[Flashback] China Bank-Fraud Case Shows Accountability in Short Reserve

http://www.wsj.com/articles/SB105993647616119000

Posted by LOW Hwan Hong, Year 4 undergrad at the School of Business, Singapore Management University

China Bank-Fraud Case Shows Accountability in Short Reserve

Fund-Transfer Scam Was Able to Run For Four Years Until Depositor Railed

KARBY LEGGETT Staff Reporter of THE WALL STREET JOURNAL

Updated Aug. 4, 2003 12:01 a.m. ET

TAIYUAN, China — On a chilly day in January 1999, Xue Wenjie, a young government bureaucrat, walked into the Taiyuan City Commercial Bank, plunked down less than $1 in registration fees and opened two new bank accounts. A few hours later, he wired $1.2 million in social-security funds into the new accounts.

The transfers were the start of a financial scam. Mr. Xue, who managed the funds for the government, had cut a deal with a senior manager at the Taiyuan bank to move the money there temporarily in return for a kickback. By the time Mr. Xue was arrested last year, nearly $32 million had been surreptitiously lifted out of the social-security fund, as well as from corporate and individual bank accounts. Along with Mr. Xue, the senior banker and others, the scam also allegedly involved the owner of an upscale restaurant who needed cash to pay off her debts.By the standards of China’s banking industry, the fraud is small. But the ease with which Mr. Xue and his associates were able to operate undetected for 3½ years casts a new light on the rot gnawing at China’s banking system. Financial fraud in China has risen in tandem with the economy, as soaring prosperity has turned China’s banks into guardians of $1.12 trillion in individual deposits as of June. Though official figures are incomplete, China reported more than 8,000 cases of financial fraud, totaling an estimated $12 billion, in 2000 alone, according to Hu Angang, a professor at Tsinghua University in Beijing. That compares with only a few dozen officially acknowledged cases in the late 1980s.

In recent years, financial scandals have engulfed top bankers at Bank of China branches in Shanghai, Hong Kong and a handful of other cities, as well as the presidents of China Construction Bank and China Everbright Bank. In the southern province of Guangdong, bankers looted $483 million from the Bank of China last year and then fled the country. In June, dozens of bankers at the Construction Bank in Guangdong were charged with issuing $120 million in fraudulent home-mortgage loans.

The growth in financial fraud comes as foreign banks such as Citigroup Inc. and HSBC Holdings PLC are gearing up for a push into China, buying shares in local banks and setting up new branches. Under its agreement with the World Trade Organization, Beijing has promised to give them free access in 2007. Yet if China’s banks continue to stumble, some foreign bankers fear Beijing may try to delay the process.

A decade into a bank-reform program, Beijing has largely focused on another banking problem: bad loans, the legacy of years of government-mandated financing for state-owned enterprises. Even after the government spent nearly $200 billion over the past five years to fix the problem, the nation’s banks remain buried under $375 billion in bad debt, by the government’s own count. Many say the problem is far larger. Ryan Tsang, an analyst with Standard & Poor’s in Hong Kong, estimates that nearly half of all bank loans in China are nonperforming, suggesting that the value of bad loans is closer to $750 billion. It’s impossible to know what percentage of bad loans stem from fraud.

China has also upgraded technology and created a new legal and regulatory framework. But it hasn’t addressed the root of the problem: the supreme role that Communist Party officials play in managing banks — from the largest state-owned lenders down to hundreds of tiny rural banks owned by local governments. On personnel appointments, many lending decisions and even annual deposit quotas, China’s bankers report not to an independent board of directors or shareholders, but to party bosses in Beijing.

The result, bankers and industry experts say, is a system often void of accountability, where corruption can thrive. “The controls exercised by the Communist Party have proved ineffective in many cases,” says Stephen M. Harner, a banking consultant in Shanghai. “The system simply isn’t set up to effectively constrain misconduct.”

While fraud is a problem in the U.S., financial institutions in many cases view combating it to be in their interest, since fraud often costs them money. They have large internal fraud departments to track down allegations of wrongdoing. Those that do exist in China aren’t nearly as extensive. U.S. state and federal regulators also monitor banks’ activities looking for fraud. In China, there is less of an incentive for government-owned banks to monitor their own affairs, since any losses ultimately will be the government’s problem.

News of the missing money in Taiyuan — an industrial city 320 miles southwest of Beijing — didn’t reach bank regulators in Beijing until earlier this year, four years after the fraud began. They dispatched a team of investigators to Taiyuan for several days. Regulators decline to discuss what they learned. The head of Taiyuan City Commercial Bank’s supervision department says the fraud wasn’t detected earlier because “the case was extremely complicated.”

Mr. Xue, 35 years old, has admitted his role in the scheme, according to a report by the Taiyuan Commission for Discipline Inspection, which investigates corruption. The tale of Mr. Xue and his associates was pieced together from that report — called “Facts of the Main Mistakes Committed by Xue Wenjie” — an internal police report and interviews with people involved and government officials.

Some of the depositors have gotten their money back, after investigators froze accounts and other assets. Earlier this year, about $6 million was still missing, including about $2.4 million in social-security funds, the reports say.

Mr. Xue remains in police custody. Prosecutors say he will be charged at a minimum with embezzling public funds, and could go on trial in the next month or two, along with nearly a dozen other people. Under Chinese law, he faces a lengthy prison sentence or even the death penalty.

Mr. Xue has hired a lawyer, his wife says, but she declined to provide the lawyer’s name. Taiyuan’s police department declined a request to interview Mr. Xue, as did the Taiyuan Finance Bureau.

