basel Reporting: No Disclosure
Continue in next post
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