Difficulties in Modelling the Volume of Illicit Financial Flows

AA's Done the Math So You Don't Have to

In a previous post, AA discussed some of the shortcomings in and misunderstandings about currently accepted estimate for money laundering.

Today we’ll look at issues surrounding modelling these flows.

What can be done to add more precision to the process and to what extent?

Models in General and Their Problems

What follows is a discussion of “direct” modelling.  That is, mathematical models consisting of equations that (a) estimate a current state of affairs or (b) predict one in the future using observable data.

These models are based on assumptions about fundamental processes underlying events. For example, according to most economic theories, lowering interest rates spurs capital investment.  Capital investment spurs increased production, employment, and thus, higher GDP.

Once these relationships are identified the modeler’s job is to quantify the impact of a particular action or development by reducing it to a mathematical relationship (equation).

One example might be a 1% decrease in interest rates will result in a 5% increase in capital investments.  As more and more of these relationships are reduced to equations, a model is constructed.

Observable data are the inputs for the models.

Predictions from the models can be retroactively compared to actual results, providing a feedback loop of sorts.

It sounds very scientific but it is not.

Assumptions about underlying economic processes are often little more than conjectures based on the teaching whether real or imagined of some economic prophet. There’s an interesting book “Economics as Religion”  that describes this process.

It is scarcely better with modeling the value of firms.  Here assumptions are made about growth rates, the risk free rate, risk premia, etc.  If you know this discipline, you know that these models are very sensitive to slight changes in growth and discount rates.

And despite the best efforts of modelers, no model has yet been developed that reliably predicts GDP several years out or the value of a firm.

The point of this is to emphasize that these models and their results are not infallible. 

IFF Models and Their Additional Problems

When we look at modelling IFFs, we see that much of what is available to economic or financial models is not available.

That means that IFF modelling is going to be more difficult and is likely to result in less reliable results.

We don’t have a satisfactory theory or theories that explain the volume of volume of various types of IFFs that can be expressed in mathematical terms.

What drives corruption?

We might say that it is directly related to cupidity and opportunity and inversely related to morality.  Corruption is also dependent on the bribe payer’s cupidity and inversely related to its morality. For both the risk of being caught is a negative factor.

How do we model this?  What is the equation that describes this?

If we could specify these relationships in equations, we don’t have data on the variables in the equations.

How much cupidity is there in the elites in Country A?  If average cupidity in a Country A is X, what is the standard deviation?  It may just be a subset of the elite that engages in corruption.

We have some estimates of data, e.g., ranking of countries for corruption by Transparency International.  But you’ll notice TI call their assessment “Perceptions of Corruption”.

Perceptions seem a slim reed to build a case on.

According to an unscientific poll that AA recently saw, 84% of Twitter users who responded didn’t like the new format.  Should AA have the “perception” that overwhelmingly Twitter users don’t like the new format? NBL! 

We have some single point data from discovered IIF transactions.  But there is no robust set of available statistics.

No actuals we can compare the predictions from of our model to.

In fact, if we had that data, we wouldn’t need the model.

But there are more difficulties.

UNDOC had a working meeting in 2017 to refine its methodology.  Here’s a link to the gateway page with a brief overview and links to more detailed material.

UNCTAD has created a “task force” that held its last meeting this July.

That material outlines two key problems with estimating IIFs with AA’s commentary on each in the “bullet” points immediately below each boldfaced sentence.

There is no single accepted definition of Illicit Financial Flows (IFFs)

1. IIFs range from tax avoidance schemes on legally earned profits to the movement of money arising from illicit activities, e.g., drug and human trafficking, corruption, embezzlement.
2. One of the tasks of the meetings referred to above is to try and develop an accepted definition of IFFs.
3. “Tax minimization” is technically legal. Presumably, transfer pricing transactions between MNC do not belong in IFFs. But how or where does one draw the line between “tax minimization” and “tax avoidance” (clearly illegal)?  Is it a difference of degree or difference of kind?
4. Can we separate out the various subtypes of IFFs from the aggregate total? We want information on IFFs not out of academic curiosity, but to craft policy and further enforcement.  One deals with tax avoidance schemes with a particular set of policies and with drug trafficking or corruption with others.
5. We want to make sure that we don’t double count sub-types in our gross IFFs totals. Are bribes to law enforcement officers and politicians part of the drug trade IFFs? Or do we account for these as part of corruption?
6. Within these high level definitional problems there are some other problems.  When we consider IFFs do we look both at intra-country and inter-country flows?

There is no single accepted method for estimating IFFs.

