Case Study

roses and presents, a horror was unfolding at Punjab National

largest lender.

Three minutes after 9 am on 14 February, when the local stock markets opened for trading, the
government-owned lender informed the stock exchanges that it had detected a fraud of $1.8
billion (around Rs11,400 crore), shaking the financial community and the nation at large. As
the day progressed, it became clear that the PNB fraud was engineered by companies of
diamond tycoon Nirav Modi, helped along by bank officials at its Brady House branch in

of the bank fell 9.81% by the end of the day, dragging down shares of other state-owned banks

has slipped 1.33%. For Indian banks creaking under a mountain of bad loans, the news could
not have come at a worse time.

The fraud took place between 2011 and at least 2017. It was detected in the third week of
January 2018, according to the PNB management which approached the Central Bureau of
Investigation on Jan. 29. In 2011, the scam began with a much smaller amount with a single
letter of undertaking (LoU) worth around Rs800 crore. The first LoU was issued by two PNB
employees on behalf of the bank via SWIFT, sanctioning loans to be disbursed abroad. When
the credit due was not paid in time, more LoUs were issued on behalf of PNB to offset the
payment. When the borrower did not repay the first Rs800 crore, the bank ought to have stepped
in and booked a default by the group company. Instead, the two PNB employees, who were
allegedly party to the fraud, issued more LoUs on behalf of PNB, asking other banks to give
out fresh loans to the firms. This continued until two weeks before the whole operation came

caught napping and the overdue loans exceeded Rs11,000 crore.

PNB sources said Core Banking System (CBS) which could

have immediately detected the discrepancy. According to so
was initiated in 2002. The technology took a decade to become developed. It should have been
SWIFT transactions are supposed to be regularly reviewed. PNB
sources said there is a system to check SWIFT transactions daily by the manager and a
concurrent auditor within the branch,
wherein officials are rotated within departments, ideally every few months. But the two accused
were in the same role in the same branch for seven years. The moot point is, we are at a loss to
find out now. So many managers changed, so many auditors and inspectors came and went.
 Questions & Answers:
1. What was the Modus Operandi (method) of conducting the scam/irregularity? OR
What are the Key Points of the PNB Scam?

Following are mentioned the points in chronological order, which would have affected
the scam to occur:
Role of LoU: There is a provision of bank guarantee known as a letter of
undertaking (LOU) under which a bank can allow its customer to raise money
from another Indian bank's foreign branch in the form of a short-term credit.
The LOU serves the purpose of a bank guarantee.
Breaking the norms: However, to be able to raise the LOU, the customer is
supposed to pay margin money to the bank issuing the LOU and accordingly,

limit, nor did he ever give any margin money.

Glimpse of Loans: Nirav Modi, via his three firms, Diamond R Us, Solar
Exports and Stellar Diamonds, managed to pay to its suppliers of rough stones
on a regular basis. The payment was made through the loans by banks including
Axis Bank, UCO Bank (Rs. 2,636 crore) and Allahabad Bank (around Rs. 2,000
crore). The loans were raised by Nirav Modi's firms on showing the letters of
undertakings issued by the PNB.
No Official Record: Incidentally, there was no official record of such letters of
undertaking in the PNB records as the bank discovered early this year before
reporting the matter to the CBI.
Repayment Fault: Ideally, Nirav Modi and his firms are supposed to repay the
loans but so far, all these loans have allegedly been rolled over for want of funds.
In the scenario when the borrower fails to make the repayment, the bank issuing
the LOU (PNB in this case) is duty-bound to honour the commitments on the
behalf of its customers.
LoU Fault: So, in effect, Indian bank's foreign branches make payment to Nirav
Modi's suppliers in the form of loans to Modi. As guarantee, the firms show the
letters of undertaking issued by the PNB's Brady Road branch in Mumbai.
Unveiling of Scam: In January, the fraud was unearthed when Modi's firm
requested further LOUs for paying the overseas suppliers. On this, the bank
officials refused on the ground that Modi's firm need to keep 100% collateral
for the same. The Modi's firm argued that no such money was kept 'on margin'
in the past either. Following which, the bank officials scanned the records only
to discover that there was no trace of any such transaction. This implies that the
guarantees/ undertakings were issued by bypassing the rules in collusion with
some PNB employees.
Violation of Bank Rules: The violation of banking rules as mentioned in the
point 8 above was too glaring a blunder to ignore. Hence, Punjab National Bank
filed a criminal complaint with the CBI on January 29 accusing Nirav Modi and
others of defrauding the bank and causing it a loss of Rs. 280 crores ($43.8
 million). The complaint was filed against three companies and four people,
including Nirav Modi and Mehul Choksi, managing director of Gitanjali Gems.
The Director Words: Sunil Mehta, The Managing Director and Chief
Executive Officer of Punjab National Bank. told investors' conference call on
Friday. "We will get back to normalcy within six months. Bank has the size and
capacity to come out of the problem," The bank was going through some
problems but "we will fix it,".
Prevention Spree: The Reserve Bank of India (RBI), meanwhile, said on
Friday it has undertaken a supervisory assessment of control systems at Punjab
National Bank and will take "appropriate supervisory action"

