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Title: Crime and Corruption
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Crime and Corruption
1st EDITION
Sam Vaknin, Ph.D.
Editing and Design:
Lidija Rangelovska
Lidija Rangelovska
A Narcissus Publications Imprint, Skopje 2002
First published by United Press International – UPI Not for Sale! Non-commercial edition.
© 2002 Copyright Lidija Rangelovska.
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or reproduced in any manner without written permission from:
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Visit the Author Archive of Dr. Sam Vaknin in "Central Europe
Review":
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Created by: LIDIJA RANGELOVSKA
REPUBLIC OF MACEDONIA
C O N T E N T S
I. Slush Funds II. Corruption and Transparency III. Money Laundering in a Changed World IV. Hawala, the Bank that Never Was V. Straf – Corruption in Central and Eastern Europe VI. Russia’s Missing Billions
VII. The Enrons of the East
VIII. The Typology of Financial Scandals
IX. The Shadowy World of International Finance X. Maritime Piracy XI. The Author
XII. About "After the Rain"
Slush Funds
According to David McClintick ("Swordfish: A True Story of Ambition, Savagery, and Betrayal"), in the late 1980's, the FBI and DEA set up dummy corporations to deal in drugs. They funneled into these corporate fronts money from drug-related asset seizures.
The idea was to infiltrate global crime networks but a lot of the money in "Operation Swordfish" may have ended up in the wrong pockets. Government agents and sheriffs got mysteriously and filthily rich and the whole sorry affair was wound down. The GAO reported more than $3.6 billion missing. This bit of history gave rise to at least one blockbuster with Oscar-winner Halle Berry.
Alas, slush funds are much less glamorous in reality. They usually involve grubby politicians, pawky bankers, and philistine businessmen - rather than glamorous hackers and James Bondean secret agents.
The Kazakh prime minister, Imanghaliy Tasmaghambetov, freely admitted on April 4 to his country's rubber-stamp parliament the existence of a $1 billion slush fund. The money was apparently skimmed off the proceeds of the opaque sale of the Tengiz oilfield. Remitting it to Kazakhstan - he expostulated with a poker face - would have fostered inflation. So, the country's president, Nazarbaev, kept the funds abroad "for use in the event of either an economic crisis or a threat to Kazakhstan's security".
The money was used to pay off pension arrears in 1997 and to offset the pernicious effects of the 1998 devaluation of the Russian ruble. What was left was duly transferred to the $1.5 billion National Fund, the PM insisted. Alas, the original money in the Fund came entirely from another sale of oil assets to Chevron, thus casting in doubt the official version.
The National Fund was, indeed, augmented by a transfer or two from the slush fund - but at least one of these transfers occurred only 11 days after the damning revelations. Moreover, despite incontrovertible evidence to the contrary, the unfazed premier denied that his president possesses multi-million dollar bank accounts abroad.
He later rescinded this last bit of disinformation. The president, he said, has no bank accounts abroad but will promptly return all the money in these non-existent accounts to Kazakhstan. These vehemently denied accounts, he speculated, were set up by the president's adversaries "for the purpose of compromising his name".
On April 15, even the docile opposition had enough of this fuzzy logic. They established a People Oil's Fund to monitor, henceforth, the regime's financial shenanigans. By their calculations less than 7 percent of the income from the sale of hydrocarbon fuels (c. $4-5 billion annually) make it to the national budget.
Slush funds infect every corner of the globe, not only the more obscure and venal ones. Every secret service - from the Mossad to the CIA - operates outside the stated state budget. Slush funds are used to launder money, shower cronies with patronage, and bribe decision makers. In some countries, setting them up is a criminal offense, as per the 1990 Convention on Laundering, Search, Seizure, and Confiscation of the Proceeds from Crime. Other jurisdictions are more forgiving.
The Catholic Bishops Conference of Papua New Guinea and the Solomon Islands issued a press release November last in which it welcomed the government's plans to abolish slush funds. They described the poisonous effect of this practice:
"With a few notable exceptions, the practice of directing funds through politicians to district projects has been disastrous. It has created an atmosphere in which corruption is thought to have flourished. It has reduced the responsibility of public servants, without reducing their numbers or costs. It has been used to confuse people into believing public funds are the "property" of individual members rather than the property of the people, honestly and fairly administered by the servants of the people.
The concept of 'slush-funds' has resulted in well-documented inefficiencies and failures. There were even accusations made that funds were withheld from certain members as a way of forcing them into submission. It seems that the era of the 'slush funds' has been a shameful period."
But even is the most orderly and lawful administration, funds are liable to be mislaid. "The Economist" reported recently about a $10 billion class-action suit filed by native-Americans against the US government. The funds, supposed to be managed in trust since 1880 on behalf of half a million beneficiaries, were "either lost or stolen" according to officials.
Rob Gordon, the Director of the National Wilderness Institute accused "The US Interior Department (of) looting the special funds that were established to pay for wildlife conservation and squandering the money instead on questionable administrative expenses, slush funds and employee moving expenses".
