Robi Dattatreya, managing director Total Solutions Europe and Guido Kalmijn, consultant for ABN AMRO Asset Management, follow last month's analysis of the collapse of Barings with a look at Daiwa
At the end of July 1995, the chairman of the Management Board of Daiwa Bank in Tokyo received a 30-page letter from Toshihide Iguchi, executive vice president in New York, in which he confessed to having lost approximately $1.1 billion while trading in US Treasury Bonds. In his letter, Iguchi explained that over the preceding 11 years he had managed to conceal losses in his trading activities by falsifying the custody data.
Daiwa Bank opened its office in the US in the 1950s. In the 90s, Daiwa was the sixth largest bank in Japan, and ranked as twelfth largest in the world. Daiwa began trading in US Treasury Bonds as a service to its customers and, in the 80s, evolved into a major player, being awarded primary market dealer status in 1986.
In 1996, as a result of the fraud and the way the management subsequently dealt with it, Daiwa Bank was forced to pull out of the American market. The fraud at Daiwa was ultimately one of the largest in history, involving about $200 million more than the fraud committed at Barings. The fact that Daiwa itself was able to cushion the losses is probably the reason why it made less impact than the Barings fraud. This article first examines the career, duties and responsibilities of Toshihide Iguchi, the central figure involved, and provides background information about the organisation. It then looks at the fraud and the way in which the losses were obscured. It finally sets out what Daiwa NY did after Iguchi admitted his fraudulent operations.
Iguchi and his responsibilities
Toshihide Iguchi joined Daiwa in 1977, starting work in the back office where he was responsible for custody operations. An American born in Japan, Iguchi had studied psychology at an American university. The custody department was responsible for administering and keeping custody of securities for Daiwa and its customers, receiving or delivering securities when purchase and sale transactions took place, and paying interest and dividends on securities held in custody. The securities that Daiwa held were partly owned by Daiwa itself through its own positions, and partly owned by customers who had placed them in custody with Daiwa. On behalf of Daiwa, the T-Bonds securities were for their part kept by Bankers Trust, where Daiwa had a sub-custody account. Bankers Trust reported to Daiwa's custody department and not directly to Daiwa's customers. It was the responsibility of Daiwa's custody department to reconcile the Bankers Trust sub-custody account with its own books. Daiwa's reports to its customers and supervisors were based on its own books. The customers in turn reconciled Daiwa's reports with their own books. In 1984, Iguchi was given a new position as trader in T-Bonds. Despite this new position, he also retained responsibility for the custody department in the back office. He continued to hold these two positions until he confessed his fraud.
No separation of responsibilities
Initially, the New York office was situated on Broadway in downtown Manhattan, New York's financial district. In 1986, with the permission of the Japanese Ministry of Finance, Daiwa later moved to an office in Rockefeller Plaza in Midtown Manhattan. Daiwa reported to the Japanese Ministry of Finance that trading activities would be concentrated in the midtown office. The management was there and it was able to exercise sufficient supervision over trading activities. Daiwa held onto the downtown office space in order to have somewhere close to Wall Street for settling security transactions.
As head of the custody department, Iguchi was stationed in the downtown office. However, a problem arose when trading operations moved to the new midtown office. The fact was that he could not be responsible for custody operations in the downtown office and at the same time trade on the stock exchange from the midtown office. The idea was that Iguchi would no longer be involved in trading operations. The actual situation after 1993, however, was that trading was still taking place from the downtown office, that Iguchi supervised traders in that office, and that he also traded independently.
Daiwa's management was aware of all this. Given the separation-of-responsibilities requirement, it was inappropriate anyway that Iguchi had responsibilities both in the front and back offices. But by moving part of the staff to the midtown office, it became even more difficult for the management to exercise supervision.
This non-separation of responsibilities was comparable with Nick Leeson's position at Barings in the same period, and was quite common among small organisations at the time. Supervisors and accountants, however, were already warning of the risks of such constructions.
