How to Fraud

Plus: Branch Banking After Covid, United Bank of Switzerland, Cross-Border Links

This week in Net Interest we have something special: a guest post from Dan Davies. Like me, Dan is a former equity research analyst, but his interests range widely, across economics, regulation and … fraud. He’s the author of a highly recommendable book called Lying for Money, about the economics of fraud. John Kay called it “an engaging and indispensable guide for novice fraudsters” and Nassim Taleb, while cautioning people not to commit fraud, said, “if you absolutely must, first read this.” Dan’s post takes a fresh look at Wirecard through the lens of the Parmalat fraud that hit Europe fifteen years earlier and draws conclusions about how and why these things happen. I think you’ll enjoy it.

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How to Fraud

Before there was Wirecard, there was Parmalat.  The two companies don’t have much in common on the face of it—one’s a German payments processor with a Chief Operating Officer who used to enjoy pretending to be (and indeed, perhaps being) a secret agent, while the other’s an Italian dairy products company whose owner just liked owning football clubs and being a hometown hero in Emilia-Romagna.  But in both of these mega-frauds, the final denouement was linked to the disappearance of an asset which should have been, literally, money in the bank.

Wirecard is still under investigation, and it’s not completely clear how and why they faked up $2.1bn of bank accounts in the Philippines.  The story of Parmalat, though, gives you a whole menu of options of how this sort of thing could have been done; between the telecoms bust of the early 2000s and the financial crisis of the late 2000s, Calisto Tanzi and his accountant Fausto Tonna briefly held the record for the world’s biggest accounting fraud.  When you look at the things that Parmalat did, the Wirecard scandal becomes a little bit more comprehensible in its scale.

The Play

Tanzi’s fortune was to a surprising extent built on his foresight in being the first dairy owner in Italy to adopt cardboard packaging for milk.  Parmalat was, at the height of its success and expansion, one of the largest customers of Tetra Pak worldwide.  Given this status, it could expect, and indeed received, a discount for volume.  But that discount would vary from month to month, from quarter to quarter, depending on how much milk, juice and soup Parmalat’s bewildering profusion of subsidiaries were able to pack into boxes.  And it would have been inefficient for Tetrapak to deal with each subsidiary individually when its relationship with Parmalat was handled globally out of Collecchio, Tanzi’s hometown.  So what happened was that over the course of a trading period, the Swedes would total up the amount of packaging material they had supplied, and then make a consolidated payment to one of the finance companies within the Parmalat group, at the direction of the top management.  It was at this point, according to accusations made by Tonna at a later trial, that a significant part of the money got diverted to fund the lifestyle of the Tanzi family.

This was the kind of thing that went on at Parmalat; this specific allegation almost got lost in the forensic accountants’ later reconstruction of the way that Parmalat’s finances were intermingled with the businesses of its founder and his relatives, businesses which included the bankrupt travel agency Parmatour and football clubs in Parma and Brazil. But while a common thief can take money and run away, a commercial fraudster has to stay around and conceal the existence of the crime itself.  The way this was done was to create a “receivable”—an accounting item recording a debt from the Tanzi-family-owned company which received the money to the Parmalat-owned company which should have done.

The Cover-Up

The sort of receivable Tanzi created is one of the fundamental building blocks of a false set of accounts—it’s a purely fictitious asset, and its creation is accounted for as purely fictitious income, the counterpart of the real asset and income that has been diverted.  In the normal course of business, such a receivable should not have lasted long; it would cease to exist when the cash was passed on.  But if a way could be found to leave the receivables hanging around, the day of discovery of the theft could likewise be postponed.  Wirecard also had big receivables; indeed, the unusually large balances here were one of the first things noted in the FT’s investigation.

Another way to create purely fictitious assets is to indulge in “double billing”, which is just what the name implies; you send two invoices to the same customer for the same goods.  You won’t get paid twice (unless your customer is unforgivably sloppy), but the likelihood is that before the “mistake” is noticed, you’ll get two copies of a legitimate invoice.  And an invoice is effectively an asset, every bit as much so as a tanker full of yoghurt.  You can take it down to the bank and use it as collateral to borrow money.  In fact, if you have a business with invoices coming in all the time, you can even (with a compliant investment bank) bundle them up and issue a long term bond, borrowed against the invoices as a whole.  And if half the invoices are fakes, you can borrow twice as much money.

And receivables can also be “overvalued assets”, if the customer is bankrupt or otherwise unable to pay.  The auditor will usually require you to account for credit losses on bankrupt customers, but there are tricks that can be used to avoid this; for example, if a Chilean supermarket owes a few million euros for Italian milk products and doesn’t want to pay, you can sell the debt from the Italian company to a Latin American subsidiary.  This doesn’t change anything in the real world – it’s like moving a dollar bill from one pocket to another.  But it means that the auditor in Italy sees a local operation with a load of cash from selling milk to Chile, and may miss the fact that a far-flung entity somewhere else in the Parmalat group has a bad receivable that it is pretending to be good.  Wirecard, of course, had the Philippines and Dubai, similarly many time zones away from the auditor’s head office and therefore more difficult to check up on.