2. What is the loss to stockholders & other banks?

Following are mentioned the losses that stockholders and other banks are prone to face,
due to the PNB Fraud:
Loss to stockholders: There are 34 Listed banks in India. Share price of the
34 listed banks fell between February 12 to February 15, 2018. The sudden
volatility in prices eroded the market cap of these 34 stocks by over Rs. 36380
crores an
worth Rs. 8077 crores and its stock tanked 20.6% between February 12 and
February 15, 2018.
Loss to other banks: The value of PNBs fraudulent transactions are nearly 50
There were 5 banks
that were directly affected by the fraudulent transactions as they offered credit
based on the LOUs issued by PNB. UCO bank, Allahabad bank, Axis bank,
Union bank of India and SBI. It was clear that all the banks suffered losses as
the banking stocks showed a downward trend post Feb 14th, 2018.

3. What are the after-effects of Nirav Modi Scam?

Following are mentioned the after-effects of PNB Scam:

Banning of the LOU: The most significant action by the Reserve Bank of India
is the total discontinuation of the Letter of Undertaking (LoU). This was the tool
used by Nirav Modi to defraud the Indian taxpayer to the tune of $2 billion.
Indian importers have always used Letter of Undertaking (LoU) to obtain very
cheap credit. This helps them keep the cost of goods low which in turn helps
them to stay competitive in the domestic market. A Letter of Undertaking (LoU)
is basically an agreement between two branches of a bank. The money is
deposited in the domestic branch. This deposit is then used as collateral by the
foreign branch to give out a loan. Hence, it is the creditworthiness of the bank
that comes into the picture and not the creditworthiness of the individual. This
is the reason why credit obtained for Letter of Undertaking (LoU) is very cheap
as compared to other forms of credit. Also, it needs to be understood that Letter
of Undertaking (LoU) was only used by Indian importers. All over the world,
instruments such as Letters of Credit and Bank Guarantees are used. These
instruments are quite expensive as compared to Letter of Undertaking (LoU)
because they consider the creditworthiness of the importer and not of the bank.
The discontinuation of the Letter of Undertaking (LoU) will cause importing
firms to seek alternate forms of credit. The big firms may find some financiers
who are willing to extend loans at reasonable rates. However, the small and
medium enterprises are likely to face a cash crunch.
Loss of Arbitrage: As per the terms and conditions of the Letter of Undertaking
(LoU), importers were allowed to earn interest on their deposit made in Indian
banks. On the other hand, they had to pay interest which was linked to the
LIBOR rate abroad. The domestic interest rate is far higher than the LIBOR
rate. As a result, the importers earned money by using the Letter of Undertaking
(LoU) route. This was an arbitrage opportunity for importers if they were able
to neutralize the foreign exchange risks using derivatives.
Depreciation of the Rupee: The Letter of Undertaking (LoU) was a mechanism
wherein the foreign currency paid to the exporters was taken from a foreign

country. As a result, there were very few transactions selling Indian currency
and buying foreign currency. Now, the market will be flooded with these
transactions. Since a lot of people will be willing to sell the rupee, the rupee will
depreciate. This will make the imports a lot more expensive. The
competitiveness of these imports vis-à-vis domestic production will also take a
hit.
Exports Impacted: Most Indian exporters are also importers. Consider the case
of gems and jewelle
exports. However, the sector imports more than 50% of its raw materials.
Hence, if the price of imports goes up, so will the price of exports. This will

general feeling that the Reserve Bank of India may have gone too far. The Letter
of Undertaking (LoU) should have been properly regulated instead of being
discontinued.
Integration with Swift: From the technology point of view, it has now become
mandatory for banks to ensure that their core banking systems are well
integrated with SWIFT systems. The bank fraud was possible only because the
transactions happening in SWIFT were not reflecting in the core banking
system. Also, multiple levels of approvals have to be designed to prevent the
misappropriation of funds in the future. This will be an additional expense for
the banks involved which will ultimately be borne by the borrower in the form
of high-interest rates.
 Rotation of Employees: The rotation of employees needs to be done every
three years. However, in case of Nirav Modi fraud, the same branch manager
was handling the branch for seven years. RBI has now issued strict guidelines
that rotation of employees needs to be carefully followed.
Impact on Importers: Banking will be more tightly regulated. More
regulations will add up to extra cost that will have to be borne by the importers.
Nirav Modi scam has made life difficult for all importers in India.

