How the Harshad Mehta Scam Led to a Reform

The Harshad Mehta scam of the ‘90’s. What has this scam got to do with the reforms story that is the theme of Montek Singh Ahluwalia’s Backstage? To answer that, one needs to understand how the scam worked.

 

Banks buy and sell bonds to/from each other, either to meet regulatory requirements, or sometimes to earn money via interest for short durations. Back then, with no electronic systems, banks would do such transactions via brokers. The buying bank would issue a check, and the selling bank would issue a BR (banker’s receipt) to convey money had been received. So far so good.

 

Centralized records of the owners of government securities was maintained by the Public Debt Office (PDO). With non-electronic record systems, it would take time for a change in the owner (seller to buyer bank) to be recorded in PDO records. Since many inter-bank transactions of this kind were of short durations (15 days), it often made no sense to even record such transactions with the PDO – after all, by the time PDO record was updated, it was quite likely the 15 day was already over, and the transaction between the banks was reversed. The fact that 15 day transactions never even made it to the PDO was the seed for the scam.

 

Weirdly, the check issued by the buying bank was encashed by the broker first, who would then transfer the money to the seller bank. In case of 15 day transactions, the brokers found an “opportunity”. They could (1) claim the check had not yet been encashed and thus delay transferring money to the selling bank, (2) then use the money to do their own share transactions for 15 days, (3) return the money at the end of the 15 day period. This may not sound like much, but cumulatively, step #2 meant a lot of illegally obtained money was sloshing around the stock market and thus causing the Sensex to rise.

 

Once such a “mechanism” is found, corruption and bribes entered the mix. The brokers “persuaded” smaller banks to sell government bonds that they didn’t even own! The buying bank, not knowing this was the case, would issue the check to the broker, who would then use it to speculate in the stock market. This accelerant, the sale of fake/non-existent bonds by smaller banks, had turned the fire into an inferno, aka the Harshad Mehta scam.

 

Once the scam broke out, a parliamentary probe was setup. Ahluwalia points out the irony of the situation. Yes, there were corrupt individuals (brokers, bankers, company owners who stood to benefit if stock prices went up etc), but it was also true that the root cause lay in the lack of electronic systems to track transactions. But any such assertion was viewed by both the public and the opposition as a cover-up, a way to blame the system and thus let the perpetrators as well as politicians to get away scot-free.

 

Now, we can get to the connection of this to the reforms story. Until then, the labour unions had opposed computerization, fearing job losses. The government used the scam to push through computerization in the finance industry by threatening the unions - the public is furious about the scam, the government is trying to fix the root cause by computerizing financial records, were the unions still going to block it and become the bad guys in the eyes of the public?

“Shortly thereafter, in 1993, the unions signed an agreement allowing a phased process of computerization.”

 

The path to reforms is never as simple as we like to imagine.