Faking the receivables is the sort of accounting fraud which comes under the category of “things you have to hide from the auditors”.  But in order to get everything looking completely hygienic, Parmalat also had to make considerable use of “things the auditors will help you with”.

The Accomplice

Consider the stylised transaction above—selling a bad receivable from one company to an overseas subsidiary.  Where does the Latin American subsidiary get the money from?  It presumably borrows it, with a guarantee from head office.  But if you report that transaction accurately, then it looks like you’re borrowing money from the bank in order to buy something from yourself, and that is, frankly hard to pass off as a profitable transaction.  In order to report a profit, you need to conceal the debt.

Parmalat’s auditors (who probably don’t need to be named here, as they are a different company these days, having been reformed after the old practice had to be dissolved), put together a number of tricky little “partnerships” with branches in tax havens, in which a global bank would make an “investment” on terms that looked very much like a loan in economic terms, but not quite so similar to a loan that it had to be disclosed as one on the balance sheet.  Parmalat gave these partnerships milk themed names, like “Geslat” (Gestione Centrale Latte) and “Bonlat”.  Their bankers were less subtle; the auditor was severely criticised at a later date for not asking questions about a partnership entitled “Buconero”.

Borrowing money and selling receivables through off-balance sheet vehicles isn’t anything like as popular these days. As a result of the collapses of Parmalat itself and of Enron, the accounting standard setters very much tightened up the rules on what you have to consolidate on your own balance sheet, and on the standards for what constitutes a loan and what an “investment”. (Indeed, the audit regulators vehemently disagreed, shortly after it was too late to help, that Parmalat had made correct use of the existing standards.)  But it’s very difficult for a set of accounting rules to encompass the whole variety of business and finance, so there’s always scope to invent a new way of achieving the old goal.

In Wirecard’s case, there were “trustee accounts”, allegedly holding cash in escrow against chargebacks on the credit card business.  These performed the same function as the off-balance sheet vehicles in terms of being a place to hold fictitious cash and assets, but with sufficient separation that the usual audit checks couldn’t be applied to them without considerable legal and operational difficulty.

The Motive

It is clear that one of the major motivations for the Parmalat fraud was that the finances of the company and those of the Tanzi family had become completely intermingled since the earliest days (when Calisto Tanzi had used Parmalat corporate funds to bail out a television company he had bought).  And some of the extraction of cash was clearly carried out with this aim in mind.  But in the forensic reconstruction of Parmalat’s finances which was carried out by the bankruptcy administrators, only a minority of the fraud appeared to relate to this motive; about €2.3bn out of a total of €14.2bn, most of which was spent on bailing out financially troubled businesses and sports teams.  More than twice as much (€5.4bn) went toward “Acquisition of companies and investments”.

Because this was the real story of Parmalat; as far as those who have studied the case in detail can make out, Calisto Tanzi’s motivation was not simple greed, but a pathological desire for growth.  He had taken very significant risks to build his business from a small dairy processor in a suburb of Parma – even being the first guy to replace glass bottles with Tetrapaks was a substantial leap – and had become addicted to the sensation of doing so.  Parmalat was, on an underlying basis, a marginally profitable business, which needed to pretend to be an extremely profitable one if it were to grow.  Once the company was floated on the stock exchange, of course, this motivation was reinforced, and Parmalat’s management received all the wrong kinds of feedback from an investing public which also wanted to see rapid growth.  The parallels with Wirecard are sufficiently obvious not to need labouring.

Exponential growth is a bad drug to get addicted to.  Nearly half the total fraudulent profits generated between 1990 and 2003 in Parmalat – €6.5bn – were spent on financial and interest expenses related to the fraud itself.  The system of “borrowing money to buy false receipts” had the snowball property; because of the operation of compound interest, every time the fraud had to be extended, it got bigger.  Bonlat, in particular, ended up becoming a huge reservoir of bad receivables, and since the point of its existence was to prevent the admission that these receivables were bad, it had to pretend to be collecting on them and taking in cash.  It ought to have had €3.9bn in its bank account.

This feature of Parmalat’s financial management mystified the capital markets of the day; why did a company which apparently had so many bank accounts with billions of euros in them keep borrowing money?  And why did it often miss seemingly comparatively trivial payments and fail to pay its own bills on time?  People asked to see a statement of the account in Bank of America where Bonlat was meant to be storing its cash.

