28294047 the Securities Scam of Indian Stock Market

8/8/2019 28294047 the Securities Scam of Indian Stock Market

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THE SECURITIES SCAM

We are here talk about one of most famous scams thathas been unearthed “ The Securities Scam”.

The Securities Scam refers to the diversion of funds tothe tune of Rs. 3500 Crores in Banking system to various

stockbrokers in a series of transactions (primarily inGovernment securities) during the period of April 1991to May 1992.

Harshad Mehta is an Indian stockbroker

and is alleged to have engineered the rise in the BSEStock Exchange in the year 1992. Exploiting severalloopholes in the Banking system, Harshad Mehta andhis associates siphoned of funds inter-bank transactionsand bought shares heavily at premium across many segments, triggering a rise in Sensex.

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HARSHAD MEHTA

AND

SECURITIES SCAM

Presented By

Ujjal Bhandari



INTRODUCTION In April 1992, the first press report appeared indicating that

there was a shortfall of Government securities held by StateBank of India. In a little over a month, investigation revealedthat this was a just a tip of iceberg which came to be called“The Securities Scam”, involving misappropriation of funds to be tuned of over Rs. 3500 Crores.

In an ever expanding ambit, the scam has engulfed topexecutives of large national banks, foreign banks and financialinstitution, brokers, bureaucrats and politicians.

The function of money market and stock market has beenthrown in disarray.

A large number of agencies, namely, the Reserve bank of India(RBI), the Central Bureau of Investigation(CBI), theIncome Tax Department, the Directorate of Enforcement andthe Joint Parliamentary Committee(JPC) are currently investigating various aspect of the scam. 3



THE TWO SECURITY MARKET

The scam is the essence a diversion of funds from thebanking system (in particular inter bank market in

government securities) to brokers for financing their

operations in the stock market. A clear understanding in

Government securities market and the stock (Corporate

securities) is a prerequisite for understanding the scam.

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THE READY FORWARD DEAL (RF)

The Ready Forward Deal (RF) is in essence asecured short term (typically 15 days) loan from one bank to another bank. The lending is done againstGovernment Securities exactly the a pawnbroker

lends against jewelries.

In fact one can say that the borrowing bank actually sells the securities to the lending bank and buys

them back at the end of the period of the loan at(typically) a slightly higher price.

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THE MECHANICS OF THE SCAM

As explained previously, a Ready Forward deal is, insubstance, a secured loan from one bank to another bank. To make the scam possible, the RF had toundergo a complete change. In other words it

practically had to be an unsecured loan to a broker.

This was wonderfully engineered by the Brokers. Togive a better understanding of the mechanism, the whole process has been segregated into 3 differentparts viz.

1. The Settlement Process.

2. Payment Cheques.

3. Dispensing of Securities. 6



THE SETTLEMENT PROCESS The normal settlement process in Government securities is that

the transacting banks makes payment and deliver the securitiesdirectly to each others.

During the scam, however, the banks or at least some banksadopted an alternative settlement process which was similar to

the process used for settling transactions in the stock market. In this settlement process, deliveries of securities and payments

are made through the broker. That is, the seller hands over thesecurities to the broker who passes them on to the buyer, whilethe buyer gives the cheque to the broker who then makes the

payment to seller.

In this settlement process, the buyer and the seller may not evenknow to whom they have traded with, both being known only to

broker. 7



THE SETTLEMENT PROCESS

There were two important reasons why the brokerintermediated settlement began to be used in theGovernment securities market:

1. The brokers instead of merely bringing buyers and sellers

together started taking position in market. In other words,they started trading on their own account, and in a sense became market makers in some securities thereby impartinggreater liquidity to the market.

2. When a bank wanted to conceal the fact that it was doing aRF deal, the brokers came in handy. The brokers provided

the contract notes for this purpose with the fictitious counterparties, but arranged for the actual settlement to take place with correct counter parties.

