In the case of a standard investment a business collects funds from people, spend these fund in the real economy to create value. Part of the value added is used to cover the costs and the rest constitute the reward for the investors. It happens that sometimes funds do not go directly to the real economy but are invested in financial assets like stocks of other companies. In either case, a value creation process take place and investors are rewarded from that.
A Ponzi scheme is created by swindlers who attract financial investors with promises about unrealistic returns that are very highly above market rates. In 1920 Mr. Charles Ponzi was promising 50% return in one quarter at a time when bank interest was roughly at 5% per annum. We saw something similar with the B.Madoff case in 2008 and more recently in Mauritius with the Sunkai/Whitedot affair.
Unless someone is Harry Potter, funds injected in capital projects in the real economy or, in the alternative, in a portfolio of financial assets cannot not provide returns that allow initiators of a Ponzi scheme to pay the highly excessive returns promised to those who have provided the schemers with the funds. In order to appear credit worthy the initial investors are rewarded and the money just then comes from new investors who are attracted by the excessively high returns. Often the information is spread by word of mouth from early investors who will implicitly act as voluntary agents and bring in new customers, usually friends and relatives by telling them that this is a promising and safe investment. It happens that initial investors get a financial compensation for bringing new investors.
Initially, it is quite feasible for the plotters to meet their obligations by using a proportion of the funds collected. They thus appear to be credit worthy in the eyes of the general public. They would also at times use part of the money to acquire luxurious office space to create an illusion in the eyes of potential clients who will tend to believe that the business is prosperous. At maturity period, people would initially get paid and be invited would to rollover the investment or at least part of it. That type of scheme works for some time and as long as new investors keep on joining. That is unfortunately not sustainable because there is no value creation process to reward investors. After some time a drying up of new investment is generally observed and cash inflows fall short of cash outflows. The Ponzi scheme collapses because lack of liquidity prevents the schemers from meeting their obligations. Such investment schemes are simply financial scams because right from inception they were designed to swindle people’s savings.
Was Bramer bank’s business model similar? The answer is NO. Was BAI investment doing that? Based on the limited available information, we cannot yet make a conclusive statement.
Ponzi schemes are often unregistered so that regulators have no access to information. Were Bramer /BAI unregistered – the answer is NO. Both were fully licensed operators and were reporting to Bank of Mauritius and to the Financial Services Commission.
Were these two institutions attracting clients with excessively high return? Yes and no. Yes they provided returns higher that what competitors proposed. These rates were known to everybody but were not as excessive as what we see in Ponzi schemes (e,g Sunkai &White dot). That probably explains why nobody decided to not sound the alarm. These financial products have also been approved all financial regulators. If there was a Ponzi scheme the regulators should have queried the Directors a long time back or should have alerted customers to be careful as they did in November 2012 in the context of the Sunkai/Whitedot crisis. The FIU should have already initiated a financial investigative analysis to check for any financial crime.
The Bramer Situation
Should the Bank of Mauritius (BoM) have bailed out Bramer Bank? Bramer was still a profitable bank though not very profitable. It has however for some time been facing a liquidity deficit and also had non-performing loan issues. It must be pointed out that a liquidity deficit situation is something quite normal at the level of individual banks and that can happen to any sound bank on any day. The cash deficit bank can then obtain overnight funds from the interbank market or from the central bank as a lender of last resort.
In recent years, in an attempt to drain a persistent liquidity surplus from our banking sector, the BoM has raised both the fortnight average and the minimum daily cash reserve ratio.
Therefore while the banking system in Mauritius was flushed with liquidity, Bramer bank had been facing a liquidity deficit on a continuous basis. A cash deficit situation that is not one-off but chronic indicates inadequate liquidity management and that has normally far reaching consequences.
Given that Bramer’s situation looks more to be a lingering case of liquidity deficit that prompts several questions:
Under the BoM guidelines to banks on liquidity risk management, internal audit department in a bank is responsible for reviewing the implementation and effectiveness of the agreed framework for controlling liquidity. Did the internal auditors request the top management to remedy the situation? The same guidelines suggest that once being informed of liquidity concern, senior management is to take appropriate remedial actions within the least delay. What actions did they initiate in 2014 to fix the problem?
