* Police: Mumbai branch auditor ignored illegal activities
* U.S. firm of accused jeweller Modi seeking buyers
* Firestar Diamond filed for bankruptcy protection in Feb
* Discussing debtor-in-possession financing with lenders (Adds latest auditor arrest in paragraph 3, 4 and 5)
By Abhirup Roy and Krishna N. Das
MUMBAI/NEW DELHI, March 1 (Reuters) - Federal police in India on Thursday told a court an internal auditor at a Mumbai branch of Punjab National Bank conspired with other officials to carry out a $2 billion fraud at the country's second-biggest state lender.
The Central Bureau of Investigation (CBI) on Wednesday arrested auditor Mohinder Kumar Sharma, widening its probe into the biggest bank fraud in India's history. On Thursday it accused Sharma of conspiracy in a filing to a Mumbai court, which committed him to police custody until March 13.
CBI also arrested a former PNB manager, Bishnubrata Mishra, who it said was responsible for audits at the same branch between 2011 and 2015. Mishra could not immediately be contacted for comment.
CBI has so far arrested at least 14 people, eight from the bank and six from companies owned by billionaire jeweller Nirav Modi and his uncle, Mehul Choksi, who owns Gitanjali Gems Ltd .
Modi and Choksi have been accused of colluding with Punjab National Bank (PNB) officials to secure unauthorised loans between 2011 and 2017, mostly from the overseas branches of Indian state banks. They left India in January before the fraud was unearthed, but have denied the charges through letters and statements.
Sharma was the internal chief auditor at the Brady House branch "who was supposed to verify the daily transactions, report the irregularities and ensure that the same are rectified to protect the interest of the bank," CBI Inspector D. Damodaran said in the court filing.
But he, "in conspiracy with other co-accused persons, deliberately ignored to point out the issuance of illegal" letters of undertaking (LOUs) for companies owned by Modi and Choksi to raise loans from other banks, the inspector added.
Sharma's lawyer Apoorv Vijay Singh told the court his client "had no opportunity to know about the messages" sent on international payments platform SWIFT by other bank officials as he did not have access to SWIFT.
PNB has accused two low-level employees of the Brady House branch - where Sharma also worked - of issuing the LOUs without making corresponding entries in the bank's main software, helping the fraud go undetected for years.
Finance Minister Arun Jaitley told reporters on Thursday evening the cabinet has approved the establishment of an independent regulator for auditors in the country. The cabinet also decided to present a bill in parliament aimed at making it easier to seize properties of "fugitive economic offenders".
"We can't allow people to make a mockery of the law," Jaitley said.
A bankruptcy court filing in New York on Wednesday showed interest from potential buyers of a U.S. firm of Modi's that filed for creditor protection in the United States on Feb. 26, after the CBI seized assets of other companies owned by the jeweller.
"Early expressions of interest in purchasing some or all of the debtors' business operations have been strong," Modi's Firestar Diamond Inc said in the filing.
It has also told secured lenders it was in discussions with lenders for debtor-in-possession financing as it weighed options.
Firestar Diamond and its affiliates had annual sales of around $90 million, it said, adding that the assets seized included factories in India that produced fine jewellery.
The company is a wholly owned subsidiary of Firestar Group, which in turn is wholly owned by Synergies Corp. Both are Delaware incorporated.
Synergies is in turn wholly owned by Firestar Holdings Ltd, a Hong Kong corporation itself wholly owned by Modi's Indian company Firestar International Ltd, according to the court filing.
Separately, an Indian agency that targets offences involving foreign exchange and money laundering said on Thursday it had seized 41 properties, worth about 12 billion rupees ($184 million) belonging to Choksi and companies he controls.
Stung by criticism of a slippage in the government's management of state-run banks, the finance ministry has announced a series of measures, including setting banks a 15-day deadline to kick off action to improve risk oversight.
On Thursday the ministry said state-run banks would consolidate 35 overseas operations, with another 69 being considered for consolidation. The term operations covers bank branches, joint ventures, subsidiaries, remittance centres and representative offices.
Following the discovery of the alleged fraud, several bankers told Reuters there was a need to prune the overseas branches of state-run banks and rein in competition that sometimes leads to lax monitoring of transactions.
"PSBs to consolidate 35 overseas operations without affecting international presence of PSBs in these countries," finance ministry official Rajeev Kumar said in a Twitter message, using an acronym for public-sector banks, as India describes its state-run banks.
"Sixty-nine operations identified for further examination," he added, without naming the banks or the affected operations.
Additional reporting by Tom Hals in Wilmington, Delaware; Suvashree Dey Choudhury and Devidutta Tripathy in Mumbai; Malini Menon in New Delhi Editing by Clarence Fernandez and John Stonestreet