1. Examples of methods that have been used are (a) analyzing discrepancies in Balance of Payment data and in trade statistics (value differences in the goods traded between two countries), (b) cash to GDP measures (assumption is that cash is the preferred payment method for crime and the informal economy).  Sometimes multifactor models are used in an attempt to compensate for shortcomings in a single factor model.
2. Each of these methods used has drawbacks. We’ll take a look at this topic in a subsequent post.

Alternative Approaches

There are alternatives to direct modelling to estimate IFFs.  But these are likely to be less precise than direct models--if available--would produce.

1. One could for example, focus on a handful of countries which are the largest consumption markets in the world for illicit drugs and estimate what percent of world drug trade these countries represented.
2. Then estimate the annual physical flow of drugs to those countries by making estimates that interdictions are x% of the total shipments to those countries.
3. And then from observable street prices estimate the gross sales proceeds.
4. Then make an assumption about the profit margin to the overseas cartel as well as costs associated with the drugs outside the country of consumption/final sale, making as well  foundational assumptions about the costs the local distributor in the country defrays, e.g. transport, protection, sales and marketing, plus its profit margin.  

As you can appreciate from the chain of assumptions, this sort of alternative model is likely to be less accurate than a direct model.   

The problems with direct modelling and alternative approaches suggests that if new models are developed, we treat their results with healthy skepticism.  They will most likely give directional rather than locational results.

To be clear, that doesn’t mean that we should ignore such models or not try to create such models.

But rather that we not treat their results as incontrovertible “fact”.

Estimating the Volume of Illicit Financial Flows – Definitely Not a Science Probably Not Yet an Art

Ainsi parlait Michel

There’s no central authority that keeps track of and publishes details of illicit financial flows.  No national central banks of crime.  No international (criminal) organization akin to the OECD or the IMF.

No major listed criminal enterprises that report their annual results of operations including sector information, costs of doing business, including those related to bribes and threats from which we might construct estimates.

By their natures these flows are undisclosed.

Parties to illicit transactions, the intermediaries they use, and parties they co-opt don’t self-report for obvious reasons.

But you do see figures for these flows.

For example, UNDOC states: 

“The estimated amount of money laundered globally in one year is 2 - 5% of global GDP, or $800 billion - $2 trillion in current US dollars.”

You’ll often see that latter number USD 2 trillion cited in press reports.  Here’s one from January this year in which Bloomberg states that “shady transactions continue to reach as much as $2 trillion a year.”

That wording implies that amount of money laundering is capped.  Apparently, once they reach USD 2 trillion in a year, criminals have to stop money laundering.  Unclear how this information is communicated.

Let’s stop for a minute and reflect.

Amounts and Percentages

UNDOC states the amount of money laundering in one year is estimated as a percentage of global GDP.  It then goes to give a range of USD estimates.

What do those estimated amounts work out to in terms of global GDP?  To USD 40 trillion.

According to World Bank data, that’s roughly the estimated world GDP in  2003.

Are we blindly repeating 16 year old estimated amounts?

Referring to the same World Bank source above 2017 world GDP was some USD 80.886 trillion and in 2018 some USD 85.791 trillion.

That would make

1. 2017 money laundering USD 1.687 trillion to USD 4.044 trillion and
2. 2018 money laundering USD 1.716 trillion to USD 4.290 trillion.

Now it could perhaps be that money laundering is not a growth business.  It’s capped at USD 800 billion to USD 2 trillion.  More Sears than Amazon.

AA doubts that.

So, is the answer that we just need to update the amounts?

It’s not that simple.

Origin of the Estimated Range

Before we do, we should know where and when this 2% to 5% estimate came from.

As near as AA can tell, it was first mentioned in a speech by then IMF Managing Director Michel Camdessus in 1998:

“While we cannot guarantee the accuracy of our figures—and you have certainly a better evaluation than us—the estimates of the present scale of money laundering transactions are almost beyond imagination—2 to 5 percent of global GDP would probably be a consensus range.”

Note the words “we cannot guarantee the accuracy” and “would probably be a consensus range”.

Clearly, models are estimates so they are not 100% accurate. Hard to quibble with that statement, though it does serve to warn that one should treat the model’s results with caution.

But “would probably be”.  On its face, that means we really don’t know if it is a consensus or not.  Or who the parties to the consensus might be. Or how they achieved consensus.

Or whether Mike pulled this out of his hat.

Age of the Model

But let’s assume there was a formal model of some sort, which is unclear, and this range is not based on graph drawn on a cocktail napkin in a bar somewhere.  Or a discussion in a bar.

Are we working with a model from 1998?  Should we be?

Is the world the same as it was some 20 years ago?

Results of the Model

The model has a range from 2% to 5%.

At the risk of understatement (which AA delightfully accepts, the risk not the understatement), that’s a wide range.

