The most shocking cases of financial fraud

Introduction

Financial fraud is an intentional action aimed at obtaining property or money from a business through fraudulent transactions. Most financial fraud is committed by people who belong to the organization itself, such as the cases presented here.

The financial mess at JP Morgan Chase

In the case of JP Morgan Chase Bank, speculative, market, financial and legal risks have blemished the organization's image, which has led to a decrease in its assets and a loss of confidence on the part of its customers and investors. 

The magnitude of the cases of financial fraud related to this bank has been echoed all over the world, from Argentina to the United States, through Europe and even Asia.

Hernán Arbizu: the fraud of a senior executive

In June 2016, the Argentine Federal Police arrested Hernán Arbizu, former vice president of the JP Morgan Chase bank, in a house in the Belgrano neighborhood of Buenos Aires.

Arbizu had an extensive career as a banker, holding various positions in the world's most prestigious banks: Citibank, Bank Boston, Bank of America, UBS and Deutsche Bank.

Arbizu left each bank with a vast list of data including user names and company names. Accessing this privileged information, which he then used to contact potential clients, brought him juicy commissions as a reward.

When he became Vice President of JP Morgan Chase, Arbizu continued to secretly manage different bank accounts from different banks in which he had already worked. He was also carrying out unauthorized bank transfers. Through them he was laundering the money of some of his clients in Argentina, by moving the assets to tax havens.

When the situation became untenable, Arbizu extracted confidential information from the bank and used it as evidence to report JP Morgan Chase for tax evasion.

Eventually, the banker's complaint turned against him, resulting in his own extradition to the United States, accused of fraud, money laundering, identity theft and fraudulent transfers.

Although this case appears to be an isolated personal action, the truth is that much of the responsibility fell on the bank itself.

Lack of oversight and poor financial risk management within the bank allowed Arbizu to operate comfortably to set up an asset laundering and tax evasion scheme at the expense of the financial institution's own resources.

Bernard Madoff: a pyramid scheme difficult to ignore

With a sad look and the appearance of an old man, when he speaks, Bernard Madoff moves his hands like a snake charmer. He swings them in the air and rocks them like an orchestra conductor. He pauses for a moment and, in the meantime, crosses the fingers of both hands to stop and think about what he will say next.

Behind that harmless face and the grandfatherly gaze that calculates every word, hides the brain of the biggest financial scam ever seen in the United States.

USD 64,000 million, 13,600 people swindled and several suicides, including Madoff's own son, are the result of an unprecedented pyramid scheme, a financial scam that looks like something out of a film.

The supposed multimillion-dollar trades that Bernard Madoff was carrying out on Wall Street were nothing more than an illegal money-raising system that worked by adding new "investors" who contributed capital to pay off the old ones.

Madoff was using JP Morgan Chase accounts to conceal his transactions. However, the outrageous amount of money and the enormous volume of transactions seemed difficult for the bank to ignore.

In spite of this, some of the bank's employees ignored the warning signals triggered by the scammer's transactions and failed to report the suspicious transactions in a timely manner. In addition, the bank's money-laundering policies seemed very flexible or were not implemented as thoroughly as required.

These were the arguments of the U.S. financial authorities when it ordered the bank in 2014 to pay a sum of USD 1,700 million dollars to compensate the victims of the pyramid built by Bernard Madoff.

Bear Stearns: an unprofitable purchase

On the verge of bankruptcy, Bear Stearns was acquired by JP Morgan in 2008 with the authorization of the U.S. Federal Reserve.

Bear Stearns had gone bankrupt after making large investments in subprime mortgage securities. These mortgages were granted to people with low financial solvency or who did not have a stable income, i.e. high risk profiles. For this reason, the banks were insuring the investment by charging high interest rates or by seizing the properties that were mortgaged, a vicious circle driven by unpayable loans.

Through misleading information provided by bank employees, many of these mortgages were offered as secure investments.

Thus, subprime mortgages, which were granted to people who could not afford them, created a false appearance of growth in the U.S. real estate sector, but when the bubble burst, it wound up affecting the global banking system.

