Is the PNB Fraud Just the Tip of the Iceberg?

Another major financial scam hit headlines in January 2018 involving “fraudulent and unauthorized” transactions involving letters of undertaking (guarantee) to Antwerp based diamantaire Nirav Modi amounting to over Rs. 12,500 crores at the Punjab National Bank (PNB). Initial reports have suggested that this originated at a branch in Mumbai where a manager allegedly took advantage of the incomplete integration of the bank’s core banking platform with the Society for Worldwide Interbank Financial Telecommunication (SWIFT) network. The LOUs provided Nirav Modi access to huge foreign exchange loans provided by banks including the State Bank of India, Axis Bank, Allahabad Bank and Canara Bank. The diamantaire’s subsequent default on the loans blew the lid.

It is well known that the Banking industry all over the world, including India, is a highly regulated industry. Yet, with so many regulations and agencies monitoring it, Indian banks have been subjected to high profile, high value frauds with a regularity that is numbing. What is even more galling is the apparent ease with which the fraudsters seem to get away and live happily ever after. It makes us wonder if the authorities are really capable of providing a safe and secure banking environment for the people in India or are really just paper tigers. Whatever be the truth, the money has disappeared and there is little hope of retrieval.

This scam is reminiscent of the fraud that bought down Barings Futures Singapore (BFS) in the late 90s. Investigations had then revealed that Nick Leeson, a broker at the Bank’s Singapore office allegedly unbeknownst to the management, had entered into unauthorized speculative trading, that bought the bank down.

 It is precisely to fix these types of frauds by lone wolves as well as risks arising from technology related issues that the Bank for International Settlements (BIS) brought out guidelines for enhanced scrutiny in the subsequent release of the Basel II guidelines. These robust guidelines have further been expanded in Basel III release and have largely succeeded in plugging these types of frauds worldwide. Like many countries, India too has mandated its banks to adopt these guidelines to bolster their risk management capabilities.

It will be instructive to look at the level of scrutiny banks in India, in particular, are subjected to. Firstly, each of these banks have their own set of guidelines for periodic – usually annual - mandatory audit of high value transactions both by internal as well as external auditors. This means, in the PNB scam case, at least ten internal and external audits of the five banks must have reviewed the same high value transactions of Nirav Modi at different points in time.

In addition, these banks themselves conduct periodic governance, risk and compliance audits that would specifically look into any operational or enterprise risks. Over and top of all this, the Reserve Bank of India (RBI) meticulously inspects the banks regularly. This includes on site as well as offsite surveillance of the banks by dedicated teams.

The million dollar question on everybody’s mind is how did the diamantaire manage to pull wool over the eyes of PNB and the regulators? The obvious answer is that the auditors and agencies appear to have been silenced by invisible hands.

A look at the data published by RBI is indeed telling. (Please see table below - Bank-wise and Bank Group-wise Gross Non-Performing Assets report published by RBI at www.rbi.org.in). The non-performing assets (NPA) or bad loans as a percentage of gross loan jumped from 6.55% in 2015 to 12.90% in 2016 and then to 12.53% in 2017.

It must be mentioned here that loans take several payments cycles and considerable delinquency (non-payment of dues) and/or a default to be classified as an NPA. In other words, Nirav Modi’s loan accounts and consequent exposure to banks arising out of the letters of undertaking would have been in active audit and regulatory scrutiny for considerable amount of time before it became a hot potato.

The report itself points to the fact that RBI knew about this precipitous jump in NPAs at PNB in 2016 or even much earlier. This would have automatically raised red flags internally and triggered closer review by the regulator. There is absolutely no gainsaying the fact that Dr.Raghuram Rajan, the then Governor of the RBI, must have been fully aware of this scam. 

 

As is the wont of such high profile scams, many questions, including the most obvious ones, remain unanswered. If data available in public domain was already pointing to almost doubling of delinquent accounts in just twelve months at PNB, what actions did the regulators take? Were they prevented from discharging their duties? If so by whom? What was the role played by the then Ministry of Finance?

At least some things can be deduced from the above report. PNB must have been aware of this much before the RBI or the Ministry of Finance were informed since they compiled and sent the data to RBI.  The RBI knew what was going on at PNB long before the matter became public. Hence the arrest of low level officers at PNB or the alleged lack of connectivity to SWIFT are nothing but scapegoats in what now appears to be a premeditated loot of public money.

The PNB executive management and the auditors cannot escape responsibility for their negligence and apparent inaction, for that is tantamount to abetment of this colossal crime. The need of the hour is to revamp the bank’s executive management and clean up its audit and compliance processes. PNB has to step up the transparency in disclosures and come clean on the fraud so the real culprits face the law.

 Recent media reports have pointed to the involvement of a senior politician of the UPA regime in this scam. Fingers point to a former minister in the UPA regime who has also been at the center of multiple other corruption accusations. Given India’s post-independence history of corruption, this comes as no surprise at all. That the scam leaked into public domain is the real surprise if at all there is any.

