Vivek Kulkarni & M S R Manjunatha
The news of purported fraud committed by Nirav Modi and Gitanjali Gems groups and subsequent investigation by the CBI, ED, etc, have sent shock-waves among the public and bankers alike. While the amount involved in the PNB fraud is indicated to be ~Rs 11,000 cr, the total exposure of the banks, including working capital facilities, is Rs 20,000 cr. The public, now used to large NPAs in the steel and power sectors, may as well take this amount in its stride! However, the regularity with which gems & jewellery businesses, particularly diamond traders, figure among large defaulters should make us take notice. Winsome Group and Shree Ganesh Jewellery House are the other large defaulters who come to mind. Overall exposure of the Indian banking system to diamond and jewellery trade is estimated at ~Rs 70,000 cr, with stressed assets contributing around 15%. This brings up the question whether the methods followed by banks for normal working capital lending are suitable for the risks associated with this sector.
Until the early 1980s, very few banks had credit exposure to this segment, and only four banks in Mumbai had some specialisation, including two European banks. Over 30 years, banks have increased financing, to these three sub-segments, viz, (a) import,cutting and polishing of rough diamonds for export; (b) manufacture of diamond-studded jewellery for both domestic sales and export; (c) manufacture and/or sale of plain gold jewellery or studded with less precious stones. Lending to the first category has the highest risk, and to the last, the least.
Diamond business is predominantly involved in imports and then exports. Large diamond traders, like DTC SightHolders, buy roughs from the Diamond Trading Corporation, Antwerp. Banks allow advance remittances against sight allotments and then follow-up for the consignment of roughs to be received. When the rough diamond packet lands in India and passes through Customs, the lumps go to Surat or other Gujarat centres for cutting and polishing. Valuation is based on colour, clarity, cut and carat (size). These stocks are declared to banks in a stock statement, as hypothecated security. Banks have no expertise in inspecting the stocks nor on evaluating their value.
The joke in banking circles is that their staff can’t even distinguish a zircon or a crystal from a diamond, leave alone looking at clarity or colour! The standard refrain is that ‘this business runs on trust’. Thereafter, the finished diamonds (or studded jewellery) are exported to various traders in Europe, Middle East or Hong Kong. The practices here are even more peculiar. Most importers are associate concerns of the exporters themselves, or of their close relatives. This practice, the industry says, is required as the buying party should have trust in the selling party on the quality and value of merchandise. The export cargo also goes through Customs.
As the goods are couriered through airlines, there is no meaningful ‘shipping document’ attached to a bill of exchange. Goods would have reached the destination even before the documents with the airway bills are handed over to the bank. There is also the problem of high handling charge levied by overseas banks. Hence, there is hardly a system of ‘accepting’ the bill of exchange or release of document of title to goods against ‘acceptance’. These are called ‘direct bills’. It means that banks are simply financing 100% against export receivables, based on invoices raised by the exporter, relying on Customs declarations.
Information on the importer is quite sketchy, and most of them are paper offices. While credit period initially agreed could be 90 days, it is very common to extend them up to 180 or even 360 days, as permitted under regulations. Banks do not enquire why the counter-party is taking so much time, or if he has already realised sales proceeds and is using it for his own business purposes. When the 360 days’ deadline approaches, such overdue bills are adjusted against any other inward remittance (allowed by RBI), thus failing to record delinquent counter-parties. The letter of undertaking (LoU) issue surrounding the Nirav Modi case adds the dimension of ‘operational risk’, with the trade finance software allowing only letter of credit and not LoU. Thus, the core banking system does not recognise LoU.
Thus, when a situation for recovery arises, banks scramble to get hold of the stocks and bills as per their records. By that time, these are either non-existent, fictitious, irrecoverable, or of such a meagre value that the exposure has turned substantially unsecured. In some instances, the promoters escape overseas, ostensibly for collection of receivables, and remain untraceable. The importers are in different countries, and difficult to contact. If pressed, some importers raise counter-claims against the exporter, both in terms of merchandise or disputes arising out of previous supplies. Banks have not reported success stories where they filed cases against the importers and recovered any money.
This situation of weak lending has arisen due to several reasons. Firstly, all banks want export credit, to meet regulatory requirements. Diamond exporters provide a major avenue, as ticket sizes are big. Fee income on imports, remittances, bills, forward covers, etc, is quite attractive. Secondly, in view of the large exposure, banks have to resort to consortium lending, and the consortium leader practically takes all decisions. Third, there is no meaningful audit of stocks (due to the nature of inventory) or receivables.
Fourth, established exporters, who are flush with funds, have diverted the funds for real estate, stock markets or other overseas businesses—including failed mining ventures. Some observers say that banks have unwittingly even funded ‘round tripping’ of diamonds, where the same commodities frequently get exported and imported. Going by the increasing number of claims, Export Credit Guarantee Corporation has now excluded the cover for diamond and other jewellery exporters under whole turnover policies. Specific approvals are needed, which is difficult to come by.
So, what is the way forward? Banks should now sit with the Gems & Jewellery Export Promotion Council, and work out a different way of financing the business. ‘Trust’ alone can’t be the basis for large exposures. Banks should have access to the funding trail all along, and should be well secured—both by hard collaterals and personal guarantees. Bills on related parties should not be discounted, and they should push for LC-based exports.
‘Direct bills’ should be abolished, and all bills should be routed through banks only. Experts who can certify stocks should be empanelled, and electronic records of all stock movements should be put in place. Quantum of lending should be drastically reduced by raising the margin requirement, and in a risky business like this, there should be more promoter-funding. RBI should come with stringent guidelines for lending to this sector, similar to those against shares, commodities or commercial real estate.
Kulkarni is MD and Manjunatha is head of ratings, Brickwork Ratings. Views are personal