This study deals with the intersection of law and economics through the analysis of the Punjab National Bank scam. The essential requirement for the smooth operation of the economy is an effective and strong banking system. This study highlights how law and economy should work together to implement strong measures to prevent fraud, misuse of the banking system, and protect the interest of the public. This study also delves into how law and economics have the power to enforce efficient and powerful regulations to prevent such problems, maintain economic stability, and ensure public welfare.

Instruments Used in the Scam

• Letter of Undertaking (LOU): A letter of undertaking is a legal document where a bank assures another bank or customer that it will fulfill a specific obligation or guarantee a payment, which is often used in international trade or to secure short-term credit.
   
• SWIFT Transaction: SWIFT (Society for Worldwide Interbank Financial Telecommunications) is a global messaging system that facilitates secure and standardized communication between financial institutions for international money transfers. It does not handle the transfer of funds itself but only facilitates its process.
   
• Nostro Account: It is a bank account that a domestic bank holds in a foreign currency with a foreign bank. Its purpose is to facilitate trade, manage liquidity, conduct global financial operations, and reduce the cost of currency exchange and other transaction charges.
  
  Example: If an Indian bank has an account with a US bank in the US, the Indian bank’s account in the US bank is maintained in American dollars.
   
• Core Banking System (CBS): It is a central back-end software that manages a bank’s daily operations, including transactions, account management, and customer data across all branches and channels. Its main function is to process daily banking transactions, update accounts, and manage financial records, serving as the backbone of the bank’s operations.
   
• Shell Companies: These are legal entities that exist primarily on paper with no significant business operations or assets. They are often used to obscure ownership or facilitate financial transactions for purposes like money laundering or tax evasion.

Illustration (Process Of LOU)

Let’s assume there is a jeweller Mr. B in India who wants diamonds for his Jewellery Business. There is an exporter Mr. K (who is a diamond merchant) in the USA who exports raw diamonds to jewellers. Mr. B and Mr. K had a deal for the import and export of 1000 diamonds. In this deal, Mr. K asked Mr. B for Rs. 100 Crore for 1000 diamonds. As Rs. 100 Crore is a big amount and Mr. B doesn’t have that much amount.

So Mr. B decided to take a loan from a bank named X. Bank X has agreed to give a loan to Mr. B but on one condition, to give collateral for the loan. Mr. B has agreed and put one of the branches of his company as surety. Then after collecting the collateral from Mr. B, Bank X agreed to be a guarantor to Mr. B and issued LOU (Letter of Undertaking) to Mr. K and promised that in case in future Mr. B fails to pay in full or remaining payment Bank X will step in and pay the amount on behalf of Mr. B. After considering and inquiry of all documents and LOU, Mr. K exported 1000 diamonds to Mr. B.

Procedure of LOU

Step 1:

 

Step 2:




Step 3:
Core Banking System (CBS): When LOU is given through SWIFT Messaging then it is recorder in the CBS system, which means the details of the LOU is recorded in the system of Banks like, How much of LOU’s are given by the banks and to whom its is given, how much loan was passed all these things are maintained by banks through CBS system.

Background Of The Scam

Who Is Nirav Modi?

• Nirav Modi is a diamond designer and jeweler. He was positioned 57 on the list of Forbes very rich people in the year 2017.
• He is the chairman of Firestar’s International Jewellery, which has stores across the world.
• It has 17 stores in various locations such as Delhi, Mumbai, Hongkong, London, and Macau.
• He was also known as the ‘Diamond King of India’.

Main Reason For The Scam:

• In 2010, Nirav Modi used two famous diamonds (one from Golkonda Mines in Hyderabad and another from Argyle Mines in Australia with specialty ‘Pink Diamonds’) to design a unique necklace called ‘Golkonda Lotus Necklace’.
• This necklace gained worldwide recognition and was sold at an auction by Christie’s for Rs. 16 crore 29 lakh.
• After this auction, Nirav Modi gained huge fame. Leveraging this fame, he established a brand under his name and launched it.
• Later, he opened several stores in India and started his own diamond jewelry company, manufacturing and selling designer jewelry at global auctions.
• As the demand for his jewelry surged, he struggled to deliver orders on time. Since the diamond business requires substantial capital, Nirav Modi began taking Letters of Undertaking (LOUs) from banks, which marked the beginning of the scam.

