PNB fraud: What is it, how it happened, and will it snowball?

Banks (especially PSU banks) have been grappling with structural asset quality issues, but over last few days risks have got exacerbated following fraud reported by Punjab National Bank (PNB) pertaining to Letter of Undertaking (LoUs) issued in favour of three diamond companies run by Mr. Nirav Modi. The unauthorised fraud has taken place in connivance with bank staff that casts shadow on robustness of process and expands risk beyond funded credit risks. Gross exposure is significantly higher at USD1.8bn, though at this juncture it will be difficult to ascertain financial impact across the banking system as investigations are on. However, we believe such instances of fraud and further pressure on asset quality will be an overhang on valuations for PSU banks (especially PNB in this case).

What has happened?

PNB’s officials had issued unauthorised Letter of Undertaking (LoUs) in favour of three companies (run by Nirav Modi namely Solar Exports, Steller Diamonds and Diamond R Us) for availing buyers’ credit. PNB employees in fact misused the SWIFT network to transmit messages to other banks bypassing the core banking system (CBS), and hoodwinking management about same. On these LoUs, overseas branches of Allahabad Bank, Axis Bank, etc., credited PNB’s Nostro account (from where funds were moved to certain overseas parties). Axis Bank has issued a clarification that it has sold down all the referred transactions and there is no financial implication relating to this case.

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Will this spread elsewhere?

A cautionary note has been issued by PNB to several banks, suggesting similar modus operandi may have been used by these officials too in companies belonging to Mehul Choksi - Gitanjali Gems, Gili India and Nakshatra, while issuing LoUs/LCs. The transactions were initially routed through CBS, but later changed, the amount increased substantially and transmitted through SWIFT. The liability on respective banks depends on investigation outcome. Even Bank of India in Q3FY18 reported stress of INR94bn pertaining to stand-by LCs discounted by its overseas branches.

What is worrying us?

The amount involved is substantial (cumulative gross exposure relating to fraudulent transactions is USD1.8bn), but more worrying is the stark process lax and repeated instance of similar frauds (Winsome Diamond, etc).  PSU banks continue to grapple with weak systems, raising questions on why the processes are not centralised, unlike most private banks where bypassing CBS is not easy.

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At this juncture, investigating agencies have been roped in and it will take some time to ascertain the financial impact on banking system. As these raise concerns particularly with respect to exposure in gems & jewellery segment. However, higher exposure to gems & jewellery segment does not necessarily suggest stress as the transaction being discussed is one-off, intentional and unauthorised incident.

(Source: Edelweiss Securities)