The statement, when it came, was an embarrassing forgery.  Tonna and one of his accountants, Gianfranco Bocchi, cut a Bank of America logo out of some correspondence, scanned it into a computer and ran their printout through a fax machine a few times.  The bankers’ and auditors’ suspicions were very much raised.  And of course, the Bonlat fake was like a fly in the buttermilk—not only was it unappetising itself, it made people unwilling to consume any more of the dairy’s output. 

Nearly twenty years later, Wirecard took the same tumble; the “trustee accounts” were finally investigated as a result of whistleblowers and press scrutiny, and they turned out not to exist.  Maybe it will turn out that the motivation of the top management team was similar to that of Calisto Tanzi, or maybe it will be something different.  But one last thing that’s really very likely to be common to the cases is that the investigation into the auditors will pick up the same problem which has dogged the profession since the Companies Act 1844—although they say they do, nobody really cares about auditing.  Even the requirement to have an audit was dropped in 1856 and not brought back until 1900.  Audit is a loss-leader service, sold by the accounting firms as a way in to get more profitable business, and you don’t get a Sherlock Holmes service by paying mall cop money. 

A new US edition of Dan’s book, Lying for Money, will be published next year.

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Branch Banking After Covid

Svenska Handelsbanken, one of Sweden’s largest banks, announced that it will close almost half its branches by the end of 2021. It’s a big deal because compared with almost any other bank anywhere in the world, Svenska Handelsbanken has traditionally been very branch oriented. It promotes each branch as “a local bank, fully empowered to serve customers, build relationships and take all the important decisions locally.”

The bank will reallocate some of its cost savings into digital. One of the consequences of Covid for banks globally has been an acceleration of the shift from branch banking to digital but Svenska Handelsbanken is the first to accommodate the shift in its strategy. The bank has a number of advantages. First is that digital penetration is anyway very high in the country. Sweden has less cash in circulation than anywhere else in the world, at around 1% of GDP, compared with 8% in the US and more than 10% in the Euro area. Second is that its economy is outperforming others, as discussed in More Net Interest here.

It seems likely that other banks will follow suit. Svenska Handelsbanken is taking a SEK 1.5 billion restructuring charge up front, equivalent to around one year of cost savings. If other banks can’t afford that kind of hit, they may choose to do it under cover of a merger instead. 

United Bank of Switzerland

Before 1998 there were three large banks in Switzerland—Credit Suisse, Union Bank of Switzerland (UBS) and Swiss Bank Corporation (SBC). They often talked—in 1996 Credit Suisse was rebuffed in a merger approach to UBS. Then, in 1998, two of them got together when UBS merged with SBC. The original proposal was to call the new bank United Bank of Switzerland but someone forgot to check whether the name was already in use and it turned out it was, so they went with just UBS instead. 

This week a Swiss financial blog reported that UBS and Credit Suisse are in preliminary talks (“Project Signal”) so three could become one. 

A combination of the two banks would allow a lot of costs to be cut. The UBS/SBC deal targeted cuts of around 20% of the combined cost base, and there seems little reason a similar programme couldn’t be re-run. Nor would the merger necessarily trigger competition concerns. Although these are big banks, there are lots of banks in Switzerland. The combined market share of the new bank would be ~25%. 

What it would trigger though is financial stability concerns. Both banks have massive balance sheets and the combination of the two would take the size of this one close to 4x Swiss GDP. Retrenchment in investment banking could reduce that but 4x GDP for a domestic share of ~25% is not a trade local policymakers would likely want to underwrite and so capital surcharges would probably apply. Whether the upside from lowering costs offsets the downside from higher capital is an issue Project Signal will have to analyse. 

One thing they won’t have to analyse though is what to call the new bank. I’ve checked and United Bank of Switzerland is now available. Where do I send my invoice?

Cross-Border Links

The Bank for International Settlements (BIS) does a good line in macro-financial research. Their latest looks at cross-border links between banks and non-bank financial institutions (otherwise known as shadow banks). It comes complete with an interactive graph which shows banks’ cross-border positions vis-à-vis non-bank financial institutions.

The assets of non-bank financial institutions have grown significantly in the past ten years. But behind them often sit banks. This issue was highlighted in the context of India in Net Interest a while ago. India’s linkages are mostly domestic. The BIS research maps the cross-border linkages, which have grown from US$4.6 trillion in Q1 2015 to US$7.5 trillion in Q1 2020. There are all sorts of reasons why banks may have claims on non-bank financial institutions in other countries. For Japanese banks it may be holdings of securities such as CLOs; for US banks it may be prime brokerage business with hedge funds. Curiously, European banks have large claims on non-bank financial institutions in the US, reflecting exposure to US finance companies. 

In particular, large flows are apparent between the US and the UK. This may be due to the presence of central counterparty clearing houses in the US and UK, where derivatives are cleared. The size of these flows is another reflection of the power that clearing houses have over other financial players—something we explored in The New Power Brokers in Net Interest two weeks ago.