Were Senior Managers Asleep At Punjab National Bank?

Investors will be forgiven for wondering whether senior managers at Punjab National Bank are fans of Rip Van Winkle. How else can one explain the staggering volume of fraudulent transactions at India’s second-largest state-backed bank by assets that went undetected for the past seven years?

PNB on Wednesday disclosed that $1.8 billion of unauthorised transactions had been made at one of its branches in Mumbai for the benefit of a few account holders with their apparent connivance. It added that based on unauthorised letters of understanding, or bank guarantees, issued by PNB to these customers, other banks appear to have advanced money to these clients abroad.

“This cancer that’s been going on since 2011, we have brought it out and we are resolving it,” PNB’s Chief Executive Sunil Mehta, who took charge of the bank in May last year, told reporters at a recent news conference, adding that the 123-year old bank  has survived crises in the past and would honour all its commitments; he stopped short of clarifying the expected hit to the bank’s bottom line pending investigations.

While the nitty-gritty of the extent of liability to PNB will become clearer over the next few months, depending on how much the bank is able to recover from those companies it accuses of connivance in the unauthorized transactions, and on any liability of counterparty banks, the disclosure leads to some disturbing conclusions about lapses in operational/risk management and regulatory failures. Given the size of the fraudulent transactions, estimated at roughly one-third the size of the bank’s market capitalization, this should have raised alarm bells earlier.

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The case also heightens concerns about the overall health of India’s banking system amid an escalating crisis of soured corporate loans, which forced the government to announce a $32 billion bank recapitalization plan in October. India’s central bank, the Reserve Bank of India, in its biannual Financial Stability Report in December warned that the overall risks to India’s banking sector remained elevated due to asset-quality concerns. Investors and analysts who have pinned their hopes of India’s growth on private investment and credit picking up are rightfully worried about the risk of contagion and whether a probe into systems and procedures at other public-sector banks would reveal similar operational lapses that quickly translate to a credit risk.

Tough questions need to be asked about PNB’s risk-control procedures. PNB’s claim that it wasn’t aware of the unauthorized guarantees issued on behalf of select account holders to obtain foreign-exchange credit from the overseas branches of mainly Indian banks simply doesn’t cut ice. CEO Mr. Mehta, at a recent news conference, pinned the blame on a couple of staffers who acted in “apparent connivance” with a few account-account holders. It isn’t clear how a junior staffer could have access to the SWIFT interbank messaging system for authorisation of letters of credit in collusion with another officer. Where were the checks and balances? Shouldn’t transactions such as these require the sign and seal of senior managers? If anything, Nick Leeson’s 1995 destruction of Barings should be a painful reminder of how, in the absence of adequate risk-control procedures, even one employee can destroy a bank. Indeed, it is necessary to continuously appraise the bank’s risk-management systems so that a couple of employees aren’t able to bring a bank to its knees. As of Friday, the bank had suspended a total 18 employees following the scandal. It is unclear whether these include senior management who are arguably to blame for the failure of oversight, if not collusion.

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The case further reflects operational failure on part of the bank. How did the bank allow the issuance and rollover of such guarantees without raising red flags? The staffers, the bank alleges, violated the bank’s own rules and issued unauthorized letters of credit to companies associated with billionaire jeweller Nirav Modi without making corresponding entries in the bank’s own systems, which is why the fraud went undetected for so many years. The unauthorized transactions, according to news reports, came to light only last month when Mr. Modi’s companies sought a fresh loan – by which time the bank officials who had previously helped them had retired. It beggars belief how such non-fund exposure was left out of the core banking system for so many years without being detected. Mr. Modi hasn’t spoken about the case so far, but his flagship company Firestar Diamond has denied involvement. PNB’s Mr. Mehta has said that Mr. Modi has written to the bank about a possible repayment but hadn’t come up with any concrete plan.

Moreover, the fraud also exposes the failure at counterparty banks to detect the unauthorised letters of understanding. Surely there should have been a system of shared communication/documentation between the banks regarding the loan extended to these companies based on the credit guarantees from PNB? It is yet unclear whether these overseas bank branches acted in collusion. Collusion, if proved, would reduce the liability of PNB for the fraudulent transactions, putting at least some of the blame on the counterparty banks.

Finally, it reflects failure on the part of the banking regulator to identify lapses in risk control and operational processes at the bank.

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(Indrani Dattagupta is a financial journalist and has previously worked for The Economic Times, Dow Jones Newswires and The Wall Street Journal.)

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