1992 Indian stock market scam

The scam was the biggest money market scam ever committed in India, amounting to approximately ₹ 5,000 crores. The main perpetrator of the scam was a stock and money market broker Harshad Mehta. It was a systematic stock scam using fake bank receipts and stamp paper that caused the Indian stock market to crash. The scam exposed the inherent loopholes of the Indian financial systems and resulted in a completely reformed system of stock transactions, including an introduction of online security systems.[1]

Security frauds refer to the idea of diversion of funds from the banking system to various stockholders or brokers.[2] The 1992 scam was a systematic fraud committed by Mehta in the Indian stock market which led to the complete collapse of security systems. He committed a scam of over 1  billion from the banking system to buy stocks on the Bombay Stock Exchange.[3] This impacted the entire exchange system as the security system collapsed and investors lost hundreds of thousands of rupees in the exchange system. The scope of the scam was so large that the net value of the stocks was higher than the combined health and education budget of India. The scam was orchestrated in such a way that Mehta secured securities from the State Bank of India against forged cheques signed by corrupt officials and failed to deliver the securities. Mehta made the prices of the stocks soar high through fictitious practices and sold the stocks that he owned in these companies.[4] The impact of the scam had many consequences, which included the losses incurred by lakhs of families and the immediate crash of the stock market. The index fell from 4500 to 2500 representing a loss of ₹ 1000  billion in market capitalization.[2] The 1992 scam raised many questions involving bank officials responsible for being in collusion with Mehta. An interview with Montek Singh Ahluwalia (Secretary, economic affairs at the Ministry of Finance) revealed that many top bank officials were involved.[5]

In the early 70's, banks in India were not allowed to invest in the equity markets. However, they were expected to post profits and to retain a certain ratio (threshold) of their assets in government fixed interest bonds. Mehta squeezed capital out of the banking system to address this requirement of banks and pumped this money into the share market. He promised the banks higher rates of interest, while asking them to transfer the money into his personal account, under the guise of buying securities for them from other banks. At that time, a bank had to go through a broker to buy securities and forward bonds from other banks. Mehta used this money temporarily in his account to buy shares, hike up demand of certain shares (such as that of ACC, Sterlite Industries, and Videocon) dramatically, sell them off, pass on a part of the proceeds to the bank and keep the rest for himself. This resulted in stocks like ACC, which was trading in 1991 for ₹200/share, catapult to nearly ₹9,000 in just 3 months.[6]

Another major instrument was the bank receipt (BR). In a ready forward deal, securities were not moved back and forth in actuality. Instead, the borrower, i.e. the seller of securities, gave the buyer of the securities a BR. The BR serves as a receipt from the selling bank, and also promises that the buyer will receive the securities they have paid for at the end of the term. Having figured this out, Mehta needed banks, which could issue fake BRs, or BRs not backed by any government securities.

Once these fake BRs were issued, they were passed on to other banks and the banks in turn gave money to Mehta, plainly assuming that they were lending against government securities when this was not really the case.[7] He took the price of ACC from ₹200 to ₹9,000. That was an increase of 4,400%. Since he had to book profits in the end, the day he sold was the day when the markets crashed.[8][9]

The ready forward deal is a way where a single broker liaisons between two banks. When one bank wants to sell securities, it approaches the broker. This broker goes to another bank and tries to sell the securities and vice versa for buying. Since Mehta was a renowned broker, he got cheques issued in his name instead of the bank. When the bank wanted money for the securities, he approached another bank and repeated the same process, and invested the bank money in the stock market.[10] Mehta used the ready forward deal and applied it to the Bank Receipts system of the Indian financial systems. This system was the most flawed system as the Janakiraman Committee restructured the entire Bank Receipts system after the 1992 scam.[11]

Mehta used forged BR's to gain unsecured loans, and used several small banks to issue BRs on demand. Since these banks were small, Mehta held on to the receipts as long as he wanted. The cheques in favour of both the banks were credited into the brokers' accounts which was the account of Mehta. As a result, banks made heavy investments in BOK and MCB as they showed positive signs of growth.[1] Using the BR scam, Mehta took the price of ACC from ₹200 to ₹9000 in a short span of time. This 4400% percent increase was seen in several other stocks and as he sold the stocks, the market crashed.[8]

This went on as long as the stock prices kept going up, and no one had a clue about Mehta's operations. Once the scam was exposed, though, a lot of banks were left holding BRs which did not have any value – the banking system had been swindled of a whopping ₹4,000 crore (equivalent to ₹310 billion or US$3.9 billion in 2023). They knew that they would be accused if their involvement in issuing cheques to Mehta was discovered. Subsequently, it transpired that Citibank, brokers like Pallav Sheth and Ajay Kayan, industrialists like Aditya Birla, Hemendra Kothari, a number of politicians, and the RBI Governor S.Venkitaramanan all had played a role in allowing or facilitating Mehta's rigging of the share market.[12]

The scam first became apparent in late April 1992, when it became clear that Mehta was a disproportionately large investor in government securities. At the time, Mehta was doing more than a third of the total securities business in India. When the public realized that Mehta's investments were illegitimate and that his stocks were likely worthless, it set off a selling frenzy of Mehta's stocks. The banks that had loaned money to Mehta were suddenly holding hundreds of millions in unsecured loans. The combination of the selling frenzy and the fact that numerous banks been defrauded crashed the Indian stock market, with prices dropping 40% immediately.[13] Stocks eventually dropped 72%, and a bear market lasted for about 2 years.[14]

This table illustrates the extent of money certain banks lost.[11]

Mehta raised a furore on announcing that he had paid ₹10 million to the then Congress President and Prime Minister, P.V. Narasimha Rao, as a donation to the party, for getting him off the scandal case.[19][20]

The first reform was the formation of the National Stock Exchange of India (NSE). It was followed by the development of the CII Code for Desirable Corporate Governance by Rahul Bajaj. The CII Code commanded the formation of two major committees headed by Kumar Mangalam Birla and N. R. Narayana Murthy, and overseen by the Securities and Exchange Board of India (SEBI). The objective was to monitor corporate governance and prevent future scams.[26] The SEBI were to monitor the NSE and the National Securities Depository. For the equity market, the government introduced ten acts of parliament and one constitutional amendment based upon the principles of economic reform and legislative changes.[27] The introduction of online trading by NSE changed the dynamics of stock buying and selling. The financial market opened up nationally rather than being confined to Bombay (now, Mumbai).[1]

The 1992 scam collapsed the Indian stock market; around 40% of the market value or ₹1,000 billion was wiped out. It led the authorities to reconsider existing financial systems and restructure it. The first structural change was to record payments made for purchasing investments in reconciled bank receipts and subsidiary general ledgers to prevent fraudulent transactions. On the advice of the Janakiraman Committee, a committee was established to oversee the Securities and Exchange Board of India. The primary recommendation of the committee was to limit ready forward and double ready forward deals to government securities only. All banks were made custodians rather than principals in transactions. Banks were to have a separate audit system for portfolios, and it were to be monitored by the Reserve Bank of India (RBI).[11]