When those mortgage securities lost value, Bear Stearns owed more than USD 48,000 million, and confidence in that bank declined to the point where the bank had to file for bankruptcy.

That was when JP Morgan Chase appeared on the scene. Although this bank also participated on its own account in the subprime mortgage housing bubble, its influence in the 2008 crisis increased after buying Bear Stearns Bank to save it from collapse.

This blemished JP Morgan Chase's reputation as an organization and caused its credibility as a financial institution to diminish significantly. That is why this bank was sanctioned with a fine of USD 13,000 million dollars for engaging in bad practices.

Again, poor financial risk management, poor credit risk management and poor operational risk management management led to a series of reputational risks, that are still impacting the image of the largest bank in the United States.

1MDB: a risky present

By the end of 2017, JP Morgan Chase was under investigation by the financial authorities of Switzerland, Singapore and the United States, all on account of the 1MDB (1Malaysia Development Berhad) scandal, a state investment fund belonging to the Malaysian government.

Malaysian Prime Minister Najib Razak reportedly appropriated several million dollars of the 1MDB fund through illegal financial transactions he carried out in different banks around the world.

Specifically, JP Morgan Chase is accused of failing to identify money laundering risks associated with transactions between business and personal accounts of this state fund.

In one case, billions of dollars were transferred from the 1MDB fund account, allegedly to buy a business, to the personal account of an individual close to a company associated with the Malaysian fund

JP Morgan Chase did not question the origin, purpose or procedure of this transaction, which involved an extraordinary sum of money. It also approved inconsistent customer data without first conducting a rigorous review thereof.

For now, the U.S. bank will not be fined, but the mismanagement of money laundering risk and the poor segmentation of its customers were unmistakable

Like the 1MDB case, many of the legal issues JP Morgan Chase has suffered in its history still have repercussions today. Some of them have not been settled or have negative consequences that seem permanent.

This shows that, when one risk materializes, it not only triggers others, as if it were a snowball, but can also have a long duration over time, leading from a lawsuit to a sanction, and from a fine to a bankruptcy.

That is why it is important for financial institutions to have tools that allow them to have good risk management and avoid future lawsuits, claims or million-dollar fines.

Fraud by Jérome Kerviel in Société Générale

The Société Générale Bank suffered one of the most monumental financial frauds of our time, due to the unauthorized transactions of Jérôme Kerviel, one of its employees.

In the financial world, rogue traders are individuals who independently and recklessly make investments within a company. Their actions usually cause harm to the capital of customers or the institutions for which they work. This is because rogue traders make high-risk investments that can involve large losses or even huge profits.

Many banks have been victims of this type of individuals. The activity of just one of its officers has caused not only the bank to collapse, but even the entire financial system to be affected.

Barings Bank and Nick Leeson are an example of this. Similar to this case is that of Jérôme Kerviel, former official of the French bank Société Générale. Without holding a major position or extraordinary responsibilities within the bank, Kerviel managed to circumvent controls and carry out countless fraudulent transactions.

In addition to the damage caused by Kerviel's actions as a rogue trader, the Société Générale Bank had to pay a fine of EUR 4 million to the French authorities.

Cases like these highlight the importance of good financial risk management. This process consists of measuring the risks to which a company is exposed due to market movements.

In other words, financial risk management is intended to minimize the effects caused by economic, credit or liquidity factors.

In addition, a company's financial risk analysis should be based on the organization's risk acceptance policy, which clearly defines risk appetite and tolerance levels. This way, it serves as a starting point for the financial risk manager to make a decision about a company's investments.

When controls are lacking or a company's financial risks are not considered, operations may lose direction, to the point of suffering major losses of money.

To help you better understand what we're talking about, in the following video we explain in more detail the financial fraud of the Société Générale Bank and the activities of rogue trader Jérôme Kerviel.

