Thursday, 27 January, 2022
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We have not seen the last of bank scams. Put the entire diamond industry under the scanner

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Though Rs 11,000 crore is a large number, it is not a single credit or operations risk event but a bubble built over years. 

Bankers classify risks as market, operational and credit risk.

Market risk is about the ups and downs of prices of financial assets, which are headed south with the rising budget deficit that has increased real interest rates in the system.

Credit risk is our age-old NPA problem around non-recovery of dues.

Operational risks are mainly risks associated with transacting the business of banking.

We will explore operational risks and related credit risks associated with the much talked about diamond merchants and their banking transactions.

As is typical of the diamond industry in question here, raw diamonds are purchased in the international markets and imported to India for processing (either polished diamonds or diamond-based jewellery). These are then re-exported to international markets or sold domestically.

Typically, lenders avail of buyer’s credit facilities for importing diamonds for 90 days and settle them with the pre-shipment credit in foreign currency (PCFC) facility on export or funded working capital limits for domestic sales. Where there is no overseas limit, the local banks in India offer a ‘guarantee’ in the form of ‘Letters of Undertaking’ or similar to foreign banks, who offer credit based on the issuing bank’s credit limit. The money is deposited into the local bank’s foreign currency account, and from there on to the customer’s account. On repayment, the ‘guarantee’ expires and the amounts are paid back to the lending bank.

So, where is the issue? The problem is when the customer is unable to honour the repayment of the buyer’s credit for various reasons, including lack of funds. The customer then normally raises a ‘guarantee’ for an amount, including principal and interest, and discounts the same against further buyers’ credit, and the money flow carries on as usual. Each time the flow circles around, the amount gets larger by the interest component. Also, there is a risk of fictitious transactions involving siphoning of funds. Over time, the pie cumulates and results in what we see today as the Rs 11,000 crore problem.

This is only one customer through multiple entities; you never know how many have used this modus operandi over years. Hence the amount at risk is virtually non-quantifiable.

What about the controls, credit limits, counter-party actions and internal approvals? Does the system not take care of these transactions? What was the loophole that enabled the above modus operandi? To understand the attendant operational risks, one will need to get a bit technical to understand how the trade finance operates.

Banks have a core operating system (core banking system or CBS), which all of the banks’ transactions are recorded and processed through. Banks send trade and other messages through a global, secure messaging system called by the acronym ‘SWIFT’. It acts pretty much like WhatsApp or any other messenger, just that it is secured in transmission and in input (typical maker/checker password protection). Normally, SWIFT is interfaced with the CBS by a trade finance software, but reconciliations between the CBS and SWIFT are done manually.

However, in most cases, the transactions are originated in the CBS by various branches and SWIFT messages are generated through the interface software. This ensures that entries are appropriately recorded in the CBS and matched against counter-party limits. Whilst best practice demands that CBS entry is decentralised to trade branches which originate, the SWIFT messaging is centralised to ensure that all entries are included.

However, in some cases, the respective branches are delegated the SWIFT messaging. These branches may collude with customers to not enter the transactions in the CBS and instead directly send messages in SWIFT. This leads to the transactions not being in the books of the bank, and yet, messages are sent out. Limits may or may not exist, but credit is availed. The counter-party bank, in most cases, accepts the ‘guarantee’ SWIFT message and extends cash against available inter-bank limits. There could be multiple counter-party banks for related firms. Accordingly, credit is given by a branch manager with limited trail and reconciliation process. However, on frequent transfers, such transactions can get detected. In the present case, such transfers too did not happen.

Best practices would require the discipline of input only through CBS to enable checking of credit limits as also creating transaction trail for reconciliation. Further, SWIFT operations need to be centralised at least at a regional level to make sure that the originator is not the one sending messages. These, apart from an analytical tool run on the bank’s foreign currency account, operations beyond traceable cash flows, credit ratios above benchmark, and automated reconciliation are some of the key features modern risk management can offer through technology which needs to be used.

Finally, I would like to say that though Rs 11,000 crore is a large number, it is not a single credit or operations risk event, but a bubble built over years. Senior management seems less conniving and more ignorant of the size of the problem, which in my view, is a bigger worry. One cannot stop the thought that such transactions are many in the system and we may not have seen the last of these.

The rest of the diamond industry clearly needs to be under the radar, with big names like Shri Ganesh, Winsome, Nirav Modi and Gitanjali group facing these situations of late; all of whom had plans to redeem their situations either through IPOs, fundings or new lines of business.

However, the problem got too large to conceal, and hence we are where we are. Banks and their political bosses need to focus on remedy while aggressively pursuing their recoveries.

Abizer Diwanji is Partner and National Leader – Financial Services, EY India.

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