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The Typology of financial scandals
The Typology of Financial Scandals
By:
Sam Vaknin,
Ph.D.
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Tulipmania - this is the name coined for the first pyramid
investment scheme in history.
In 1634, tulip bulbs were traded in a special exchange in
Amsterdam. People used these bulbs as means of exchange and value
store. They traded them and speculated in them. The rare black
tulip bulbs were as valuable as a big mansion house. The craze
lasted four years and it seemed that it would last forever. But
this was not to be.
The bubble burst in 1637. In a matter of a few days, the price
of tulip bulbs was slashed by 96%!
This specific pyramid investment scheme was somewhat different
from the ones which were to follow it in human financial history
elsewhere in the world. It had no "organizing committee",
no identifiable group of movers and shakers, which controlled and
directed it. Also, no explicit promises were ever made concerning
the profits which the investors could expect from participating
in the scheme - or even that profits were forthcoming to them.
Since then, pyramid schemes have evolved into intricate
psychological ploys.
Modern ones have a few characteristics in common:
First, they involve ever growing numbers of people. They
mushroom exponentially into proportions that usually threaten the
national economy and the very fabric of society. All of them have
grave political and social implications.
Hundreds of thousands of investors (in a population of less
than 3.5 million souls) were deeply enmeshed in the 1983 banking
crisis in Israel.
This was a classic pyramid scheme: the banks offered their own
shares for sale, promising investors that the price of the shares
will only go up (sometimes by 2% daily). The banks used
depositors' money, their capital, their profits and money that
they borrowed abroad to keep this impossible and unhealthy
promise. Everyone knew what was going on and everyone was
involved.
The Ministers of Finance, the Governors of the Central Bank
assisted the banks in these criminal pursuits. This specific
pyramid scheme - arguably, the longest in history - lasted 7
years.
On one day in October 1983, ALL the banks in Israel collapsed.
The government faced such civil unrest that it was forced to
compensate shareholders through an elaborate share buyback plan
which lasted 9 years. The total indirect damage is hard to
evaluate, but the direct damage amounted to 6 billion USD.
This specific incident highlights another important attribute
of pyramid schemes: investors are promised impossibly high yields,
either by way of profits or by way of interest paid. Such yields
cannot be derived from the proper investment of the funds - so,
the organizers resort to dirty tricks.
They use new money, invested by new investors - to pay off the
old investors.
The religion of Islam forbids lenders to charge interest on
the credits that they provide. This prohibition is problematic in
modern day life and could bring modern finance to a complete halt.
It was against this backdrop, that a few entrepreneurs and
religious figures in Egypt and in Pakistan established what they
called: "Islamic banks". These banks refrained from
either paying interest to depositors - or from charging their
clients interest on the loans that they doled out. Instead, they
have made their depositors partners in fictitious profits - and
have charged their clients for fictitious losses. All would have
been well had the Islamic banks stuck to healthier business
practices.
But they offer impossibly high "profits" and ended
the way every pyramid ends: they collapsed and dragged economies
and political establishments with them.
The latest example of the price paid by whole nations due to
failed pyramid schemes is, of course, Albania 1997. One third of
the population was heavily involved in a series of heavily
leveraged investment plans which collapsed almost simultaneously.
Inept political and financial crisis management led Albania to
the verge of disintegration into civil war.
But why must pyramid schemes fail? Why can't they continue
forever, riding on the back of new money and keeping every
investor happy, new and old?
The reason is that the number of new investors - and,
therefore, the amount of new money available to the pyramid's
organizers - is limited. There are just so many risk takers. The
day of judgement is heralded by an ominous mismatch between
overblown obligations and the trickling down of new money. When
there is no more money available to pay off the old investors,
panic ensues. Everyone wants to draw money at the same time. This,
evidently, is never possible - some of the money is usually
invested in real estate or was provided as a loan. Even the most
stable and healthiest financial institutions never put aside more
than 10% of the money deposited with them.
Thus, pyramids are doomed to collapse.
But, then, most of the investors in pyramids know that
pyramids are scams, not schemes. They stand warned by the
collapse of other pyramid schemes, sometimes in the same place
and at the same time. Still, they are attracted again and again
as butterflies are to the fire and with the same results.
The reason is as old as human psychology: greed, avarice. The
organizers promise the investors two things:
That they could draw their money anytime that they
want to, and
That in the meantime, they will be able to continue to
receive high returns on their money.
People know that this is highly improbable and that the
likelihood that they will lose all or part of their money grows
with time. But they convince themselves that the high profits or
interest payments that they will be able to collect before the
pyramid collapses - will more than amply compensate them for the
loss of their money. Some of them, hope to succeed in drawing the
money before the imminent collapse, based on "warning signs".
In other words, the investors believe that they can outwit the
organizers of the pyramid. The investors collaborate with the
organizers on the psychological level: cheated and deceiver
engage in a delicate ballet leading to their mutual downfall.
This is undeniably the most dangerous of all types of
financial scandals. It insidiously pervades the very fabric of
human interactions. It distorts economic decisions and it ends in
misery on a national scale. It is the scourge of societies in
transition.
The second type of financial scandals is normally connected to
the laundering of capital generated in the "black economy",
namely: the income not reported to the tax authorities. Such
money passes through banking channels, changes ownership a few
times, so that its track is covered and the identities of the
owners of the money are concealed. Money generated by drug
dealings, illicit arm trade and the less exotic form of tax
evasion is thus "laundered".