Barings Bank Fraud

Barings Bank, one of the oldest in Britain and the world, was created in 1792. Throughout its history, it had financed the Napoleonic wars for the British Crown and the purchase of Louisiana by the Americans. It also had customers such as Queen Elizabeth II.

In 1980, Barings was considered to be one of the role models of commercial management in Europe. Its recognition as a financial entity became such that management decided to expand its operations in Asia, the Pacific and Latin America.

Despite its prestige, Barings Bank became insolvent on February 26, 1995, due to transactions performed by Nick Leeson, one of its officers, from the bank's small office in Singapore, Barings Securities Singapore (BSS), which had opened its doors in 1987.

The rise of a young prodigy

Nick Leeson started his career as an employee of Coutts & Company and years later he moved to Morgan Stanley, where he learned about the world of financial investments. At the tender age of 22, Leeson began working at Barings Bank on July 10, 1989.

In 1992, Leeson was sent to the BSS as general manager of futures market transactions. In order to develop stock trading on the Singapore Stock Exchange, he had to hire staff for the back office area, the unit responsible for the settlement, documentation, support and accounting of derivative transactions. However, the guidance received by the young manager stated that the amount and salary of his staff should be restricted. Therefore, Leeson ended up hiring young, inexperienced professionals.

Later, he was authorized to trade personally, which was not part of a general manager's job. In turn, as head of operations, he made sure the accounting was accurate.

The beginning of the end

On July 17, 1992, in order to cover up the failure of one of his employees, who had mistakenly purchased twenty futures contracts from the Japan Governmental Bond, Leeson opened account 88888 to follow up on the error. The account was then used to conceal unauthorized transactions. Through this account, dozens of transactions of the same type were performed between September and December of the same year.

When those negative transactions began to grow, Leeson began trading in the options market to cover losses. In July 1993, Leeson had temporarily reversed his loss-making position and had achieved astronomical gains. However, by continuing to perform unauthorized transactions without any supervision, he managed to accumulate losses of more than one million pounds, but Leeson concealed his daily margins by asking for transfers from the Barings headquarters in London, a situation which was not suspicious for the bank's management.

Inadequate management and poor risk management

The fact that Leeson's requests were accepted was due to several reasons. The lack of controls over the Singapore office, the disinterest of supervisors in reviewing transaction records and internal auditor reports, the number of customers with large volumes of transactions and the positive figures that Leeson reported as profits made it easier for transfer orders to be accepted without many obstacles.

This scenario was also favored by the lack of controls. Leeson reported directly to only four people: the regional operations manager of Barings in South Asia, the global futures and options manager based in Tokyo, and two executives of Barings Securities Limited in London. In this sense, management failed to restrict a trader who was generating disproportionate profits from a small area of the bank. 

In July 1994, an internal audit was conducted on Baring Futures Singapore (BFS). Although no irregularities were identified regarding unauthorized transactions, it was noted in the final report that Leeson was exercising the dual function of trader and back office manager, which allowed him to perform transactions and then adjust them according to his own instructions, but this warning signal was ignored by Barings' managers.

In January 1995, Leeson performed a transaction hoping that the Japanese market would not change until the next day. However, little did he imagine that Asian markets would collapse as a result of the earthquake in the Japanese city of Kobe. Leeson tried to recover losses through various risky transactions, which ended up creating an even larger gap.

A month later, the only external audit on BFS was conducted by Coopers & Lybrand. To avoid detection by the audit firm, Leeson forged several documents, including bank statements and a positive preliminary report on the status of the shares. Until then, the bank's financial situation could have recovered, as losses amounted to GBP 200 million and the bank's share capital totaled GBP 500 million. However, during the three weeks following the audit, losses tripled to 600 million pounds.

Leeson fled to Kuala Lumpur when the situation became unsustainable, and the bank's auditors finally discovered the fraud through a note that Leeson himself had sent to management. So, Barings Bank was declared insolvent on February 26, 1995 and was bought by Dutch bank ING for the symbolic sum of 1 pound.

