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. Last Updated: 07/27/2016

Scandal Opens Up Local Banking Wonderland

Not long ago, MDM Bank, one of the hundreds of modest-sized banks that sprang up after the collapse of communism, offered a service that allowed companies to cut costs, at the government's expense. Instead of paying salaries to their employees - and the associated pension contributions to the government - the firms gave the employees interest payments on company deposits in the bank.

Though MDM has discontinued the service, it is an example of the Alice-in-Wonderland world of local banking, where such complex maneuvers have been common.

"A major business for Russian banks is to find ways to do transactions in an economically efficient way," said Richard Hainsworth, the Moscow representative for Thomson Financial BankWatch, a credit rating agency. "And that means getting around taxes and getting around obstructions. That is the way you survive in the Russian environment."

Such was the state of banking when billions of dollars slipped out of the country from 1996 to 1999 in an alleged tax-dodging and money-laundering scheme that has resulted in some criminal charges, including those against a former Bank of New York executive.

U.S. prosecutors have not charged the Bank of New York with any crime. But, seeking to untangle the money-moving maze, the prosecutors have been looking at MDM and three other Russian banks mentioned in documents filed in the Bank of New York case.

Lucy Edwards, a former Bank of New York executive, and her husband, Peter Berlin, pleaded guilty in February to a range of criminal charges, including money laundering. According to the charges filed against the couple, MDM and Sobinbank were the principal owners of DKB, one of two conduit banks involved in an operation that moved some $7 billion through front-company accounts at the Bank of New York.

MDM and Sobinbank, the charges say, also helped raise capital in 1996 for the other conduit bank, Commercial Bank Flamingo. And both, prosecutors add, did move money through correspondent accounts at the Bank of New York.

DKB has lost its banking license, according to the Central Bank's web site. Flamingo was raided last fall, and Russian prosecutors have brought charges o f illegal banking activity. Sobinbank was also raided, but says it has not been told of any charges.

MDM and Sobinbank both say they have done nothing wrong. They argue that what they did do they did at the direction of clients, and that the web of interconnections in banking has confused prosecutors. Gleb Kostin, 30, the deputy chairman of MDM, argues that the only problem is "the cultural difference" between the United States and Russia. U.S. prosecutors, he said, "don't know anything about Russian banking."

Nonetheless, a look at the banks mentioned provides a glimpse of the tangled local banking world.

As First Deputy Prime Minister Mikhail Kasyanov acknowledged at a briefing in Washington, most Russian banking institutions "have never been banks in the real sense."

Often, they were the private preserves of their owners, known as pocket banks or political banks, giving the owners a ready source of money for investments. In fact, Sobinbank's 1998 annual report, the latest one written under international accounting standards, suggests it was a pocket bank, existing for the needs of its investors. It gave out 80 percent of its loans that year to just five borrowers, whom it would not disclose.

The report also shows that Sobinbank moved a big portion of its assets - nearly 40 percent - outside the country. In 1998, Sobinbank had foreign exchange transactions totaling 3.14 billion rubles (about $515 million before the August 1998 devaluation and about $110 million at current rates) with one related party that the bank refused to name. The transactions indicate it was outside of Russia.

MDM, whose formal name is Moscow World Business Bank, and Sobinbank are, typically, politically connected. And they illustrate the intertwining relationships common in local banking.

At one time, each had investments in the other. And Alexander Mamut, a young banker who was closely tied to the inner circle of former President Boris Yeltsin, has held high positions at each bank, including his current post as chairman of MDM's coordination council.

One of Sobinbank's main investors was SBS-Agro, a bank headed by Alexander Smolensky, who has ties to the prominent financier and media mogul Boris Berezovsky. (SBS-Agro largely collapsed during the 1998 financial crisis along with many other banks.)

Sobinbank and MDM also illustrate the kind of activities that stretch the use of the word "bank."

In the salary-substitution scheme offered by MDM Bank, a company would take a loan from the bank and redeposit the cash from the loan in the bank. It would then make interest payments on the loan. The bank would pay a higher interest rate on the deposit than the company paid on the loan, and the difference would be paid to the company's employees instead of a salary. The banks received compensation for providing this service through other complex moves.

Kostin, MDM Bank's deputy chairman, reluctantly acknowledged the existence of the ploy but said it was not used anymore.

The most complex procedure in the banking system, however, is the method for raising capital that conveniently hides a bank's real owners. According to Kostin and Hainsworth, in 1996 the Central Bank, seeking to prevent any single person or company from controlling a bank, limited who could invest in a bank and how much they could invest.

So investors took to finding a group of companies or banks or both willing to purchase all or part of the equity in the bank for them. After the sale was approved by the Central Bank, the companies that "invested" would sell the stock to companies chosen by the real investors, according to Kostin and Hainsworth.

This is the role that MDM Bank said it played in raising capital for both DKB and Flamingo Bank, the banks through which U.S. prosecutors say a lot of the money moved in the alleged money-laundering scheme. Kostin said that in 1996, at the direction of a client, MDM Bank bought stock in Flamingo Bank and held it from Sept. 3 to Dec. 10, and owned stock in DKB, or Depozitarno-Kliringovy Bank, from June 13 to Dec. 10. After that, Kostin said, the stock was sold to other companies, also at the client's direction. He would not name the companies or the client.

MDM Bank says it was just acting for a client in the transactions, and that it is cooperating with Russian and American law enforcement officials.

Sobinbank officials refused to comment for this article. But a spokesman referred to a February interview with Vedomosti newspaper. In the article, Alexander Zanadvorov, Sobinbank's chairman, also said his bank was merely acting for a client when it held an interest in DKB and Flamingo.

A Russian banker involved in the Bank of New York investigation said Sobinbank was the organizing bank in raising capital for DKB and Flamingo Bank, and that both DKB and Flamingo were actually bought for one or both of the DKB bankers who are said by U.S. prosecutors to be co-conspirators of Edwards and Berlin.

Officials involved in the investigation have identified the two men that prosecutors referred to as co-conspirators in the charges against Edwards and Berlin as Ivan Bronov and Kirill Gusev. Both worked at DKB at some point, and Bronov also once worked with Zanadvorov of Sobinbank. Neither Gusev nor Bronov has been charged.

The Edwards-Berlin charges say the two men moved to take control of Flamingo Bank in 1998, two years after the capital-raising efforts for DKB and Flamingo. MDM Bank says it did not help raise new capital for DKB or Flamingo Bank in 1998.

The Russian banker also told U.S. prosecutors that the group organized by Sobinbank to buy DKB and Flamingo involved at least five other banks, some of which are now effectively defunct as a result of the 1998 financial crisis, though they were a who's who in Russian banking at the time.

In his February interview with Vedomosti, Zanadvorov of Sobinbank said a team of managers from a prominent Moscow bank that had lost its license asked Sobinbank to help them acquire DKB and Flamingo. "Such deals," he said, "are usual in banking practice."

Usual, that is, in Russian banking practice.