We have no clear answer to these questions but we all do realize that Bramer did not fix the problem as a matter of urgency, thereby acting for a sustained period in violation of the BoM guidelines and with no fear of sanction. It is then obvious that in spite on the pompous statements made by previous governor Bheenick in the 2014 BoM annual report about strengthening ‘our regulatory and supervisory framework to reinforce the resilience of our banking sector’ in practice the standard , at least in the case of Bramer, was watered down. Thanks to political connections, a veil of legitimacy was provided by the BoM and indirectly by previous government to banksters at Bramer for actions that would typically warrant sanctions. Such collusion between a powerful private group and government reveals the extent to which until recently we were living in a state of crony capitalism that was bound to sooner or later create havoc.
With a change in government it was obvious that BAI affiliates would no longer find it easy as in the past to win public contracts. Sooner or later that was to impact adversely on the level of non-performing loans and liquidity at Bramer. To compound the matter further, in February 2015, the new government has apparently made a withdrawal of around Rs 1.6 bn from that bank. Was there any justification for such a massive withdrawal? Maybe yes, maybe no. Without trying to impute motives, it can nonetheless be considered that this withdrawal has contributed to a further weakening of the liquidity position of a bank that was already financially fragile.
From information published in the press, it appears that in 2015 Bramer Bank tried to obtain liquidity from the interbank market. However, no other bank was prepared to provide such liquidity despite the presence of an excess of liquidity in the banking system. That situation is understandable because since beginning 2015, rumours had it that Bramer bank was in trouble. Given the context, there was then a risk for other banks to accumulate some toxic assets. Additionally, some might have seen it as a good opportunity to let a rival get trapped in the downward spiral.
Quite rightly, in 2015, the BoM asked the management at Bramer to recapitalize the bank so as to clean the mess these banksters created and according to information disclosed in the press Bramer bank was recently willing to recapitalize via an injection of Rs 350 million (?) but needed some time to do so and in the meantime it needed some liquidity which it did not receive neither from the interbank market nor from the central bank.
One should give the devil his due and accept the idea that Bramer’s top management finally agreed to recapitalize the bank. Why then has the banking license been revoked? To be able to better assess the situation let’s recall what happened with Delphis Bank in 2002. Prior to revoking the license of the Delphis bank, the BoM had, on 25th February 2002, pressed the management to request its shareholders to inject, on or before 4 March 2002, additional funds in the bank. Delphis was therefore a given reasonable time (slightly more than one month) to be recapitalized and failure from Delphis to satisfy this condition led to the closure of the bank. That was the right approach because a Governor of the central bank has to be cautious and he did not act as a “samourai” when dealing with a fragile bank. He was concerned with giving a possibility to the shareholders to fix the problem, failing which sanctions would be taken. Rather than adopting a ‘samourai’ approach the governor in 2012 acted with “des mains de fer dans des gants de velours”.That is always a better option, not because it is about doing a favour to those shareholders, but because if the latter decide to recapitalize the bank that tends to be a solution with a reduced social cost.
The approach in the Bramer case appears to be a different one although with the same Governor in office as in 2002. If Bramer needs to be closed down, then let it be so but the timing of revoking the license is debatable. For the sake of transparency it is the duty of the authorities to clarify why, before dropping the axe on Bramer, a reasonable delay has not been granted for recapitalization to be possible.
If the shareholders stood by their words and Bramer had been recapitalized, the shareholders rather than taxpayers would have been made to foot the bill and the social cost would have been lower.
The BAI Case
BAI is a more complex case. In so far as the insurance products are concerned, these have existed for quite some time and it is probably true that some agents might have tried to encourage people to rollover at time of maturity. But that does not constitute enough evidence to allow us conclude that there is existence of a Ponzi scheme. However, the possibility is there because sometimes we do have the combination of legitimate financial activities with Ponzi schemes. In such cases, the initiators would invest the money collected from savers and lend these or acquire financial instruments. However, right from inception they know that the return from the “underlying business” in which they are investing the money cannot be high enough to allow them meet their obligations. Is that the case with BAI? Not sure. So far we only know that BAI was operating with “a substantial proportion of its assets invested in its related companies” and that was in contravention with regulations made by FSC about exposure limits of 10% of the assets in any related company. That over exposure with related companies put BAI in a risky posture and the management was just happy with that until being pressed to improve.
