Conspiracy theories abound in this age of social media. As do some wonderfully politically incorrect jokes revolving around the Modi name and foreign travel. The Nirav Modi scam simply provided fuel to an already merrily burning fire of scams and defaulters, and the jokes and memes and “theories” came thick and fast.

It’s all very funny, no doubt, but it’s also dark humour. It’s the laughter of a nation that’s becoming accustomed to financial fraud on a large scale and knows nothing much will be done about it. Nothing, that is, apart from squeezing the average taxpayer even more. Our history is replete with examples, but let’s just look at the most recent—the unfolding saga of how jewellery designer Nirav Modi managed to play a public sector bank to the tune of Rs 12,000-plus crore. (That amount is increasing almost on a daily basis, as more details come to light.)

For the very few who have not been following the scam, this is what happened. Diamond jewellery designer and trader Nirav Modi took loans from foreign banks (or foreign branches of Indian banks) on the strength of letters of undertaking (LoUs) from his bank, Punjab National Bank (PNB). Typically, such letters work as the issuing bank’s guarantee of the borrower’s soundness and ability to pay. Except, it now appears, most of these letters were not sanctioned by PNB’s bosses; someone low on the pecking order at PNB used the inter-bank messaging system SWIFT to send out messages that the letters had been issued. Since these messages are seen as “official”, the receiving banks went ahead to issue loans. Modi, meanwhile, began taking larger loans, sometimes using one loan to pay off an older one. It was a classic Ponzi scheme that ended like most of these schemes: with a crash.

There’s a Latin tag that could well have been written for India: Quis custodiet ipsos custodes? Translated, it means ‘who will guard the guards themselves?’ When news of the Nirav Modi scam broke, there was confusion first. But as the dust began to settle, PNB knew it had to take action, or at least be seen to take action. And so it sacrificed some of its low-level functionaries. Not a single boss has been penalised yet, and the bank’s leadership continues unscathed.

There’s a nice little circular game of finger-pointing going on now; with the government blaming the Reserve Bank of India, the RBI in turn saying the government has to take responsibility, and the PSU banks blaming everyone other than its own inefficient management. The scam “highlights an inherent weakness in the governance and transparency standards in the Indian banking system as a whole”, says Deepali Seth-Chhabria, credit analyst at S&P Global Ratings.

Sudhir Dash, former chief executive at Investec India who now runs his firm JagaK Consultants, says the PNB scam is a huge failure on the part of the RBI, which is “the first port of call” for the banking sector. “The RBI has failed in monitoring and develop - ing a fool-proof system,” he says.

Finance Minister Arun Jaitley is clearly on the same page. He has pointed out how despite having certain powers under Sections 35, 35A and 36 of the Banking Regulation Act of 1949, which empowers it to inspect any bank’s records and stop a bank from acting in a manner which is detrimental to the interests of a depositor, the RBI did not.

RBI governor Urjit Patel recently hit back, saying the apex bank actually had less authority over public banks compared with private banks. In a speech at Gujarat National Law University, Patel is reported to have said: “Market discipline mechanism for public sector banks is appreciably weaker compared to that at private banks.”

Compare this with what happens elsewhere in the world when such major scams come to light. Remember Bernie Madoff who ran perhaps the largest Ponzi scheme in the early 2000s? He was jailed for 150 years. Then there’s the cross-selling scam at Wells Fargo. The bank’s chairman and chief executive officer, John G. Stumpf, was forced to resign, denied severance pay, made to forgo his salary during the period of investigation, and had to forfeit $41 million in outstanding unvested equity awards (read stock options).

In India, however, other than Ramalinga Raju of Satyam, there have been almost no high-profile punishments for egregious fraud by promoters and auditors.

