Must Read: The Great Diamond Heist

'If there is any industry that is unfit for modern corporate form it is the diamond trade.'
'But no one was asking the right questions.'
'The music was playing and so the game was on,' says S Murlidharan, former managing director, BNP Paribas.

The newspapers are full of stories of how billions vanished from the vaults of PNB.

The carefully coiffed young ladies and gents of sundry financial television channels are frothily holding forth on this affair with more anger and indignation than facts and figures.

Politicians have jumped in with both feet; the Congress has thrown the first punch, fearing the BJP's attempts to pin it on the UPA (which might still come to pass) and the BJP is clueless on how exactly to return the favour; the Left has thrown the kitchen sink at Modi, Didi is probably considering creating a Bangla Banking Network in her fiefdom, and the Metropolitan Elite is blaming it all on Modi's intolerance in matters of faith and tolerance of financial shenanigans.

The CBI is clueless as usual, and will remain so for the foreseeable future.

It appears to be business as usual in India.

What really happened? 

At the surface level, what happened was that a diamond firm borrowed money from Indian banks, in India as well as from branches of Indian banks overseas.

One bank was 'persuaded', somehow, to issue a 'Letter of Undertaking' so that this firm could borrow even more overseas.

Such an undertaking was issued, reportedly fraudulently, by a certain low-level official in the Punjab National Bank, without the approval of his superiors, or indeed even their knowledge.

The firm thereafter 'cashed' out this 'undertaking' and took many more millions from other banks.

This far the facts are well known and documented.

There is some speculation, which is more likely true than not, as to why this firm needed so much money.

Some reports claim that this firm has not been meeting its liabilities to its creditors, others that it has been unable to claim the dues from its debtors.

Yet others suggest diversion of loans to buy real estate and swish apartments in the toniest parts of the glitziest cities in the world.

It would be safe to assume that in the time-honoured Indian business tradition, the firm diverted bank finances for purposes other than the one for which they had been lent.

It is a certainty that huge sums were lost in those diverted investments or in the least the investments were illiquid, loss making, or both.

So when the time came to return the money to the lenders, the firm could not do so.

Details are sketchy here, but I would bet my bottom dollar that the firm faced illiquidity and therefore sought more cash through the 'Letter of Undertaking' method.

The lack of liquidity could have arisen due to genuine business losses, but that would only have been a fraction of their normal turnover.

In trading you could at worst lose the entire amount of the trade, not more.

You could, however lose, much more if you speculated in some forms of derivatives such as options.

There is no shortage of things to speculate in: Derivatives, interest rates, stocks, exchange rates, commodity prices, etc.

There has so far been no suggestion that the Modis and Choksis were fond of the high life involving fast women and slow horses as was a certain fugitive from Indian justice.

They were, however, pretty damn quick to evade the arm of Indian law.

In the best of times, the diamond business is difficult to understand and impossible to regulate.

75% of the world's diamond trade is controlled by the De Beers group. This group, founded by the infamous colonialist Cecil Rhodes (of Rhodesia and Rhodes Scholarship fame), not only mines most of the world's diamonds, it also controls the distribution and sales through the Diamond Trading Company based in London.

The DTC ensures that the price of diamonds do not fall or rise too much by withholding or increasing supply of the 'rough' stones.

The supplies are through what is called 'sight-holders' auctions. You and I cannot walk in and buy the stones even if we had the cash.

The sight-holders are a few hand-picked and trusted 'cutters' from around the world, mostly from Antwerp, Mumbai and Israel.

The Indians usually get the smallest stones which are cut manually by skilled artisans.

Surat is the centre of this industry which is controlled almost entirely by Palanpuri Jains.

The diamonds are transported between Surat and Mumbai by nondescript couriers we won't spare a second glance at.

They carry the cut and uncut stones on their person and travel second class unreserved on trains between the two cities.

Suffice to say that trust and faith aided by the long standing ties within the close-knit community are key to its success.

The Indian diamond community is, as already noted, almost entirely of Palanpuri Jain origin. This ensured that the trust and confidence which were essential for its smooth functioning were maintained at all times and disputes, if any, were resolved rapidly and quietly among themselves and no one faced public loss of money, face, or outside scrutiny.

It also perhaps ensured that they were seen as branches of one big Indian family which no doubt helped them get the best deals from DTC or even get any deal at all given DTC's own tendency to operate secretively in an opaque environment.

