Shadow banking, or who is a bank and who is just pretending

The collapse of Amber Gold has generated a number of calls for liquidating parabanks or bringing them, on a mandatory basis, within the scope of oversight. However, identifying financial institutions that are not subject to supervision exercised by the Polish Financial Supervision Authority (KNF) with pyramid schemes is a major simplification.

No explicit definition of a parabank exists. To refer to every non-bank provider of financial services which, however, are not banking services, as parabank is a gross misunderstanding.

Pyramid schemes – ours and someone else’s

In its purest form, pyramid schemes are rarely found and rather in countries with poorly developed financial institutions and a low public awareness of finances. Central and East European countries were most affected by this plague. Luckily, Poland has avoided pyramid scams of a similar size to those in Albania, Romania or Russia.

The Safe Savings Association (BKO) of Lech Grobelny (operated in 1989-1990), the Galician Capital-Investment Trust (GTKI) of Stanisław Kotarba (1991-1992) or Amber Gold of Marcin P. have milked several thousand people of a total of 20-30 million US dollars. For the aggrieved it was a tragedy but this amount made no difference to Poland’s financial stability. When complaining about the ineffectual actions taken by a number of state authorities to address the Amber Gold scandal, let us not forget that in other countries the collapse of pyramid schemes led to revolutions and economic chaos.

Typical pyramid schemes carry on no profit-generating business and they pay out high interest on deposits using funds contributed by new clients. They operate as long as money keeps flowing in. To attract more clients, they are forced to raise the promised interest, especially if a few rival institutions operate in the market. Romania’s Caritas was a pure pyramid scheme. Its owner, Ion Stoica, never concealed the way in which his institution operated.

Most pyramid schemes do, however, carry out some investment activities but their results are insufficient to justify the amount of interest paid out. Charles Ponzi, after whom the “Ponzi scheme” was named, which is the synonym of a pyramid scheme, exchanged European international reply coupons (IRC) used by senders to send return postage for American postage stamps. The return on such transactions was huge. However, financial analyst Clarence Barron calculated that for Ponzi to be making as much as he vaunted, 160 million IRCs would have to be in circulation. Meanwhile, there were only about 27 thousand.

Companies that have simply made bad investments often turn out to be pyramid schemes. Before becoming a fraudster, Bernard Madoff had managed Bernard L. Madoff Investment Securities LLC, a prospering company, and was Chairman of the Board of Directors of the American OTC NASDAQ market. When his business was not doing well any more, instead to admitting it, he offered high returns to clients which he paid with new clients’ funds.

Only for banks

In Poland, the demon asleep in pyramid schemes was roused by Lech Grobelny. In February 1992, members of parliament who were stunned by the collapse of the Safe Savings Association and an epidemic of pyramid schemes in the neighbouring countries, amended the Polish Banking Act (a new Act was enacted in August 1997 and subsequently amended several times).

They included this provision into the Act: “Whosoever:

1)            carries out, without authorisation, the business of accepting funds or deposits from natural persons in order to extend loans or cash advances or use such funds in another way, or

2)            is pursuing gainful activity in contravention of the provisions of the present Act, employs the terms “bank” or “kasa” in the name of an establishment which is not a bank, or to describe or advertise the activities thereof

shall be liable to imprisonment for a term of up to 3 years or restriction of freedom.”

The above cited provision was reiterated in the Banking Act of 1997 (in force in an amended form till today), but it additionally provides for a fine of up to 5 million zloty. Among activities that require an authorisation it also lists activities that “expose such funds to risk in another way”. It seems that the business carried on by Amber Gold meets the statutory criteria of this paragraph.

The Banking Act explicitly defines operations that may be carried out solely be banks, i.e. institutions regulated by special provisions of law and supervised by the Polish Financial Supervision Authority.

These operations comprise:

1)            acceptance of deposits payable on demand or at a specified maturity, and the operation of such deposit accounts,

2)            operation of other bank accounts,

3)            extension of loans,

4)            issue and confirmation of bank guarantees, and issue and confirmation of letters of credit,

5)            issue of bank securities,

6)            performance of bank monetary settlements,

7)            issue of electronic money,

8)            performance of other operations reserved solely for banks under separate legislation.

Non-bank financial institutions cannot extend loans but can grant cash advances. They cannot accept deposits but can… borrow money from clients at interest, intermediate between lenders and borrowers or issue stocks or equities. Financial institutions operating without a specific authorisation cannot expose accepted funds to risk. This implies they cannot, for example, convert funds into loans. Yet, any economic business is a risk-bearing activity and requiring that the KNF or any other state authority eliminate the risk is a misunderstanding.