Banking, as we all know, is a business built on trust and relationships. Repeated breach of public trust in banks in India are symptomatic of a deeper malaise in the banking system.  It is now incumbent on the government and it’s investigating agencies to get to the bottom of the PNB scam and book the culprits – be it lowly officers or the high and mighty political overlords and bring them to justice. Any delay will only widen the public’s trust deficit in India’s banks.

President Trump orders review of Dodd Frank Act

Among the slew of executive orders that President Trump signed in his first few weeks in office, was one directing the Treasury secretary to submit a report on the review of Dodd-Frank Act (DFA) and recommend changes in 120 days. I believe this is a step in the right direction to resetting complex banking regulations and ease credit flow and kick start the economy. In this context, it is worthwhile to understand the importance of this law and how it has impacted the financial services industry in a post-recession America.

The banking and financial services industry in the US contributes over 8% of the GDP and is considered as the life blood of the business and economy of the country. Because of the big economic impact banks have on the economy, it is no surprise that it is also one of the most highly regulated industries in the US and probably in the world. Hence the need for prudent regulations is understood and justified. Therefore, the laws that govern its growth and welfare are expected to be living documents and subject to periodic changes so as to be relevant in a dynamic environment. Hence the executive order to review the DFA is a welcome initiative.

The DFA is a big legislation. It is indeed a massive piece of law that runs over 2300 pages incorporating more than 400 rules and mandates. It can be broadly divided into eight key pillars that seek to protect the consumers and regulate the financial markets.

Among the key provisions in DFA, are the creation of the Consumer Financial Protection Bureau (CFPB) -which is responsible for implementing and enforcing compliance with consumer financial laws, stringent regulatory capital requirements, significant changes in the regulation of over the counter derivatives, reforms that regulate credit rating agencies, changes to corporate governance and executive compensation practice and the Volcker Rule ( which bans banks from using or owning hedge funds for their own profit).

The provisions in the DFA were designed to create and sustain a safe and sound banking industry. For instance, the enhancement of the capital requirements of banks created sufficient cushion to absorb loan losses in an unfavorable economy. It also mandates banks to keep a significant portion of their assets in cash and government securities so that they could be easily liquidated in the event of a run on the bank or fast deteriorating macro-economic conditions.

It is easy to see the good intent of the Act. But the experience of banks, regulators and experts since 2010 have been very mixed.  As would be expected, experts in the field have sharply divided views on the efficacy of the Act in achieving its stated goals.

The Dodd-Frank Act had an acrimonious birth and had sharply divided influential Senators and Congressmen. While President Obama claimed victory, the Republicans then had warned that this massive piece of legislation would arrest the flow of credit and slow down recovery and impact job creation.

DFA was enacted to safeguard the consumers and prevent a repeat of the financial crisis of 2008. One of its important objectives to end ‘too-big-to-fail’ banks. But what has the DFA achieved in six years? The ‘too big to fail banks’ remain intact. On the other hand, it has adversely impacted small and medium banks by imposing a heavy regulatory burden on them. 

A study by American Action Forum published in 2016 found that the DFA in six years had cost a total of $36 billion – including $10.4 billion in its sixth year of existence. The study further showed that in the six years, DFA has resulted in a burden of 73 million paperwork hours. DFA has indeed been a logistical nightmare for banks.

A Harvard study on the impact of DFA found that the top five bank-holding companies control nearly the same share of U.S. banking assets as they did in the fiscal quarter before Dodd-Frank’s passage. But community banks with $1 billion or less in assets have seen a significant decline.

It would be pertinent for me to point out here that often in their zeal to protect consumers, legislators tend to over-regulate to the point of almost killing the industry.  Human history is replete with instances where laws are often enacted as a knee-jerk panic reaction in the aftermath of a crisis. But these very same legislations are rued over by the same legislators when the crisis has passed and the severity of their actions dawns on them. We have seen this happen periodically in America, Europe and elsewhere. Is it the legislators’ curse on the democratic world - killing us with their concern and zeal?

As a former bank regulator, I have been an advocate of minimum and prudent regulations that achieve the stated goals by imposing minimal financial costs on banks and regulators. Complying and supervising well-intentioned legislations must not by itself be a Herculean task. I have always believed that DFA has been a logistical and expensive nightmare for the bankers and the regulators. To pass the smell test, a law has to be simple, unambiguous, easy to implement and enforce and achieve its stated objectives with ease. On all these counts, in my view, the DFA fared poorly.  

But that is not to say that I advocate the repeal of the law. By no means.  The Feds need enabling and powerful laws to maintain a disciplined financial system where banks power the engines of growth by funneling credit flows to big and small consumers alike to achieve sustainable business growth. The review is a welcome move and hopefully make DFA easier and less expensive to comply.

The Trump administration has to exercise caution to not bring in legislations that are too big and expensive to administer, comply and enforce and carry the risk of collapsing under its own weight. The incoming administration has a great opportunity to make a big difference. President Trump has taken the right steps to review the Dodd-Frank Act.