Thursday, January 20, 2011

The Citibank Fraud

Rupees four hundred crores siphoned off into his relatives' account by a relationship manager. People are very surprised that this has happened, but come to think of it, If not Citi, it would be some other bank; if not this type of fraud, it would be something else.

The very fact that you are custodian for someone else's money, and the fact that you are bang in the center of flows running into crores of rupees, is a situation that is ripe for such frauds.

It starts with the very top. The government encourages banks to lend money to depositors in the name of farmer loans, or priority sector lending, where the cost of operations and probability of recovery, and the returns in terms of interest, are much lower.  The fact that many of these loans are subsidized introduces a kind of power in the hands of the branch manager that can only lead to favors being doled out for a fee. Once the fee is given for the favor that is doled out,  is it also implicitly understood that repayments can follow their own logic ?  Once in a while, to make a political point, the government announces loan waivers.  The borrowers are aware of this and they take full advantage of it. It is usually the rich farmers who gain from such schemes; for such favors, I am sure other favors are percolated back up, in return, to politicians who make this happen.

The manager who sanctions the loan at the bank is dealing with someone else's money and discharges a fiduciary responsibility for the depositors. The branch manager sitting in  a  remote town with the power of patronage at his disposal, who is not earning very much by way of salary, has an incentive to tweak the system a little bit. He can if he wishes rationalize it to himself ,  since person A to whom he grants the loan who is in a position to help him in other ways, may be an equally sound borrower as person B, so what is the harm? There are also all kinds of intimidation tactics used on branch managers at remote village branches to dole out loans, or else.   The recent case that came to light last month of a few public sector bankers making money on loan sanctions surprised no one. Thankfully, in that instance, even the expected outrage from the media was a bit muted; perhaps they realized that it would be na├»ve to protest too much.

Apart from their interest income, every bank is into increasing fee - based income nowadays. This leads them to sell all kinds of products to their customers, sometimes whether they need them or not. In my own case, when I was CFO of a company that had both revenues and expenses only in rupees, I had this guy from a multinational bank trying to sell me a product that involved rupee - dollar interest rate swaps, and dollar-yen rate differentials. The way it was being sold, I could easily have fallen for it, except that I knew my board would think I had gone nuts. Again, with reference to behavior patterns, this may have no direct bearing on corruption, but it does do a lot to the way business and revenues are viewed inside the bank. There is also the proprietary trading desk of every bank. The bond trader who buys and sells billions worth of bonds every day, stands to make huge profits (or losses). The bonuses of people in the trading desk, and of course of those who are in the merchant banking division, are quite substantial. This I am sure puts an overall pressure on the system and on others to become aggressive and earn more, which are all risk - inducing behaviors.

It is not as if banks are in a position to recover their  moneys   easily, if the borrowers decide to turn sticky. The legal procedures to be followed are very complex and time consuming. Sending bouncers to recover the money is not permitted. Attaching property takes time; and when the time comes, there may be nothing to attach. Borrowers use the legal system to their advantage to delay things. Frequently banks are forced to offer fresh loans under a different guise to enable repayment of installments due, in order to reduce the amount of defaults shown in the books. Yes Bank recently asked its Microfinance borrowers to repay 400 crores owed by them to  Yes   Bank prematurely; I do not know what the status is right now but I am sure the repayments have not flowed in – how can they ,  given that the moneys have already been lent out and the institutions themselves are in some amount of trouble?

Then you have the institutional fund managers which include banks, insurance companies and the like. They buy debt securities from the market in various forms and guises. When the subprime crisis hit, several banks the world over almost went under; some of them were bought over by others, and almost all were severely dented. This was due to such securities on their books.

Barings which was an old and venerable institution went down because of a rogue trader in derivatives. The internal controls of the bank were not strong enough to stop bad money chasing good. 

As a depositor, there is a lot of comfort that the government has insurance in place to cover for banks going bust. However, there are limits for such covers, and if several banks decided to go bust at once, there will never be enough money in the system to cover it. As an investor  though , there is no comfort available.

In the Citibank case, it was a case of forgery, coupled with naivete on the part of some, and collusion in case of others. Reminds one of the Bernie Madoff scandal, again quite recent, where Mr. Madoff of New York hoodwinked several sophisticated institutional investors over several years, with fictitious investment statements generated on his office computer. He was just running a Ponzi scheme. You thought such investors would know better.

Banks of course have elaborate mechanisms and internal controls to mitigate these risks. All companies do. But such controls are frequently bypassed. And when it comes to companies dealing only in money, it is far easier for lapses to go unnoticed for far longer, and the effects could be far more devastating. All this constitutes a case for a significantly higher risk quotient when it comes to institutions where money is the product being bought and sold.

If you want to invest in a bank as a shareholder it is something worth keeping in mind.

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