Oversight, yes, but exercised with restraint

Financial services have evolved and any attempt to define them precisely and cover all entities by financial oversight would not only be difficult but would lead to the winding up of some businesses that perform well and do not expose clients to excessive risk. Businesses that operate without licenses and are not subject to oversight by the KNF carry out such activities as:

extending loans,

accepting cash deposits (in different legal forms, e.g. as loans from clients),

carrying out factoring services or debt selling and buying,

providing payment services (transfers),

intermediating in other services, e.g. dealing with “paper work” related to loans, for a fee.

A growing portion of such services is carried out via the Internet, including via web portals registered outside Poland.

Public warnings of the KNF

The list of KNF public warnings includes sixteen entities accepting cash deposits in order to charge clients with risk. In addition, the Non-Bank Guarantee Fund “guarantees” the payouts of funds invested in entities that do not hold a KNF licence, several firms conduct brokerage activity without authorisation, and – according to the KNF – BNY National Trust Towarzystwo Funduszy Inwestycyjnych SA (eng. BNY National Trust Investment Fund Association), illegally uses the name “investment fund”.

As regards Flexworld Inc. that offered cash advances to borrowers on the condition of a prior payment of a 150 euro registration fee and 1000 euro worth of a Flexworld share, the prosecutor’s office initiated an investigation already in March 2008. In January 2009, Gordon Bartosik-Schmidt, the President of Flexworld Inc. was sentenced to a two-year suspended imprisonment and a 100,000 zloty fine. The company ceased operations.

The prosecutor’s office is also looking at Finroyal, a company registered under a virtual address in London and actually operating only in Poland. In June 2012, Finroyal stopped accepting deposits.

As a matter of fact, Amber Gold has also discontinued its activities.

Perfect Money Finance Corp. is a company registered in Panama which conducts business via the Internet. Weksel Bank – Aida System Sp. z o.o., with its office in Konstantynów Łódzki, has manifestly breached the Banking Act by using the word “bank” in its name. The company lured clients by offering high and quick returns. It organised meetings of prospective investors who were promised to receive a return of 100% for 1 million zloty paid in. In 2009, the company was entered in the KNF public warnings list and… disappeared.

Dobra Lokata Sp. z o.o. was established in 2009. Its capital amounts to 100,000 zloty. It is owned by Wojciech Dziedzic, also linked to the real estate developer BudNest Sp. z o.o. The minimum contribution to the company is 10,000 zloty which the company invests in BudNest Sp. z o.o. The interest offered – 12%, 13%, 14% and 15% – is obviously unrealizable.

Pozabankowe Centrum Finansowe, a company registered in Grodzisk Mazowiecki, has been operating since 2004 and has a few branches in Poland. It started its operations by offering loans. Today, it also accepts deposits of the minimum amount of 5,000 zloty. For deposits exceeding 100,000 zloty interest may be negotiated – up to 15%. The company claims it guarantees 100% of the capital contributed and the guarantee is… its participation in the Rzetelna Firma (eng. Reliable Firm) programme.

PHU PROMOTOR has been sold to the Promotor-Finanse company. The latter offered investment opportunities yielding a return of 4%, 6%, 7% and 9% per month. As soon as the KNF had started to investigate the company, it disappeared.

Lex-Security Mysłowice and Nova New Katowice are tied with Robert Chuchla, a Katowice-based lawyer. They offer financial advisory services, and also intermediate between persons who need loans and those who offer them. It is difficult to question the business as the legal form of the investor’s participation is a loan agreement. Investors have the right to receive profit, which, technically, is calculated and paid as a percentage on the capital engaged. Money is lent to clients for a short term and at very high interest. If managed properly, such a business may survive. However, one condition has to be met: the risk of loan non-repayment has to lie with the lender rather than with the entity intermediating between parties.

The following text can be found on the website of Care&Cash: “CareCash Sp. z o.o. has never accepted and will never accept deposits. CareCash Sp. z o.o. is a company that deals, among others, in extending loans from own funds and as such does not accumulate funds of third parties in order to extend loans using such funds”.

Kasomat does not offer acceptance of funds on its website. It only offers loans that it claims are extended from its own funds. However, the prosecutor’s office conducted an investigation into the company as it used to offer investment schemes.

