{"id":253,"date":"2018-02-18T12:08:10","date_gmt":"2018-02-18T12:08:10","guid":{"rendered":"http:\/\/vikkichoudhry.in\/?p=253"},"modified":"2019-03-31T17:28:44","modified_gmt":"2019-03-31T17:28:44","slug":"what-actually-happened-in-pnbscam-lets-start-from-the-concept","status":"publish","type":"post","link":"https:\/\/vikkichoudhry.in\/index.php\/2018\/02\/18\/what-actually-happened-in-pnbscam-lets-start-from-the-concept\/","title":{"rendered":"What actually happened in #PNBScam? Let\u2019s start from the concept and #Fix It, #ASAP!"},"content":{"rendered":"

ct\"\"<\/p>\n

First, The Concept<\/strong><\/p>\n

let\u2019s first\u00a0understand how things work.<\/p>\n

Some importer, let\u2019s calls 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).<\/p>\n

PNB says look, I\u2019ll give you a loan but it will be like at 10% Interest<\/p>\n

NM thinks hard and says, no, that\u2019s too much. Wait,\u00a0why don\u2019t I take a foreign currency loan instead, after all I\u2019m buying in dollars? Much lower interest rates no? I can get at LIBOR+2% and LIBOR is like 1.5% so I\u2019ll have the money at 3.5%!<\/p>\n

But who will give NM a foreign currency loan? A bank abroad? They don\u2019t know NM. They don\u2019t have any history of NM, so\u00a0why will they give him money?<\/p>\n

SO NM goes to PNB and says, boss, you\u2019re my banker, so please help some foreign bank give me some money to buy diamonds. Say that\u00a0you will guarantee my loan by giving me a \u201cLetter of Undertaking\u201d (LOU).<\/p>\n

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\u00a0collateral.<\/p>\n

But PNB, for some strange reason, doesn\u2019t ask for collateral. More on that later.<\/em><\/p>\n

So now the foreign bank is ready to lend NM the money.\u00a0Because PNB will guarantee it. And the foreign bank trusts PNB. Why does it trust PNB?<\/p>\n

Because PNB sends a message on SWIFT\u00a0\u2013 the banking message service \u2013 that PNB guarantees Rs. 100 cr. of money for 180 days for Mr. NM at an interest rate of, say, LIBOR + 2%.\u00a0 It\u2019s like a message \u2013 written in stone, effectively \u2013 that says PNB will pay if NM doesn\u2019t pay.<\/p>\n

In fact the foreign bank trusts only PNB.\u00a0So it gives the money to PNBs account with it, called by PNB as a \u201cNostro\u201d \u2013 the account that PNB maintains with banks abroad, usually in the currency of that country, where the other bank will send money meant for PNB customers.<\/p>\n

PNB\u2019s Nostro account gets the money.<\/p>\n

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.<\/p>\n

Note this carefully:<\/em> The other bank gives money to PNB\u2019s Nostro account. Not to NM. They don\u2019t care about NM.\u00a0They only know that PNB has given a guarantee on the SWIFT channel.
\nNote:<\/em>\u00a0The other bank is nowadays mostly the foreign branches of Indian banks. Because the\u00a0foreign banks have realized something sinister \u2013 that PNB\u2019s guarantee is a strange beast that isn\u2019t backed with much, but we\u2019ll come to that<\/p>\n

The foreign bank couldn\u2019t care less about whether NM was buying diamonds or bitcoin \u2013 to them, PNB would pay back even if NM\u2019s bitcoin wallet got stolen.<\/p>\n

Why does PNB give a guarantee? Fees. Each year, a bank may charge upto 2% to give the LoU.<\/p>\n

So What Happens When It\u2019s Time To Pay Back?<\/strong><\/p>\n

NM has to get the pearls in India, sell them, receive the money and pay PNB. On the due date written on the LoU.\u00a0\u00a0Then PNB will pay back the foreign bank saying okay, we got the customer\u2019s money so we\u2019re giving it back to you. With interest etc.<\/p>\n

That\u2019s what is supposed to happen. But in reality, things went a little berserk, it seems<\/p>\n

The Reality: A Bit of a Ponzi\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0<\/strong><\/p>\n

NM might not pay back at all. NM might use the money to speculate in the markets. Or do something else.<\/p>\n