Imagine you came to AA Investment Advisors (AAIA) and asked AA, the firm’s Chief of Research and Head Strategist, what the value of a single share of Company XYZ and of Company DFE were worth.

If you got the answer about Company XYZ from “USD 20 to USD 50” and Company DFE “from USD 40 to USD 100”, what would you think?

You’d probably not think this was particularly useful, nor something that should be relied on for your investment decisions. Or that the nature of these stocks made it impossible to perform a more precise valuation.

Now if you went to Goldman Sachs and got the same answer, what would you think?

Would you think that AA wasn’t much of a financial analyst, but the analysis of the good folks at the Goldmine was spot on and highly useful simply because they were at GS?

In responding, don’t overlook the fact that  you're unlikely to be able to get a decent cup of Turkish coffee at all of GS's global offices.  But at all of our one office in the world at AA Investment Advisors, you can get what is probably one of the best cups of Turkish coffee in the world.

100% organic Arabica coffee hand-ground fresh for each cup using only the finest Turkish grinders. As long as you promise not to spill it on Madame Arqala’s antique furniture or rugs. There are some severe penalties for such infractions as AA can testify.

Hopefully not, you should think the same in both places and with respect to this model.

The right conclusion is that model is pretty much a rough estimate.  Another understatement.  Probably given the task it has set for itself:  to estimate IFFs that are deliberately hidden.

Don’t be dazzled by the source of the model.  “Aristotle says” or “the IMF, UNDOC, UNCTAD, FATF say” doesn’t make it true. Nor confirm precision where none is possible.

Don’t be More Royalist than the King

If you’re still not convinced by AA, if you dig a bit deeper, you’ll see that UNCTAD believes less in the model than many outsiders appear to.

In UNCTAD’s 2018 Annual report go to Goal 16 and look for the dropdown menus.  Pick the one about illicit financial flows.  There you’ll find this quote:

“In close cooperation with the United Nations Office on Drugs and Crime (UNODC) and the United Nations Economic Commission for Africa (UNECA), UNCTAD is working on developing a measurement framework for Goal indicator 16.4.1. This is a complex project that involves defining and designing measurement tools to capture both illegal and illicit activities which, by their very nature, are hidden deliberately.  As a co-custodian of the Goal indicator 16.4.1, we are striving to define, estimate and disseminate statistics on IFFs in the context of developing economies in Africa, some of the most affected by this developmental challenge. Through a series of implementation guidelines, pilot activities and technical assistance, by 2020 NCTAD, UNODC and UNECA will have developed the capacity to measure IFFs in several participating countries in Africa.  The result will be the capacity to more accurately estimate IFFs in participating countries. The lessons learned will inform the national monitoring of IFFs and will guide policy actions in affected countries to curb these flows. As such, it will also increase the likelihood of developing countries achieving the 2030 Agenda for Sustainable Development.”

This post marks the start of series on Illicit Finance.

In following posts, we’ll take a closer look at  difficulties in modeling IFFs, in measuring the probability of corruption, etc.

Almost a Prime Minister Reveals Secret English Landing on the Moon in 1969

Rare Archival Photograph Shows English Astronauts

After 1969 Moon Landing

Today, almost an English Prime Minister, the Right Honourable Alexander Boris de Pfeffel Johnson (clearly a very very English name) revealed that in 1969 well before the Americans staged their fake landing,  English astronauts actually landed on the Moon.

In a tribute to English handicrafts and the famous English can-do spirit, he noted that:

“If they could use hand-knitted computer code to make a frictionless re-entry to Earth’s atmosphere in 1969, we can solve the problem of frictionless trade at the Northern Irish border”

Responding to his stirring words, patriotic English men and women across the country, with the reported centres of activity being London and Nottingham, immediately began hand-knitting the almost 50,000 meters of frictionless doilies required for the Irish border.

Jacob Rees-Mogg a humble craftsman from North East Somerset, vowed that the task would be completed well before 31 October this year, using only the finest English silk to ensure no friction.

Russian SPFS – Not a Serious Sanctions “Buster”

AA Explains SPFS and Venezuela : "Много шума из ничего"

Regular readers of this blog, by all evidence a select group of a handful of individuals or perhaps even more sadly bots, will recall the “great hysteria” (or in some quarters joy) of 2016 that CIPS, the China International Payment System, was poised to be the final nail in the coffin of the primacy of the dollar.

AA dispatched that canard in short order with two posts here and here.

Recently the good folks at Bloomberg reported that Weary of Sanctions, Venezuela Mulls Using Russian Payment System.

Fair enough.  When in a desperate situation, one is likely to consider all sorts of things, including those not likely to be of much utility.

Venezuela has issued its own crypto currency el Petro as a way of countering sanctions. It has also discussed using the Russian ruble in bi-lateral trade with the Russian Federation.