How This Scam Was Started

Who Is Involved In This Scam:

• Nirav Modi: The mastermind behind the scam.
• Mehul Choksi: Maternal uncle of Nirav Modi and owner of Gitanjali Gems, a major beneficiary of the fraudulent funds.
• PNB Employees: Managers and several officials who processed LOUs.
• Other Banks: Banks that provided loans based on fraudulent LOUs.

How This Scam Was Implemented:

1. In 2010, Nirav Modi wanted to import pearls from Hong Kong for resale. He approached Punjab National Bank (PNB)’s Brady Branch and manipulated the manager and employees into issuing fraudulent LOUs.
2. PNB Brady House Branch employees issued LOUs for 365 days without requiring collateral and bypassed the Core Banking System (CBS), allowing Nirav Modi to obtain LOUs without proper records.
3. His three companies-Diamond R US, Solar Export, and Stellar Diamond—allegedly secured loans from Axis Bank and Allahabad Bank using these fraudulent LOUs.
4. The firms also raised funds from overseas branches of Indian banks.
5. PNB employees misused the SWIFT messaging system to issue fraudulent LOUs without recording them in the CBS system. This allowed Nirav Modi’s firms to secure large loans from foreign branches of Indian banks, which had lower interest rates compared to domestic Indian banks.

 

Breakout of the Scam

• In 2018, Nirav Modi’s firm again went to the PNB Brady House branch for the issuance of LOU. At that time the manager of that branch who helped Nirav Modi in the scam was retired and another new manager was appointed.
   
• When the firm asked about the issuance of LOU as usual as they regularly did when they used to ask the old manager, but the new manager asked about the collateral. The firm said that they used to take LOU without any collateral. When the new manager checked the CBS system, he didn’t find any records of LOU which were issued by the PNB to Nirav Modi for past years (i.e. from 2011-2017).
   
• Then the new manager informed the higher authorities of the PNB and they investigated the matter deeply and found that some of the PNB employees, especially the old retired manager and other employees, had misused the SWIFT network system to transmit messages to Allahabad Bank and Axis Bank on fund requirements. While all these processes were happening using SWIFT passwords, the transactions were never recorded in the CBS system, which became a huge loophole in the banking system and a big advantage to Nirav Modi.
   
• Later, PNB lodged an FIR with CBI in which they stated that the fraudulent LOUs that were issued were worth approximately Rs. 2.8 billion (Rs. 280.7cr). The scam has reached up to Rs. 14,000 cr.
   
• When the scam was broken out, Nirav Modi with his family flew to the U.K.
   

Impact of Nirav Modi Scam on Different Areas

Impact on the Banking Sector:

1. This scam had a huge impact on the credibility of the banking sector. It affected various aspects of banking operations, stability, and public trust.
    
2. Customer Trust: Customers started to question the safety of their deposits and the integrity of the bank’s functions. After this type of scam, the security of banks was questioned by customers, leading to potential withdrawals and a liquidity crisis. Customers started believing in private banks rather than government banks after this scam.
    
3. Financial Stability: Due to this scam, banks faced financial losses which affected their CAR (Capital Adequacy Ratios). Consequently, banks in India struggled to lend and support economic activities, negatively impacting the Indian economy.
    
4. Stock Market: Due to this scam, PNB bank stocks declined, affecting investor trust and overall financial market stability. Not only did PNB’s stock decline, but also the stocks of other major banks like Union Bank of India, Allahabad Bank, Axis Bank, and State Bank of India.
    
5. Import-Export Industry: Letters of Undertaking (LOUs) were crucial for import-export businesses to provide short-term credit at low-interest rates. Following this scam, the RBI banned the use of LOUs in this industry. While alternative credit options exist, higher interest rates have negatively impacted businesses, especially small traders who are the worst sufferers. The scam resulted in loss of investment for businesses, depreciation of the Indian Rupee, and several other economic challenges.

 
Introduction Of Reforms Post Scam:

• The Reserve Bank of India (RBI) issued a notification on March 13, 2013, about one month after the fraud made headlines, prohibiting banks from providing guarantees in the form of Letters of Undertaking (LOUs) to stop any further misuse of this instrument. Therefore, by the RBI’s instructions, commercial banks in India banned the issuing of LOUs for trade-related businesses.
   
• Additionally, the RBI mandated that the SWIFT communication system be integrated with the bank’s core banking system (CBS), which serves as their record-keeping system, by the deadline. SWIFT and CBS’s connection will stop such frauds in the future.
   
• A better Risk Management Framework was put into place with an efficient system of checks and balances to optimize the risk management system.
   
