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Bank Scams - A Threat to the Economy: Case of Punjab National Bank

Sahaj Manocha

ABSTRACT


"Public sector banks will be provided Rs 70,000 crore to boost capital and improve credit," quoted

our Finance Minister while presenting the budget for the financial year 2019-20. In this stage of the

economy where the government’s allotment for the public sector banks are exhibiting an accumulative

trend, the banking sector scams are also swelling up in leaps and bounds. Banking scams being a

headliner in the newspapers now and then, is a growing concern of our economy. This paper examines

the case of the Punjab National Bank Scam, which came as an enormous setback to the entire financial

sector, amounting, to Rs. 12,000 crore involving six other banks is now labelled as the greatest banking

scam in the record of the banking system of India. This study aims to scrutinize the PNB scam to reveal

the internal and externals dynamics that lead to the occurrence of the scam. The study also attempts to

address the problems faced by the general public as a result of this scam and the overall economic

impact of the case by identifying the negative externality of a bank scam. An effective way of preventing

the occurrence of such cases is a proper understanding of the loopholes in existing the system and

correcting them by the Central Bank of India -RBI. In the end, the main ingredient for a powerful

economy is its banking system which cannot be at stake.


INTRODUCTION


Glancing through the daily headlines of any newspaper in India, definitely draws your attention

towards the increasing levels of bank scams and frauds. Scams have now become a common

phenomenon when it comes to the Indian Banking structure. However, our country has

observed a plethora of these unnecessary parasites over the last three to four decades. Economic

scams are the key reason behind the economic slump our country is facing now.

Post the liberalization of the economy, the banking sector of India has witnessed a substantial

advancement and revolution but, even though after frequent efforts of the government to

improve its regulation, it still suffers from its challenges and bottlenecks with respect to

“ethical practices, corporate governance, and monetary depression”(Kolte & Wagh, 2019).

These fraudulent practices have grown over the years at an increasing rate as stated by the

Reserve Bank of India which defines fraud as “a deliberate act of omission or commission by

any person, carried out in the course of a banking transaction or in the books of accounts

maintained manually or under computer system in banks, resulting into wrongful gain to any


person for a temporary period or otherwise, with or without any monetary loss to the bank”

(Singh et al., 2016).

Over the last three decades, the banks in the public sector have exhausted around Rs. 23,000

crore of money due to bank frauds and scams (Business Line, 2019). “These scams range from

the well-known ones of Harshad Mehta, Ketan Parekh, Satyam, Subroto Roy and Spectrum

Scam to the latest ones of Nirav Modi, Vikram Kothari, and Simbhaoli Sugars, many other

players are hamstrung and the investigators are left to get choked” ("Impact of Banking Scams

on Indian Economy", 2018). Nevertheless, the banking sector had finally begun to show few

signs of vigilance after the reveal of the largest bank scam of the Punjab national bank. On

January 14, 2011, the second-largest Public Sector Bank (PSU) of our country, Punjab National

Bank was defrauded by one of its richest debtors, Nirav Modi costing PNB one-third of its Net

Worth (The Economic Times, 2018a)

Out of the 21 Government-owned banks, 11 of them are now under the Reserve Bank of India’s

supervision on account for bad loans, low level of yield on assets and fragile level of capital.

When the government was busy devising the measures to cure this contagious disease of bank

scams through recapitalization, the Punjab National Bank fraud case came as a major threat to

the measures of the government (The Economic Times, 2018b). Since the day the scam was

discovered and brought in front of the public the Punjab National Bank has adopted all the

possible measures to prevent the happening of such events in the near future, but it seems like

such efforts are not showing its immediate results as the instances of the bank’s name being

flashed through news has shown a growing trend (The Economic Times, 2018a)

Various studies have been undertaken to understand the impact of Bank Fraud on the economy

which highlights how these scams are financially draining our economy, but no adequate

research and study has taken place for the Punjab National Bank’s scam and its economic

implication. Therefore this paper attempts to focus particularly on the case of Punjab National

Bank’s scam, explaining how it drained the country’s money supply and its other economic

implications. It follows a case-based analysis approach to apprehend the depth of banking

scams. The study hopes to depict a relationship between the money supply in the economy and

the frequent bank scams with the help of PNB’s case. It also aims to highlight how corporate

mismanagement can lead to such a distressing state of affairs.