The issue that I found quite fundamental is the core banking system not being integrated with the SWIFT managing system.
Harsh Goenka, chairman, RPG Enterprises

The government keeps pumping in ever-increasing sums to keep the system going. The numbers tell the shameful story far better. In FY16, the government levied a 3% surcharge on individuals with annual income of Rs 1 crore and above. In FY17, a 1% surcharge was levied on those with an income of Rs 50 lakh to Rs 1 crore. The effective tax rate of companies was increased from 23.22% in FY14 to 26.89% in FY17. Sure, taxes are used for many things, but a large chunk seems to be going to bail out public sector banks, which incurred a net loss of Rs 21,396 crore in FY17, with nine out of 21 public sector banks reporting losses.

“It’s a kind of scam cess,” concedes Harsh Mariwala, chairman of consumer goods major Marico. “The government has to put in extra money into these banks and that has to come from the taxpayer.” He adds that there’s another set of people hit hard by such scams. “Everyone talks of taxpayers, but investors also suffer,” he says. Losses of such scale have an adverse impact on a bank’s reserves, which in turn can impact the profit and loss account, leading to a fall in share prices.

Harsh Goenka, chairman, RPG Enterprises, is more philosophical. “I feel a fraud of this magnitude, particularly in one of the nationalised banks, entails a cost to the exchequer. Hence, logically, this leads to cost of incurrence devolving onto the common man.”

It’s one thing to make taxpayers pay for the fault of the system. It’s quite another to do nothing to fix that system. And that’s what the Nirav Modi episode has brought to light: that nothing has been done for so many years despite several red flags raised about the banking system.

It’s a kind of a scam cess. The government has to put in extra money into the banks and that has to come from the taxpayer.
Harsh Mariwala, chairman, Marico

The government’s answer to the inexorably rising non-performing assets or NPAs of PSU banks has so far been its default response: Throw more money into the system. The Indradhanush scheme to revamp PSU banks has already overshot its budget by close to 11%. In 2015, under Indradhanush, the government had promised a capital infusion of Rs 70,000 crore over a period of four financial years. Earlier this year, a new plan was put in place to infuse Rs 2.11 lakh crore: Rs 1.35 lakh crore as recapitalisation bonds and Rs 18,139 crore through budgetary provision.

What everyone except the government seems to have seen is that this is just not working. The Comptroller and Auditor General of India (CAG), in its June 2017 performance audit report on recapitalisation of public sector banks from FY09 to FY17, notes that the government pumped Rs 118,724 crore into banks over these years. More telling, the CAG report added that the rationale for distribution of capital among the banks was often not on record. Back in 2012, the CAG report says, the department of financial services had signed agreements with PSU banks regarding performance-linked capital infusion. That was “not adhered to”, adds the report.

Take the case of PNB, which has seen eight rounds of recapitalisation worth a total of Rs 12,774 crore. But the bank’s NPAs have continued to grow; PNB’s NPAs are second only to SBI’s, accounting for 8.1% of the total gross NPAs. That’s Rs 55,370 crore in FY17. And that’s just one bank. Now add fraud to the mix, and the amount involved just gets higher. Goenka says he was surprised to read that state-run banks reported more than 8,000 loan fraud cases worth $10 billion over the last five fiscals.

The government’s answer? More recapitalisation, funded by taxpayers. (Meanwhile, more dark humour: Indradhanush is also the name the government has given to its health mission to provide immunisation to the poor against a specific set of diseases. Clearly, there’s no vaccine for the banking sector.) It’s not that the government is entirely blind to the futility of recapitalisation in this form. A recent statement from Parliament’s Standing Committee on Finance said: “In such a scenario of regulatory failure, the current recapitalisation exercise of banks may end up as throwing good money after bad.”

So, is there a solution? Corporate leaders say there are bound to be changes now that the PNB scam has come to light. “There will be stricter vigilance but how effective it will be will depend on design and implementation of the proposed changes,” says Goenka. He adds that knee-jerk reactions will not work. “A more coordinated and organised effort by all stakeholders may be the way forward.” Goenka calls for strengthening the design and monitoring of the banking system, implementation of automated risk management systems, and core banking system integration with the SWIFT network. SWIFT payments, he says, need to be assessed more rigorously. This apart, fraud risk assessment, strengthening internal controls through staff rotation, encouraging rigorous redressal of whistleblower complaints and redflags raised are critical.