Charles Griffin, the Deputy Director of the Heritage Foundation's Government Integrity Project, charges:
"The federal budget provides numerous slush funds that can be used to subsidize the lobbying and political activities of specialinterest groups."
On his list of "Top Ten Federal Programs That Actively Subsidize Politics and Lobbying" are: AmeriCorps, Senior Community Service Employment Program, Legal Services Corporation, Title X Family Planning, National Endowment for the Humanities, Market Promotion Program, Senior Environmental Employment Program, Superfund Worker Training, HHS Discretionary Aging Projects, Telecomm. & Info. Infrastructure Assistance. These federal funds alone total $1.8 billion.
"Next" and "China Times" - later joined by "The Washington Post" - accused the former Taiwanese president, Lee Teng-hui, of forming a $100 million overseas slush fund intended to finance the gathering of information, influence-peddling, and propaganda operations. Taiwan footed the bills trips by Congressional aides and funded academic research and think tank conferences.
High ranking Japanese officials, among others, may have received payments through this stealthy venue. Lee is alleged to have drawn $100,000 from the secret account in February 1999. The money was used to pay for the studies of a former Japanese Vice-Defense Minister Masahiro Akiyama's at Harvard.
Ryutaro Hashimoto, the former Japanese prime minister, was implicated as a beneficiary of the fund. So were the prestigious lobbying firm, Cassidy and Associates and assorted assistant secretaries in the Bush administration.
Carl Ford, Jr., currently assistant secretary of state for intelligence and research, worked for Cassidy during the relevant period and often visited Taiwan. James Kelly, assistant secretary of state for East Asian and Pacific Affairs enjoyed the Taiwanese largesse as well. Both are in charge of crafting America's policy on Taiwan.
John Bolton, undersecretary of state for arms control and international security, admitted, during his confirmation hearings, to having received $30,000 to cover the costs of writing 3 research papers.
The Taiwanese government has yet to deny the news stories.
A Japanese foreign ministry official used slush fund money to finance the extra-marital activities of himself and many of his colleagues - often in posh hotel suites. But this was no exception. According to Asahi Shimbun, more than half of the 60 divisions of the ministry maintained similar funds. The police and the ministry are investigating. One arrest has been made. The ministry's accounting division has discovered these corrupt practices twenty years ago but kept mum.
Even low-level prefectural bureaucrats and teachers in Japan build up slush funds by faking business trips or padding invoices and receipts. Japanese citizens' groups conservatively estimated that $20 million in travel and entertainment expenses in the prefectures in 1994 were faked, a practice known as "kara shutcho" (i.e., empty business trip).
Officials of the Hokkaido Board of Education admitted to the existence of a 100 million yen secret fund. In a resulting probe, 200 out of 286 schools were found to maintain their own slush funds. Some of the money was used to support friendly politicians.
But slush funds are not a sovereign prerogative. Multinationals, banks, corporation, religious organizations, political parties, and even NGO's salt away some of their revenues and profits in undisclosed accounts, usually in off-shore havens.
Secret election campaign slush funds are a fixture in American politics. A 2-year old bill requires disclosure of donors to such funds but the House is busy loosening its provisions. "The Economist" listed lately the tsunami of scandals that engulfs Germany, both its major political parties, many of the Lander and numerous highly placed and mid-level bureaucrats. Secret, mainly party, funds seem to be involved in the majority of these lurid affairs.
Italian firms made donations to political parties through slush funds, though corporate donations - providing they are transparent - are perfectly legal in Italy. Both the right and, to a lesser extent, the left in France are said to have managed enormous political slush funds.
President Chirac is accused of having abused for his personal pleasure, one such municipal fund in Paris, when he was its mayor. But the funds were mostly used to provide party activists with mock jobs. Corporations paid kickbacks to obtain public works or local building permits. Ostensibly, they were paying for sham "consultancy services".
The epidemic hasn't skipped even staid Ottawa. Its Chief Electoral Officer told Sun Media last September that he is "concerned" about millions stashed away by Liberal candidates. Sundry ministers who coveted the prime minister's job, have raised funds covertly and probably illegally.
On April 11, UPI reported that Spain's second-largest bank, Banco Bilbao Vizcaya Argentaria (BBVA), held nearly $200 million hidden in secret offshore accounts, "which were allegedly used to manipulate politicians, pay off the 'revolutionary tax' to ETA - the Basque terrorist organization - and open the door for business deals, according to news reports."
The money may have gone to luminaries such as Venezuela's Hugo Chavez, Peru's Alberto Fujomori and Vladimiro Montesinos. The bank's board members received fat, tax-free, "pensions" from the illegal accounts opened in 1987 - a total of more than $20 million.
Latin American drug money launderers - from Puerto Rico to Colombia - may have worked through these funds and the bank's clandestine entities in the Cayman Islands and Jersey. The current Spanish Secretary of State for the Treasury has been the bank's tax advisor between 1992-7.
The "Financial Times" reported in June 2000 that, in anticipation of new international measures to curb corruption, "leading European arms manufacturers" resorted to the creation of off-shore slush funds. The money is intended to bribe foreign officials to win tenders and contracts.