THEORETICAL BACKGROUND


BANK SCAMS/FRAUDS

Financial fraud, in essence, is a situation in which the legal and ethical management of financial

resources does not take place (Rathinaraj & Chendroyaperumal, 2010). The huge turmoil and

breakdown, faced by the global loan market during the economic crises of 2007-08 resulted in

the bankruptcy of huge banks like Lehman Brothers(Adu-Gyamfi, 2016). Several economists

suggest that the periods of depression with are accompanied by the crunches in the banking

system, are too grave and problematic to restore from when compared to the other recession

periods (Sanches, D, 2014). The mergers of huge banks gave rise to the well-known concept

of “too big to fail” which not only resulted in risky objectives in the financial sector but also

the financial crises of 2008. The Dodd-Frank Act, a corrective action taken in response to the

2008 economic crises, led to setting up of new regulatory agencies to assist the banking

structure in detecting and preventing the frauds occurring in the banks (Gayathri &

Mangaiyarkarasi, 2018). This brings forward the idea of how a bank scam can be a cause as

well as an effect of economic failure and fraud.

TREND OF BANK FRAUDS IN INDIA

The available news articles and literature states that in current years, the cases of fraud and

scams have shown an increasing trend. Post the liberalization, the number, complexity and the

number of frauds being reported in India to have been mounting since then (Singh et al., 2016).

As mentioned in “An Analytical Study on Bank Frauds and Scams In India,” a publication by

Sardar Vallabhbhai Patel (2002), the number of bank frauds have definitely been increasing

since 1990 with the peak toughing in 1993/94, number of frauds have been maximum in

1993/94 registering a sharp rise of 34 and 35 % respectively as compared to the previous year,

this reflects that the number of frauds has a tendency to increase with the liberalization of the

economy which has started from 1990 onwards. Meaning thereby that liberalization has been

set into motion without ensuring sufficient checks in place.

The current situation of the banking sector in India highlights how the banks are being

defrauded of crores of Rupees which is resulting in lower confidence of the investors, the

incidence of 2005 suggesting the withdrawal of an approximate 1111 crores of rupees in

banking scams which is two times more than what was reported in the previous financial year

(Khanna & Arora, 2009). The non-performing assets have been plaguing the banking structure

for several years, struggling for its sustainability. Chakrabarty (2013) put forth his thought that

the highest number of banking frauds have been registered with the banks of the public sector,

even though the private and the foreign sector has borne the brunt of it but, they were more


successful in dealing with it than the public sector could ever be .“As many as 861 bank

advance related fraud cases of Rs 1 lakh and more, involving Rs 4,920 crore, were reported in

the first half of 2015-16. During 2014-15, 1,651 such cases were reported that involved an

amount of Rs 11,083.11 crore”(Swain & Pani, 2016). Scandals, shortages of cash at ATMs and

rising wilful defaulters occurring all at once have shaken the roots of the banking procedures

and how the complications have risen (The Economic Times, 2018b). The Indian economy has

witnessed a series of scams ranging from the Neerav Modi, Vijay Mallya and the Allahabad

scam which highlights the major reasons and factors that have led to such massive levels of

scams in our country.

FACTORS LEADING TO BANK SCAMS

As mentioned in the reports published by the Reserve Bank of India, frauds have been classified

based on its types and provisions of the Indian penal code, and the reporting guidelines have

been set for those according to RBI. In an attempt to monitor scams through the vigilance of

the banks’ board of directors, the Reserve Bank of India issued a circular suggesting to set up

a regulatory mechanism to look over the auditing and inspection inside the bank to devise an

appropriate plan of action to prevent such defaulting of the borrowers (Gayathri &

Mangaiyarkarasi, 2018).