4. What is the loss to employees?

Following are mentioned the points which clearly showcase the loss faced by the
employees:
At the receiving end: Thousands of employees of the firms owned by diamond
businessmen Nirav Modi and Mehul Choksi faced the receiving end of the Rs.
12,600 crore Punjab National Bank scam. The employees of the Firestar
Diamond International Pvt Ltd and Firestar International Ltd owned by Nirav

faced an uncertain future as the units of the firms were either locked out or
sealed by investigative agencies.
Firms in SEZ:
at Surat, Gujarat were able to pay salaries to their employees for January, as
their bank accounts were frozen by the Enforcement Directorate (ED) and the
Central Bureau of Investigation (CBI), said a PTI report.
Management locked the units: About 700 employees of the two firms in the
SEZ lost their jobs as the management locked the units and asked the employees
to look for jobs elsewhere. The management told the workers that it cannot pay
the outstanding salaries for January and February as all the bank accounts were
frozen by the ED and the CBI.
Employees held protests: Another 700 employees of the Gitanjali Gems Park
owned by Mehul Choksi in Hyderabad held protest to save their jobs after five
jewellery units in the park, which is also an SEZ, were sealed by the ED.
Disabled Employees: About 300 among the employees were disabled, with 100
among the 300 being women. Many of them had a salary of Rs. 750 per month
when they started working at the SEZ and on the eve of the firms being sealed,
they were drawing salaries of Rs. 12,000 to Rs. 15,000. The employees were
trained to work at jewellery units, and had no other source of livelihood.
Inception of Telangana Government: The Gitanjali Gems Park known as
Rajiv Gems Park till 2014 was set up in 2005 on land allocated when YS
Rajasekhara Reddy was the Chief Minister of Andhra Pradesh. Sources at the
Centre of Indian Trade Unions (CITU) told News click that 171 acres had been
allotted to the park for a paltry sum of Rs. 4 crores in 2005. The workers
 demanded that the Telangana government should take over the firms so that
work can be continued and their jobs protected.
Nirav Modi and Gitanjali Gems stores in various cities in India shut down,
throwing life out of gear for their employees. Mehul Choksi sent a letter to the
3500 employees of his firms on Friday, 23 February, in which he asked them to
look for jobs elsewhere as he may not be able to pay their salaries.

5. What is the loss to society?

In a country where nearly 270,000 farmers have been driven to suicide since 2000, and
nearly 80 percent because of an inability to repay small loans (the average value of most
of these outstanding loans is about $3,000), it is criminal that millionaires and
billionaires live it up as their unpaid loans suck dry the banking sector, and then simply
take the next flight to London or Antwerp or Dubai, never to return.

A recent report on scams wilful

-sector banks about $8.65 billion, much more than the
government allocation for agriculture and farmer welfare. Yet, because these men make
edded deep within the political system, their
violations are handled with kid gloves until it blows up in our faces.

The massive bank fraud allegedly perpetrated by jewellers Nirav Modi and Mehul
Choksi is threatened eopardising at least 3,000 jobs.
While the narrative
business and its foreign trade that the $2 billion scam has hit the hardest, according to
domestic ratings firm CARE Ratings. This also impacted credit flow to the industry or
cause delays in extending advances.

This eventually made

exports in the financial year 2017. The shutdown of the two companies had an impact
of 5% to 6% on the diamond and jewellery foreign trade in value terms over the year
2018-19.

6. What is the loss to clients?

Following are mentioned the points which clearly depicts the loss that has been faced
by clients, due to the PNB Scam:
Impact on Stock market: There are more than thirty banks listed on the stock
market, if we take precise number, there is total of 39 banks listed on the Indian
stock market, due to such activity the share prices of all thirty-nine banks fell
between the date 12th and 15th of February, and witnessed the huge price
volatility which ultimately resulted into erode of market capital of more than
thirty-four banks by more than Rs. 30,000 crores.