So why not consider the SPFS?

The question is whether the SPFS is a solution. Or like el Petro not much of a solution.

At this point the Система передачи финансовых сообщений (the Financial Messaging System – clearly more sinister in the Cyrillic than English) has not yet risen to the level of a new imaginary threat.

What is missing so far is an assessment of whether joining SPFS will give Venezuela a significant way around US sanctions, especially if Venezuela is de-SWIFT-ed.

Before SPFS becomes a source of unwarranted hysteria or joy, AA will “put the spike in that optic” with a hopefully timely prophylactic post making "the call".

Summary: SPFS is not a significant work-around to sanctions and does not herald the end of the role of the US dollar in the global economy.

Some basics about international cross-border payments to set the stage.

Payments versus Payment Instructions

Both the SPFS and SWIFT are systems for the exchange of messages relating to financial transactions. Neither SPFS nor SWIFT hold bank accounts. Neither makes payments.

They simply relay messages containing financial information, including payment orders, between the institutional holder of an account and the bank where the account is held and vice versa.  Note that individuals may not be members of either system.

How messages are sent to one’s bank is only one part of the issue.  More important is the willingness of the bank to make the requested payment.  

The bank that is asked to make the payment will make the payment or not depending on a variety of factors.  These include the balance in the customer’s account, whether the bank grants an overdraft facility to that specific customer and for what amount, and any legal constraints.

Sanctions are a possible legal constraint. The branch or affiliate of a bank located in a foreign country will generally have two laws to consider: that of its home (parent) jurisdiction and that of the jurisdiction of its location, though the US “doctrine” of “secondary sanctions” or as Europeans both “old” and “new” like to put it “extraterritoriality” also comes into play.

The payment will be either in (a) the national currency of the country where the bank holding the account is located or (b) the national currency of another country.

Payments in the national currency of the paying bank’s location are fairly straightforward.  They are made through the payment systems in that country or as “book transfers”.

A book transfer takes place when the recipient of a payment (the beneficiary) has an account with the bank that has been instructed to make the payment by its customer.  That is, both parties have an account with the paying bank in the same currency.

Unless the party instructing the payment states otherwise, the paying bank will debit the account of the instructing party and credit the account of the beneficiary on its books.  No money will leave the paying bank. A book transfer is simply an accounting entry.

Generally beneficiaries like to get their payments credited to the accounts they use most often.  They may have an account with the paying bank, but really don’t use it as their primary account.

They could receive the book transfer there and then send the money to their main account at another bank.  But that is not costless both in terms of time and bank payment charges.

Or they can tell their counterparty to send the payment directly to the main account at that other bank.

Of course, there could be non-commercial reasons for favoring a book transfer, e.g., desire for confidentiality, desire to avoid exposure to a certain juridiction's laws, etc.

Payments in another national currency are more complicated.

By luck it may be that the bank that has to make the payment holds an account for the beneficiary in the foreign currency of the payment.  Then unless instructed otherwise by its customer (who has been told by the beneficiary where it wants the money sent) the bank will make a book transfer. As above, the money never leaves the paying bank until the beneficiary issues a subsequent payment order that itself is not a book transfer at that bank.

In some rare cases, there is a local payment “utility” for making foreign currency payments.  For example, CHATS in Hong Kong. There are few of these.  They offer fewer options for making payments in terms of number of participating banks and ultimately number of customers (potential beneficiaries). If the money is to be used outside the local system, it will almost certainly need to transit a payment system in the country of the currency of the payment.

In most cases, neither of these alternatives apply—book transfers or CHATS-like systems. So, a bank in Russia, France, or Germany seeking to make a payment in US dollars will likely route that payment through a bank in the USA.

While that payment transits the US payment system, it is subject to US law. Authorities in the USA may block the payment.  Thereafter a subsequent review of completed transactions can result in fines and other penalties.

As mentioned above, the USA applies a doctrine of “secondary” sanctions for actions by non US parties outside the USA.  So a bank in Moscow or Minsk could fall afoul of US sanctions.

The method for transmitting payment instructions is only part of the “problem”.  Substituting one messaging system for another by itself is not a workaround for sanctions.

One has to have a willing bank.

This is the critical factor because there are many ways--not all of them as convenient or quick or secure as others-- to get a message to one's bankers.

Messaging System Coverage

When considering an alternative to SWIFT, one has to look closely on the relative geographic and institutional coverage.  Will the alternative meet the needs of party seeking or being forced to switch?  Or in other words can it use the alternative to communicate with all or a large percentage of those banks and countries it wants to communicate with?