Major findings in RBI (2014) highlighted “the stress of asset quality and marginal

capitalization faced by the public sector banks” along with the various suggestions to resolve

such issues wherever they crop up while performing the banking functions. Rajan (2014)

stressed how good corporate governance and decentralization of authority in public sector

banks will assist them by increasing their competitiveness and market reputation enabling them

to easily raise money.Raju (2014) supports the view put forth by Ranjan by stating that it’s not

the strict regulations which will enable the banks to face the current crises, instead it acts as a

hurdle in the efficiency of the bank. Subbarao (2009) on the other hand believes that trust and

presumption of truth are the basis for a strong and vast banking sector, it’s the evolution of

“moral hazard” which causes the scams to undertake which is an outcome of socialization of

costs.

A study undertaken by Khanna & Bindu(2009) to question the factors responsible for frauds

in banks and the application of precautionary security regulation in Indian Banking Industry,

attempted to draw attention towards the major reasons for the occurrence of bank frauds with

the help of hypothesis testing, the results showed that delay in submission of control returns

to the controlling regulators with respect to the sanctioned loans, bills of exchange, drawing

rights have been one of the major reasons that have led to the banking frauds.

Further as pointed out by Raghuram Rajan "It turns out that we don't need to be really clever

in the Indian system to make away with a billion dollars. Some of these banks have antiquated


systems also...You worry that the systems are not adequate to prevent rogue dealers, rogue

employees colluding and making off with stuff. That is the fraud part," which also tells us how

the lack of proper system and management and experienced persons can lead to a scam

(Business Today, 2018b).

ECONOMIC IMPLICATIONS OF A BANK SCAM

A working paper by the Indian Institute of Management (IIM), expressed that Indian banks had

lost over 23,000 crores of Rupees in cheats over the past three years while the expense of

scams for the most recent five years can be added to around 61,200 crore rupees. Nonetheless,

if one intently takes a gander at the general credit in the banking framework which was INR

83 lakh crore a year ago, these cheats will show up as a little extent of it (Singh et al., 2016).

The failures of banks lead to huge social consequences in any country due to its association

with the entire functioning of the economy which is commonly known as “network

externalities” ("Impact of Banking Scams on Indian Economy", 2018). The social

consequences could be seen through the delay in the number of infrastructural projects that

faces the brunt of these fraudulent practices in the form of restricted credit (The Economic

Times, 2019).

The banking scams have led to the need for massive structural reforms to clear the mess in the

public sector banks and the government is left with no other option but to use the taxpayers’

money to bail out the public sector banks hit by corruption (Sudhaman, 2018). “ Goldman

Sachs Group economists had trimmed their growth projections for 2018, ending March to 7.6

percent from 8 percent amid concerns that the banking system’s woes are more widespread

than previously thought” shows how the banking systems globally are facing the problems of

frauds (Nag, 2018). “The problems in India’s banking system are self-inflicted mostly because

of lack of due diligence,” said N.R. Bhanumurthy, a Delhi-based economist at the National

Institute of Public Finance & Policy. With enormous social outcomes of disappointments


because of banking frauds, an informal stop on loaning by petrified investors might be counter-

profitable for some organizations. The rising view of Public Sector banks (PSBs) as a nexus of


defilement is ending up progressively like social commitments to be guaranteed by citizens. It

is the ideal opportunity for the administration to make successful measures in perspective on

the financial judiciousness of the nation as opposed to working responsively (Nag, 2018).


