the securities scam of indian stock market

8/14/2019 The Securities Scam of Indian Stock Market

1/25

1

he Securities Scam We are here talk about one of most famous scams that has

been unearthed The Securities Scam. The Securities Scam refers to the diversion of funds to the

tune of Rs. 3500 Crores in Banking system to variousstockbrokers in a series of transactions (primarily in

Government securities) during the period of April 1991to May 1992.

Harshad Mehta is an Indian stockbroker and isalleged to have engineered the rise in the BSE Stock

Exchange in the year 1992. Exploiting several loopholes inthe Banking system, Harshad Mehta and his associatessiphoned of funds inter-bank transactions and boughtshares heavily at premium across many segments,triggering a rise in Sensex.


2/25

arshad Mehtandecurities Scam

Presented ByUjjal Bhandari


3/25

3

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 calledThe Securities Scam, involving misappropriation of funds tobe 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 ofIndia(RBI), the Central Bureau of Investigation(CBI), theIncome Tax Department, the Directorate of Enforcement andthe Joint Parliamentary Committee(JPC) are currentlyinvestigating various aspect of the scam.


4/25

4

he Two Security MarketThe scam is the essence a diversion of funds from the

banking system (in particular inter bank market ingovernment securities) to brokers for financing theiroperations in the stock market. A clear understandingin Government securities market and the stock

(Corporate securities) is a prerequisite forunderstanding the scam.


5/25

5

he ready forward deal( )f The Ready Forward Deal (RF) is in essence a secured

short term (typically 15 days) loan from one bankto another bank. The lending is done againstGovernment Securities exactly the a pawnbroker

lends against jewelries.

In fact one can say that the borrowing bank actuallysells 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.


6/25

6

he mechanics of thescamAs explained previously, a Ready Forward deal is, in

substance, a secured loan from one bank toanother bank. To make the scam possible, the RFhad to undergo a complete change. In other wordsit practically had to be an unsecured loan to abroker.

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.


7/25

7

he settlement process

The normal settlement process in Government securities is that thetransacting 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 thepayment 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.


8/25

8

he settlement process There were two important reasons why the broker

intermediated settlement began to be used in theGovernment securities market:

1.The brokers instead of merely bringing buyers and sellerstogether started taking position in market. In otherwords, they started trading on their own account, andin a sense became market makers in some securitiesthereby imparting greater 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 thefictitious counter parties, but arranged for the actualsettlement to take place with correct counter parties.


9/25

9

ayment ChequesA broker intermediated settlement allowed the broker to

lay his hand on the chequeas it went one bank to anotherthrough him. The hurdle now was to find a way ofcrediting to his account though it was drawn in favor of abank and was crossed account payee.

As it happens, it is purely a matter of banking custom thata account payee cheque is paid only on to the payeementioned on the cheque. In fact, exception were beingmade to this norm, well before the scam came into light.

Privileged (corporate) customers were routinely allowed tocredit account payee cheques in favor of a bank into theirown accounts to avoid clearing delays, thereby reducingthe interest lost on the amount.


10/25

10

ayment Cheque Normally, if a customer obtains a cheque in his own favor

and deposits it into his own account, it may take a dayor two for the cheque to be cleared and for the funds tobecome 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 theRBI, 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 moneyand credit his account the same day.

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


11/25

11

ispensing thesecurity The brokers thus found a way of getting hold of the

cheques 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 wasnecessary now was to find a way to eliminating thesecurity itself.

There are three routes adopted for this purpose:


12/25

12

ispensing thesecurity Some banks (or rather their officials) were persuaded

to part with chequeswithout actually receivingsecurities in return. A simple explanation of this isthat the official concerned were bribed and/or

negligent. A more intriguing possibility is that thebankers senior/top management were aware of thisand turned a Nelsons eye to it to benefit fromhigher returns the broker could offer by divertingthe funds to the stock market. One must recognize

that as long as the scam lasted, the banks benefitedfrom such agreements. The management frombanks might have been sorely tempted to adoptthis route to higher profitability.


13/25

13

ispensing thesecurity The second route was to replace the actual securities

by a worthless piece of paper a fake Bank Receipt(BR).

The third method was simply to forge the securities

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


14/25

14

ank receipt In an RF deal, as we have discussed it so far, the

borrowing banks actually delivers the actual securitiesto the lender and takes them back on repayment of loan.In practice, however, this is not usually done. Instead,the borrowers gives a Bank Receipts (BR) which servesthree 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 thesecurities 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 borrowers assurance thatthe borrower has the securities which can/will bedelivered if/when need arises.


15/25

15

r Issued without Backingf Securities As stated earlier, a BR is supposed to imply that the issuer

actually has the securities and holds them in trust for thebuyer. But in reality the issuer may not have the securities atall.

There are two reasons why a bank may issue a BR which is notbacked by actual securities:

A bank may shortsell securities, that is, it sells securities it doesnot 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. Shortselling 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.


16/25

16

r Issued without Backingf Securities The second reason is that the bank may simply want an

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

During the scam, the brokers perfected the art of using fake BRsto obtain unsecured loans from the banking system. Theypersuaded some small and little known banks the Bank ofKarad (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.In effect, several large banks made huge unsecured loans tothe BOK/MCB which in turn made the money available to thebrokers.


