China's Fraud Paper Trail Shows Flaws in Booming Funding System

  • Recent incidents at two Chinese banks highlight risks
  • China's bank regulator pushing lenders to tighten controls

An archaic part of China’s banking system meant to provide short-term funding to companies is coming under renewed scrutiny after at least two cases of fraud were uncovered recently.

An alleged fraud of almost 1 billion yuan ($152 million) was discovered late last year at China Citic Bank Corp., where an employee colluded to fake documentation that companies typically use to get quick funds, people familiar with the matter said Thursday. Agricultural Bank of China Ltd. last week announced a 3.9 billion yuan “risk incident” that local media reported was tied to a bills-financing fraud by employees.

Bills financing, also known as bankers’ acceptance, has been rising in popularity in part because it gives banks a low-risk way to circumvent loan quotas. The $700 billion market, which doubled in size in the past two years, also has other pitfalls: Because some 80 percent of transactions are recorded on paper rather than electronically, fraud has been common and illicit proceeds have often been invested in stocks or real estate.

"Bill financing is a business rampant with loopholes and operational risks, and is taken advantage of by many banks for regulatory arbitrage," said Ma Kunpeng, a Shanghai-based analyst at Sinolink Securities Co. “It’s hard to imagine that after so many years the transactions are still mostly done on a piece of paper."

Fake Documents

The bills, in use before the People’s Republic of China was founded in 1949, are short-term debt instruments issued by a company with a maturity of up to six months and guaranteed by a commercial bank, usually as part of a commercial transaction. The bill can be sold to another financial institution or the central bank at a discount before it matures, making it a common tool for obtaining financing.

China’s first law governing bill finance took effect in 1995. Five years later, Industrial & Commercial Bank of China Ltd. set up the nation’s first operations center for such instruments in Shanghai. In 2010, Qilu Bank Co. in Shandong province suffered 2.3 billion yuan of losses after criminals faked documents to defraud the lender through bill financing, and the case led to the departure of its top three executives.

In Citic Bank’s case, an employee at its branch in Lanzhou city allegedly conspired with other people between May and July last year to falsify documents that were used as collateral to obtain a bankers’ acceptance, said the people familiar with the matter, who asked not to be identified as they aren’t authorized to speak publicly. The acceptance was later sold on several times at discounted prices, swelling the size of the total exposure, they said.

Citic Bank said in an e-mail late Thursday that it uncovered a “risk incident” involving 969 million yuan in relation to its notes business, adding that police have started a probe. The bank is cooperating with authorities.

For Agricultural Bank, two bank employees allegedly stole real bills and replaced them with newspapers in the lender’s safe box, according to Caixin magazine. The proceeds were invested in stocks, Caixin reported last week.

Electronic Reform

The recent fraud incidents are being uncovered after Chinese stocks slumped to a 14-month low, crystallizing losses from funds that were siphoned off into equities. Now, the banking regulator is stepping up efforts to curb abuses.

The China Banking Regulatory Commission issued a notice earlier this month asking banks to review bill-financing businesses for violations and risks, people familiar with the matter have said. The CBRC identified violations including fraudulent transactions, the use of the financing to inflate deposits and loans, and adjustments intended to lower capital charges, according to a notice from the regulator seen by Bloomberg News.

Despite a multi-year effort by the central bank to get banks to adopt electronic bill financing, just 20 percent of transactions were done that way in the first half of 2015, People’s Bank of China data shows. Lenders have been reluctant to get on board because the paper-based system allows them to evade oversight and hide irregularities, according to Ma and Chen Shujin, an analyst at DBS Vickers Hong Kong Ltd..

That may start to change as banks take steps to avoid fraud.

"Banks will from now on be more proactive to push for electronic form of bills rather than papers to improve transparency and guard fraud risks," said Chen of DBS Vickers. She said her research shows several big banks now only accept electronic bills for discounting.

— With assistance by Jun Luo, and Steven Yang

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