EPW Editorial


The Punjab National Bank (PNB) “scam” is the latest addition to the list of scams, real and imagined, that have rocked India in recent years. In the case of PNB, two things should be highlighted upfront. One, it is clear that a bank fraud was perpetrated.


A bank fraud is a situation in which employees or outsiders subvert rules and regulations at the expense of the bank. This is different from a situation where the bank itself violates rules and regulations in order to benefit shareholders and managers at the expense of customers or taxpayers. Non-performing assets (NPAs) may involve a fraud (with bank employees colluding with a borrower) or they may simply arise from a bona fide business decision that has gone wrong.


Two, at this point it appears that the fraud relates entirely to what is called operational risk, that is, subversion of systems and processes. It does not relate to credit or loan risk. The distinction is important given that the losses have quickly acquired enormous political overtones. The opposition has been quick to point an accusing finger at the National Democratic Alliance government. The Bharatiya Janata Party, in turn, has responded by alleging links between the accused, Nirav Modi, and members of the Congress party.


In the case of credit risk, political or bureaucratic interference can always be a factor. We have what is called “behest” lending. Politicians and bureaucrats are known to have pressured public sector banks (PSBs) to make loans that are not commercially sound. This is not true of operational risk. In the very nature of things, operational frauds typically benefit employees and, in some cases, outsiders, but political interference is seldom a factor. Whatever the political patronage Modi may have enjoyed, as of now there is no evidence that the particular operational fraud that happened at PNB enjoyed political direction or support.


The details of the fraud itself are not yet clear. From media reports, it appears that several letters of understanding (LoUs, which are a form of guarantee) were issued by PNB in favour of Modi’s firms operating abroad. One employee, using the SWIFT system—a messaging system used by banks—did this without the appropriate authorisation. He is accused of having issued multiple LoUs on the strength of which banks abroad provided loans to Modi’s firms.


Although LoUs are typically issued for short tenures, such as 90 days, the employee was able to issue LoUs for longer tenures, such as 365 days, in contravention of regulations. Reports indicate that this had been going on for seven years. This would mean that the loans issued to Modi’s firms were duly repaid on maturity, as otherwise fresh LoUs from PNB would not have been accepted by lenders abroad. Did the music stop playing because Modi was unable to make repayments in recent months? Or was it because a new employee, who had replaced the employee at fault, refused to renew the LoUs? This is one of the key issues that needs to be clarified.


It is important to be clear about what must be done, and also what must not be done on the basis of hasty inferences. The first order of business is to determine the total dues owed to banks against the various LoUs and the assets available to meet these. From this, an assessment of losses can be made. It is imperative to get a handle on the losses quickly as speculation about the magnitude of losses has resulted in a large fall in the shares of many PSBs.


Second, we need to ascertain how internal controls came to be violated. One reason is said to be that the SWIFT system at PNB was not linked to its core banking software. Even if that was the case, we must know why the violation of internal norms was not picked up by internal audit and by the concurrent auditors. The government has been quick to fault the Reserve Bank of India for alleged supervisory lapses. In general, it is not for the supervisor to pick up frauds at banks: the supervisor reacts after frauds have been duly reported by the banks concerned.

The PNB affair has predictably led to another bout of PSB-bashing. We are told that it is government ownership that is responsible for lax controls and frauds at PSBs. Managers at PSBs are said to lack the incentives to prevent frauds or misuse of public funds. It is only a short leap to the conclusion that privatisation alone can put an end to this state of affairs.


These propositions must seem laughable to those familiar with the spectacular frauds at some of the most reputed financial institutions in the world over the years. In 1995, the investment bank Barings was brought down by one rogue trader, Nick Leeson. Individuals have caused enormous losses to institutions like these by violating rules and regulations.


Then, there are the notorious instances where the world’s leading banks, all privately owned, have breached the law and ended up paying billions of dollars in fines. Libor rigging, manipulation of exchange rates, money laundering, mis-selling of retail products—international banks have been guilty of these and other violations. Managers at private banks have huge incentives for transgressing laws and regulations as the profits they make translate into enormous bonuses for themselves. Frauds and failures in banking are ownership neutral. To think that privatisation is the answer to misbehaviour in banking is sheer delusion.



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