IMF Survey: IMF Advice Helps Fight Financial Fraud as Schemes Multiply
February 12, 2009
- IMF learns of rising financial fraud, especially in shallow financial systems
- Financial fraud schemes emerge by skillfully operating in regulatory gaps
- Controlling, closing down financial fraud schemes can be politically difficult
Better communications, more financial complexity, and multinational business operations have made it a lot easier to commit financial fraud.
PYRAMID, PONZI SCHEMES
Thwarting fraudulent financial schemes and dealing with unlicensed financial institutions are rising priorities, and the IMF is advising member governments on policies to deal with this growing problem.
For the past several years, the IMF has been informed of a rising number of financial frauds, especially in—but not limited to—countries with shallow financial systems. IMF technical assistance has helped Jamaica, Lesotho, and Swaziland to address cases of financial fraud. In addition, Kenya, Namibia, Nigeria, and Seychelles are among other countries that have relayed instances of fraud to the IMF.
Simple fraud—entering into a contract with no intention of honoring the contract's terms—is made more difficult to identify when some financial trappings are added to make the deal or scheme appear more sophisticated and legitimate. Typically, such frauds are considered only a nuisance to the economy and not a systemic threat, but when such schemes get very big, as in Albania in 1996 or Lesotho in 2007, they can cause or threaten major damage.
Pyramids and Ponzis
Common forms of financial fraud include pyramid schemes (see Box 1)—typically referred to by scheme organizers as multilevel marketing schemes—and Ponzi schemes (see Box 2), which are usually promoted as investment schemes. Except in the case of Lesotho, where the liability of a major Ponzi scheme was estimated to have grown to about 8 percent of GDP before it was shut down, small pyramids have been the most prevalent fraud schemes.
Pay Here to Enter
A typical pyramid scheme involves members who pay a subscription price to join. Each member is promised a reward (in cash or kind, and typically large relative to subscription) for recruiting more members. For example, each member may be required to recruit five others who each recruit five more, and so on to get the reward. While the promised large reward draws in members, the number of recruits required to be ultimately rewarded grows exponentially, and quickly exceeds the target population, leaving most members empty handed. While unfortunate for the defrauded investors, it is fortunate that individual schemes collapse very quickly and usually do not grow to systemically threaten the financial system or the economy.
A major reason such schemes constantly emerge is that they skillfully operate in regulatory gaps. It is difficult for regulators to stop unlicensed financial institutions, as they must prove that the scheme or enterprise is engaging in deposit-taking, insurance, or other regulated activities. They must prove that an enterprise is doing something illegal or that requires a license—and information can be scarce or obscure on institutions not applying for licenses or charters.
Action to obtain information can be legally complicated, and many regulators prefer not to take the risk of legal proceedings. Too often, statutes do not define and prohibit Ponzi or pyramid schemes, and it is not yet legally clear how such statutes are enforced.
It is puzzling that authorities have problems dealing with pyramid and Ponzi schemes, and that they occur continually. Moreover, as recently demonstrated with what appears to be a multibillion dollar Ponzi operating on Wall Street in the United States, it is a myth to believe that Ponzis, pyramids, and other fraudulent schemes are limited to unsophisticated victims or are most prevalent in shallow financial systems. Indeed, based on numbers alone, the United States has probably experienced more Ponzi and pyramid schemes than anywhere.
Pyramid and Ponzi schemes typically go through the following stages:
• Initiation, when the first subscriptions or investments are handed over
• Validation, when large and easy rewards earned by initial members generate strong word-of-mouth publicity
• Expansion, when a large number of people join or massive investments are received, and
• Collapse, when defaults occur and promoters seek to abscond with invested money.
Too Good to be True
Ponzi schemes are different from, and potentially more dangerous than, pyramid schemes. Ponzis promise to pay relatively high rates of returns for fixed-term investments. Rather than investing collected funds, they initially make promised payouts from subsequent subscribers. Scheme payouts to initial investors build credibility for the schemes to attract more investors. While simple arithmetic shows that the schemes will eventually collapse, successful Ponzi operators use selected payouts to build credibility and get investors to reinvest rather than take payouts. This rollover of funds can let schemes operate for many years before cash flow leads to collapse. Accumulation of liabilities to investors—both principal and promised interest or yields—can grow large enough to be systemic.
Both pyramids and Ponzis typically have no true business activity or investments to generate the promised high returns, although some business, product, or service may be used as a front. In addition, fraudulent operators may use separate schemes, incorporating Ponzi and pyramid characteristics, to prolong operations.
Pillars of the community
Interestingly, many Ponzi operators have managed to extend their operations by ostentatious charitable contributions, significant political contributions, and pretentious demonstrations of their or their scheme's wealth. Prior to collapse, Ponzi operators may be regarded as pillars of their communities. This makes it even more difficult for government authorities to intervene.
Controlling and closing down pyramids, and particularly Ponzi schemes, can be politically difficult—especially if politicians or other important people are subscribers to the scheme. Once they grow, the authorities may be increasingly reluctant to trigger their collapse.
While Ponzis are fundamentally unsustainable, only if a Ponzi scheme collapses by itself will subscribers blame the scheme's operators. If government authorities close or suspend a Ponzi—curtailing the Ponzi's ability to meet its cash flow obligations—faithful subscribers could blame such intervention for their losses rather than the inherent flaws of the financial scheme.
■ The IMF will supply technical support for a Workshop on Dealing with Ponzis, Pyramid Schemes, and other Financial Frauds to be held in Mbabane, Swaziland, in March 2009. The workshop is organized by the Central Bank of Swaziland and will include participants from sub-Saharan African countries.
■ In 2006 the IMF issued a statement to warn the public about fraudulent e-mail messages and financial scams misusing the name of the IMF.
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