• RBI had also set up an expert committee headed by YH Malegam, a former member of the Central Board of Directors of RBI, to investigate the reasons for the divergence observed in asset classification, various incidents of fraud, breach of trust, and necessary interventions (also in terms of IT intervention) to prevent such frauds in the future.
   
• To encourage banks such as UCO Bank, Dena Bank, IDBI Bank, Oriental Bank of Commerce, Indian Overseas Bank, Central Bank of India, Corporation Bank, Bank of India, Bank of Maharashtra, Allahabad Bank, and United Bank of India to refrain from riskier banking practices and place an emphasis on capital conservation, the RBI also issued the Prompt Corrective Action (PCA) framework to these banks.
• Additionally, the RBI mandated that banks strengthen their usage of the SWIFT framework, impose a cap on foreign currency payment instructions for people as beneficiaries, and provide an extra degree of protection for transactions above a specific level.
   
• To address the threat of criminals fleeing to other nations and evading punishment, the Indian government passed the Fugitive Economic Offenders Act (2018) on April 21, 2018. Any individual who has committed crimes under this Act totaling at least Rs. 100 crores, such as counterfeiting government stamps or currency, check dishonor, money laundering, transactions defrauding creditors, and other offenses, and who has fled India to evade prosecution and refuses to return, may be designated a fugitive economic offender. Furthermore, all of his assets, including benami properties, are subject to confiscation by the federal government, and all associated rights and titles will pass to the Indian government free and clear.
   
• Fugitive Economic Offenders Act, 2018: The Fugitive Economic Offenders Act (2018), which was approved by the government in response to the massive bank fraud, went into effect on April 21, 2018. The purpose of the Act was to stop financial criminals like Nirav Modi from fleeing the nation. Under this Act, courts have the authority to seize all assets and properties belonging to criminals accused of defaulting on payments above Rs. 100 crores as well as those who intentionally avoid the Indian judiciary's jurisdiction to avoid prosecution. The property and other important assets of the fleeing economic offender are seized in compliance with this Act.

 
Conclusion
The Scam at Punjab National Bank (PNB) is a frightening example of how financial criminality can threaten economic stability, public trust, and institutional stability. As this Scam shows, a strong legal and economic framework is important to prevent, detect, and reduce financial fraud. Economics and law must work together to provide public benefit, economic stability, and financial safety, it can be considered as proof while considering fraud from these two angles. The PNB fraud serves as a reminder that to ensure financial security, economics and the law must work together harmoniously.

Regulations are based on legal measures, but their effective execution is guided by economic concepts. A strong and effective economy depends on a well-regulated financial system that is reinforced by legal responsibility and standard economic judgment. To preserve economic assets, uphold public confidence, and avert future financial crises, India has to strengthen its legal and financial institutions by taking this case as a lesson.
 
Bibliography

• E-Newspaper:
  • Business Standard: < https://www.business-standard.com/about/what-is-pnb-scam>.
• E-Journals:
  • IJCRT: < https://www.ijcrt.org/papers/IJCRT24A4531.pdf>.
  • Pramana Research Journal: <https://www.pramanaresearch.org/gallery/prj-p1051.pdf>.
• Articles:
  • Legal Case Analysis: Punjab National Bank (PNB) Scam.
  • The Collapse Of Credibility: Analysing The Impact Of Nirav Modi Scam On Indian Banking.
  • The Punjab National Bank (PNB) Scam Case Study.

End-Notes:

1. Aman Srivastava and Mr. Sandeep Mishra, “Behind The Façade: The Rise And Fall Of Nirav Modi And The PNB Fraud Case”, 12IJCRTn.302, n302-n.310(2024).
2. Lawful Legal, < https://lawfullegal.in/legal-case-analysis-punjab-national-bank-pnb-scam/>.
3. Dr. Sushil Pande and Mr. Ved Prakash, “Case Study On Scam In Indian Banking Industry (Nirav Modi), 9 pramanaresearch626, 626-630(2019).
4. ResearchGate, <https://www.researchgate.net/publication/354447361_THE_PUNJAB_NATIONAL_BANK_PNB_SCAM_CASE_STUDY>.
5. Aman Srivastava and Mr. Sandeep Mishra, “Behind The Façade: The Rise And Fall Of Nirav Modi And The PNB Fraud Case”, 12IJCRTn.302, n302-n.310(2024).
6. Dr. Sushil Pande and Mr. Ved Prakash, “Case Study On Scam In Indian Banking Industry (Nirav Modi), 9 pramanaresearch626, 626-630(2019).

Written By: G.V.L. Prashasti