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PAYMENT CHEQUES

A broker intermediated settlement allowed the broker tolay his hand on the cheque as it went one bank to anotherthrough him. The hurdle now was to find a way of crediting to his account though it was drawn in favor of a

bank and was crossed account payee. As it happens, it is purely a matter of banking custom that

a account payee cheque is paid only on to the payeementioned on the cheque. In fact, exception were being

made to this norm, well before the scam came into light. Privileged (corporate) customers were routinely allowed

to credit account payee cheques in favor of a bank intotheir own accounts to avoid clearing delays, thereby reducing the interest lost on the amount.

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PAYMENT CHEQUE

Normally, if a customer obtains a cheque in his ownfavor and deposits it into his own account, it may take aday or two for the cheque to be cleared and for the fundsto become available to the customer. At 15% interest, theinterest loss on a clearing delay of two days for a rupees

100 Crores cheque is about Rs. 8 lakhs. On the other hand, when banks make payments to each

other by writing cheques on their accounts with the RBI,these cheques are cleared on the same day.

The practice which thus emerged was that a customer would obtain a cheque drawn on the RBI favoring nothimself but his bank. The bank would get the money andcredit his account the same day.

This was the practice which the brokers in the money market exploited to their benefit.

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DISPENSING THE SECURITY

The brokers thus found a way of getting hold of thecheques as they went from one bank to another andcrediting the amounts to their accounts. Thiseffectively transform an RF into a loan to a broker

rather than to a bank.

But this, by itself, would not have led to the scam because the RF after all is a secured loans, and asecured loan to a broker is still secured. What was

necessary now was to find a way to eliminating thesecurity itself.

There are three routes adopted for this purpose:11




Some banks (or rather their officials) werepersuaded to part with cheques without actually receiving securities in return. A simple explanationof this is that the official concerned were bribed

and/or negligent. A more intriguing possibility isthat the bankers senior/top management wereaware of this and turned a Nelson’s eye to it to benefit from higher returns the broker could offer

by diverting the funds to the stock market. Onemust recognize that as long as the scam lasted, the banks benefited from such agreements. Themanagement from banks might have been sorely tempted to adopt this route to higher profitability.

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The second route was to replace the actualsecurities by a worthless piece of paper – a fakeBank Receipt (BR).

The third method was simply to forge the securitiesthemselves. In many cases, PSU bonds wererepresented only by allotment letters rather thenthe certificates on security paper. And it is easier toforge a allotment letter for Rs. 100 crores worth of

securities then it is to forge a 100 rupees note!Outright forgery of this kind however accountedonly a very small part of total fundsmisappropriated. 13



BANK RECEIPT

In an RF deal, as we have discussed it so far, the borrowing banks actually delivers the actual securities tothe lender and takes them back on repayment of loan. Inpractice, however, this is not usually done. Instead, the borrowers gives a Bank Receipts (BR) which serves three

function:1. The BR confirms the sale of securities.2. It acts as a receipt for money received by the selling bank. Hence

the name – Bank Receipt.3. It promises to deliver the securities to the buyers. It also states

that in the mean time the seller holds the securities in trust for buyer.

In short, a BR is something like an IOU (I Owe Usecurities!) and the use of BR de facto converts an RFdeal into unsecured loans. The lending bank no longerhas securities; it has only the borrower’s assurance thatthe borrower has the securities which can/will bedelivered if/when need arises.

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BR ISSUED WITHOUT BACKING OF

SECURITIES

As stated earlier, a BR is supposed to imply that the issueractually has the securities and holds them in trust for the buyer. But in reality the issuer may not have the securities atall.

There are two reasons why a bank may issue a BR which is not backed by actual securities:

A bank may shortsell securities, that is, it sells securities itdoes not have. This would be done if the bank thinks that theprices of these securities would decrease. Since this would bean outright sale (not an RF!), the bank issues a BR. When thesecurities do fall in value, the bank buys them at lower pricesand discharges the BR by delivering the securities sold. Short

selling in some form is an integral part of most bond marketsin the world. It can be argued that some amount of shortselling subject to some degree of regulation is a desirablefeature of a bond market. In my opinion, an outright saleusing a BR which is not backed by securities is not harmfulper se though it violates the RBI guidelines. 15



BR ISSUED WITHOUT BACKING OF

SECURITIES

The second reason is that the bank may simply want anunsecured loan. It may then do an RF deal issuing a "fake" BR which is a BR without any securities to back them. Thelending bank would be under a mistaken impression that it ismaking a secured loan when it is actually advancing an

unsecured loan. Obviously, lenders should have takenmeasures to protect themselves from such a possibility.