Impact on Banks: There are five banks which got directly affected due to such
fraudulent transactions which are listed below:

Sr no. Bank
1 Allahabad Bank
2 Axis Bank
3 UCO Bank
4 Union Bank of India
5 SBI

All above mentioned banks faced the impacts due to the LoUs which were
issued by them. LoU is Letter of Undertaking is assurance given by one bank to
another to meet the liability in behalf of customer. In this case the customer was
Nirav Modi who acquired fake LoUs to carry on the scam.

If we talk about the stocks of these all banks, effects are explained as under:

Name of the Bank % lost in prices Market Capital loss Net Loss
Allahabad Bank -9.9% Rs. 484 crores Rs. 1263.79 crores
Axis Bank -3.4% Rs. 4800 crores 25.3% growth
Union Bank -5.8% Rs. 633 crores Rs. 1249.85 crores
SBI -3.34% Rs. 8329 crores Rs. 2416.00 crores
Impact on LIC: Life Insurance Corporation is largest institutional investor in
major entities, LIC has also invested into PNB, due to scam it has also suffered
from losses, which amounts around Rs. 1400 crores. If we talk about the
holdings of PNB with LIC, On December 31st, 2017 LIC owned;
13.3% of shares in PNB
13.24% shares in Union Bank of India
13.17% shares in Allahabad Bank
2.88% shares in Gitanjali Gems.

This are the largest holdings in all these four entities by single institution. The
estimated loss to LIC is as under

Impact on Rating of PNB:

creditworthiness of Punjab National Bank, after putting it to observation, they

currency deposit rating of Baa3/P-3.

 CRISIL, Indian Credit Rating Company has given AAA rating which clearly
means the highest safety which will be revised once it starts covering its
negatives.
CARE has given AA+ rating on PNB. And asked PNB to clarify the banks
liabilities and profits.
ICRA and more two credit rating companies has given AAA and AA+ ratings
but it will be revised soon, to do this their (
under watch.

Finally, the customers and their trust, also the name of the bank, due to such
activity bank has faced many issues regarding the queries of their customers
about the money in the accounts, many of them even shifted their accounts from
PNB to different banks.

7. How should the involved company/individual should have acted so that the
scam/irregularity may not have happened?

Following are mentioned the points following which the Nirav Modi Scam could have
been prevented:
Enabling SWIFT Transactions: SWIFT stands for Society for Worldwide
Interbank Financial Telecommunication. The Letter of Undertaking (LoU)
operates via the SWIFT, a message service for banks. A SWIFT message poises
as a proof the borrower will pay back the amount within 180 days. SWIFT is
the reason why foreign banks lend the amount to the borrower. Any and every
bank should seek for full integration and reconciliation of SWIFT transactions
with the core banking solution software.
Rotation of employees: Rotation of employees in every three years - a standard
practice in banks and elsewhere - was not done. One particular bank officer,
who is an accused, stayed posted on the same desk in the same department for
seven years.
Non-sharing of passwords: Every probationary officer of the bank is asked
during the orientation and training programmes that sharing of passwords is
prohibited even with the colleagues. In the 2016 advisory, the RBI had warned
that unauthorised sharing user IDs and passwords might put SWIFT transactions
at risk. In PNB fraud case, one employee used two or at times three officers'
passwords.
Authentic & Regular Reconciliation: The maker-verifier-approver chain was
not followed in issuing the Letter of Undertakings to firms linked with diamond
merchants Nirav Modi and Mehul Choksi. LoUs were issued to customers
having no sanctioned credit limits. The follow up on these LoUs was not done
as many of them were not repaid even after expiry of prescribed period of 90
days. No communication was recorded for issue of LoUs and end transactions
caused by the credit assurances. Inter-bank communication involving the
lending overseas branch was not maintained. Reconciliation and confirmation
processes were not followed.
Ethical Business Practices: Ethical banking practices should be preferred.
Disclosures to RBI, SEBI and other regulators should be made with consistent
periodicity.
Review System should be maintained: All the banks should review their
critical systems and processes including the IT segment regularly. Banks should
ensure that there are adequate systems and controls in place to identify potential
risks and that they are being followed at all relevant branches.
Regular Audits must be made: All internal and external audits must be
completed on time at branch level. The audit reports should be shared with the
government's auditors and examined by the RBI, which should conduct a
separate audit every year. In the PNB fraud case, the bank has told the finance
ministry that the last audit by RBI was done in March 2009.
Training of bank staff: Training of bank staff should be undertaken for skill
upgradation and creating awareness about the possible modes of banking fraud.
Use of technology for preventing fraud should be encouraged within banking
ecosystem.