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RBI may have to intervene to bring discipline in the banking ecosystem.
Three Cs are considered critical in the business of lending- character, capacity and collateral coverage of the borrower.
The Punjab National Bank (PNB) has undoubtedly faltered on these banking principles while issuing the Letters of Undertaking (LoUs) to firms linked with diamantaires Nirav Modi and his uncle Mehul Choksi.
To understand the PNB fraud case involving Nirav Modi, it is important to know the operational behaviour of banks, particularly the public sector undertakings (PSUs), in India. Suppose an importer like Nirav Modi, plans to purchase diamond and other jewels from a foreign-based exporter and sell it through his own network of stores.
HOW AN IMPORTER GOES ABOUT HIS BUSINESS?
Import of diamonds and pearls by a desi jewel merchant requires a huge amount as Nirav Modi needed. Now, the importer would approach a bank. In Nirav Modi's case, he approached the Punjab National Bank.
As per existing practices, the PNB would offer the required loan at around 10 per cent interest rate. But an importer of the scale of Nirav Modi would find the interest rate very high. And, here begins the making of a bank fraud.
The importer would find it tempting to take a foreign currency loan instead. He would anyway be paying in dollars for his imports. Foreign currency loans attract lower interest rates at LIBOR plus something.
LIBOR stands for London Interbank Offered Rate or Intercontinental Exchange London Interbank Offered Rate. It is the benchmark rate for short-term loans and serves as the base for calculating interest rates on loans throughout the world.
LIBOR is about 1.5 per cent while in Indian banking practices an additional two per cent interest rate on short-term loans may be charged. So, effectively in place of 10 per cent, Nirav Modi could actually get loan at 3.5 to 4 per cent interest rate.
Also Read| Rs 11400 crore fraud case: Not limited to Nirav Modi and Punjab National Bank only, explained
THE LETTER OF UNDERTAKING
However, an importer like Nirav Modi would face difficult questions, who would give him foreign currency loan? Why would a foreign bank that does not know about the credentials of the borrower offer him a loan?
Now, the importer would approach bank, the PNB in this case, once again asking it to issue an LoU instead of loan.
An LoU is a guarantee from the bank that should the borrower default on repayment, it would pay back to the original lender.
Ideally, the PNB should ask the borrower to furnish a collateral coverage worth 110 per cent of the guarantee amount, i.e. Rs 110 crore for Rs 100 crore LoU. But the bankers say that in cases of big corporate, loan or LoU guarantee can be as high as six to 10 times of the collateral coverage. This has happened in the cases of both Vijay Mallya and Nirav Modi.
The LoU operates through the Society for Worldwide Interbank Financial Telecommunication (SWIFT), which is a kind of banking message service. A SWIFT message is a guarantee that the PNB, in this case, would pay Rs 100 crore (a supposed amount) if Nirav Modi (the supposed borrower) does not pay back in 180 days.
The SWIFT is the reason why a foreign bank would trust the PNB in disbursing millions of dollars for the borrowers use.
The foreign bank would get interest at LIBOR while the PNB charge around two per cent of the loan amount as its fee towards LoUs.
WHY GIVE LoU AND NOT LOAN?
The lender bank transfers money to the PNB's account as it trusts only this bank in lieu of the LoU through the SWIFT.
The money is deposited in what is called nostro account of the PNB. A nostro account is an account that a bank holds in a foreign currency in another bank.
It is commonly used to facilitate foreign exchange and trade transactions. The LoU issuing bank gives money to the borrower or most of the times directly to whoever the borrower is buying his diamonds and jewels from. The payment is made outside India.
Those who have worked in the forex department of some of the leading banks of the country say that in India's case, a foreign bank usually refers to a branch of an Indian bank abroad.
Foreign banks have been suspicious of Indian banks for several years now in the matters of giving loans, primarily for not backing the LoUs by appropriate collateral coverage.
So, the foreign banks or foreign branches of Indian banks do not give money to the borrower directly and they hardly care whether the borrower is using the money for imports or for investment in stock exchanges of low to very high risks. It is assured of getting its money back because of LoU.
Why would PNB or any other bank do such risky business for an importer like Nirav Modi? The bank gets a lucrative return merely for acting as a guarantor.
A two per cent return is good for banks like PNB if they don't have to lend a penny.
THE VICIOUS CYCLE
All is well if the borrower repays his loan within 180 days. The money comes back to the LoU issuing bank, which honours its commitment to keep its credibility intact. In Nirav Modi's case, it did not work for the PNB.
There could be two situations. One, Nirav Modi could not earn enough through his sale of jewels and jewellery to repay his loans or secondly, a part of or the whole of the loan amount was diverted to some other destination (economic activity). The result: due date could not be honoured.
Now, the borrower has two options. One to declare bankruptcy and the bank will sell the collateral coverage to recover as much as it fetches.
Secondly, if the borrower intends to remain in the business, he would again go to the PNB and ask for another LoU opening. The new LoU will be for an amount that covers previous loan plus interest.
The money received through fresh LoU is used by the defaulting borrower to repay the previous loan. In common banking parlance, it is called rolling over of credit. Interestingly, a similar practice has been found to be followed in ponzi schemes.
The bank may or may not agree to it depending upon its estimation of the three critical parameters of lending character, capacity and collateral coverage.
The PNB agreed to issue another LoU and several ones thereafter. The cumulative amount today stands at Rs 11,400 and is likely to go upward.
Since almost all the banks are engaged in the same practice, there is fear that the PSU banks may soon plunge into deep trouble if tight scrutiny is done and audit is conducted properly.
The PNB fraud is a telling proof that that checks and balances are not followed in banks and auditors have been sloppy in their job.
The Reserve Bank of India (RBI) and the government may have to intervene to bring some serious discipline in the banking ecosystem of the country lest the loan bubble bursts into something similar to 2008 US sub-prime lending crisis in India.
(The analysis is based on conversations with bankers working in the field of corporate loans and advances)