METHODS AND MATERIALS

The method followed for research is a case-based analysis wherein the factors and the

economic implications of a bank scam will be explained through the case of the Punjab

National Bank Scam, the biggest scam the banking industry has ever witnessed in India. This

particular case study has been preferred as it has been one of the major scams which shook our

economy and raised a question on the operations and the efficiency of the Indian banking

structure. The analysis has been done by adopting a secondary method of research hence

various research papers, newspaper articles, blogs, and website data have been referred to and

used throughout the course of the study. The study aims to highlight the loopholes that exist in

the system and what are the negative externalities of the same.

CASE STUDY

THE STORY PUNJAB NATIONAL BANK (PNB) SCAM

The banking sector of India, the integral sector of our economy has recently been the most

vulnerable among all the sectors that are operating in our country. The various banks have been

facing all sorts of problems ranging from minor ATM scams to enormous scandals and bad

debts that have shaken the roots of the structure. This paper has centered its research and

analysis on the biggest scam in the history of our banking sector- the Punjab National Bank

Scam. “The state-run Punjab National Bank disclosed an Rs. 11,000 crore fraud on Valentine’s

Day, allegedly by one of the country’s richest men, diamantaire Nirav Modi” (The Economic

Times, 2018b).

“Diamonds are so rare, so are the chances of a diamantaire defrauding a bank of more than

11,300 crores.” (Business Today, 2018a). PNB's home branch situated in Brady which is not

exactly a kilometre far from the glamourous Nirav Modi precious stone showroom in Kala

Ghoda has been turned into the focal point of the greatest financial extortion recognized in the

nation. This huge amount of involved in the Nirav Modi Scam put forth numerous questions

on how the scam was initiated and were the internal or the external factors were responsible

for the occurrence of such a financial

Modus Operandi of the Fraud.

Three diamond firms owned by the Nirav Modi Group and some other firms under the

ownership of Gitanjali Gems held current accounts at a branch of Punjab National Bank, these

firms obtained the required credit in foreign exchange through the LOUs issued by the Punjab

National Bank. (Hanumantu, Worlikar & Narayanaswami, 2019).


The root cause of the scam lies in the working of the Society for “Worldwide Interbank

Financial Telecommunication” or simply the SWIFT messaging system. SWIFT is an online

mechanism developed for securely transmitting instructions for financial transactions by the

means of a standardized system of codes (Seth, 2019). SWIFT currently being used by almost

11,000 financial institutions all over the world, is a secure mode of sending inter-bank

messages with its fundamental role of providing a channel of transmission that is safe and

secure so that banks involved in the process of transmission are sure that message is received

and sent to the correct source and recipient respectively (Merwin, 2018).

The operation and usage of the SWIFT system various form banks to banks which is due to the

difference in the business processes they have in place (Seth, 2019). It is a recognizable fact

that the bank will want to have some checks and approvals before actually sending any message

relating to a financial transaction. For Punjab National Bank such authorizations and checks

were evidently comprised which enabled such an incident to occur which was initiated by

sending a SWIFT message from PNB’s Mumbai branch to the overseas banks offering

unauthorized LoUs (Hanumantu, Worlikar & Narayanaswami, 2019). In an ideal situation, a

letter of Undertaking or simply the LoU allows a customer or a firm, Nirav Modi in our case,

to raise credit from the foreign branch of an Indian Bank to make payments to in foreign

currency to the overseas suppliers (Prasad, Prasad & Zeeshan, 2018). Taking advantage of

such a situation Nirav Modi was successful in rolling over the credit and ensuring that

following LoUs repay the money due on the previous LoUs which prevented him from being

caught for such a long period (Merwin, 2018).

Detection of the Fraud

The scam was identified and brought in front of the public through a First Information Report

(FIR) being filed by a Punjab National Bank official against other bank employees for the issue

of fraudulent Letters of Undertaking (LoUs) to the firms owned by Nirav Modi (Prasad, Prasad

& Zeeshan, 2018). In the complaint filed, Punjab National Bank alleged that Nirav Modi was

assisted, Gokulnath Shetty, the former deputy general manager heading the foreign exchange

department of PNB’s branch located in Bombay. (The Economic Times, 2018). The fraud was

detected when associates of Modi’s companies contacted the Mumbai branch of Punjab

national for granting of new loans, by this time, Shetty had retired and the employee succeeding

him his post rejected the request. “At this, the firms contested that they have been availing this

facility in the past also but the branch records did not reveal details of any such facility,” PNB

said. This was the event which enabled PNB to discover that fake LoUs were being granted to

Nirav by their former employee. (The Economic Times, 2018).


