The Alchemist's Handbook to India's Financial Secrets
BY PREETHA MUKHERJEE / SEPTEMBER 14, 2024
DESIGNED BY RIDDHI JAIN
Alchemy is about distortions, a process so effective it seems like magic. Surprisingly, financial markets work in a similar way. Markets consist of financial intsruments that hide their true financial health using alchemical processes fraught with deception.
ompanies often create complex financial products and use off-the-books accounts to conceal debt and risks, making themselves look healthier than they are. They might report revenue too early, inflate asset values, or engage in fake trades to show false growth. Insiders can manipulate the market by spreading positive news and then selling their stocks at high prices. These tactics project pseudo stability and success, hiding problems that can lead to unexpected economic troubles when revealed.
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Thus, while finance and alchemy might appear to be opposing concepts, they complement each other perfectly. Financial alchemy uses clever methods to hide a company's true financial state and manipulate how the market sees it. Scientific method seeks to understand things as they are, while alchemy seeks to bring about a desired state of affairs. To put it another way, the primary objective of science is truth - that of alchemy, operational success (Soros, 1987). This embodies the enigmatic and intricate nature of financial markets, where distortions and ambiguities are skillfully manipulated to serve the interests of a select few, often manifesting as financial fraud.
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Each participant in the market seems to operate within their own perception of truth and market reality, creating a complex web of individual narratives that challenge the notion of a singular financial truth.
By creating an illusion of value and masking the actual state of economic health, companies significantly impact India’s landscape. Each participant in the market seems to operate within their own perception of truth and market reality, creating a complex web of individual narratives that challenge the notion of a singular financial truth. This dynamic interplay of perspectives underscores the inherent fluidity and susceptibility of financial systems to manipulation and deception.
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With a vibrant history of financial alchemy, India ranked 93rd out of 180 countries on the 2023 Corruption Perceptions Index, with its overall score remaining relatively unchanged, according to a report by Transparency International (Transparency International, 2023). The Harshad Mehta scandal of 1992 stands out as an infamous example. Mehta, a stockbroker, manipulated stock prices using the banking system's funds, creating an artificial boom in the stock market. In the early 1990s, India’s credit system was tightly controlled by the government. They set interest rates and required banks to lend 40 percent of their funds to priority sectors, with specific targets for different areas within those sectors.
Seeing Mehta's swift and intricate securities transactions, the banks were eager to capitalise on his transactions for quick profits. This symbiotic relationship allowed him to orchestrate one of the most notorious financial scams in India's history. When the scam was uncovered, it led to a market crash exposing significant regulatory gaps and resulting in losses for countless investors.
Despite the Harshad Mehta scam, it seems the lessons weren’t fully learned, as the Satyam scam of 2009 became the epitome of financial alchemy in India. Ramalinga Raju, the founder and chairman of Satyam Computer Services, admitted to manipulating the company's accounts and inflating profits for years. Estimated at around INR 14,000 crore, the scam severely undermined the confidence of investors, shareholders, and stakeholders in the Indian corporate sector (The Hindu, 2015). This case was a pivotal moment in corporate history, underscoring the critical need for increased corporate governance, transparency, and ethical conduct in business. Its repercussions echoed far and wide, prompting significant changes in corporate regulations and auditing practices both in India and around the world: a transformation towards greater accountability and integrity in the corporate landscape.
As a result, the Companies Act of 1956 was replaced by the Companies Act of 2013 which had clauses for greater accountability and transparency for companies. Additionally, a new provision for auditor rotation was adopted, requiring auditors to be replaced after five years and audit firms to be changed after 10 years. It also stipulates that the Director's Responsibility Statement, a declaration by a company's board of directors, affirming their accountability for accurate financial reporting, compliance with laws, and effective internal controls, should be included in the Board of Directors' Report. This ensures transparency and builds trust among stakeholders. Furthermore, the Serious Fraud Investigation Office was founded, and was given the status of a statutory body under the Companies Act of 2013, which looks into business and accounting fraud (Ministry of Corporate Affairs, 2013). These regulations are proving to be effective in raising accountability of companies and are at par with international standards.
However, the practice of financial alchemy still remains prevalent in India, as exemplified by the recent Infrastructure Leasing & Financial Services (IL&FS) scam in 2018. By using complex financial structures and creative accounting, IL&FS hid its true debt levels and liquidity issues, misleading investors and regulators. The company borrowed heavily through short-term loans to fund long-term projects, leading to a liquidity crunch when repayments were due. This false sense of security attracted more investment, perpetuating the cycle until the company's collapse revealed the underlying financial instability.
The crisis revealed major regulatory failures, drained liquidity, and disrupted the financial system, showing the dangers of risky financial practices. It led to tighter credit availability, particularly affecting Non-Banking Financial Institutions reliant on short-term borrowing. Interbank lending froze, while increased regulatory scrutiny further stalled economic activities and exposed significant systemic vulnerabilities. Further, the severe liquidity crisis struck the corporate sectors. It resulted in the downfall of major corporations such as DHFL and the Reliance Anil Ambani Group. DHFL faced mounting debt and eventually went into bankruptcy, with its assets being auctioned off to repay creditors. The Reliance Anil Ambani Group struggled with significant financial distress, leading to defaults on debt obligations and a dramatic decline in the company's market value and operations. Additionally, the situation led to banks and mutual funds especially to struggle, which made it harder to get loans and caused severe financial stress to people. The crisis resulted in over INR 1 lakh crore in debt, with only INR 55,000 crore addressed, leaving about 62% unresolved (IL&FS: The Crisis That Has India In Panic Mode, 2018).
