The BASEL II committee defines Operational Risk as “The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events”. The Letter of Understanding (LOU) scam involving Punjab National Bank (PNB), the second largest PSU of India, and Nirav Modi, a Surat born billionaire diamond jewellery designer, is a classic example of Operational Risk. The flamboyant and ambitious diamond businessman is accused to have exploited loopholes in the processes of PNB to acquire fraudulent LoUs to raise credit worth about ₹11,400 crore.
What is a Letter of Understanding (LOU)?
Letter of Undertaking is a bank guarantee under which a bank allows its customer to avail loan from another Indian bank’s foreign branch in the form of a short-term credit. The issuing bank receives a fee and in return guarantees payment to the receiving bank and the companies on a specific date. The loan is generally used to make payment to the customer’s offshore suppliers in their designated currency.
Diamond business like almost every other business runs on credit which is progressively availed and settled across the value chain. Nirav Modi acquired fraudulent LoUs from the Brady House branch of PNB in Mumbai, to make payment to the suppliers of the imported pearls and diamonds.
What is the fraud?
LoUs are highly risky and prone to default. Banks by design avoid risky businesses and issue LoU(s) only on securing collateral against the same. On issuing an LoU, the issuing branch sends a SWIFT message (an inter-bank messaging network designed for secure transmission of instructions for financial transactions) to the overseas banks party to the LoUs. Each transaction is required to be recorded by the issuing bank in the core banking systems (CBS).
In this case, LoUs were fraudulently issued without any collateral and the SWIFT messages were routed without following the prescribed procedure of recording the transactions in the CBS. Further, RBI guidelines requires an LOU to expire after 90 days from the date of shipment. However, in this case, the LoUs were rolled over after each expiry which essentially meant, new LoUs were being used to service the old LoUs.
The complete story:
Gokulnath Shetty, was posted as deputy manager at PNBs foreign exchange department in the Brady House branch, Mumbai on March 31, 2010. Shetty along with another bank official Manoj Kharat is alleged to have fraudulently issued the first LOU in favour of Nirav Modi and his companies in 2011. After that over 150 such LOUs were issued in the next seven years and none of these transactions were routed through the CBS. As a result the fraud remained undetected for over 7 years.
After Gokulnath Shetty retired in May 2017, the new officials, as per procedure, demanded 100% cash margin or collateral to issue LOUs. This demand was contested by Nirav Modi companies who revealed to have been receiving LOUs in the past without any collateral or margin. This is when the fraud came to light and after initial investigation, on 29th January 2018, PNB filed a complaint with the CBI declaring it as a ₹280 crore scam. Further investigations revealed that the rot ran much deeper and on 14th February, PNB issued another statement declaring the scam to be worth $1.77 billion or approximately ₹11,400 crore. Allahabad Bank, Axis Bank and Union Bank of India are some of the banks that are believed to have extended credit based on the LoUs issued by PNB.
The PNB LOU scam brings forth the importance of identifying and mitigating operational risk in the banking services sector. It’s a classic example of operational risk where the established processes were manipulated and bypassed by internal people to mount a serious fraud worth about $1.77 billion. The magnitude of the fraud can be estimated from the fact that the scam is worth more than twice the amount that PNB was allocated under bank recapitalization scheme and 49 times the net profit posted by PNB in quarter preceding the detection of the fraud.
Olive Ridley 