According to SWIFT-published statistics as of April 2019 SWIFT:

1. Was connected to participants in more than 200 countries.
2. Had 11,367 live users.
3. Handled some 2.7 billion messages relating to financial transactions during the month of April.  This includes more than just payment orders, though these were the bulk.

Statistics on SFPS are not as detailed.

1. What we do know from the Central Bank of Russia is that as of 1 July 2019, there were 397 live participants in the SPFS, almost all from the Russian Federation.
2. According to Bloomberg article cited above, a financial institution in Belarus (a subsidiary of Gazprom as identified elsewhere) was a member.  And reportedly the central banks of Southern Ossetia and Abkhazia.
3. Let’s call that 4 “countries”.  AA suspects that Venezuela has little current business with 3 of them.  And prospects for significant business with them are limited. (To use a “charitable” term).
4. AA couldn’t find any statistics regarding number of transactions processed but recalls reading somewhere that some 10% to 16% of domestic Russian payments were made using SFPS.
5. This is a red flag of sorts.  It seems that SFPS is more of a "fire extinguisher" than a replacement for SWIFT.  It’s there in case Russia is de-SWIFT-ed.  Not to replace SWIFT today.
6. There’s more that confirms that assessment. According to a Russian news source, Alma Obaeva, Management Board Chairman of the National Payments Council in Russia said this April that if Russian banks are obliged to join SFPS (currently they are not), they only need connect to the system.  Usage is optional.

What can we conclude from this comparison?

1. SPFS lacks the coverage to give Venezuela a workable alternative to dealing with its correspondents outside of Russia and three rather small countries.  
2. Remember: if a foreign bank isn’t a member, it can’t get a message through SPFS. So SPFS offers no way for Venezuela to communicate with Mexico, China, Brazil, India, Cuba, etc.  to name just a few of its major trading partners.  Its current major trading partner the US is another kettle of fish.
3. SPFS doesn’t seem to be widely used by Russian banks, though AA supposes one could argue that if all Russian banks are connected, they would get a message from Caracas.  
4. But Venezuela almost certainly doesn’t need to deal with 397 or more banks in Russia.  It would probably deal with just a handful, if that many.
5. In such a case, Venezuela would be better served establishing a bi-lateral system for sending and receiving messages with Russian banks. This would be cheaper and quicker.
6. Most banks these days offer customers a PC-based SWIFT like system (meaning it uses the same message formats that SWIFT does).  Such systems can be modified to accommodate a large number of transactions per day and to be linked to the customer's accounting system for Straight Through Processing.
7. There are press reports of discussions to connect with the Chinese, Iranian, Indian and other systems.  These seem mostly aspirational.  
8. SPFS may indeed grow and link to these other centers.  New currencies may supplant the dollar sometime in the future.
9. Pero el presidente Maduro no tiene tiempo para esperar.  His problem is today not in the future.
10. In the future when these alternatives have fully blossomed, surely the world proletarian revolution will have occured, transforming the US Government from an adversary of the Bolivarian Revolution to a supporter.  

Why Did the Russian Federation Create SPFS and NSPK?

The answer to this question is important in understanding what these systems are designed to do.

Prior to sanctions being imposed on the RF related to Ukraine, Russian banks almost exclusively used (and thus relied) on SWIFT to send instructions for domestic ruble payments.

Russian banks similarly relied on Visa and MasterCard to provide processing services for domestic credit and ATM cards. Both these firms conducted these processing services from outside the RF, outside the jurisdiction of the RF.  Russian banks also issued primarily domestic Visa and MasterCard cards.

A 2014 shutdown of credit card processing for sanctioned banks rang the first alarm bells in Moscow.  Calls by the British PM and some other politicians around the same time to de-SWIFT the RF led Moscow to realize that its domestic financial system was vulnerable to disruption by foreign powers and companies. You can read more about it here.

So the RF began building these alternative systems to protect itself, including issuance of a Russian card “Mir” and expansion of business relations with other card providers, China’s Union Pay, etc.

A Few Words on the “De-Dollarization”

The main cause of de-dollarization is and will remain policies of the US Government.  Fiscal policies and trade policies.  And overuse of sanctions.

While these trends were present in prior US Administrations, the current Administration seems to be doing its “best” to undermine the US dollar and international institutions which by and large have supported the US’s dominance of the global economy.  

Acting a brake on de-dollarization will be the absence of credible alternatives.  A credible alternative currency would have to have a market of size that was liquid. With an abundance of good investment opportunities. Good regulation.  Transparency. A market where one could rely on a reasonably fair legal system to protect one’s interests.

Would you want to put substantially all your reserves into securities issued by the Government of China?  The Government of Russia?  Or invest in those markets in non-government securities?

