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Fraught with Fraud

Last week PNB announced that it was the victim of fraud amounting to more than Rs. 11,000 Crores. While this was not foreseeable, the story has been unravelling. PNB has fallen victim to other cases of fraud in the past. In fact, it began disclosing fraudulent transactions in January that are associated with the current case. Jewellers and traders of precious metals are considered risky borrowers, yet a large part of its loan book is linked to these entities.

The bank wasn’t defrauded overnight. A deeper investigation indicates that the fraud has been ongoing for seven years. To understand what transpired, it is important to analyse the instruments and mechanisms involved. Lenders who want to borrow foreign currency (for import/ export) often find that credit facilities are cheaper abroad and may not be subject to currency fluctuations. To do this, they approach Indian banks who offer them a LoU (Letter of Undertaking) in exchange for collateral (security). Using these securities, the Indian bank then guarantees the foreign bank repayment of the loan it extends to the borrower.

PNB claims that no collateral was taken in exchange for these LoUs. Additionally, none of these transactions were recorded and there appears to be an unspoken understanding between some bank officials and the borrowers. This implies collusion on multiple levels and a systemic failure of the bank, its auditors, and the regulator.

Effectively, this has opened a Pandora’s box and leaves room for more discoveries of fraud. Ideally, this should result in greater scrutiny and tighter regulation. From a corrective standpoint, it is likely that there will be the integration of systems within banks so that all transactions are recorded. In particular, PNB may not be recapitalized.

Market Outlook

This incident leaves a stain on the Indian banking system. Demand for Indian credit will take a hit, which could further spike yields. In light of these circumstances, it is important to continue to manage risk in debt portfolios. Investments should be made into secure avenues that will be shielded from market volatility going forward. High-quality, low-duration, ultrashort-term funds would be ideally suited to the current market scenario.

Patience is Key

Benefits always follow a pattern of flow. They have an origin point, a direction, a  trajectory and several points of delivery. Economic benefits also follow a pattern of flow. Investors closely following the Indian economic recovery have been looking for all round improvement. This is not happening. It is not going to show up anytime soon. But, there definitely is a pattern of flow. Improvements have begun to show up in several parts of the economy. A normal monsoon will raise the flow of benefits significantly. Falling inflation, falling interest rates and falling commodity prices have created the early flows of benefits. But, the monsoon has the ability to further catalyse the flow of benefits. Good rains will stabilise inflation further. This will lead to further cut in interest rates. Commodity prices have bottomed out and seem to be gradually moving up. This will lead to increase in inventory levels. Stocking will lead to more demand. All this will flow into the markets as better sentiment. Investors can use this window of time to invest into equities.  Benefits will flow in due course. This is no time to even think of selling equities.

Risk mean more things can happen than will happen.” – Howard Marks.