Dash of JagaK says the method of reconciling SWIFT and core banking systems manually must be done away with and the whole system modernised. Additionally, the RBI would need to ensure a mechanism whereby the entire non-fund exposures across the system should tally. “For instance, if a bank has $10 billion of LoUs and those who have funded it show $12 billion that cannot work. All non-fund exposures should match.”

The other huge issue that the PNB scam has highlighted is the talent at public sector banks. “The quality of talent is a major issue, both at the top and down the line at these banks,” says Mariwala. “Pay scales are low, and that is compounded by weak systems. I was looking at some of the names of the statutory auditors; I haven’t even heard of their names. There are also weak internal auditors.”

PNB’s non performing assets are second only to SBI’s and account for 8.1% of total gross NPAs.

Dash agrees. “I have seen how banks sometimes do project appraisals. There’s often very low technical understanding and on-site due diligence. That apart, there’s pressure from the bureaucracy and a poor working environment,” he says.

Coming to the PNB issue, most of the bankers we spoke to believe that a few middle- and low-level bank employees could not have issued fraudulent LoUs and letters of credit, without the top management, board or the internal and external auditors knowing about it.

The scam ought to have been detected at some level, say bankers, even if PNB had failed to integrate its messaging network for securely transmitting instruction or SWIFT with its core banking system—cited as a major reason for the scam. “It is highly unlikely that different sets of auditors like concurrent, internal, statutory, and RBI auditors did not catch the amount being deposited in PNB’s New York branch because of the commissions earned from issuing LoUs or payments in foreign exchange by other banks into that account,” says a senior banker, requesting anonymity.

If the internal and external auditors are of poor quality, accountability gets further diffused, adds Mariwala. Then there is the role of the board and the issue of how board members of state-owned banks are selected and remunerated. The role of the RBI is also to be examined in such cases.

Goenka adds that banks must keep their eye on technology. “The issue that I found quite fundamental is the core banking system not being integrated with the SWIFT managing system. It is a primary control deficiency, which can be and was easily exploited by account holders in connivance with corrupt bank officials,” he says.

Despite warnings from the RBI, PNB failed to act and link its core banking system with SWIFT, he adds. Another problem is not giving due respect to raised red flags. Goenka says PNB missed out on conducting stringent due diligence of its major customers. “People had raised concerns in the past which essentially are possible red flag indicators,” he says.

In the aftermath of the current scam, there’s bound to be some action taken by the government and the RBI. The RBI has already discontinued LoUs with immediate effect, although that’s a bit like closing the barn door after the horse has bolted. “The government will try and improve things I am sure,” says Mariwala. “But what you need is a long-term sustainable solution—merging some of the banks, and eventually privatising them.” Goenka seconds that. “The ultimate answer, I believe, is to gradually privatise the PSU banks, with State Bank of India being the only bank continuing to be majority government-owned, albeit with more autonomy. This can lead to greater accountability and a more robust and healthy banking system.”

It’s not just the private sector pushing for privatisation. RBI deputy governor Viral Acharya, in a speech last year, seems to have hinted at this. “The Indradhanush was a good plan, but to end the Indian story differently, we need soon a much more powerful plan—“Sudarshan Chakra”— aimed at swiftly, within months if not weeks, for restoring public sector bank health, in current ownership structure or otherwise,” he said.

Meanwhile, the government continues to believe it can fix the system. “The party is over for the likes of Nirav Modi and others,” claims Rajiv Kumar, secretary, department of financial services at the ministry of finance. “Now we will have clean, transparent, and responsible lending, where the debtor-creditor relationship will change fundamentally.” How will that happen? “The government is taking steps to check aggressive and imprudent lending,” he says hopefully. And until it is implemented in its entirety, it looks like the government will continue propping up these inefficient behemoths—with a little help from the taxpayer.

(The article was originally published in 15 March-14 June special issue of the magazine.)

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