During the scam, the brokers perfected the art of using fakeBRs to obtain unsecured loans from the banking system. They persuaded some small and little known banks – the Bank of Karad (BOK) and the Metropolitan Cooperative Bank (MCB) -

to issue BRs as and when required. These BRs could then beused to do RF deals with other banks. The cheques in favourof BOK were, of course, credited into the brokers' accounts. Ineffect, several large banks made huge unsecured loans to theBOK/MCB which in turn made the money available to the brokers.

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BREAK DOWN OF CONTROL

SYSTEM

The scam was made possible by a complete breakdown of the control system both within the commercial banks as well as the control system of the RBIitself. We shall examine these control systems to understand how these failedto function effectively and what lessons can be learnt to prevent failure of control systems in the future.

The internal control system of the commercial banks involves the followingfeatures:

Separation of Functions: The different aspects of securities transactions of a bank, namely dealing, custody and accounting are carried out by differentpersons. Dealing refers to the decision about which transactions are to beentered into with which parties.

Counterparty Limits: The moment an RF deal is done on the basis of a BR rather than actual securities, the lending bank has to contend with thepossibility that the BR received may not be backed by any/adequatesecurities. In effect, therefore, it may be making an unsecured loan, and itmust do the RF only if it is prepared to make an unsecured loan. This requiresassessing the creditworthiness of the borrower and assigning him a "creditlimit" up to which the bank is prepared to lend. Technically, this is known as a

counterparty limit.

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OTHER ASPECT OF THE SCAM

Coupon Changes and Insider Trading

During the period from September 1991 to June 1992, the governmentraised the interest (coupon) rate on its fresh borrowing three times. Oneach occasion the coupon rate was increased by 1/2%, thereby raising thecoupon rate from 11.5% to 13% during this ten month period. The major

implication of raising interest rate on new borrowings is that it wouldtrigger a fall in the market prices of the old loans which are pegged at theold (lower) interest rates. The price of the 11.5% Government Loan 2010dropped by 3% to 5% with each coupon rate hike.

If anyone has advance information about these changes in the couponrates, he could make enormous amounts of riskless profit by shortselling

the old securities just before the announcement of rate hike and buying back (covering his position) after the prices have fallen. Somebody whotook a short position of Rs. 500 crores before the coupon hike of September 1991 could have made a profit of Rs. 15 crores, practically overnight! Since several persons in the Finance Ministry and the RBI arelikely to be aware of the impending hike in the coupon rate, the chance of leakage of this all important information is always there. There have beenseveral allegations in this regard.

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OTHER ASPECT OF THE SCAM

Window Dressing Bank Balance Sheets

This means that a bank would be reluctant to sell these securities

and show the loss in its books. It was in this context that the

banks and the brokers resorted to innovative methods of window

dressing the bank balance sheet. The basic idea is as follows:

a) The bank sells the securities trading at a discount to a broker atface value or at a price which is much higher than the prevailing

market prices. The broker incurs a huge loss in this transaction

as he will have to resell the securities to some other bank at

market prices.

b) The bank then buys some other securities from the same brokerat prices well above market prices. The broker therefore makes a

huge profit in the second transaction which compensates him for

the loss incurred in transaction

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WHERE HAS THE ALL MONEY GONE?It is becoming increasingly clear that despite the intensive efforts by several

investigating agencies, it would be impossible to trace all the money swindled from the banks. At this stage we can only conjecture about

where the money has gone and what part of the misappropriated amount would be recovered. Based on the result of investigations and reportingso far, the following appear to be the possibilities:

A large amount of the money was perhaps invested in shares. However,

since the share prices have dropped steeply from the peak they reachedtowards end of March 1992, the important question is what are theshares worth today? Till February 1992, the Bombay Sensitive Index was

below 2000; thereafter, it rose sharply to peak at 4500 by end of March1992. In the aftermath of the scam it fell to about 2500 before recoveringto around 3000 by August 1992. Going by newspaper reports, it appearslikely that the bulk of Harshad Mehta's purchases were made at low prices, so that the average cost of his portfolio corresponds to an index

well below 2500 or perhaps even below 2000. Therefore, Mehta's claimthat he can clear all his dues if he were allowed to do so cannot bedismissed without a serious consideration. Whether these shares are infact traceable is another question.

