Why the Nirav Modi fraud is much more than just a fraud

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During the course of the last one week, the hottest news-story in India has been that of a jeweller named Nirav Modi, allegedly defrauding one of India’s largest government owned banks, the Punjab National Bank (PNB).

PNB is India’s second largest government owned bank (with assets of around Rs 7,203 billion ($111.7 billion, assuming $1 = Rs 64.5) as on March 31, 2017). The total amount of the fraud has been estimated to be at $1.8 billion (or around Rs 114 billion). News report suggest that Modi (no relation to the current prime minister of India Narendra Modi) fled the country in early January. His immediate family also left India, during the course of the month.

Nirav Modi is believed to be holed up in a luxury hotel in New York and was last seen in Davos, as a part of a business delegation which got a picture clicked with the prime minister Narendra Modi. Before Nirav Modi, Vijay Mallya, another businessman, who hasn’t repaid loans worth Rs 90 billion ($1.4 billion) due to Indian banks, fled the country.

The latest fraud basically involves PNB guaranteeing loans issued to Nirav Modi by issuing a letter of undertaking (LOU). Every time a loan became due, Nirav Modi got PNB to open another LOU equivalent to the loan amount plus the interest that was due on it. The money from the new LOU was used to pay off the loan and the interest due on the previous LOU. In the process, Modi never repaid the loan.

Currently, it is being suggested that he was helped in the process by two employees of PNB. That such a huge Ponzi scheme could be run without the top or the middle management of the bank knowing about it, is a little difficult to believe.

Thus, Modi managed to operate a Ponzi scheme, with money from the new LOU being used to pay off the previous one. Of course, like all Ponzi schemes, Nirav Modi’s scheme collapsed as well. And before the authorities came after him, he left the country, along with his family.

How does Nirav Modi’s fraud look in light of the other frauds that Indian banks face? In July 2017, the ministry of finance had shared some interesting data in this context.

Between the years 2012-2013 and 2016-2017, the banks in the country had seen a total number of 22,949 frauds, with total losses to banks amounting to Rs 698 billion ($10.8 billion). The average loss on a fraud thus amounted to Rs 30.4 million ($0.47 million). The interesting thing here is that of the 78 banks on the list, PNB faced the highest losses when it came to frauds. Over the five-year period, the bank faced 942 frauds with losses of Rs 90 billion ($1.4 billion). The losses amounted to around 12.9% of the total losses faced by the Indian banks due to frauds.

In fact, the average loss for PNB due to frauds stood at Rs 95.5 million ($1.48 million), which was three times the total average of Rs 30.4 million. Also, more than that, PNB faced more frauds than the State Bank of India, the country’s largest bank, with an asset base which is 4.6 times that of PNB.

What this tells us is that PNB’s control systems were in bad shape and hence, the bank got defrauded significantly more than the other banks did. Having said that, the average fraud at PNB between 2012-2013 and 2016-2017 had cost the bank Rs 95.5 million. In Nirav Modi’s case, the size of the fraud is around Rs 114 billion, which is much bigger than the size of the average fraud PNB has faced in the recent years.

What this tells us is that Nirav Modi’s case is more than a petty bank fraud. It is basically more along the lines of a large bank loan default; which many of India’s crony capitalists specialise in.

India’s government owned banks have been facing a huge pressure of corporate loan defaults over the last few years. As of September 2017, the bad loans ratio of these banks stood at 13.5%. This basically means that of every Rs 100 of loans given by these banks, Rs 13.5 had been defaulted on. A bad loan is a loan which hasn’t been repaid for a period of 90 days or more. The corporate default rate has been even higher.

Largely due to corporate loan defaults, the Indian banks have had to write off loans worth around Rs 2,500 billion ($38.8 billion) for the period of five years ending March 31, 2017. Nirav Modi’s bank fraud will only add to this.

To keep these banks going, the government of India has to regularly keep infusing capital in them. In fact, an estimate made by The Times of India suggests that the government has infused Rs 2,600 billion ($40.3 billion) in the banks that it owns, over the last 11 years. Every rupee that goes into these banks is taken away from more important areas like agriculture, education, health, defence etc.

The reason why many Indian businessmen blatantly default on loans is because they know that given India’s slow judicial system and their closeness to politicians, their chances of getting away with a loan default are very high. Nirav Modi is just a small part of this significant whole.

No wonder, former governor of the Reserve Bank of India, Raghuram Rajan, in a November 2014 speech had said that, India was a “country where we have many sick companies but no “sick” promoters”.

A slightly different version of this column appeared on BBC.com on February 20, 2018.

For their size, Public Sector Banks Have Had Fewer Frauds Than Private Sector Ones.

 

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A lot has been written on the jeweller Nirav Modi defrauding Punjab National Bank to the tune of $1.8 billion (or Rs 11,400 crore). One line of thought that has been pursued is that of the difference between the public sector banks and the private sector banks.

The logic offered here is that frauds happen only in public sector banks and not private sector banks. And even if they happen at private sector banks, the taxpayer does not pick up the tab. The taxpayer did pick up the tab when the private Global Trust Bank went belly up and had to be merged with the Oriental Bank of Commerce. If the bank is big enough and is going bust, the government has to ultimately come to the rescue, irrespective of whether it is privately owned or government owned. No bank of any significant size can be allowed to go bust.

Now let’s look at the first point I raised, whether public sector banks are defrauded more?

In a recent answer to a question raised in the Lok Sabha, the ministry of finance pointed out that between 2014-2015 and 2016-2017, the total number of bank frauds were 12,778.
Of these 8,622 frauds happened in public sector banks and the remaining 4,156 at private sector banks. The ratio of the total number of frauds at public sector banks to the total number of frauds at private sector banks is 2.07.

The ratio of the average assets of public sector banks to the average assets of private sector banks, between 2014-2015 and 2016-2017, is 2.95. If the ratio of frauds between the two types of banks were to be the same at 2.95, the total number of frauds at public sector banks would have amounted to 12,260 (4,156 multiplied by 2.95). This is not the case. The number of frauds is significantly lower than that. Hence, this basically means that public sector banks are having fewer frauds in terms of their size in comparison to their private sector counterparts in India.

Having said that what is true about public sector banks in general may not necessarily be true for the Punjab National Bank in particular. Punjab National Bank is the second largest public sector bank in the country. As of March 31, 2017, it had total assets worth Rs 7,20,331 crore.

In July 2017, the ministry of finance had provided some very interesting data points with regard to bank frauds. Between 2012-2013 and 2016-2017, a period of five years, the Punjab National Bank faced 942 bank frauds with losses amounting to Rs 8,999 crore.
The only other public sector bank bigger than Punjab National Bank, is the State of Bank of India. As of March 31, 2017, it had assets worth Rs 33,23,191 crore, making it significantly bigger than the Punjab National Bank.

Between 2012-2013 and 2016-2017, the State Bank of India, faced 2,786 frauds with losses amounting to Rs 6,228 crore. Even though the State Bank of India faced more frauds, its total losses were 30.8% lower than that of Punjab National Bank.

Further, of the 78 banks that data was offered on, the Punjab National Bank faced the highest losses due to frauds. It’s average loss on a fraud was also three times the overall average loss on a fraud.

This tells us very clearly that the control systems at the Punjab National Bank were weaker than in comparison to the other banks, and that allowed bigger frauds to happen. In comparison, other banks were placed better than Punjab National Bank. Does this mean that if the bank had better control systems, Nirav Modi wouldn’t have been able to defraud the bank, to the extent that he did? On that your guess is as good as mine.

The column originally appeared on Firstpost on February 20, 2018.