Daiwa also reported its proposed Chinese walls to the US Federal Reserve Board (the "Fed"). However, they were not put in place. During audits, to keep trading activities in the downtown office hidden from supervisors, traders were moved temporarily to the midtown office, while the trading part of the downtown office was disguised as storage space. Eventually, in 1993, Daiwa admitted this to a Fed auditor.
The losses
In 1984, shortly after Iguchi started as a trader, he suffered his first loss, which amounted to $200,000. He tried to recover it by trading aggressively, but lost even more. The losses increased gradually, from $31 million in 1984 to three times that in 1987. In 1987, these losses were disguised through a legal entity in the Cayman Islands. Finally, in 1995, losses totalled over a billion dollars.
Not wanting to lose his job, Iguchi decided to conceal the losses. He later said himself, "There is always a way of cushioning your loss. As long as that possibility exists, you can do two things: admit your loss and lose face as well as your job, or wait until the opportunity arises to recover the loss."
The loss-making transactions were not entered in Daiwa's books. Only profitable parts of the transactions were booked, to create the impression that the trade in T-Bonds was profitable. Over the years, ever more complex trading strategies were employed in order to be able to book profitable parts of the transactions.
The losses were covered by selling T-Bonds held by the custodian. Until November 1990, Iguchi used securities belonging to Daiwa's customers; from 1990 on Iguchi also sold T-Bonds from Daiwa's own position. These sales were obviously not entered in Daiwa's books.
Deception regarding reconciliation
Bank statements from the custodian, Bankers Trust, were sent to Iguchi, head of the custody department.
Iguchi received these and then falsified them, first using a typewriter and later a text processor. On these falsified statements, the positions corresponded with the positions as shown by Daiwa's books, i.e. just as if no unauthorized sales had taken place. Iguchi himself kept Bankers Trust's original statements. He still had all of them at hand when the fraud was finally exposed.
The task of Daiwa's custody department was to reconcile the Bankers Trust accounts with Daiwa's own books. The actual reconciliation was carried out by employees, but for their task they were given falsified statements by Iguchi, their boss. These employees did not have independent access to Bankers Trust statements. They compared the statements given to them by Iguchi with data from their own books in which Iguchi had entered the transactions. Logically, they noticed no problems.
From time to time, customers of Daiwa issued instructions for the transfer of securities, based on the (false) statements they received. Regular interest payments on the T-Bonds also had to be made to customers. In such cases, Iguchi sold more T-Bonds from the Bankers Trust custody accounts and used the income to buy back the required securities or pay the coupon rate to customers who were entitled to it. Using about 30,000 unauthorised transactions, Iguchi sold a total of $377 million of customers' T-Bonds securities over a period of 11 years; the remainder of the $1.1 billion in T-Bonds securities was from Daiwa's own positions.
None of these 30,000 unauthorised transactions were noticed by accountants or supervisors. Not only were customers given false statements to hide the actual state of affairs, auditing agencies such as the Fed were given false information, losses suffered being concealed from them. Daiwa was obliged to provide the Fed with a quarterly statement of assets and liabilities. While the fraud was being committed, Daiwa systematically reported incorrect data to keep the losses hidden. It continued reporting falsely to the Fed even after the fraud had come to light internally. In the report for the second quarter of 1995, drawn up after the fraud had become known internally at the end of July, Daiwa reported a total of over $615 million to the Fed. Of this, Iguchi had already sold about $600 million.
Discovery of the fraud
Eventually, on 13 July 1995, Iguchi confessed the fraud in a letter to the chairman of Daiwa's management board. At first, unaware that he had committed fraud, Iguchi presumed he had violated internal rules. With his confession, Iguchi wished to make the fraud known internally and give Daiwa the opportunity to save the situation. At the end of July, Daiwa NY's management had internal information about the fraud as well as the scale of it.
At first, Daiwa decided not to report the matter to the Fed but rather to plug the gaps. In its quarterly report to the Fed, the amounts stated were as if no one knew about the fraud, while the management was well aware at the time that the amounts were incorrect. The Daiwa New York management also instructed Iguchi to continue trading fraudulently until a solution had been found. Thus instructed, Iguchi continued selling customers' securities for four weeks after the fraud had become known internally in order to be able to meet delivery obligations and make interest payments to other customers. In the middle of August, at the home of Daiwa NY's general manager, Iguchi reconstrued the positions in missing T-Bonds securities based on Daiwa's books at the time (which gave a false account of them) and the statements from the Bankers Trust sub-custody account (which gave the actual tradable positions). The total deficit in T-Bonds securities was calculated at $377 million for customers of Daiwa and over $600 million for Daiwa's own account.
