Banks reveal exposure to alleged fraud

The financial papers are abuzz with the news of leading European banks' exposure to the alleged fraud committed by Bernard Madoff of Bernard L. Madoff Investment Securities, headquartered in the US.

HSBC, RBS, Spain's Santander and France's BNP Paribas reportedly have varying levels of exposure to Mr Madoff's "alleged $50 billion pyramid scheme", which according to the Financial Times, prosecutors allege operated on the basis of paying old investors with money raised from new investors.

RBS, a recipient of the UK government's bail out package in October, reported a potential exposure of £400 million to the alleged pyramid vehicle. According to the Financial Times report, HSBC's potential exposure may be considerably higher (approximately $1 billion). Not good news at a time when banks are already experiencing a significant reversal of fortunes thanks to their exposure to subprime assets. And with counterparty risk high on everyone's agenda, this revelation will come as yet another blow for an already beleaguered banking industry which is likely to face some pointed questions from investors regarding the due diligence they undertook before placing money with Bernard L. Madoff.

It appears that the regulators (in this case the US Securities and Exchange Commission) have also come under fire for ignoring early warning signs pertaining to Bernard L. Madoff Investment Securities. If there had been no credit crisis, then perhaps Madoff's alleged "pyramid scheme" would never have come to light. It also highlights the increasing number of links being made between fraud and the credit crisis.

Before the Madoff incident, a couple of Bear Stearns hedge fund managers were arrested on securities fraud charges and since the subprime meltdown, the US Federal Bureau of Investigation has launched investigations into the collapse of Lehman Brothers, the insurer AIG, and mortgage providers Fannie Mae and Freddie Mac.

According to newspaper reports, the FBI is investigating whether these firms unduly influenced agencies to "inflate" their ratings. It is also looking at whether these firms misled investors about the true state of their assets. The FBI is also believed to be investigating a number of firms over what it terms "subprime lending practices".

The following is taken from a Financial Crimes Report published in 2007 by the FBI and alludes to the potential for fraud in light of the subprime meltdown:

"As publicly traded subprime lenders have suffered financial difficulties due to rising defaults, analyses of company financials have identified instances of false accounting entries, and fraudulently inflated assets and revenues. Investigations have determined that many of these bankrupt subprime lenders manipulated their reported loan portfolio risks and used various accounting schemes to inflate their financial reports. In addition, before these sub prime lenders' stocks rapidly declined in value, executives with insider information sold their equity positions and profited illegally."

The FBI's 2007 Financial Crimes Report shows that the incidence of pending cases related to corporate and securities and commodities fraud has been steadily increasing every year since 2003. The Serious Fraud Office in the UK is also reported to be targeting corporate fraud in the wake of the crisis, calling on bankers and City "whistle blowers" to come forward with any information.