THE HARSHAD MEHTA SCAM
Harshad Shantilal Mehta was born in a Gujarati Jain family of modest means. His early childhood was spent in Mumbai (Kandivali) where his father was a small-time businessman. After completing his secondary education Harshad left for Bombay. While doing odd jobs he joined Lala Lajpat Rai College for a Bachelor’s degree in Commerce. After completing his graduation, Harshad Mehta started his working life as an employee of the New India Assurance Company. During this period his family relocated to Bombay and his brother Ashwin Mehta started to pursue graduation course in law at Lala Lajpat Rai College. In the late seventies every evening Harshad and Ashwin started to analyze tips generated from respective offices and from cyclostyled investment letters, which had made their appearance during that time. In the early eighties he quit his job and sought a job with stock broker P. Ambalal affiliated to Bombay Stock Exchange (BSE) before becoming a jobber on BSE for stock broker P.D. Shukla. In 1981 he became a sub-broker for stock brokers J.L. Shah and Nandalal Sheth. Harshad along with his brother Ashwin started their venture GrowMore Research and Asset Management Company Limited. While a brokers card at BSE was being auctioned, the company made a bid for the same with financial assistance from Shah and Sheth, who were Harshad's previous broker mentors. He rose and survived the bear runs, this earned him the nickname of the Big Bull of the trading floor, and his actions, actual or perceived, decided the course of the movement of the Sensex as well as scrip-specific activities. Harshad is alleged to have engineered the rise in the BSE stock exchange in the year 1992. Exploiting several loopholes in the banking system, Harshad and his associates siphoned off funds from inter-bank transactions and bought shares heavily at a premium across many segments, triggering a rise in the Sensex. When the scheme was exposed, the banks started demanding the money back, causing the collapse. He was later charged with 72 criminal offenses and more than 600 civil action suits were filed against him. He died in 2002 with many litigations still pending against him.
THE TWO SECURITIES MARKETS:
The scam was in essence a diversion of funds from the banking system (in particular the inter-bank market in government securities) to the brokers for financing their operations in the stock market. The key to understanding the scam is therefore a clear understanding of these two markets: the government securities market and the stock (corporate securities) markets. We present below a comparison of these two markets:
The crucial part of the comparison is the last element which indicates that the cost of finance in the informal money market which finances stock market operations is about twice that of the formal market in which banks lend to each other against government securities. Restrictions of various kinds kept the two markets insulated from each other allowing this massive differential to persist. It is also quite clear that there were enormous profits to be had for anybody who could find a way of breaching the artificial wall separating the two markets and arbitrage between them. That in essence was what the scam was all about.
THE READY FORWARD DEAL:
The crucial mechanism through which the scam was effected was the ready forward (RF) deal. The RF is in essence a secured short term(typically 15 day) loan from a bank to another bank. Crudely put, the bank lends against government securities just as a pawnbroker lends against jewellery. In form, however, the RF is not a loan at all. 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. The price difference represents the interest on the loan.
In India, the RBI allowed banks to do RFs only in government securities and not in...
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