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WHERE HAS THE ALL MONEY GONE?

It is well known that while Harshad Mehta was the "big bull" in the stock market,there was an equally powerful "bear cartel", represented by Hiten Dalal, A.D.Narottam and others, operating in the market with money cheated out of the

banks. Since the stock prices rose steeply during the period of the scam, it is likely that a considerable part of the money swindled by this group would have beenspent on financing the losses in the stock markets.

It is rumoured that a part of the money was sent out of India through the havalaracket, converted into dollars/pounds, and brought back as India DevelopmentBonds. These bonds are redeemable in dollars/pounds and the holders cannot beasked to disclose the source of their holdings. Thus, this money is beyond the reachof any of the investigating agencies.

A part of the money must have been spent as bribes and kickbacks to the variousaccomplices in the banks and possibly in the bureaucracy and in the politicalsystem.

As stated earlier, a part of the money might have been used to finance the lossestaken by the brokers to window-dress various banks' balance sheets. In other words, part of the money that went out of the banking system came back to it.

In sum, it appears that only a small fraction of the funds swindled is recoverable.

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IMPACT OF THE SCAM

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The immediate impact of the scam was a sharp fall in the share prices.The index fell from 4500 to 2500representing a loss of Rs. 100,000crores in market capitalization.

Since the accused were active brokersin the stock markets, the number of shares which had passed through

their hands in the last one year wascolossal. All these shares became"tainted" shares, and overnight they

became worthless pieces of paper asthey could not be delivered in themarket. Genuine investors who had

bought these shares well before thescam came to light and even got themregistered in their names foundthemselves being robbed by thegovernment. This resulted in a chaoticsituation in the market since no one

was certain as to which shares weretainted and which were not.



IMPACT OF THE SCAM

The government's liberalization policies came under severecriticism after the scam, with Harshad Mehta and othersbeing described as the products of these policies. Bowing tothe political pressures and the bad press it received duringthe scam, the liberalization policies were put on hold for awhile by the government. The Securities Exchange Board

of India (SEBI) postponed sanctioning of private sectormutual funds.

Implementation of some aspects of the NarasimhamCommittee recommendations on the banking system werealso delayed. Some question marks arose regardingprivatization as the chairman of the committee looking into

this ended up in jail on charges of involvement in the scam. The much talked about entry of foreign pension funds and

mutual funds became more remote than ever.

The Euro-issues planned by several Indian companies weredelayed since the ability of Indian companies to raiseequity capital in world markets was severely compromised.

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POLICY RESPONSE REQUIRED

It is clear that the government, the RBI and the commercial banks areas much accountable as the brokers for the scam. The brokers wereencouraged and abetted by the banks to divert funds from thebanking system to the stock market. The RBI too stands indictedbecause despite knowledge about banks over-stepping the boundariesdemarcating their arena of operations, it failed to reign them in. Thelooting was done with active connivance and sometimes full

knowledge of the very individuals who were to guard against such apossibility.

Discover and punish the guilty: This task has been entrusted to theCentral Bureau of Investigation (CBI) and to the Joint ParliamentaryCommittee (JPC). A special court has also been set up to facilitatespeedy trial.

Recover the money: The draconian provisions of the Ordinance for

attachment of property and voiding of transactions with theconsequent creation of "tainted“ shares were attempts in thisdirection.

Reform the system: The government's response so far has consisted of measures like banning of RF deals and going slow on liberalization.

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H AVE A

NICE DAY

THANK you25

28294047 the Securities Scam of Indian Stock Market

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