What if NM in the above example simply didn\u2019t have the money to pay back? Instead, he asks a PNB official to open\u00a0ANOTHER LoU.\u00a0For 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.<\/p>\n

The money from the second LoU is used to repay the first.\u00a0 It\u2019s just rolling over of credit. Over and over. Standard definition of a ponzi scheme.\u00a0<\/strong><\/p>\n

This can easily balloon into a larger amount, so large that it\u2019s too much. In effect many such arrangements have turned into semi-ponzi schemes, with one LoU being opened to repay another and so on.<\/p>\n

Which is what is likely to have happened. We don\u2019t know the details, but it looks like:<\/p>\n

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<\/p>\n

The orders never showed up in the core banking system for monitoring<\/p>\n

LoUs were rolled over all the way since 2011, and possibly increased over time too.<\/p>\n

The rogue official retired in 2017, and the replacement refused to roll over the LoU which came due in Jan 2018 because he couldn\u2019t find the past transactions in the system<\/p>\n

No rollover means a default, since there was no money to pay. So PNB quickly files an FIR saying oh God !! we have lost 280 cr. on the Jan 17\u00a0LoUs<\/p>\n

Then someone try to, \u201crealise, is there more of these not-in-system LoUs? check !<\/p>\n

Then someone checked. Oh God !. 11,400 crores.<\/p>\n

That\u2019s a lot of crores.\u00a0Everyone in the PNB bank panicked.<\/p>\n

Why couldn\u2019t Nirav Modi just pay it back? He must have the original money ?<\/p>\n

Because if it was ever intended to be paid back, the rollovers wouldn\u2019t have been required. At some point, things got so out of hand that rollovers were required in order to stay current.<\/p>\n

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.<\/p>\n

But, and here\u2019s the real issue :\u00a0PNB\u00a0didn\u2019t have any collateral.<\/strong><\/p>\n

Why did PNB give a guarantee without collateral?<\/p>\n

If you and I go for a loan to a bank, they\u2019ll 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 highly validated\u00a0collateral.<\/p>\n

Especially after the\u00a0episode \u00a0with #VijayMallya where loans to #Kingfisher were given on nearly no collateral (though even there they had a house and some promoter shares pledged)<\/p>\n

Why did PNB give this guarantee then? It\u2019s typical \u2013 banks give guarantees for more the amount you give as collateral. Because business relationships etc. And then:\u00a0\u00a0Because nearly every bank is doing it.<\/p>\n

The loan was not a \u201cfund based limit\u201d. 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 \u2013 like a Bank Guarantee or an LC or an LoU.<\/p>\n

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 \u201cnon-fund-based\u201d loan.<\/p>\n

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.\u00a0\u00a0\u00a0\u00a0 From my sources, the scale is huge. For every Rs. 100 that a bank has collateral, they will easily\u00a0provide LOUs for upto 6x the amount. This is a real problem \u2013 that\u00a0most public sector banks do not keep much collateral against non-fund-based limits given to importing customers.<\/p>\n

So even if a bank has collateral, it\u2019s nowhere near enough. And then, such unfunded liabilities are not even reported to RBI!<\/p>\n

Basel Reporting: No Disclosure<\/strong><\/p>\n

PNB has \u201cunfunded\u201d exposure of 11,000 cr. they say. But they don\u2019t even reveal it in their latest\u00a0Basel III disclosure:<\/p>\n

The funded exposure to \u201cGems and Jewellery\u201d is\u00a0shown at 1860 cr.\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 Unfunded to the same sector: 842 cr.<\/p>\n

This doesn\u2019t even add up. So, in effect, PNB didn\u2019t reveal that it was funding massive quantities of \u201cunfunded, contingent exposure\u201d. They will of course pretend that they didn\u2019t know, because the transactions weren\u2019t in the core banking system.<\/p>\n

Did Employees Hide it?\u00a0 Was PNB Responsible or was it a fraud?<\/p>\n

Can employees be responsible? Could they have hidden the credit and the rolling over of LoUs? But honestly, how does a 11,000 cr. credit pass muster without top management realizing it?<\/p>\n

Think of it \u2013 your nostro account with these other banks keeps getting big credits that add up to 11,000 cr. Will you not reconcile it in the accounting? The \u201cwhy is this money even here?\u201d question should have been asked by someone who audits accounts, one thinks?<\/p>\n

