Many of the scams of the pre-reforms era occurred because the hucksters were able to take advantage of yawning regulatory gaps in the market. Some of these scams and dirty trades spilled over into the post-reforms era too. One good example is the Harshad Mehta-led securities scam, which is analogous to the tip of the iceberg. Below that tip sat a myriad of other malpractices, which were essentially arbitrage plays between different instruments and markets, funded in a manner that skirted the existing rules and approved processes.

Many of these transactions and deals were outright illegal, while many existed in the grey areas of legitimacy. An example of the ‘grey zone’ scams was the trading in units issued by the government-owned mutual fund, Unit Trust of India, which was set up by an Act of Parliament. These units were popularly called US-64, after the year of their launch. The idea behind a government-owned mutual fund was to create another means for channelizing household savings to the capital markets.

The fund’s net asset value, or NAV, was never declared, but its sale and repurchase prices were announced at the beginning of the fund’s financial year (June). The two prices could also change every month and there was a secondary market for these units, the price of which fluctuated within the sales-repurchase band.

The funny thing is that these prices often had no connection to the fund’s real, intrinsic value, which the NAV ideally represents. The fund also declared a dividend every year, which kept rising every year and helped create the illusion of assured returns, thereby leading to higher inflows of household savings.

Savvy traders always bought units from the open market before the fund’s annual declaration of dividend and salesrepurchase prices. These units, pregnant with dividend, would be available at a premium. Once the dividend was declared, the price would readjust downwards, whereupon the trader would sell them at a lower-than-purchase price and book a loss. This trading strategy allowed traders to adjust their dividend-based taxable income against the capital loss arising from their unit purchase-sale transactions. Plus, the overall capital loss also helped in setting off other tax liabilities incurred during the year.

Traders were, essentially, adjusting one kind of income against another kind of pecuniary loss. While this was not strictly illegal, it was still bad accounting practice because it involved the adjusting of apples against oranges. However, traders indulged in it because the tax laws did not explicitly forbid the dodge. In fact, Manmohan Singh stopped this rampant practice in the historic 1991 budget speech: ‘The present provision for offsetting short-term capital losses against income leads to tax avoidance. I, therefore, propose that any loss on transfer of a capital asset will be set off only against gain from transfer of another capital asset. This is only logical. It should also stop the practice of buying short-term capital losses being resorted to by some unscrupulous tax payers.’

Cover of Slip, Stitch & Stumble: The Untold Story of India’s Financial Sector Reforms, by Rajrishi Singhal, published by Penguin Random House India

But some of the other scams of the later years made this tax-arbitrage trade—which, by the way, was legitimate—look like child’s play. As has been illustrated in this chapter, the pre-reforms Indian financial system often played host to scams, frauds, funds misappropriation and forgery. The frequency and nature of these mishaps may have been varied, but they have been a regular feature in the Indian financial system.

It might be tempting to think that scams and crises are unique to the Indian financial system. It is not; all financial services industries across the world, whether in the developed economies or the emerging markets, have seen scams and frauds. Here are two examples.

Former chairman of the stock exchange NASDAQ, Bernie Madoff, was considered an investment guru and his promises of high returns enticed investors—from individuals to even pension funds—to entrust their savings to him. In the aftermath of the 2008 financial crisis, when investors started asking for their money, Madoff was unable to repay. It eventually transpired that the investments were not yielding the outlandish returns he had promised and that he was using fresh investor inflows to pay back existing investors. It is estimated that Madoff lost about $20 billion of investor money and was sentenced in 2009 to 150 years of prison time. He died in April 2021.

The second example relates to US-based bank Wells Fargo, which was reputed for its prudent management, emerging unscathed from the 2008 financial crisis even after acquiring failed bank Wachovia. In a complete reversal of fortunes, news emerged in 2016 that Wells Fargo had fraudulently opened millions of savings and checking accounts in the names of the bank’s existing clients without seeking their consent, transferred money surreptitiously from existing accounts to the new ones and sold credit cards and other financial products to these fake accounts. The ostensible reason for this underhand activity was to demonstrate growth in the bank’s sale of financial products.

On complaints from some customers, regulators cottoned on to the fraud in 2016 and fined the bank $165 million; the bank faces additional damages of $3 billion in civil and criminal suits. One of the enduring themes in all these Indian scam episodes has been that of hucksters exploiting regulatory deficits or artificial barriers between different markets or instruments with varying yields. Money, like water from a higher level to a lower one, will flow from low-yielding financial instruments to high-yielding ones. If artificial barriers are stopping this flow, people managing this money will always find ways to side-step the rules or even break them outright.

Excerpted with permission from Slip, Stitch & Stumble: The Untold Story of India’s Financial Sector Reforms, by Rajrishi Singhal, published by Penguin Random House India, 326 pages, ₹599.