Given the opacity of the trade, the tightly close-knit nature of the diamond network, and an effective cartel of producers and processors, outsiders found it impossible to break into this trade. They did not even know where to begin.

Russian and Australian producers' attempts to break the diamond cartel failed comprehensively, leaving the field for the old players.

Consequently, there has never been a clear insight into, let alone oversight of, this business worth billions.

Global bankers wisely stayed out of this business they knew very little of and found impossible to pierce the veil of.

Indian bankers were not so wise.

The business mainly operates out of Southern Africa (mining), London (distribution of the 'rough' stones) and Antwerp and Mumbai (cutting and polishing).

In 2016 India accounted for 33% of the total global diamond imports (all of the EU accounted for only 30%).

In dollar terms India imported $16 billion worth of diamonds in 2016 (about Rs 1.12 lakh crore). That is a humongous amount.

Indian diamond families operate with one leg in Antwerp and another in Mumbai/Surat.

In recent times they have reportedly moved into Hong Kong as well, perhaps as a gateway to the important Chinese market. But the Antwerp-Mumbai axis is the key one for Indian diamantaires.

We noted that most global bankers avoided the diamond trade because they did not understand it or were able to penetrate its veil of secrecy to gain an understanding, the exception being a couple of 'diamond banks' from Holland and Belgium.

Well known among them was ABN Bank which also operated out of Mumbai.

This bank has since ceased to exist, having been split up and gobbled up by a trio of European banks over a decade ago.

For a long time none of the Indian banks was able to make inroads into what they considered a lucrative diamond trade business, and it remained the preserve of ABN with a few crumbs falling to other European banks in Mumbai.

The exports drive of the decades of 1970s, 1980s and 1990s saw the diamond industry thrust into the economic forefront and into the public eye for a number of reasons:

1. They already had an established and running export business model; 2. No fresh investments were needed; 3. It was labour intensive; 4. its working capital needs were relatively modest; and 5. It was earning DOLLARS!

Some young turks of the diamond families wanted to ape the great stockmarket success of Dhirubhai Ambani and took a few diamond firms public, much to the dismay of the patriarchs of the industry.

One of them went on to innovate even the lobbying efforts of his industry through street protests (by Surat diamond labour trucked in to Mumbai for the purpose) in order to gain favourable financial and tax treatment.

This no-longer-young turk is a fugitive in a country which has no extradition treaty with India.

Given the parlous state of India's external reserves in 1991 and manufacturing industries' inability to break significantly into foreign markets, the diamond industry was one shining hope for the political masters running the economy.

The software boom was still a decade away. The political class favoured and fawned on the diamantaires.

Sensing the mood, Indian banks walked in en masse.

Specialised 'diamond branches' were opened, staffed by people with little or no knowledge of the industry and even less basic credit appraisal skills.

The belief that the industry was serving to save the nation from external default was in sync with the then current political thought, which egged them on to thrust ever bigger wads of cash into the diamantaires' pockets.

As the Indian banks were walking in, unnoticed by them the traditional 'diamond banks' were walking out.

The Great Diamond Heist had truly begun.

More and more diamond firms went 'public', a warning sign that was ignored by all.

How do you operate and manage a public company in accordance with fair accounting and business principles in an environment of total opacity, cartelisation, and multiple behind-the-scene linkages?

The code of honour, faith in 'the good name of the family', and honesty in business dealings were sacrificed at the altar of separation of ownership and management that a listed company implies.

But was the management truly independent of the erstwhile owners?

If there is any industry that is unfit for modern corporate form it is this; one handful of raw material if smuggled out can mean a loss of crores of rupees.

But no one was asking the right questions. The music was playing and so the game was on.

A parallel and unrelated development in the management of the economy helped the diamantaires who, being very sharp businessmen, were quick to see the opportunity and take advantage of it.

In order to show improvement in foreign reserves the government permitted Indian companies to borrow overseas and bank the money with Indian banks overseas until required for investments.

Indian banks were also allowed to do the same in order to lend foreign currency to Indian companies buying/setting up facilities abroad.

The banks also raised vast sums through by the so-called FCNRB route, a veritable turkey shoot for foreign banks and wealthy Indians living abroad.

Foreign reserves thus (falsely) bolstered, it was time to use it.

So the lending began.

Companies were bought, subsidiaries established, long-defunct factories purchased at inflated values, etc, etc.

The names of the resulting failures are only too well known for me to list here.