17/25

17

reak down of controlsystemThe 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 RBI itself. Weshall examine these control systems to understand how these failed to functioneffectively and what lessons can be learnt to prevent failure of control systems inthe future.

The internal control system of the commercial banks involves the following

features: 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 the possibilitythat the BR received may not be backed by any/adequate securities. In effect,therefore, it may be making an unsecured loan, and it must do the RF only ifit is prepared to make an unsecured loan. This requires assessing thecreditworthiness of the borrower and assigning him a "credit limit" up towhich the bank is prepared to lend. Technically, this is known as acounterparty limit.


18/25

18

ther aspect of thescam Coupon Changes and Insider Trading

During the period from September 1991 to June 1992, thegovernment raised the interest (coupon) rate on its fresh borrowing threetimes. On each occasion the coupon rate was increased by 1/2%, therebyraising the coupon rate from 11.5% to 13% during this ten month period.

The major implication of raising interest rate on new borrowings is that itwould trigger a fall in the market prices of the old loans which are peggedat the old (lower) interest rates. The price of the 11.5% Government Loan2010 dropped by 3% to 5% with each coupon rate hike.

If anyone has advance information about these changes in thecoupon rates, he could make enormous amounts of riskless profit by

shortselling the old securities just before the announcement of rate hikeand buying back (covering his position) after the prices have fallen.Somebody who took a short position of Rs. 500 crores before the couponhike of September 1991 could have made a profit of Rs. 15 crores,practically overnight! Since several persons in the Finance Ministry andthe RBI are likely to be aware of the impending hike in the coupon rate, thechance of leakage of this all important information is always there. Therehave been several allegations in this regard.


19/25

19

ther aspect of thescam Window Dressing Bank Balance Sheets

This means that a bank would be reluctant to sell thesesecurities and show the loss in its books. It was in this contextthat the banks and the brokers resorted to innovativemethods 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

at face value or at a price which is much higher than theprevailing market prices. The broker incurs a huge loss in thistransaction as he will have to resell the securities to someother bank at market prices.

b) The bank then buys some other securities from the samebroker at prices well above market prices. The brokertherefore makes a huge profit in the second transaction whichcompensates him for the loss incurred in transaction


20/25

20

here has the all moneygone?It is becoming increasingly clear that despite the intensive efforts by several

investigating agencies, it would be impossible to trace all the moneyswindled from the banks. At this stage we can only conjecture about wherethe money has gone and what part of the misappropriated amount would

be recovered. Based on the result of investigations and reporting so far, thefollowing 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 ofMarch 1992. In the aftermath of the scam it fell to about 2500 beforerecovering to around 3000 by August 1992. Going by newspaperreports, it appears likely 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 claim that he can clear all his dues if he were allowedto do so cannot be dismissed without a serious consideration. Whetherthese shares are in fact traceable is another question.


21/25

21

here has the all moneygone?

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 likelythat 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 thereach of 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.


22/25

22

mpact of the Scam The immediate impact of the scam was a

sharp fall in the share prices. Theindex fell from 4500 to 2500representing a loss of Rs. 100,000crores in market capitalization.

Since the accused were active brokers inthe stock markets, the number ofshares 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 gotthem registered in their names foundthemselves being robbed by thegovernment. This resulted in achaotic situation in the market sinceno one was certain as to whichshares were tainted and which werenot.


23/25

23

mpact of the scam The government's liberalization policies came under

severe criticism after the scam, with Harshad Mehtaand others being described as the products of thesepolicies. Bowing to the political pressures and the badpress it received during the scam, the liberalizationpolicies were put on hold for a while by the

government. The Securities Exchange Board of India(SEBI) postponed sanctioning of private sector mutualfunds.

Implementation of some aspects of the NarasimhamCommittee recommendations on the banking systemwere also delayed. Some question marks aroseregarding privatization as the chairman of thecommittee looking into this ended up in jail oncharges of involvement in the scam.

The much talked about entry of foreign pension fundsand mutual funds became more remote than ever.

The Euro-issues planned by several Indian companieswere delayed since the ability of Indian companies to

raise equity capital in world markets was severelycompromised.


24/25

24

olicy responseequiredIt is clear that the government, the RBI and the commercial banks

are as much accountable as the brokers for the scam. The brokerswere encouraged and abetted by the banks to divert funds fromthe banking system to the stock market. The RBI too standsindicted because despite knowledge about banks over-steppingthe boundaries demarcating their arena of operations, it failed toreign them in. The looting was done with active connivance and

sometimes full knowledge of the very individuals who were toguard against such a possibility. Discover and punish the guilty: This task has been entrusted to

the Central Bureau of Investigation (CBI) and to the JointParliamentary Committee (JPC). A special court has also beenset up to facilitate speedy trial.

Recover the money: The draconian provisions of the Ordinance forattachment 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 hasconsisted of measures like banning of RF deals and going slowon liberalization.


25/25

25

HAVE ANICE DAY

HANK you

the securities scam of indian stock market

Documents