Action Undertaken

Following the incidence of the biggest bank fraud, the regulatory authorities took the desired

actions. The actions involved attaching of Nirav Modi’s and his associates’ assets to restore

the value of the fraud. The inquiry into the fraud exposed the involvement of Nirav’s family

members who were his partner in crime. For the enhanced investigation, the case has also been

probed to the Central Bureau of Investigation (CBI) and the various other such agencies

operating in the country (The Economic Times, 2018).

Following the detailed investigation was undertaken by CBI, the first arrest in the case was

made. CBI detained two former officials of Punjab national banks and one of the executives of

Nirav Modi’s group whose involvement in the case was seen Further the government

suspended the passports of Nirav Modi and Mehul Choksi for a period of 4 weeks (Prasad,

Prasad & Zeeshan, 2018). CBI also arrested the CFO of Modi’s firm and issued a bailable arrest

warrant against Nirav Modi which resulted in him fleeing off to the UK. For catching the

culprit, the Indian Government requested the “Interpol Manchester” to restrain Nirav Modi

Recently a Westminster Magistrates Court in London rejected the second bail application of

the culprit, Nirav Modi on the grounds of him failing to surrender (The Economic Times, 2019)

DISCUSSION AND ANALYSIS


Punjab National Bank being duped by one of its major borrowers has come as a serious blow

not only to PNB but the entire banking environment. The sudden outcome of the scam was

witnessed through the impact it had on the stock market. It shook not only the trust of the

general public but also the shares of the banks and the jewelry market in India.

Punjab National Bank, one of the key public sector banks faced the brunt of this huge scam,

but that’s not all of it. Following the Nirav Modi fraud case, PNB was yet again defrauded by

Bhushan and Power Ltd. costing PNB of approximate five hundred million dollars. Being

continuously defrauded and cheated surely points out that something is going wrong in the

operations and the functioning of the bank and steps should be taken to provide immediate

results rather than waiting till the bank needs to be bailed out.

The scam was successful in bringing out the loopholes that exist in the banking system hence,

giving an overview of what the current situation of all the public sector banks is. The courage

of a current official to file an FIR against a past employee working with Punjab National Bank

stood as an example in the history of the banking frauds. In the present date situation of

mounting scandals, the PNB scam made all the other banks more aware and skeptical of their

business borrowers. This is relevant through the number of frauds being reported post the

occurrence of Nirav’s scam. The Oriental Bank of Commerce and Bank of Maharashtra filed


complaints with the CBI against their suspicious clients. Therefore, this suggests that how the

Punjab National Bank has been instrumental in bringing forward several business clients of the

public sector banks (PSBs) who are damaging our financial sector through their fraudulent

practices.

Though positively impacting the banking structure through the detection of suspicious business

clients, the scam also throws light on how the loopholes exist in the technology which is being

used by the banks to channelize the transactions. This particular case enabled the authorities

and the general public to interpret and identify how the banking staff is taking advantage of

these loopholes existing in our system. The lack of auditing and authorization that existed in

the SWIFT system, an electronic message mechanism used for the transfer of funds overseas

was used as the key to instrumentalize the scam. The other mechanism which further enabled

the scam to be operationalized was the Core Banking System (CBS), which is an electronic

mechanism set up to link all the accounts of a particular client. Therefore in a normal case, the

SWIFT and the CBS have to be linked with each other to provide accurate figures. But for PNB

these systems were not linked and the employees were required to manually fill in the required

SWIFT data into the CBS which made it easy for the bank official to hamper the process and

prevent the detection of the fraud. This particular loophole substantiates the need for a

systematic examination of the existing methods being used to raise credit, detect the inaccuracy

existing and taking the effective steps to improve its technique of operations.