When Nick Leeson's fraud was discovered in 1995, the banks claimed they already knew how this broker had managed to circumvent the financial institution and claimed that the loopholes in the bank's system had been closed. However, according to Leeson, few things have changed since then and he assures that some cases of operational risk are identical to his own. In his opinion, "the existing holes in the banking system have not been closed to make this possible. I think, if you look at what the banks are trying to do, you will see that they are just concentrating on making money, not protecting it".

Although the systems used by brokers are continually being improved, Nick Leeson says, "not a lot of attention is being placed on the risk management areas or the complaints department, which are the ones where money can be controlled". Thus, the fall of Barings Bank shows how important it is to know how to identify, manage and control risk before events occur.

Bankruptcy of Crédit Lyonnais

Credit Lyonnais, regarded as one of the three pillars of the French banking industry, went bankrupt because it did not have adequate risk management. Here's why.

In November 1993, officials from the French Ministry of Economy, Finance and Industry announced the dismissal of Jean-Yves Haberer, the CEO of France's largest bank, Crédit Lyonnais. This action not only revealed the bank's pressing financial condition, but also made clear its awful risk management.

Crédit Lyonnais was founded in Lyon in 1863. In 1900, it was considered the largest bank in the world. After World War II, it began its nationalization process. Since then, the entity's management has been confused as to whether it should act in the interests of the French political elite or whether, on the contrary, it should give precedence to business decision and risk management.

It was precisely this climate of administrative uncertainty that set the stage for an increase in risky movements between 1988 and 1993, when Crédit Lyonnais was trying to become a global banking reference.

A bad expansion strategy

In 1987, Jean-Yves Haberer, a respected bureaucrat with important political connections, was appointed by President Francois Mitterrand as director of Credit Lyonnais. When Mitterand was re-elected for a second term in 1988, Haberer began to implement the long-term bank expansion strategy, acquiring new branches, making new investments and opening offices in France and around the world.

In the late 1980s, the bank took advantage of Europe's economic boom and came to have a huge portfolio of investments and loans for industry. When economic growth slowed down because of the Gulf War, Crédit Lyonnais had accumulated a considerable amount of capital because of the agreements made in the past.

However, two of its branches started to generate losses due to their particular actions. Firstly, Altus Finance and its agreements with some insurance companies in the United States, and secondly, Crédit Lyonnais in the Netherlands, which closed several failed deals with Hollywood film studios.

How did the crisis come about?

Altus Finance, a successful finance company, had been acquired by Crédit Lyonnais in 1990 with the intention that it would play an important role in the bank's expansion process. In 1991, Altus began a complex negotiation with the California Department of Insurance to purchase high-risk speculative bonds through Aurora, a company that the bank's subsidiary secretly controlled, in violation of U.S. government regulations.

At first, some of the deals in Altus yielded good profits, but the branch began investing in sectors in which it did not have experience: leisure, waste management, golf courses, food distribution and even luxury goods. These investments, which took place between 1989 and 1993, were responsible for millions of losses.

In addition to this, the performance of another of the bank's branches, Crédit Lyonnais in the Netherlands, worsened the situation. Since the 1980s, this subsidiary office had become the main lender for numerous Hollywood studios. Many of these deals were legitimate, but some bank officials began authorizing loans to financially and judicially troubled investors without first ensuring the protection of the bank's interests.

The purchase of Metro-Goldwyn-Mayer was one of those failed moves by the Dutch branch. It all began when Giancarlo Parretti and Florio Fiorini, a couple of Italian businessmen who had already been involved in fraud and money laundering cases, received a two billion dollar loan to acquire the producer with the lion mascot.

A year after changing ownership, the film company began to face a serious financial crisis due to the risky investments of its suspicious owners. Faced with the alarm of impending bankruptcy, and despite losses, Crédit Lyonnais continued to authorize multimillion-dollar loans to try to save the producer.

Finally, after the removal of Parretti, who was facing several legal proceedings in the United States and Europe, Crédit Lyonnais became the owner of a large portion of MGM's stock, until it sold that company to its original owner, Kirk Kerkorian. This series of loans, without adequately measuring or managing risk, generated losses that amounted to more than one billion dollars.

