A Rs. 11,400 crore scam has hit India's second largest public bank Punjab National bank. The massive fraud was perpetrated for over seven years by Nirav Modi and his firms, by procuring LoUs from PNB.
Technically, Letter of Undertaking is a bank gaurantee under which a bank allows its customer to raise money from another Indian bank's foreign branchs in the form of short-term credit. The loan is used to make payment to the customer's offshore suppliers in foreign currency. The overseas bank usually lends to the importer based on the LoU issued by the importer's bank.
So, let's say Nirav Modi wants to import diamonds for a new collection. He approaches PNB and asks it to arrange for a guarantee in the form of LoU for short-term loans from the foreign branches of indian banks, to pay his diamond supplier. Bank officials promptly send instructions from PNB's Mumbai branch to other overseas banks offering LoUs. The messages are sent through SWIFT -- an inter-bank messaging network for securely tansmitting instructions for financial transactions. Theoretically, such SWIFT instructions need to be recorded in a bank's core banking system. But because of complicity of bank officials at PNB, the actual LoUs issued over the past seven years to Nirav Modi managed to escape scrutiny. These guarantees never figured in the bank's books.
LoUs are important instruments that allow those in the import trade to transact their business. As an importer in India cannot simply buy dollarsand send it abroad to make payments to his supplier, various instruments such as LoUs transaction. LoUs have cometo be a far cheaper and convenient way for importer to raise credit. Nirav Modi, for instance, essentially had two options. One, he borrows money from PNB in rupees, converts it dollars, and pays his supplier. But here, the interest rate on such loans would by at the higherdomestic rate, say 12-13 per cent.
The other way would be through a bank guarantee offered by PNB. The bank would simply instruct the overseas bank through SWIFT to remit funds into PNB's overseas account, which is in turn used to pay Modi's supplier, PNB earns a fee and the overseas bank offering the creedit charges an interest at a spread over LIBOR. in effect, Nirav Modi gets a cheap line of credit.
So where does the fraud come in theory, having used the imported diamonds to fashion jewellery, Modi should have sold his wares and raised cash to settle the dues against LoUs. In this case though, the loan was not paid back by Nirav Movi at all. By repeatedly rolling over the loan, he ensured that new LoUs were used to repay earlier LoUs. So, there had been no default till now.
