Do you know Makar-Sankranti is one of the few ancient Hindu festivals observed in line with solar cycles each year in January. A festival, believed to be as old as 5000 years, is celebrated by observing certain social festivities. One of the festivities is kite flying. Thousands across the country fly colourful kites on the day.
Even as kite flying brings joy to the kite flyers as well as to the people who watch them, it sends shivers through the spine of banks and financial institutions. It’s considered one of the most dangerous activities in the world of finance. In the context of banking and finance, kite flying has totally a different connotation and is a means of swindling funds from the financial institutions.
Let me explain the meaning of kite flying in banks. Technically speaking, kite flying is simply a fraud committed by a fraudster through cheques or any other financial instrument. Also known as kiting, the Investopedia explains it as ‘the fraudulent use of a financial instrument such as a cheque to obtain additional credit that is not authorized. It has two variants. One, the act of misrepresenting the value of a financial instrument for the purpose of extending credit obligations or increasing financial leverage. Second, a fraudulent act involving the alteration or issuance of a cheque or draft with insufficient funds.
While having a close look at the operations of banks especially the transactions taking place from one place to another, I am privy to many such cases where kiting was common when banks were not automated. The physical mode of clearing of cheques between banks used to take lot of time. It used to be an uphill task to keep track on the movement of financial instruments for realization of their value. It’s here fraudsters used to take advantage of this delay. They used to write cheques of bank accounts actually having no funds to realize amount. These cheques were used by them at some other bank and get the amount deposited before the cheques were cashed.
Kite flying is a unfair and illegal means of obtaining bank funds by drawing fictitious bills of exchange which have actually no exchange of consideration among the parties and getting the bank to grant credit against these bills to the parties to the fictitious contract.
This is exactly what has happened in the Punjab National Bank. Here the Letter of Undertaking (LoU) has been used to swindle funds. This LoU is an explicit undertaking used to raise overseas loans. It is a facility through which a bank offers it’s undertaking to another bank on behalf of its customer, who is importing goods from overseas. The customers raise loans from the overseas banks through the LoU. It’s clear-cut responsibility of the issuing bank. The maturity of an LoU could be between 30 days and one year, depending on the type of business. The idea behind having such a scheme is to enable an importer to access low-cost foreign currency funds overseas.
Let me reproduce the genesis of PNB fraud that surfaced by using LoU mode as I could get while going through various media reports. Nirav Modi, main accused in PNB Scam, ‘devised’ a scheme to take route of bank loans ‘without actually taking a loan. This means using banks’ money without opening a loan account. He managed LoU from PNB to raise overseas loans at cheap rates. Surprisingly, he didn’t pay any margin while arranging an LoU from PNB (otherwise banks ask for a margin for LoU and it could be even more than 100 per cent of the credit facility required). It’s the trigger point of $1.77 billion fraud. The overseas loans raised through these LoUs were also not repaid within the stipulated period of time. Modi, as is evident from media reports, diverted the funds raised through these loans to some other activities.
How could he and others continue this facility for seven years without paying any money? Tamal Bandyopadhyay, consulting editor at Mint, in his anatomy of the PNB fraud sums up the answer to this question beautifully. He says: “Well, instead of paying his own money, he probably asked PNB (read Gokulnath Shetty) to open another LoU, which could cover the principal plus interest of the previous LoU. Backed by new LoUs, he would get fresh and higher buyer’s credit, which would enable him to clear the previous loans and the chain continued.”
So this is the modern way of kite flying in financial institutions like banks.
Meanwhile, PNB scam points an important question to the Reserve Bank of India. How come their inspectors missed to locate this fraud for seven long years?
(The views are of the author and not that of the institution he works for)