Three weeks after Iguchi's confession, the authorities in Tokyo were informed of the fraud. At that moment, the Fed knew nothing. The Japanese authorities themselves did not inform the Fed. Their failure to do so put pressure on banking relations between the US and Japan. The credibility of Japanese supervision authorities and creditworthiness of Japanese banks were rocked by this scandal. According to some sources, the surcharge that Japanese banks were required to pay over and above the AIBOR ('Amsterdam Interbank Offered Rate') rose at that time from 0.1% to 0.25%, making loan costs higher for the entire Japanese banking sector. Daiwa NY intended keeping the fraud hidden from the Fed, transferring the losses to Japan to avoid monitoring by the American authorities and to prevent any risk to its banking license. Together with Iguchi, Daiwa conceived a plan to transfer from Japan the missing $377 million in customer securities so that customers would be none the wiser about the fraud. Another fact that had to be concealed was that Daiwa NY did not have the reported $615 million in T-Bonds. The ultimate intention was to ensure that the loss of $1.1 billion was kept from Daiwa NY's books.
To accomplish this, Daiwa at first wanted to use the same legal entity in the Cayman Islands that had figured previously, when the multimillion dollar loss of 1987 was obscured.
However, Daiwa decided on another course of action. Daiwa NY 'sold' the missing T-Bonds effects to Daiwa Japan, for which Japan paid $600 million. This amount was then lent directly to the same Daiwa office in Japan, meaning no money changed hands in the entire transaction. In this way the (missing) T-Bonds securities disappeared from Daiwa NY's balance sheet, being replaced by a loan to Daiwa Japan of the same value.
An internal audit was planned for the end of August 1995. The management of Daiwa NY was still busy moving the loss to Japan and keeping it hidden from the American authorities. A possible consequence of the internal audit was exposure of the fraud. Daiwa tried to persuade employees to postpone the audit.
However, they were reluctant to cooperate. The general manager of Daiwa New York then announced that Iguchi would be on leave during the audit, meaning it had to be postponed anyway. At the time, Iguchi was in the general manager's house reconstruing the positions and transactions in missing T-Bonds securities.
In the middle of August, Daiwa employees had already pointed out to the general manager of Daiwa NY that Daiwa was obliged to report the fraud. If Daiwa failed to do so, employees themselves could be personally liable. To this the general manager responded that he would assume all responsibility for late reporting. In the end, on 15 and 18 September, two months after the fraud had become known, Daiwa representatives informed the Fed that Iguchi had caused losses to Daiwa NY amounting to $1.1 billion.
Daiwa was indicted on 24 points, including obstruction of the Fed's auditing processes, making false and fraudulent statements, falsifying its own accounts with the object of misleading the Fed and other authorities, concealing felonies, failure to report observed felonies, and conspiracy.
Iguchi was sentenced to four years' imprisonment and given a fine of $2.6 million, the forecast receipts for a book he was to write about the matter. Daiwa itself was fined $340 million and forced to cease all its banking operations in the US, with the exception of its assets management activities.
Following the fraud, a group of Daiwa shareholders brought legal action against 11 Daiwa senior executives in a court in Osaka, Japan. In September 2000, the court ordered the executives to pay over $750 million in damages to the bank, because they had not succeeded in preventing the employee in question from committing fraudulent acts.
In a later interview with Time magazine, Iguchi himself said, "It was not my intention to steal from the bank.
I was not strong enough to admit my own losses. Looking back, I could have stopped myself somewhere along the line. I wish there had been someone else who stopped it all for me."
This article was written in a personal capacity by: Robi Dattatreya, managing director Total Solutions Europe and Guido Kalmijn, consultant for ABN AMRO Asset Management.
© Banker Middle East 2006
