The world’s largest bank by assets, the Industrial and Commercial Bank of China (ICBC) is under police investigation over a fraud case reportedly involving RMB 3 billion worth of fake trade bills in the nation’s e-commercial draft system (ECDS). While the traditional document-based trade bill discount is often hit by fraud and the government is encouraging the migration of business from paper-based trade bill to electronic platform, this is the first time that fraud has been reported in the electronic platform. This fraud is not technical (hacking by outsiders/system manipulation by bank insiders) in nature, rather, it is a case of weak internal control and poor setup within Chinese financial institutions and markets. The current system does not fully address operational risk.
Bill financing (also known as banker’s acceptance bills) is a popular form of trade financing. It involves the issuer guaranteeing that he/she will pay its trading counterparty the sum issued under the bill when the bill expires. Backed by the issuer’s bank, the bill is frequently traded at a discount to its face value on the secondary market. Bill financing is also a popular way for companies to get short-term financing. The total balance of trade bills (discounted and undiscounted) hit a peak of RMB 10.4 trillion in January 2016, and by the end of July 2016 the wave of fraud had trimmed the amount by almost RMB 2 trillion.
In the fraud case, ICBC failed to discover that some ex-employees of a small provincial bank from central China’s Henan province, Bank of CTS, used stolen seals and forged documents to open an account at an ICBC branch in Langfang, Hebei province. The imposters then used the account to issue electronic bills of exchange. The bills issued from the fraudulent account amounted to RMB 3 billion. The criminals had cashed out RMB 1.3 billion at HengFeng Bank (HFB) in Qingdao and another RMB 650 million at Bank of XingTai in Henan by the time ICBC froze the account. The case was discovered when HFB conducted a routine internal audit in early August, and bank employees noticed that the fake Bank of CTS bills issued by ICBC paid much higher yields than the market price. Subsequent verification exposed the fraud.
ECDS was set up to minimize operational risk associated with the regular bill discount business in China. The earlier paper-based bill discount business had witnessed many cases of bank insiders acting in cahoots with criminals to steal the bills or commit other fraud. ECDS minimizes human interference and is a more secure system for the issuance, processing, and settlement of drafts, as the electronic medium enables the tracking of the process of drafts at various stages at different banks.
Although much safer than paper processing, ECDS has not been widely adopted. Based on a 2015 review done by the China Banking Regulatory Commission (CBRC), only 395 financial institutions out of more than 4,000 deposit institutions in the country are direct participants in ECDS. The remainder are indirect participants who use big banks as agents, and a good number of them are not plugged into the electronic system at all (for example the principal antagonist in the fraud, Bank of CTS, is not plugged into the electronic system). There are only three banks operating as bill processing agents on ECDS for smaller banks: ICBC, China Merchant Banks, and China Citic Bank. ICBC holds 90 percent market share in this business. After the fraud was discovered, ICBC suspended its electronic draft agent business on August 11.
The incident points to serious internal governance issues with individual institutions as well as an inherent systemic risk from the absence of a synchronous regulatory framework.
Information revealed in the Chinese press pointed to the failure by ICBC to properly verify the identity of the persons opening the account. The CBRC requires large banks to conduct face-to-face interviews to verify the client’s identity when opening an account for small lenders. However, in the case of Bank of CTS, the scammers opened the account after only a phone interview.
The incident points to serious internal governance issues with individual institutions as well as an inherent systemic risk from the absence of a synchronous regulatory framework. Both Bank of CTS and ICBC were remiss in their monitoring of current and former employees’ activities and both failed to follow the know-your-customer (KYC) rules for opening accounts. However, the absence of an officially sanctioned robust trading platform is another major cause of the fraud. It should be noted that ICBC pioneered the precursor of the ECDS platform as an inter-branch bill discounting verification system, and the system was subsequently modified and adopted by CBRC as the nationwide ECDS trading platform. Thus far, the system is robust and no fraud was reported when it was used in-house at ICBC or when it is adopted by CBRC. The fraudulent account opening would have been easily detected if Bank of CTS was hooked into the system.
The fraud case exposes the sad reality that many credit issues in China’s financial sector are tied to operational risks, although the country possesses the technical infrastructure to address those issues. ICBC is probably the most IT savvy bank in the world and its IT system cleared close to 500 million daily transactions in 2015. The bank has an in-house IT department of more than 20,000 employees and it had been running its IT function in-house since 2000. The bank is an acknowledged leader in IT infrastructure in the country. Perhaps it is a change in operational philosophy that is needed in addressing the current dilemma.
Recently, the People’s Bank of China promulgated regulation Yin Fa  No. 224 in early September. The regulation significantly promotes the use of electronic commercial drafts by banks and companies. The new rule sets caps on the use of paper-based bills. All commercial drafts worth RMB 3 million or more must be handled by the electronic platform effective January 1, 2017.
The speedy implementation of the transfer of the paper based system to the electronic platform demonstrates the information processing capacity of the system and the readiness of the Chinese regulatory agency to utilize high-tech solutions to mitigate operation risks.
The delay in operational reform of the Chinese financial sector is probably due more to the inertia of the system than the lack of a supporting technical platform or indigenous technical capability. From new regulations on universal life products, new rules on peer-to-peer lending, new rules on bond issuance, and the current measures to address operational risks of bill discounts, the Chinese regulators’ reaction times to exposed problems are speedier now than any time in recent memory.