Mr. Xue was born in a small farming town in China’s northeastern province of Shanxi. He joined the Taiyuan Finance Bureau — which manages public money in the city — as an office clerk in 1990, shortly after graduating from college. In early 1998, he was transferred to the bureau’s social-security department, where he monitored a portion of the unemployment claims submitted by Taiyuan’s 3.4 million residents.

Suddenly, millions of dollars in bank deposits were at his fingertips. China’s economy was soaring, and all around Mr. Xue were signs of new wealth — mobile phones, imported cars, fancy nightclubs and expensive restaurants. Mr. Xue found a way to pad his small salary. According to the police and corruption investigators’ reports, he teamed up with a man named Shi Zhihong, then deputy head of banking operations at the Taiyuan City Commercial Bank, and agreed to the kickback scheme.

Though both men knew that it was illegal to transfer social-security funds out of the bank approved to hold them, they believed no one would notice, people familiar with the case say. In one year, Mr. Xue stood to make almost as much in kickbacks as he had earned during his decade-long career as a clerk at the Taiyuan Finance Bureau. Mr. Shi was under pressure from city officials to meet his bank’s annual deposit quota, people familiar with the case say.

On Jan. 20, 1999, Mr. Xue completed the transfers. But what he didn’t realize, according to his account to investigators, was that Mr. Shi was planning a larger scam. Later that evening, the two men went to a local sauna and massage establishment to celebrate. According to the corruption investigators’ report, while Mr. Xue was in another room, Mr. Shi rifled through his belongings in search of Mr. Xue’s checkbook and personal chop, a small piece of stone on which Mr. Xue’s name was engraved in Chinese characters. In China, such chops are used like signatures are in the U.S. and are required to cash most checks. Mr. Shi found both, then stamped a series of checks written against Mr. Xue’s account.

Days later, the investigators say, Mr. Shi cashed the checks and transferred almost all of the funds into the account of his friend Wang Hong, the owner of an upscale Taiyuan restaurant, who then paid Mr. Shi for letting her use the money. Over the next several months, investigators say, Mrs. Wang plowed through most of the money Mr. Shi had handed to her. She cleared a personal bank loan, paid off a debt related to setting up her restaurant, and deposited $725,000 into an account controlled by Mr. Shi, according to the police report and people familiar with the case.

In the summer of 1999, they enlisted another Taiyuan bank official, a branch manager, and came up with a new scam: forging loan guarantees in the names of corporate clients of the bank. The branch manager then issued loans based on the guarantees to phony companies, investigators say. Over the next two years, Mrs. Wang and the branch manager used forged loan guarantees involving seven bank clients to issue loans to the phony companies, according to the police report.

In June 2000, Mr. Xue wanted to return the social-security funds. But when he went to check, the money was gone. When he alerted Mr. Shi, the senior bank manager came clean, telling Mr. Xue that he had stolen the money himself and, according to the police report, threatening to turn Mr. Xue in to the police if he reported it. Mr. Xue agreed to let Mr. Shi and his partners continue using the social-security funds. In 2001, according to the government reports, he wired another $3.8 million.

All of the money went to Mrs. Wang. She used some of it to repay previous loans, and some to make payments to Mr. Xue, Mr. Shi and another banker involved. The rest she kept for herself, purchasing several new cars, an apartment in an upscale residential complex in Taiyuan, and one in another city in northern China, according to the two documents.

By late 2001, the corruption investigators say, Mrs. Wang and the branch manager hit on still another plan: luring new depositors to the Taiyuan bank with the promise of high interest rates, and then stealing their money by using forged documents. In China, interest rates are fixed by the central bank, and banks are given only minimal leeway to adjust them on their own. But companies and individuals flocked to deposit their money. By June 2002, the bankers had drawn in more than $16 million in new deposits and rewired $14 million of it to accounts they controlled, the corruption investigators say.

Among the biggest depositors, according to the police report: a tax official in Taiyuan, who deposited $480,000 of his own money at the bank; a unit of the People’s Liberation Army, which dropped $1.8 million into the bank; and a private company, Taiyuan Gangyuan Trade Co., which deposited $9.7 million in cash that it had borrowed from another bank just to take advantage of the higher interest rate.

Bank regulators in Beijing still hadn’t caught wind of what was unfolding. Flush once again with cash, Mr. Xue had already moved the social-security funds back to the bank where they had originally been held. Then he set out to cover his tracks by forging interest-payment slips — to make it seem as if the money had been sitting there all along, collecting interest.

Days later, the scam blew apart — undone not by government investigators or bank regulators, but by an angry depositor who had been lured by the high-interest-rate offer. Earlier in June the head of Taiyuan Gangyuan Trade Co. had deposited $9.7 million at the bank. Several weeks later, he says, he sent an employee to check the account but the money had vanished. He reported the case to the police.

Somehow, Mrs. Wang heard the news too and asked Mr. Xue to dip once more into the social-security funds to help cover up the problem. Mr. Xue complied, taking another $4 million in public funds, the reports say.

It was too late. Taiyuan police began investigating, and a week later they detained Mr. Xue, Mrs. Wang and nearly a dozen others. Mr. Shi fled before he could be arrested and remains at large, according to the reports and people familiar with the investigation. Mrs. Wang was taken to a hotel in downtown Taiyuan, where she was put under guard and questioned. About a month later, as the police probe widened, Mrs. Wang committed suicide, according to the reports and people familiar with the investigation.

In Taiyuan, where the government until recently banned local media from reporting on the case, fearing it could unnerve depositors, some residents say the sketchy details they’ve heard have cemented their view of banks. “None of the banks in our country are trustworthy, each one has problems,” says Dong Yuzhang, a 50-year-old doorman at a residential complex. “But it doesn’t matter because the government won’t allow any of them to go bankrupt.”

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