After the IL&FS crisis, the Securities and Exchange Board of India (SEBI) enhanced its regulatory framework to address systemic risks and improve market stability. Key measures included revising corporate governance norms under the Listing Obligations and Disclosure Requirements (LODR) Regulations to strengthen board oversight and disclosure practices. SEBI also overhauled regulations for Credit Rating Agencies (CRAs), requiring more rigorous rating methodologies and internal controls. Additionally, stricter disclosure and reporting standards for listed entities were introduced,
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which mandated improved risk management practices, and increased market surveillance using advanced analytics to detect and prevent regulatory breaches. Since 2019 these much needed steps have helped at restoring investor confidence and preventing future financial misrepresentations, and has increased accountability of auditors in the country (Rao Prassada, 2019).
The cultural norm of speculative trading and herd behaviour during market fluctuations perpetuates financial illusions, making it difficult to prioritise ethical financial practices over creative exploitation of loopholes.
FACTORS INFLUENCING FINANCIAL ALCHEMY
Culture deeply impacts financial practices by shaping attitudes toward risk, investment, and innovation. For instance, in Ghana, cultural values lead to a preference for short-term, risk-free investments, reflecting a focus on security (Bonna, 2020). On the other hand, Indian culture is more focused on the concept of jugaad (improvisation) which drives market dynamics, often justifying rule-bending for quick gains. This mentality fosters an environment where corrupt practices thrive, complicating efforts to improve transparency and regulatory compliance. The cultural norm of speculative trading and herd behaviour during market fluctuations perpetuates financial illusions, making it difficult to prioritise ethical financial practices over creative exploitation of loopholes.
The objective reality and the subjective reality of the market also deeply influence and perpetuate financial alchemy. Market participants act based on their perceptions, which influences the market and alters objective reality. This new reality reshapes their perceptions, leading them to take further actions. This cycle can intensify, causing market movements that deviate sharply from what's expected based on fundamentals alone. An example of this is the 2008 Financial Crisis:rising house prices triggered more borrowing and lending, which further inflated prices. Recognising this feedback loop and the growing gap between house prices and their actual value could have helped investors foresee the market crash.
Yet, change is on the horizon. While it will not be quick or easy, the rules are starting to shift. Public frustration with poor governance, stringent anti-corruption laws such as the Prevention of Corruption (Amendment) Act, 2018 (the “Amendment Act”), are driving a movement toward greater accountability.
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India is also leveraging technology to prevent financial scams. The Reserve Bank of India (RBI) has introduced the Legal Entity Identifier (LEI) to combat the problem of dubious businessmen fleeing with large sums of taxpayer’s money. (Reserve Bank Of India, 2022). LEI is widely regarded as a critical measure for improving the quality and accuracy of financial data through better risk management. It is a unique 20-digit global reference number that identifies a company. After a certain date, entities that do not have an LEI code will not be granted credit facility renewal or enhancement. The RBI has mandated a phased implementation of the LEI for all Indian bank borrowers.
Further, banks should capitalise on breakthroughs in AI and ML technology. JPMorgan Chase is increasingly leveraging AI and ML technology to provide next-generation banking solutions. In 2017, the company introduced Contract Intelligence (COiN) chatbots that are designed to extract important data points and analyse legal documents. In June 2021, the company was ranked the largest bank in the U.S., with total assets worth USD 3.684 trillion (The Hindu, 2023). Financial institutions should ideally build or integrate advanced fraud prediction models through this technology to proactively detect irregularities and weed out suspicious applicants. It would improve ambiguity in the system that leads to the easy distortion of the market.
To address financial alchemy in India, we need more than just stopping financialisation; we must understand how market distortions influence our reality.
To address financial alchemy in India, we need more than just stopping financialisation; we must understand how market distortions influence our reality. While mob psychology and irrational excitement often mislead us about fraud, today's challenges require deeper analysis. Just as distortions inspire innovation in areas like data science and music, studying financial "noise" can help us uncover hidden truths. To detect financial alchemy, individuals must stay informed and cautious. Investors should educate themselves on market basics, be wary of unusually high returns, and question trends that seem too good to be true. By focusing on transparency and critical thinking, they can protect themselves from scams and help build a fairer economic system.
Keywords
Financial alchemy, Debt concealment, Harshad Mehta scam, Auditor rotation, Corporate governance norms, Anti-corruption laws, Artificial Intelligence, Risk management, Fraud, Transparency
References
Athanasiou, A. K. (2023, October 9). Finance As Alchemy. Aeon. https://aeon.co/essays/finance-fraud-is-not-a-deviation-from-the-norm-but-a-reflection-of-it
IL&FS: The crisis that has India in panic mode. (2018, October 1). The Economic Times. https://economictimes.indiatimes.com/industry/banking/finance/banking/everything-about-the-ilfs-crisis-that-has-india-in-panic-mode/articleshow/66026024.cms?from=mdr
India ranks 93 out of 180 countries in corruption perceptions index 2023. (2024, January 31). The Hindu.
Palande, P. (2014, August 20). Economic Milestone: Stock Market Scam (1992). Forbes India. https://www.forbesindia.com/article/independence-day-special/economic-milestone-stock-market-scam-(1992)/38457/1
Ratchana, R. (2022, November 23). Mitigating and Reducing Banking Frauds with Recent Developments in Technology. Times of India. https://timesofindia.indiatimes.com/readersblog/educurioso/mitigating-and-reducing-banking-frauds-with-recent-developments-in-technology-46948/
Satyam Scam, Satyam Scandal - Definition, What is Satyam Scam, Satyam Scandal, Advantages of Satyam Scam, Satyam Scandal, and Latest News. (2023, December 18). ClearTax.
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