Or would you prefer to dabble in the DFM or other GCC markets?  Should we put our reserves into Dana Gas Sukuk or GFH shares? The Goldilocks Fund?  Or invest in a state-owned company with a free float of 10% of its shares?  That like many state-owned firms has non-commercial motives for at least some of its decisions. Subject yourself to the jurisdiction of the eminent courts of Sharjah?

Currently the EU is the most credible alternative. But only to a point as evidenced by the fact that it has not (yet) supplanted the US.  If the EU splinters, it and the Euro will lose the position they currently hold vis-à-vis the US dollar.

Another brake is the size of the US commercial and financial market.  If you’re a company contemplating whether to deal with Iran or Venezuela, you have to weigh the relative size of the US and Iranian or Venezuelan markets, the ability to place debt or equity in the USA versus the Iranian or Venezuelan markets. If you can only be in one of these markets, which would you chose?  

Seems to AA that this is a relatively easy choice to make.

The Curious Case of Bahrain Middle East Bank (BMB) Bahrain

Perhaps Somewhat Less Currently

Read the update here.  Massive losses at BMB, the bank is likely fatally wounded barring a miracle. 

An introductory note.  There is a financial group from Brunei that uses the acronym "BMB". This post is not about that group, but about the Bahrain Middle East Bank in Bahrain.

AA generally follows the bigger fish (admittedly a relative term) in the GCC.  But BMB caught my eye.

BMB is small bank not a financial force of any measure and has been “limping along” for years.

What’s interesting about it are two scandals, the last of which caused the Central Bank of Bahrain to come down with “both boots” on the Bank.

As well there appear to be some hints as the fate of the AlFawares Group of Kuwait which dropped from sight roughly two years ago.

2013 “Scandal”

In April 2013 BMB’s Board suddenly fired the bank’s CEO and CFO as well as some other officers.

For the first official word on the cause, let’s turn to note 5 from BMB’s 1Q13 interim financial statement.  Unfortunately, the copy online is a picture and so AA can’t cut and paste the text, but has laboriously copied it.

“Subsequent to the approval of the 31 December 2012 consolidated financial statements (the “consolidated financial statements”) by the Shareholders on 28 March 2013, the Board and new management team of the Bank have discovered certain transactions and balances which were not reported in the Bank’s consolidated financial statements. As the Board of Directors was not provided with complete information and documentation relevant to these transactions and balances; based on review of the underlying documentation for the transactions and balances and extensive evaluation, the Bank has concluded that assets and liabilities arising from these transactions, along with certain other assets and liabilities which were previously reported and accounted for as customer deposits under discretionary portfolio management program, should now be reported and accounted for as Bank’s assets and liabilities.  Furthermore, in line with the International Financial Reporting Standards, the Board and new management team have concluded that since key information was not available at the date of approval of the consolidated financial statements, the corresponding figures are not required to be restated.  As a result, the assets and liabilities of US$ 138,383 thousands and US$ 143,093 thousands respectively have been reported in the consolidated financial position of the Bank as at 31 March 2013."

Recognition of these assets and liabilities increased BMB’s balance sheet from USD 55.3 million to USD 190.5 million.

The major change on the liability side was in Deposits from Financial Institutions. As per note 10, some USD 124.078 million of that category was from “quasi-government interbank placements”.

The other increase USD 18.644 million in Borrowings was described as “a secured loan from financial institutions”.  That loan does not appear in the 2Q13 financials nor do some USD 25.7 million in Trading Securities.  AA presumes it was a “repo” like transaction.

In a statement dated 12 June 2013, BMB’s new CEO stated that based on the work of an “independent team of forensic experts” “it was discovered that during 2011, 2012, and Q1 2013 BMB was the subject of various unauthorized transactions, potentially involving fraudulent activities”.

So this was a multiyear activity, roughly coinciding with the tenure of the previous CEO.

BMB’s FY 2013 Annual Report provides additional details.

“2013 was a challenging year for BMB. In April 2013, the Board of Directors became aware that the Bank had potentially been the subject of a major fraud. The then Chief Executive Officer, Chief Financial Officer and a number of other senior staff at BMB were immediately suspended and the Board of Directors commissioned urgent internal and external investigations into the activities of the Bank and the then management team. These investigations uncovered a number of serious potentially criminal activities including the apparent misappropriation of significant funds. As a result a number of senior executives, including the then Chief Executive Officer and Chief Financial Officer, were dismissed. Official investigations relevant to these executives remain ongoing. As a result of prompt and decisive action substantially all misappropriated funds have been recovered by BMB. However, given the serious nature and magnitude of what took place, BMB has instigated criminal and civil legal proceedings against a number of parties. These matters are currently being investigated by the appropriate legal authorities in the Kingdom of Bahrain.  Throughout 2013 the Board and management carried out a full review of all external contractors, legal and professional advisers to the Bank. This has led to a number of changes and corrective measures and the application of a more rigorous approach to selecting and measuring the performance of third party contractors. BDO’s contract to act as Internal Auditor of BMB was terminated in May 2013. In September 2013, EY was appointed to replace KPMG as External Auditor of the Bank."

