Punjab National Bank Scam Is an Opportunity to Reform India's Public Sector Banks

The Punjab National Bank (PNB) scam – India’s largest banking scandal – is as impeccably swadeshi (literally “of one’s own country”, indigenous) as that bank’s origins. It highlights in crass terms the divide between Bharat (the ancient name for the subcontinent) and India (a modern derivation from the river Sindhu) – old versus modern and aspiring to be global.

PNB was founded in 1894, in the cauldron of India’s freedom struggle, with the idea that Indians deserved to have their own bank rather than entrusting their capital to the British. One of the freedom struggle’s most famous sons, Lala Lajpat Rai, was instrumental in its founding, and was reportedly its first account holder. The inaugural board was comprised of a Bengali, Sikhs, a Parsi, and Punjabis – remarkably plural and modern for that time.  PNB had financial dealings with Mahatma Gandhi and Jawaharlal Nehru, among others in its early years.

From those hallowed origins, having survived many an economic crisis over its history and become one of the country’s largest lenders, PNB is now at the centre of a $1.77 billion scam. As with many recent scams in India, celebrity and Bollywood connections are part of the package. The perpetrator is Nirav Modi (no relative of the Prime Minister), a billionaire celebrity diamond merchant and jeweler, ranked in the top 60 Indian billionaires by Forbes. He is rumoured to have close ties to Bollywood actresses and has been a poster-child of India’s nouveau riche.

At the heart of the scam are fraudulent Letters of Undertaking (guarantees) issued by two employees of PNB. Pursuant to the LOUs, and relying upon them, overseas branches of Indian banks advanced funds to Modi and associates to the tune of about $1.8 billion. The LOUs were fraudulently created without following rules, and the scam apparently went on from 2008 to 2017. Whilst some PNB staff have been arrested, Modi is currently absconding from Indian law enforcement. Clearly, from the duration and the extent of the fraud, it would have taken more than a few rogue employees to orchestrate it, and the bank’s senior management was likely complicit in enabling the scam.

The evidence uncovered thus far conclusively proves that this is very much a swadeshi scam. It has every attribute of Indian financial scandals of the past (Satyam, Kingfisher, et al) – a high profile businessman with celebrity, family, and political connections, crooked cronies in financial institutions facilitating fraud from within, sham transactions without any substance, rudimentary cooking of the books, weak oversight, ineffective internal controls and poor corporate governance. To make matters worse, the regulator, the Reserve Bank of India, was asleep at the wheel. Indeed, one of the primary reasons for the scam to have survived was the very swadeshi internal controls and corporate governance – the SWIFT system by which the LOUs were transacted were not integrated with the Core Banking System (which is PNB’s centralized database), meaning that they went under the radar and were not detected. The non-integration betrays PNB and the RBI’s cavalier approach to internal controls.

The scam should immediately put a halt to the Modi government’s plan to put more money into public sector banks. Earlier this year, the government announced a plan to inject $12 billion by March 2018 into public sector banks to help them to deal with a long history of bad debts and to promote access to credit. This is a terrible idea at present – it is merely throwing good money after bad, and should await substantial reforms as a precondition. Recapitalization at public expense exacerbates moral hazard and creates no incentives for the banks to govern themselves better. It repeats the mistakes of the past and provides oxygen for the next cycle of scams.

The PNB scam should serve as the impetus for immediate reform of India’s outdated model of banking. For too long, these public sector white elephants have been playing fast and loose with public money and enabling crony capitalism under the spurious claim that they exist for the public good. Non-performing assets (NPAs) at Indian public sector banks are in excess of $135 billion this year.  Too many of these banks seek to serve mutually exclusive masters – faux welfarism (e.g., spurious loans to small farmers to appease their political benefactors etc., under the guise of providing banking to the poor) versus commercial profit. Due to this contradictory mandate, they have been utilized as wealth transfer mechanisms – from the average citizen to privileged constituencies – by a succession of political actors.

The scam is an opportunity to apply the harsh reality of the market to the mass of public sectors banks. The new insolvency climate engendered by the modernized Bankruptcy Code should be extended and applied so that bad debts are brought home to the banks, and many of them ought to be liquidated. Those that survive must be privatized. This is likely to be unpopular with the bank employee unions and many politicians, but India cannot afford to keep pouring money into insolvent banks.

The time for swadeshi banking has passed. With the massive penetration of mobile phones and e-payments, there is little need for these public sector banks as technology is leveling the problem of access in rural areas. If India’s aspirations for becoming a global player in the business world are to be realized, its banking system must make the leap to more robust corporate governance and better internal controls.

Sandeep Gopalan is the Pro Vice-Chancellor for Academic Innovation at Deakin University and a guest contributor to the Oxford Business Law Blog.