A jeweler, a fraud and the role of India’s public-sector banks

Nirav Modi, a celebrity Indian jeweler at the center of a multi-billion dollar fraud investigation, can be extradited back to India, a UK court ruled last week. 

It’s a case that has roiled India’s banking industry. Nirav — no relation to Prime Minister Narendra Modi — is being held in Britain since March 2019 as part of an investigation into his business, which at its height owned diamond stores at New York’s Madison Avenue and Old Bond Street in London. 

Using loopholes in the audit system of state-run Punjab National Bank (PNB), one of the largest in India, Nirav was able to get trade finance loans of around $2 billion — money he did not return. 

Never before had such a large fraud hit the banks in the world's fifth largest economy, which has for decades relied on public sector banks (PSBs) to fuel its growth. 

The case has put a spotlight on PSBs, which are laden with non-performing assets (NPAs), loans which are unlikely to be repaid. In the past 12 years, the Indian government has pumped $52 billion of taxpayers’ money to keep PSBs afloat. 

“Public sector financial industry has played a stellar role — call it a nation building role,” said Tamal Bandyopadhyay, a financial journalist and author of Pandemonium: The Great Indian Banking Tragedy. 

“It’s been about 51 years since the banks were nationalised and they have served the purpose of financial inclusion, the purpose of taking banking to the hinterland and bringing more people into the banking net,” he told TRT World. 

Once a saviour, now a burden

Nirav Modi spent lavishly on events showcasing his diamond pieces. Bollywood star Priyanka Chopra and supermodel Rosie Huntington-Whiteley appeared in advertisements for his rings and necklaces. 

And that business, the luxury, and glamour, was in part funded by the PNB’s Brady House branch in Mumbai. 

It was from there that Gokulnath Shetty, a mid-tier PNB employee, who received only one promotion in his 36-year career at the bank, helped Nirav borrow $1.77 billion in trade finance loans for seven years starting in 2011. 

Around a dozen PNB officials are facing charges, which range from active participation in the fraud to negligence. How such a big fraud remained undetected has embarrassed not just PNB’s top brass but also those at the Reserve Bank of India and India’s finance ministry, which oversees the PSBs. 

But high-profile bad governance cases such as the one which involved billionaire Vijay Mallya, the owner of Kingfisher Airlines, are not what have marred the balance sheets of these banks. 

“They are not the rule, they are exceptions,” said Bandyopadhyay, on the governance issues at PSBs. 

Unlike private banks, which are driven by profits, New Delhi has used public-sector creditors to pursue developmental goals such as ensuring that people in rural areas have banking services and small businesses can get loans.  

Public sector banks grew rapidly after the late Prime Minister Indira Gandhi, of the opposition Congress party, nationalised the banking sector in 1969.  

Since then, banking services including loans for small businesses rapidly increased as the state-run banks opened thousands of branches and mobilised deposits from households.

“After nationalisation, the breadth and scope of the Indian banking sector expanded at a rate perhaps unmatched by any other country. Indian banking has been remarkably successful at achieving mass participation,” Abhijit Banerjee, a MIT economist and a Nobel Laureate, wrote in a paper.

In India’s next-door neighbour Pakistan, businessmen often point out that Islamabad wasn’t able to keep up with industrialisation because risk-averse private banks don’t back big-buck projects. 

In India, PSBs, in which the government owns the majority share, account for two-thirds of all outstanding loans. Most of the banking assets in Pakistan are concentrated in the hands of privately-owned lenders. 

What went wrong?

Successive Indian governments have used PSBs as a political instrument to bankroll populist loan programmes, which did not necessarily pay back, said Bandyopadhyay. 

“Public sector banks are under pressure to make certain government schemes work. In 2015, the BJP (Modi’s Bharatiya Janata Party) launched the world’s largest financial inclusion drive. You’ll find that public sector banks have a lion’s share of it.”

That scheme known as Pradhan Mantri Mudra Yojna led to PSBs booking losses as people were not paying the interest on time. 

The problems with most Indian banks, particularly the PSBs, also stem from a shift in lending patterns — PSBs, which were experienced in meeting working capital needs of the firms, were thrust into making project finance loans from late 1990s onwards, said Bandyopadhyay. 

A factory or a power plant requires a project finance loan, which is repaid over a period of years. Not all PSB officials had expertise in this area, leaving them at the mercy of corporate borrowers to tell them if a project was economically viable. 

“They (PSBs) have not developed the expertise of appraising these projects and managing the risks,” said Bandyopadhyay. 

PSBs were also hurt by reasons beyond their control. For instance, companies faced difficulty in securing approval for their projects during former Prime Minister Manmohan Singh’s second term, which ran from 2009 to 2014. 

Often the projects — in which PSBs were heavily invested — were bogged down due to legal issues or delays in getting clearance from the environment ministry. 

A way forward 

For years the PSBs underreported the status for their loan books and hid the exact number of borrowers who had defaulted. 

That started to change in 2015 when RBI finally put its foot down, telling the PSBs to come clean about their NPAs. When the actual numbers were made public, it raised alarm bells. 

“Before the first of its kind asset quality review, the NPAs were very low. But after that review the pile of NPAs went up drastically. In some cases they touched almost one-third of the total assets of a few banks,” said Bandyopadhyay. 

Such a scenario basically indicated that a third of borrowers will probably never pay back the loans, leaving the banks saddled with financial losses. 

NPAs also increased provisioning requirements, which meant banks had to set aside money to cover the expected losses. The government being the ultimate owner of the PSBs has been forced to pump billions of dollars to keep them from going under. 

“Government would have received a far higher return if it had invested the same capital in private banks instead of the public sector banks,” said Bandyopadhyay.

New Delhi is now trying to overhaul the PSBs. It has already merged many of the state-run banks, bringing their number down from 27 to 12. Some of the banks have been marked for privatisation. 

Private banks, which are not bound by the red tape that makes it difficult for PSB to hire talent, have increasingly relied on technology to capture more of the market. 

“I think public sector banks have lived their life,” said Bandyopadhyay. 

“This is probably not the time to dwell in nostalgia anymore. It’s time to make a call whether you would allow public sector banks to continue in the old format or change them in sync with the time.”