GoGo20 was established in Thailand. Its owners do not conceal the fact that it is a typical pyramid scheme. In exchange for a transfer of 20 US dollars to the portal’s account, a client (or rather a player) is entitled to part of the money paid in by new clients.

Centrum Inwestycyjno-Oddłużeniowe from Stargard Szczeciński has a capital of 1,000,000 zloty (it is uncertain whether this is true or is just a promise advertised on the website). It accepts deposits, of at least 500 zloty, at a high interest rate – 40% per annum. At the end of July, the company marketed a new “product” – an 8-month term deposit with 15% profit per month for the minimum deposit of 10,000 zloty. This looks like a typical pyramid scheme. The deposit is guaranteed by a… bill of exchange issued by Centrum Inwestycyjno-Oddłużeniowe.

Socket Resources GmbH is registered in Switzerland and, as it claims on its website, it operates in commodity markets. In Poland, clients are offered a profit linked to the investment level, from 16.8% to 26.4% a year; capital is secured with bank deposit and additional bonuses are offered.

Almost nothing is known about IPI CAPITAL S.A. Its website is not operational. According to the National Court Register, the company provides advisory services.

Is Poland at risk of a collapse of pyramid schemes?

The above overview does not confirm the alarming tone of some politicians who, following the collapse of Amber Gold, scare the public by saying that millions have invested money in pyramid schemes. The scale of the investment is significantly smaller, though. Some dangerous businesses are not operating any more. Some are difficult to shut down because they operate just in the form of Internet portals or because agreements they conclude with clients are difficult to be legally challenged. One can, for example, imagine a limited partnership or a limited joint-stock partnership with investors as silent partners who are promised a profit. The partnership may become a pyramid scheme but it is difficult to protect investors against losses.

The KNF does not release the list of parabanks that offer fast cash loans. Yet, some may be more dangerous than deposit-accepting firms. For example, Janvest S.A., established in 2001, offers
6-month loans – from 20,000 to 1,000,000 zloty, bearing a1.6% interest per month  plus a commission of 7.85% at the conclusion of the agreement. Overall, a 6-month effective interest rate will amount to 11.8%, and the annual rate (after 6 months a new agreement may be concluded) stands at 23.6%. It is costly, even for a consumer loan. The loan is quite safe from Janvest’s point of view as it is collateralised with property. For the client who would borrow a several hundred thousand zlotys it may mean dispossession of property. Financial institutions extending uncollateralised loans charge over 100% in interest annually.

As a matter of fact, investment funds have recently generated larger losses for their clients than parabanks. The oversight by the KNF has helped little in this case.

Under the new rules, to take effect next year, financial advisers in the United Kingdom will not be allowed to receive commission offered by financial product providers. According to surveys, advisers often (if not always) act out of self-interest. They offer free of charge advice on products which are paid for by product providers. They ram these products down the client’s throat – the products the clients do not need at all. The amended rules (regrettably, only in the United Kingdom, not in Poland) mean that clients will be directly charged for advice so they will be more motivated to reconsider whether the piece of advice they receive is really sound enough to merit a several hundred or thousand zlotys’ fee.

Shadow banking

Parabanks or even pyramid schemes have often been confused, at least in Poland, with shadow banking entities. Meanwhile, a shadow banking system is understood as more sophisticated financial institutions, such as hedge funds, money market funds and structured investment vehicles (SIVs) that are not subject to financial oversight. They lend money in exchange for low rate of return securities with short maturities, while at the same time execute a reverse transaction on high rate of return securities with long maturities.

The possibility and the need to include these institutions within the scope of banking supervision have been discussed for a long time. There are at least two arguments against the move:

–              shadow banking entities execute operations so quickly that supervisory authorities would not be able to follow them. Auditing annual or even monthly balance sheets would come to practically nothing as these institutions, e.g. hedge funds, are capable of changing their portfolio structure really fast.

–              it is easy to move these institutions to places outside the jurisdiction of financial supervisors, where they will operate as virtual entities (similarly as certain Polish parabanks).

A number of shadow banking entities (especially SIVs) are established by universal or investment banks that are subject to regulatory oversight. Owing to SIVs, banks avoid showing some liabilities on their balance sheets. Whether this should be changed is a topic for debate, but it has nothing to do with the collapse of such businesses as Amber Gold.

It is worth remembering here that many clients of shadow banking entities, e.g. hedge funds, are rich. They can afford to pay not only for  huge operating costs of the funds (they usually pay 2% on asset value and 20% on generated profit) but also the high costs of advisers.


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