Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Citi fraud: a Madoff moment for wealthy Indians

India’s wealthy have encountered their Madoff moment with the fraud in the Gurgaon (New Delhi) branch of Citibank in which a relationship manager defrauded the wealth management clients of the bank of over Rs 3 billion (about $65 million). The relationship manager promised high rates of return and persuaded clients to sign blank cheques which were used to transfer the funds to bank accounts of the manager’s family members.

Why do wealthy people fall for such frauds? Why do they venture into such unregulated products where they have much lower levels of protection? I think this has a lot to do with people extrapolating their experiences of the pre reform era (prior to 1991) to the modern largely deregulated economy:

  1. Many people believe that one can earn higher rates of return in unregulated products without bearing higher risk. During the era of financial repression, it was true that interest rates in the formal market were artificially repressed below equilibrium levels (probably by as much as three percentage points). After the economic reforms of the early 1990s, this financial repression came to an end. However, those who grew up in the pre reform era still believe that there is an extra risk free return to be earned outside the formal regulated sector.
  2. During the days of the licence raj (prior to the reforms) political and business connections allowed people to get access to resources that were not available to ordinary people. Anything from train tickets to cement was easy to obtain for the privileged few. It is easy for people who grew up in that era to believe that their connections can give them access to investment opportunities not available to ordinary investors. Obviously, these opportunities would be in unregulated and opaque products.
  3. The experience of the pre reform era conditioned people to be relationship oriented rather than transaction oriented in financial matters. This makes them trust a wealth manager who comes home and collects the cheque (even blank cheques). The younger generation would probably rely on an online investment facility instead.
  4. The same distrust of formal systems leads people to ignore vital safeguards like independent custody as well as independent verification and audit of statements.

I do not believe that greater regulation is the answer to the problem. If the underlying investor attitude does not change, regulating one set of products would only drive investors to another set of unregulated products. The whole genesis of blank cheques probably lies in a misguided attempt to “empower” the investors by using a nondiscretionary portfolio management system.

In a nondiscretionary portfolio management system, the advisor only gives advice, and it is the investors that supposedly take all the decisions. By contrast, a discretionary portfolio management system is more like a mutual or a hedge fund where the client has little voice in investment decisions. A nondiscretionary system appears to give more power to the investors and is intended to protect investors from wrong investment decisions by the advisor. However, by getting investors to sign blank cheques and instruction forms, advisors are able to run what is effectively a discretionary portfolio management system while maintaining the documentary pretence of running a nondiscretionary system. Far from empowering the investor, the result is to leave investors vulnerable to fraud. In retrospect, investors might have been better off in a discretionary system.

Personally, I think financial regulators should not waste excessive amount of resources or time pursuing the Citi fraud for several reasons. First, the fraud involved unregulated products. Second, the fraud is well covered by normal criminal laws regarding theft and misappropriation. Third, the victims are very wealthy investors who are well capable of hiring the best lawyers and investigators to go after the bank. The regulators’ time and resources are much better spent on regulated products involving small investors who are less capable of looking after themselves.


One response to “Citi fraud: a Madoff moment for wealthy Indians

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