And the SWIFT messages. It\u2019s a specific kind of message. Why wouldn\u2019t PNB audit the SWIFT trail? Reconcile it with the core banking system? How many more such skeletons will tumble if they do?<\/p>\n

Their excuses are\u00a0<\/strong>\u00a0\u00a0:<\/p>\n

Data wasn\u2019t entered into the core banking system. (Of course, otherwise you would have had to report it)<\/p>\n

LOUs weren\u2019t authorized. ( Hard to believe, because the amounts are very large. Surely someone on the top would know?)<\/p>\n

The SWIFT system was illegally used. (Again, hard to believe that a bank like PNB would not audit its SWIFT messages regularly. Or its auditors. Or RBI.)<\/p>\n

On the face of it, it looks like the ex-employee is being used as a scapegoat. It\u2019s likely that a lot of people were in on this thing.\u00a0And that it generated massive, fat fees for PNB all these years.<\/p>\n

Fees wise: Imagine 11,000 cr. worth LoUs being renewed each year \u2013 that\u2019s upto Rs. 200 cr. in fees that was all hitting PNB\u2019s top line. You could bribe an employee to maybe give you a small increase \u2013 say 10-20 cr. but when you hit numbers like 11,000 cr. this is surely something the top management would know.<\/p>\n

What\u2019s the Scale of this scam?\u00a0\u00a0\u00a0\u00a0<\/strong><\/p>\n

While PNB reported it as a 11,000 cr. scam, they filed an FIR with the CBI for only Rs. 280 cr. This has probably expanded since then but even if the total outstanding is as much as that, there\u2019s a good chance that the actual loss amount will be lesser.<\/p>\n

All of it will be borne by PNB right now. Whether someone abused their SWIFT usage is not relevant, if PNB\u2019s SWIFT message said they will pay, they have to pay if there is a default.<\/p>\n

But think about the fallout. The problem was that some liabilities were not in the system. There could be more such LoUs. From the same branch or others. Other banks could have such LoUs too. It\u2019s trivial to start looking \u2013 and we know that Nirav Modi will not be an isolated case.<\/p>\n

Also, the issue was that the limits had no collateral behind them.\u00a0If all banks are told to verify their non-fund-based limits and demand collateral against them (say at least 25%) then the scale would be absolutely massive. It\u2019s not like this is happening only with #NiravModi or #MehulChoksi. A very large number of importers of commodities have been doing this, and rotating credit. A change in regulation here can change the game dramatically for every other bank (and import account) in the existing system.<\/p>\n

The simple point: this particular transaction will result in a lower loss than 11,000 cr. for PNB. Because of recoveries and such. But if RBI asks all banks to pull up collateral on such lending and stop such practices, the scale is many times larger.<\/p>\n

What about the PNB stock?\u00a0\u00a0\u00a0<\/strong><\/p>\n

It\u2019s fallen 17%. But note that it already has 60,000 cr. of gross NPAs. Another 11,000 cr. will hurt it but not kill it. It won\u2019t die \u2013 the government will take it over. Shareholders might suffer, but come on as a shareholder of a public sector bank you\u2019re used to suffering.<\/p>\n

The problem really is:\u00a0There is never just one cockroach.\u00a0When you go deeper, you are likely to find more dirty, dark secrets, and none of them will be any good.<\/p>\n

PNB is going to be hurt for a while, but so are others who will find their books similarly tarnished once they investigate.<\/p>\n

Will This Bring The Market Down?\u00a0\u00a0\u00a0\u00a0<\/strong><\/p>\n

Have you been living under a rock? Nothing will ever bring the market down, nowadays. But the one thing that does bring markets down is the outflow of liquidity. What if so much of the\u00a0#Ponzi credit \u2013 essentially money that was rolled over very month \u2013 is being invested directly, or indirectly, into stocks? If RBI tightens up, liquidity will pull money out of stocks, and that will hurt.<\/p>\n

Of course, this hurts the fiscal deficit since PNB has to be rescued. So bond yields are up to 7.6% and therefore we\u2019d avoid any long term funds or bonds. Short term it will have to be.<\/p>\n

But overall, we wouldn\u2019t worry too much. Just react, don\u2019t predict. What would you do if stocks fell? Better to answer that than to say they will, or they will not.\u00a0(And no, not buying PNB)<\/p>\n

Our View: Fix it.<\/strong><\/p>\n