The end of the shipwreck

In September 1992, the French Ministry of Economy, Finance and Industry placed Crédit Lyonnais under administrative scrutiny after discovering that the bank's loan and investment portfolios had suffered massive losses. This led to Haberer's ousting.

The European Commission insisted on the privatization of Crédit Lyonnais. Thus, in April 1995, the Consortium de Réalisation (CDR) was created to manage the bank's assets and then sell them to the highest bidder.

The investigation of those involved began in December 1996. Until then, the French government had only calmed public opinion, without first trying to identify those responsible for the collapse. However, in 1996, investigations were interrupted by the fire at the Crédit Lyonnais headquarters in Paris, which destroyed much of the bank's documentation.

The consequences of the collapse went so far as to splatter French politicians and government officials, such as Bank of France Governor Jean-Claude Trichet. According to the investigations, it seems that some government officials intervened so that the financial reports reflected lower losses than the bank was actually suffering. Thus, Crédit Lyonnais seemed to be in a better situation than it actually was.

Finally, in 1999 Crédit Lyonnais was restructured and bought by Crédit Agricole.

Lessons learned

The case of Crédit Lyonnais shows that an independent and timely risk report is crucial during periods of economic expansion and growth. It also teaches that poor customer segmentation and inadequate control of investment risk can ruin an entity's profits and reputation.

Although Haberer met with business leaders of the bank and its branches, Crédit Lyonnais lacked systematic controls over investment risks and risk reporting of its complex business network. At the end of the day, that wound up affecting the bank's profits.

Finally, the bankruptcy of Crédit Lyonnais also teaches us that when political and bureaucratic interests take precedence over commercial interests, the management of potential risks is neglected and, therefore, the capital, reputation and security of an organization are threatened.

The fall of Riggs Bank

Riggs, Washington's oldest bank, founded in 1840 and known as Abraham Lincoln's bank, ceased to exist in mid-2000 as a result of very poor risk management.

These deficiencies were evidenced by a Senate investigation, which summarized Riggs Bank's failures in two main areas: the accounts held by Augusto Pinochet and the accounts of Equatorial Guinea.

Augusto Pinochet

Between 1994 and 2002, while serving a sentence of house arrest, former Chilean President Augusto Pinochet opened six accounts at Riggs Bank and deposited millions of dollars in them. The bank never put any major restriction in the way or questioned the origin of Pinochet's money. On the contrary, Riggs facilitated the manipulation of the former president's accounts, who created several corporations to use his different names and disguise the control of the various accounts he had at his disposal.

Equatorial Guinea

Between 1995 and 2004, Riggs Bank managed more than 60 accounts for the government of Equatorial Guinea, as well as for its officials and their respective families. Handled in a way similar to the Pinochet case, the bank paid very little attention to its obligations to mitigate the risks of asset laundering. Oversight of the country's accounts was so lax that it even allowed the transfer of more than USD 1 million from Equatorial Guinea's oil account in Riggs to another bank.

Following the Pinochet and Equatorial Guinea scandals, the Senate investigation subcommittee concluded that these accounts had not been treated exceptionally, but were the result of an asset laundering prevention program with a long record of serious deficiencies. These failures included:

• Inability to identify all accounts associated with a given customer.
• Absence of a system to detect high-risk accounts.
• Inadequate customer information.
• Lack of a defined policy for managing accounts related to foreign political figures.
• Lack of monitoring for bank transfers.
• Poor system for reporting and detecting suspicious transactions.
• Incomplete and outdated internal audits.
• Inadequate training for the prevention of money laundering.

These deficiencies had been found repeatedly in regulatory inspections, but the bank merely postponed all efforts to remedy this situation.  For that reason, among the lessons to be learned from the Riggs case, it was concluded that the regulatory sanctions could have been applied much earlier and thus, would have avoided such chaos. After all, it is very tempting for banks with geographical limitations.