Weeks after the biggest fraud in the history of India’s financial industry was revealed, its trade finance sector is trying to come to terms with the fallout.

International banks are withholding guarantees for local bank instruments, the cost of funding is rising, while some are calling for the letter of undertaking (LOU) to be “extinguished”.

All of this, after an extraordinary documentary fraud was unearthed at a branch of the Punjab National Bank (PNB), the second-largest public bank in India, which some in the sector are saying could end up costing billions of dollars.

In February, it was announced that two PNB employees had “fraudulently issued LOUs and transmitted Swift instructions to the overseas branches of Indian banks”, for seven years. These were used to raise buyer’s credit for Nirav Modi, a billionaire jeweller, and his uncle, Mehul Choksi. At that point, the fraudulent transactions amounted to US$1.77bn, but one banker tells GTR that the final amount could be well in excess of that.

“I think it could be closer to US$4bn, that’s what people in the industry have been saying,” says the source, who wished not to be named.

The fraudsters were issuing the LOUs on the Swift system, but were not entering them on PNB’s core banking system (CBS). Ideally, the transactions would have been automatically flagged on the CBS, but in this case, the Swift system was not integrated, highlighting a deficit in both technology and controls which allowed this to fester for so long.

“It is astounding, every banker that I speak to is astounded. How could such a thing have happened? It exposed failures in the control system at multiple levels. Either in this particular incident the controls are very bad or, for some particular reason, they were deliberately disabled. These can be the only two explanations,” Hemindra Hazari, an independent banking analyst in India, tells GTR.

The immediate result is that local banks are struggling to get international banks to confirm their guarantees, which is in effect driving up the cost of import financing. According to local media reports, the likes of Citi, Deutsche Bank, Standard Chartered and HSBC are now reluctant to accept guarantees in the form of LOUs from local banks,

Ramesh Ganesan, head of transaction banking at IndusInd Bank, confirms that international banks have changed tack, but doesn’t think it will be long term.

“It is a kneejerk reaction by some who may not have clarity on what has happened,” he says. “The issue is all about fraud in one PNB branch and is not affecting other banks. The markets reacted because other banks abroad, who financed it, were not sure of the genuineness of the transaction and commitment of PNB. Many financing banks are Indian banks’ overseas branches. For them, PNB is very well known, it is owned by the government. I am now seeing all the banks doing their financing and taking a risk on other banks, knowing fully well that this is localised fraud. It will not have any ripple effect in the industry as a whole. The only impact I see is that the pricing has gone up.”

Aneish Kumar, managing director of BNY Mellon’s Indian operations, has also seen some market movement since the fraud.

“A lot of people are asking banks like us if we can fund LOUs, four or five banks are going slow on buyer’s credit. There’s a lot of demand, cash flows of some small import companies are suffering, which could lead to an extended receivables collecting period and working capital issues. I think there’s going to be a long working capital cycle now,” he tells GTR.

Hazari, the banking analyst, expects more dramatic change in the sector. He says that “the reputational risk is enormous” and that the fraud is a “huge blow” to the image of Indian banks abroad. He also calls for the scrapping of the LOU, an instrument widely used in India to guarantee export finance.

“In my view the LOU should be extinguished,” he says. “For one it’s not a global product. If there’s genuine trade finance, there’s a letter of credit, which is globally recognised. The documentation is far more stringent than on an LOU.”


How does it compare with other frauds? 

Documentary fraud is no new thing in trade finance, and this event has added volume to the calls for digital methods to replace paper-based trading in the sector. In recent years, the Qingdao metals fraud and the Access World warehouse receipts fraud have made headlines in East Asia.

Peter Bennett is a partner at law firm Stephenson Harwood, and advised international commodity trading group Mercuria in the Qingdao metals High Court case against Citi. He says that while the Access World and Qingdao cases were complex, involving a myriad of documents, fictitious warehouse receipts and stocks of metals, this one is relatively straightforward in comparison.

“In the case of PNB, and based upon what we have read from the press reports, the analogy is with that of the collapse of Barings back in 1995, where you had one trader inside Barings who undermined the system to create a series of financially suicidal deals for the bank and which went unnoticed and unchecked by the bank’s internal compliance system. As I understand matters, PNB’s internal IT system was abused and the internal compliance system failed so that the overwhelming number of these deals were never registered,” he tells GTR.

Something broadly similar has happened in PNB, where the internal compliance systems failed to pick up on a number of employees in one branch of the bank issuing a series of guarantees for vast sums. All of these were funnelled towards Choksi and Modi, from the accounts of the confirming banks overseas.

“It’s very straightforward. The sum involved is alleged to be at least US$1.7bn and all of those principal creditors will be looking to enforce the fraudulent guarantees against PNB. The question now is whether and to what extent those fraudulent guarantees are binding on PNB. They might have been unauthorised internally, but to the principal creditor receiving them, PNB, acting through its employees, might have been representing that they were genuine and enforceable. I expect PNB will be scrutinising every claim made,” Bennett says.


The veracity of the system

The lapse in risk controls is what most people find remarkable in this case. Banks often rotate senior staff every few years, to avoid the accumulation of knowledge and responsibility that can lead to manipulation of the system.

“Rotation of staff and segregation of duties, splitting responsibilities so it’s not just a single individual in control of every element, because that’s the foundation of fraudulent behaviour, trade or otherwise. The moment you give payroll or whatever it might be to the hands of a single individual, you create the opportunity,” Tim Phillipps, the leader of Deloitte’s Asia Pacific financial crime unit, tells GTR.

It’s also uncommon for access to the Swift network to be open to such junior staff. Gokulnath Shetty, the deputy branch manager of PNB’s Brady House outlet in Mumbai has been jailed this week, but the transmission of messages on the Swift network is usually a three-step verification process.

“He seems to have controlled the nostro accounts and therefore seems to have controlled the back office. All of these have their own check systems in the banking system. To me it looks very doubtful whether it could be a very low level person handling this. If it turns out it was, then there’s been a protocol problem. How can a low level employee have access to all of these systems? These are my two inferences from what is currently known,” Hazari says.

There is no suggestion that there is a fault in the Swift system in this case, simply that bad actors manipulated a technological deficit within PNB. One lawyer describes the systems in place as “prehistoric”, while others have said that this clearly makes the case for blockchain technology.

The Reserve Bank of India and Swift have reportedly agreed to work together to screen all cross-border trade transactions (Swift declined a request to be interviewed for this story), and for now, the overhaul that would be required by distributed ledger technology seems unrealistic.

For trade financiers in India, the priority will now be on doing the simple things right.