The Punjab National Bank is not the only party which will bear the cost of the scam, the scam

will lead to ‘negative externalities’ impacting the credit availability in the economy. Post the

scam the banks will be more conscious and hesitant in granting loans to big businessmen

dealing in jewellery resulting in the lack of credit accessibility for the growth and development

of the jewellery sector. The discontinuation of the Letters of Undertaking as a corrective

measure to prevent such scams will severely impact the MSME sector of our economy as LoUs

was an inexpensive mechanism through which this sector gained the credit to import the

requirements from beyond the national boundaries. Another negative externality resulting from

the scam is that of higher government expenditure. To enable the bank to operate smoothly


without any crunch the government has to resort to capital infusions which will direct the tax-

payers’ money towards the recapitalization of the banks. Such scams if continued will lead to


lowering of the public’s trust in the PSBs which will make the public hesitant to deposit their

money with banks leading to a lesser amount to deposits hence lesser amount to loan forward.

Altogether, the scams like that of Punjab National Bank will lead to several negative

externalities impacting the individuals and organizations who have nothing to do with the scam

but still bearing the cost of it.


SOLUTIONS AND RECOMMENDATIONS

To prevent the occurrence of such fraudulent practices, the regulatory bodies should establish

a mechanism for identifying the borrowers who pose a threat to the banks in the form of

prospective fraud and scandal. There is an immediate need for the banks to restructure their

internal working environments such as to prevent the employees from being tempted towards

being partners in crimes and frauds. For preventing the employees to be involved in corrupt

practices the bank should follow the rotation of the employees every two to three years. Doing

so will prevent the banking staff to be in constant touch with a particular client which will

enable the banks to prevent the employees from assisting any client in instrumentalizing a fraud

or a scandal. Seeing the current scenario it becomes mandatory that the steps are undertaken or

the entire economy has to bear the brunt of a weak financial structure.

CONCLUSION

As evident from the information covered in the paper, the role of regulatory bodies such as that

of the government and the reserve bank of India is indispensable when it comes to restoring

the security and safety of the banking structure of an economy. The actions undertaken by these

bodies are integral in maintaining the soundness of the financial sector. Apart from the

regulations of the government and the central bank, the efficiency of the banks itself plays a

role in structuring the financial sector of our economy. The recent threat of rising scams and

scandals is affecting the competitiveness of the banks leading to failures. A failing banking

structure is the last thing what a developing nation demands for and therefore, a strong banking

system with proper rules and regulations should be the aim of all the banks operating in our

economy. The Punjab National Bank fraud case which shook the roots of the entire banking

system is the incident through which the banking sector should learn lessons from rather than

being trapped in a vicious circle of weak banking atmosphere. The loopholes that were

witnessed in the scam should be taken as the basis to improve the current scenario of the Indian

Banks hence enabling the financial sector to move towards the path of development. A strong

developed structure of banks will lead to the prevention of such fraudulent practices, reducing

the negative externalities that the economy has to bear due to such activities.


FUTURE RESEARCH DIRECTIONS

While conducting the literature review on scams in India, it was discovered that there has not

been much research concerning this field. Though there are many newspaper articles and blogs

on this topic, they merely state the facts of the incidents rather than an analysis of the same.

There should be greater research regarding the scams that are taking place in the banking

systems to recognize the faults and take corrective measures. What is especially lacking is a

comparative study across the private and public sector banks and how the mechanisms of

dealing such issues are different across the two types of banks. Such research will help us

understand how the two co-exist and sustain in a developing economy such as that of India.

Research, specifically analysing the difference in corrective measures taken by the private and

public sector banks will significantly help in uncovering some key insights to the managing

and preventing of frauds and scams.

 

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