The financial institutions which participate in laundering
operations, maintain double accounting books. One book is for the
purposes of the official authorities. Those agencies and
authorities that deal with taxation, bank supervision, deposit
insurance and financial liquidity are given access to this set of
"engineered" books. The true record is kept hidden in
another set of books. These accounts reflect the real situation
of the financial institution: who deposited how much, when and
under which conditions - and who borrowed what, when and under
which conditions.
This double standard blurs the true situation of the
institution to the point of no return. Even the owners of the
institution begin to lose track of its activities and
misapprehend its real standing.
Is it stable? Is it liquid? Is the asset portfolio diversified
enough? No one knows. The fog enshrouds even those who created it
in the first place. No proper financial control and audit is
possible under such circumstances.
Less scrupulous members of the management and the staff of
such financial bodies usually take advantage of the situation.
Embezzlements are very widespread, abuse of authority, misuse or
misplacement of funds. Where no light shines, a lot of creepy
creatures tend to develop.
The most famous - and biggest - financial scandal of this type
in human history was the collapse of the Bank for Credit and
Commerce International LTD. (BCCI) in London in 1991. For almost
a decade, the management and employees of this shady bank engaged
in stealing and misappropriating 10 billion (!!!) USD. The
supervision department of the Bank of England, under whose
scrutinizing eyes this bank was supposed to have been - was
proven to be impotent and incompetent. The owners of the bank -
some Arab Sheikhs - had to invest billions of dollars in
compensating its depositors.
The combination of black money, shoddy financial controls,
shady bank accounts and shredded documents proves to be quite
elusive. It is impossible to evaluate the total damage in such
cases.
The third type is the most elusive, the hardest to discover.
It is very common and scandal may erupt - or never occur,
depending on chance, cash flows and the intellects of those
involved.
Financial institutions are subject to political pressures,
forcing them to give credits to the unworthy - or to forgo
diversification (to give too much credit to a single borrower).
Only lately in South Korea, such politically motivated loans were
discovered to have been given to the failing Hanbo conglomerate
by virtually every bank in the country. The same may safely be
said about banks in Japan and almost everywhere else. Very few
banks would dare to refuse the Finance Minister's cronies, for
instance.
Some banks would subject the review of credit applications to
social considerations. They would lend to certain sectors of the
economy, regardless of their financial viability. They would lend
to the needy, to the affluent, to urban renewal programs, to
small businesses - and all in the name of social causes which,
however justified - cannot justify giving loans.
This is a private case in a more widespread phenomenon: the
assets (=loan portfolios) of many a financial institution are not
diversified enough. Their loans are concentrated in a single
sector of the economy (agriculture, industry, construction), in a
given country, or geographical region. Such exposure is
detrimental to the financial health of the lending institution.
Economic trends tend to develop in unison in the same sector,
country, or region. When real estate in the West Coast of the USA
plummets - it does so indiscriminately. A bank whose total
portfolio is composed of mortgages to West Coast Realtors, would
be demolished.
In 1982, Mexico defaulted on the interest payments of its
international debts. Its arrears grew enormously and threatened
the stability of the entire Western financial system. USA banks -
which were the most exposed to the Latin American debt crisis -
had to foot the bulk of the bill which amounted to tens of
billions of USD. They had almost all their capital tied up in
loans to Latin American countries. Financial institutions bow to
fads and fashions. They are amenable to "lending trends"
and display a herd-like mentality. They tend to concentrate their
assets where they believe that they could get the highest yields
in the shortest possible periods of time. In this sense, they are
not very different from investors in pyramid investment schemes.
Financial mismanagement can also be the result of lax or
flawed financial controls. The internal audit department in every
financing institution - and the external audit exercised by the
appropriate supervision authorities are responsible to counter
the natural human propensity for gambling. The must help the
financial organization re-orient itself in accordance with
objective and objectively analysed data. If they fail to do this
- the financial institution would tend to behave like a ship
without navigation tools. Financial audit regulations (the most
famous of which are the American FASBs) trail way behind the
development of the modern financial marketplace. Still, their
judicious and careful implementation could be of invaluable
assistance in steering away from financial scandals.
Taking human psychology into account - coupled
with the complexity of the modern world of finances - it is
nothing less than a miracle that financial scandals are as few
and far between as they are.
Also Read
The Greatest Savings Crisis in History
The
Bursting Asset Bubbles
(Case Studies: The Savings and Loans Crisis, Crash
of 1929, British Real Estate)
The Shadowy World of International Finance
Hawala, or the Bank that Never Was
Money Laundering in a Changed World
The Varieties of Corruption
Corruption and Transparency
Straf - Corruption in CEE
The Criminality of Transition
The Kleptocracies of
the East
The Enrons of the East
Bully at Work - Interview with Tim
Field
The Economics of Conspiracy
Theories
The Industrious Spies
The Business of Torture
Fimaco Wouldn't Die - Russia's
Missing Billions
Treasure Island Revisited -
Maritime Piracy
Organ Trafficking in
Eastern Europe
Begging Your Trust in
Africa
Slush Funds
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The author's name and a link to this Website
must be incorporated in any
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Financial | scandals | and | scams | throughout | history | classified | according | to | their | attributes | and | effects. |
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