AA’s first thought when he read all this, particularly the bit about “quasi-governmental interbank placements”, was that a friendly government decided to help out BMB. Best guesses for that would be Kuwait (given the apparent shareholding by/related to Sh. Ali Khalifah Al Sabah) or Oman (given the then CEO’s prior roles with government institutions in Oman).

As a small bank with USD 30 million in equity, it would be very risky to place USD 140 million or so with the Bank.  However, by using a trust structure, all assets placed would be legally immune to any financial distress at BMB.

The Bank would enjoy the earnings from managing the discretionary account to increase its small income as well as develop a reputation in asset management as a potential new line of business.

So it appeared that the fraud was that certain members of senior management then appropriated these funds for their own use.

But there are some loose threads:

1. Once the assets were recovered why wasn’t the trust or discretionary account structure maintained/reinstated? If the documentation was deficient, then that could be corrected.
2. That suggests some sort of “problem” with the owner of the funds. What that is isn’t clear.
3. This would seem to pretty decisively counter AA’s initial thought that the provider of the funds was a Kuwaiti or Omani quasi-governmental body trying to help out either the major shareholder or the then CEO.
4. Also, as per point 3 in the “Key Audit Matters” section of the auditors’ report in BMB’s 2017 financials, it’s noted that in the category Due to Financial Institutions a “single bank in the region” is owed USD 127.4 million and “has been a depositor since September 2010.”
5. That certainly seems like a long time to keep one's funds with a bank. Why would that be?
6. Note that the descriptor does not include the phrase “quasi-governmental” as in the 1Q13 interim report.  Now it’s just a “single bank in the region.”  And the region is potentially very large, depending on the definition used.
7. You will no doubt note as AA did that this amount is some USD 3.3 million greater than the original amount recorded in 1Q2013. It seems strange that the regional financial institution would add such a small amount to the deposit.
8. Two possible explanations.  The deposit is not in USD but in another currency and the change is due to changes in the FX rate.  Or interest has been capitalized. Or both factors are present.  There's not enough information in the financials to determine the answer.

2018 - 2019 "Scandal"

A bit of history to set the stage.

Back in February 2014, AlFawares transferred 42.97% of its ownership stake in the bank to AN Investment W.L.L. a Bahraini company “controlled by the same shareholder as AlFawares Holding Company” as per page 22 of BMB’s 2013 FY AR.

As per records at the Bahraini MOICT (www.sijilat.bh) AN Investments CR 86835 was owned at least in 2016  by two sons of Sh. Ali AlKhalifah Al Sabah, former Minister of Finance and Oil Minister of the State of Kuwait. 

According to the MOICT website, on 26 December 2016, a request was filed to change the ownership of ANI to the names of three Turkish nationals: Huseyin Basaran (70%), Murat Solak (15%) and Ardases Saro Kavafyan (15%). This provides an indication that the sale of ANI to the Turkish three "amigos" probably took place in December 2016.

After a 26 March 2017 voluntary purchase of BMB shares and a subsequent rights offering later that year, ANI wound up owning some 81% of the bank.

Fast forward to 15 November 2018, BMB announced that its Board had met to approve September financials on 7 November but did not approve them due to the Central Bank of Bahrain putting forward “some observations that require resolution”.

In that same announcement, BMB noted that on 8 November 2018 the Central Bank of Bahrain issued a directive to the bank “restricting” the following:

1. Dealing with “specific Trade Finance related parties”.  From the Arabic we learn this means dealing with related parties to the bank in trade finance.
2. Interbank dealings with banks that are not licensed by the CBB.  The Arabic uses the term (مرخصة).  While this term is often used to mean “licensed”, AA suspects that BMB is not dealing with unlicensed banks in Bahrain, but this refers to banks elsewhere.  The CBB doesn’t license  banks in foreign jurisdictions, their own regulators, if any, do. Think of Citibank or NBAD.  However, it is likely that the CBB has set some guidelines as to which non-resident foreign banks Bahraini banks may deal with.  For example, it may forbid dealing with so-called “shell” banks, banks not licensed at all, or banks subject to international sanctions, etc.  So AA is reading (مرخصة) to mean banks outside Bahrain that the CBB does not allow Bahraini banks to deal with.
3. Making any new investments or credit.