It could be that BAI was excessively optimistic given the crony capitalism framework and it was believed that the intrinsic businesses would flourish and would generate sufficient return to meet the obligations and the attractive returns to savers was to allow them to capture market share from established competitors. There is not yet any evidence to suggest that right from inception there was an intention to rip-off savers. For now this looks more like a case of business failure because of overoptimistic expectations about future cash flows not realized in a context of crony capitalism.
Hyman Minsky (1978, 1992) developed the financial instability hypothesis arguing that the financial system evolves naturally from a stable to an unstable position and that stability is ephemeral and destabilising. Minsky considers that the real problem of economic units is the question of liquidity for survival. A situation where cash inflows from productive assets fall short of outflows from time to time is something inevitable. Firms then issue financial assets to trade future cash flows. Although it eases the liquidity issue, debt-finance leads to the “upward instability” of capitalism. During growth periods entrepreneur’s expectations about future returns are optimistic. Firms are in a robust position because they have a positive net cash flow and can easily meet their financial obligations. Firms are then considered financially safe even if profitability may be low. Was BAI investment in a robust position? That was certainly the case in the past. BAI was in the past both liquid and solvent and no client complained about the fact that these institutions have not met their obligations.
However, a robust position is never a stable position. Should events prove to be less favourable than expected as in the case of a slowdown of the economy, firms move from a robust to a fragile position with expected net cash flow being, for a certain period of time, positive while realised cash flow being negative. Firms then seek additional credit to meet their short term obligations. As expectations are disappointed, financial arrangements are disrupted. From a fragile position firms are pushed to a Ponzi position/posture, which is a situation where expected cash flows are negative and firms’ commitments are chronically above projected cash flows. Firms are then forced to increase their outstanding borrowing to meet financial obligations. A Ponzi finance posture increases the risks of systemic breakdown because of interrelated financial obligations and firms have to sell assets to pay loans. Further, the disposal of assets may lead to a drop in asset prices making the adjustment harder and sometimes “Ponzi” firms turn bankrupt.
The term Ponzi posture used by Minsky in the economics literature has nothing to do with a Ponzi scheme operated by swindlers. It simply means a risky financial posture just like Ponzi schemes are very risky.
Actually any firm in the world, even the top ones, can one day face a shift in financial position from robust to Ponzi (i.e risky) financial posture. Some years back many firms in Mauritius as well as in USA and in Europe were in Ponzi posture, Such financial distress occurs because of unanticipated decline in cash inflows due to unfavourable external environment or because of various forms of mismanagements or a combination of both. Therefore getting into a Ponzi posture has absolutely nothing to do with Ponzi schemes which are financial scams operated by swindlers
What BAI running a Ponzi scheme? There is no evidence so far to suggest that right from inception the financial products were designed to swindle people’s savings. Maybe the authorities are in possession of information that has not been exposed to us. If so, it is their duty to table all these information promptly so as to shed more light on the matter.
Is BAI in a situation of Ponzi Finance? The argument from Hyman Minsky in the economics literature suggests that now yes.
Should a conservator have been appointed by the FSC? The answer is in the positive. This is because (i) as mentioned under section 106 of the Insurance Act 2005, the insurer or its directors have “knowingly or negligently permitted its chief executive officer, any of its other managers, officers, employees, insurance agents or salesperson to contravene any provision of this Act, or any FSC Rule, or any enactment relating to anti-money laundering or prevention of terrorism or guidelines and directions issued by the Commission” and(ii) “the solvency margin of the insurer is or is likely to be deficient”.
The main lessons to this financial disaster are that (i) in a context of financial liberalization, risk management has to be reinforced and (ii) we should be on our toe with those having political power so as to avoid any form of crony capitalism in future.
Dr Karlo Jouan
Bank of Mauritus 2014 Annual Report Bank of Mauritius. Port Louis, Mauritius.
Insurance Act 2005
Minsky, H. (1978) “The Financial Instability Thesis: A Restatement”, Themes papers in Political Economy, North East London Polytechnic.
Minsky, H. (1992) The Financial stability Hypothesis, Working Paper 374, The Jerome Levy Economics Institute of Bond College, May.