Here is where the diamantaires perhaps saw their opportunity: If some can buy steel and car factories and others mining companies, why can't they start parallel diamond distribution firms, never mind De Beers' stranglehold.

While they are there, why not a château or two?

And Indian banks were only too eager to oblige -- they did have export finance targets to achieve, political masters to please, post-retirement sinecures to secure and so on.

But what do you do if you do not have a foreign branch of your own from where to lend to your favourite diamantaire?

Simple: Issue a Letter of Credit. But that presupposes a short term trade transaction.

So why not a letter of guarantee? There is an RBI prohibition against it.

But wait, what if we called it a Letter of Undertaking? It is not a 'Guarantee', but it can be phrased to the same effect. And this is what (must have) happened.

In the PNB case, clearly the LoU was not approved -- at least I have not heard or read of an approval.

If so, it was clearly a case of the beneficiary, in this case Nirav Modi, having figured a way out and using a low-level official to carry it out.

SWIFT is a decades-old interbank financial transaction mechanism which has been robustly secure for nearly five decades.

It carries financial messages between banks through secure means and, except for one or two scares recently, has proven to be secure.

It operates through three tiers of security at the point of origin: Maker, Checker and Authoriser, in additional to the encoding for transmission.

The PNB official was able to perform the role of ALL THREE and successfully send out a Letter of Undertaking.

Based on the receipt of this, the various banks lent monies to NiMo. The rest is history.

In addition to the three-tier check there are two further checks which could have caught the transaction within 24 hours of origination: The 'original' of the message is usually sent to the desk that originated the message, the 1st carbon and the 2nd carbon in roll form is scrutinised by someone senior.

Decades ago, my boss, then the senior-most woman in the Indian banking system, used to meticulously read every outgoing SWIFT message and mark the 1st carbon copy to the concerned official for comments if it looked 'abnormal'.

She would keep the second carbon for follow-up which was meticulous and UNRELENTING.

Woe betide everyone if she found the 2nd carbon copy was not in an 'uncut roll'. These simple precautions appear not to have been practised in this instance.

Where do we go from here?

Various banks acted on PNB's LoU and therefore PNB's defence that it will not honour a fraudulently made commitment is hollow and dangerous.

If we accept its contention interbank transactions will not happen smoothly, which is essential for a modern economy.

The fraud happened inside PNB. The result was others making loans based on that commitment.

PNB must assume the responsibility, period.

Three-and-a-half decades ago something similar happened on a vastly smaller scale and the Madras high court was scathing in its criticism of the bank that refused to honour its own DD it claimed had been 'issued fraudulently'.

So we must hope that saner counsel prevails in the banking and government circles.

The latter perhaps is attempting to shore up PNB by parcelling out PNB's losses to other banks, all of which it owns.

This inevitably brings us to the moral hazard of government owning banks and managing them (whimsically to suit its own political dictates).

Banking is too serious an economic activity to be left for the government to own and manage.

It is also clear that the banks would be better off not having to follow government diktats as to where and to whom to lend.

If banks had not been nudged to lend to diamantaires they would perhaps not have done that on the vast scale that now confronts us.

Even bankers are not stupid enough not to know that very little is known and is knowable about this industry.

There is also a pervasive feeling that if the government wants banks to lend to a particular sector, it must be all right.

Governments are not responsible for recoveries and no minister has lost his job in the wake of such scandals -- bankers have, albeit only a few lowly ones.

There is also a false credit dichotomy in the Indian banking system that has only gotten stronger over the years.

It is a very fundamental aspect of credit risk, but our bankers have still not 'got it'.

Guarantees, Letters of Credit, Letters of Undertaking, Letters of Participation and such-like are regarded as 'non-funded' and therefore somehow not risky.

Tell that to PNB now.

Indian bankers are trained to regard only those credit facilities resulting in immediate cash outflow as risky.

This can be traced back to the days when RBI controlled the quantum and purpose of credit.

That was based on the government's political economics of the day and the reality of scarce credit in our system.

So we have in place systems and bankers who do not appraise risk, but merely follow some procedures laid down which by definition are backward-looking and are unsuitable to a modern financial economy and unable to identify and prevent potential pitfalls and dangers.

IMAGES: Diamantaire Nirav Modi. Photographs: Kind courtesy, Nirav Modi's Facebook page.

S Muralidharan retired as managing director, BNP Paribas, after serving the bank for 20 years.