11 minutes later that same day a second announcement from BMB was published by the Bahrain Bourse that advised that the two directors representing AlFawares one of whom was Chairman of the Board had resigned on  7 November.

On November 22, BMB published another announcement stating that the CBB had issued “additional formal directions” on 15 November as follows:

1. The Board must resign immediately
2. The CEO and CFO must step down from their positions as the CBB does not consider them “fit and proper”.
3. The Bank must raise capital before year end
4. The Bank must stop dealing with specified related parties for trade finance
5. Further, as a result of identified violations and irregularities, the CBB is unable to comment on the bank’s 30 September financials.

Now you may be wondering as initially AA did why BMB’s announcements seem to be tardy.  On November 8, the Bahrain Bourse suspended trading pending release of the September financials. So timeliness of announcements wasn’t as critical as it would have been if BMB were still trading.

BMB’s AGM was held on 30 December.  According to the published minutes, shareholders holding 80.81% of shares were present.  This means that AN Investments was there.  Mr. Taqi al Alawi from the MOICT acted as Chairman.  A new slate of directors was elected.  None of them seem to have any relationship to ANI.  

The representative of ANI complained that the CBB had not approved Mr. Solak to serve as a director and demanded that the CBB should give this approval and that he should be elected as a director.  Mr. al Alawi noted the comment and proceeded.

To date BMB has not published its 3Q18 financials. And there has been complete radio silence from the Bank both on its website and the Bahrain Bourse.

So what are we to make of this?

From where AA sits, it appears that the CBB thinks this episode is more egregious than 2013. Or it has a "two strikes" rule:

1. The entire board was forced to resign. This indicates that the CBB believes that either (a) the Board was complicit in whatever irregularities occurred or (b) manifestly derelict in carrying out its functions.
2. The two AlFawares directors luckily resigned before the CBB’s directive requiring resignation of the board, thus avoiding the ignominy of being forced to resign by the CBB and possible impact on their eligibility for other board positions in Bahrain and elsewhere.  
3. Or perhaps it was more than luck.  Back when Iraq invaded Kuwait, foreign correspondents pulled their funding to Kuwaiti-owned banks in Bahrain.  Bahrain did not have the financial resources to support these banks.  A full-fledged banking crisis was on the offing.  Sh. Ali Al Khalifah then Minister of Finance of the State of Kuwait (in exile) provided the funding directly.  AA was told by his mentor that Bahrain never forgot that act.
4. The fact that the new board appears to have been chosen by the CBB with no apparent input from ANI investments also suggests (at least to AA) that the CBB assesses that the problem is not one of individual board members but an “institutional” one at the ANI level.
5. For the CBB to declare an officer of a bank as “not fit and proper” is a pretty damning assessment.
6. For the CBB to "fire" a board of directors as well.
7. For the CBB to not accept a person as a suitable candidate for the board of directors is a similar judgment.

At this point you’re probably thinking, AA what about AlFawares?  What have these scandals to do with AlFawares?  Probably nothing.

But BMB is entwined with AlFawares.  As mentioned at the beginning of this post, roughly two or so years ago, AlFawares’ star began to dim. 

Part of the problem seems to be that the members of the AlSabah family branch associated with AlFawares wound up on the wrong side of a family dispute in Kuwait -- not the Amir's side.

AA suspects there were also financial problems.  

AA has no doubt that like any typical Kuwaiti punter, AlFawares built its empire on OPM piled upon other OPM.   AA recalls reading in al Qabas that Gulf Bank was pursuing legal action against the group for unpaid debts.

As to concrete examples of financial difficulty we don’t have to look beyond BMB’s 2017 annual report.  In note 7 we see that BMB has fully provided the USD 3.533 million installment sales receivable which is guaranteed by AlFawares and two associated companies of AlFawares.

Clearly, if the guarantees were worth anything the Bank would have called them.

Additionally, it’s hard for AA to imagine that the CBB would tolerate provisioning if the guarantees had value. That the Bank has not called on the guarantees suggests they have very little value. 

The amount here is small. It is not a loan for USD 300 million but just USD 3 million.  That suggests that the three entities are in dire straits indeed.

The sale of ANI to the three Turkish “amigos” is perhaps another sign of financial distress. Giving up one’s bank is a hard move.

Other indications that AlFawares is inactive or defunct are the disappearance of AlFawares Kuwait’s website.  On AlFawares Egypt’s website all the links are to pages under construction or dead-ends. You can’t really conduct business if the first thing a prospective client sees is that your website looks untended and untethered.

Does this mean that the good shaykhs from AlFawares are sleeping rough under an underpass on the First Ring Road somewhere?  

Not bloody likely.  Any Kuwaiti punter worth his salt has salted away money somewhere "safe" and "discreet" as Mubarak al-H is reported to have done.