Kim Woo-chung, Daewoo's former chairman, is at the center of a massive scandal involving dozens of his company's executive, some of whom ended up in prison. He stands accused of diverting a whopping $20 billion to an overseas slush fund.
A mind boggling $10 billion were alleged to have been used to bribe Korean government officials and politicians. But his conduct and even the scale of the fraud he perpetrated may have been typical to Korea's post-war incestuous relationship between politics and business.
In his paper "The Role of Slush Funds in the Preparation of Corruption Mechanisms", reprinted by Transparency International, Gherardo Colombo defines corporate slush funds thus:
"Slush funds are obtained from a joint stock company's finances, carefully managed so that the amounts involved do not appear on the balance sheet. They do not necessarily have to consist of money, but can also take the form of stocks and shares or other economically valuable goods (works of art, jewels, yachts, etc.) It is enough that they can be used without any particular difficulty or that they can be transferred to a third party.
If a fund is in the form of money, it is not even necessary to refer to it outside the company accounts, since it can appear in them in disguised form (the "accruals and deferrals" heads are often resorted to for the purpose of hiding slush money). In light of this, it is not always correct to regard it as a reserve fund that is not accounted for in the books. Deception, trickery or forgery of various kinds are often resorted to for the purpose of setting up a slush fund."
He mentions padded invoices, sham contracts, fictitious loans, interest accruing on holding accounts, back to back transactions with related entities (Enron) - all used to funnel money to the slush funds. Such funds are often set up to cover for illicit and illegal self-enrichment, embezzlement, or tax evasion.
Less known is the role of these furtive vehicles in financing unfair competitive practices, such as dumping. Clients, suppliers, and partners receive hidden rebates and subsidies that much increase the - unreported - real cost of production.
BBVA's payments to ETA may have been a typical payment of protection fees. Both terrorists and organized crime put slush funds to bad use. They get paid from such funds - and maintain their own. Ransom payments to kidnappers often flow through these channels.
But slush funds are overwhelmingly used to bribe corrupt politicians. The fight against corruption has been titled against the recipients of illicit corporate largesse. But to succeed, wellmeaning international bodies, such as the OECD's FATF, must attack with equal zeal those who bribe. Every corrupt transaction is between a venal politician and an avaricious businessman. Pursuing the one while ignoring the other is self-defeating.
Corruption and Transparency
I. The Facts
Just days before a much-awaited donor conference, the influential
International Crisis Group (ICG) recommended to place all funds
pledged to Macedonia under the oversight of a "corruption advisor"
appointed by the European Commission. The donors ignored this and
other recommendations. To appease the critics, the affable Attorney
General of Macedonia charged a former Minister of Defense with abuse
of duty for allegedly having channeled millions of DM to his
relatives during the recent civil war. Macedonia has belatedly
passed an anti-money laundering law recently - but failed, yet
again, to adopt strict anti-corruption legislation.
In Albania, the Chairman of the Albanian Socialist Party, Fatos
Nano, was accused by Albanian media of laundering $1 billion through
the Albanian government. Pavel Borodin, the former chief of Kremlin
Property, decided not appeal his money laundering conviction in a
Swiss court. The Slovak daily "Sme" described in scathing detail the
newly acquired wealth and lavish lifestyles of formerly impoverished
HZDS politicians. Some of them now reside in refurbished castles.
Others have swimming pools replete with wine bars.
Pavlo Lazarenko, a former Ukrainian prime minister, is detained in
San Francisco on money laundering charges. His defense team accuses
the US authorities of "selective prosecution".
They are quoted by Radio Free Europe as saying:
"The impetus for this prosecution comes from allegations made by the Kuchma regime, which itself is corrupt and dedicated to using undemocratic and repressive methods to stifle political opposition ... (other Ukrainian officials) including Kuchma himself and his closest associates, have committed conduct similar to that with which Lazarenko is charged but have not been prosecuted by the U.S. government".
The UNDP estimated, in 1997, that, even in rich, industrialized,
countries, 15% of all firms had to pay bribes. The figure rises to
40% in Asia and 60% in Russia.
Corruption is rife and all pervasive, though many allegations are
nothing but political mud-slinging. Luckily, in countries like
Macedonia, it is confined to its rapacious elites: its politicians,
managers, university professors, medical doctors, judges,
journalists, and top bureaucrats. The police and customs are
hopelessly compromised. Yet, one rarely comes across graft and
venality in daily life. There are no false detentions (as in
Russia), spurious traffic tickets (as in Latin America), or
widespread stealthy payments for public goods and services (as in
Africa).
It is widely accepted that corruption retards growth by deterring
foreign investment and encouraging brain drain. It leads to the
misallocation of economic resources and distorts competition. It
depletes the affected country's endowments - both natural and
acquired. It demolishes the tenuous trust between citizen and state.
It casts civil and government institutions in doubt, tarnishes the
entire political class, and, thus, endangers the democratic system
and the rule of law, property rights included.
This is why both governments and business show a growing commitment
to tackling it. According to Transparency International's "Global
Corruption Report 2001", corruption has been successfully contained
in private banking and the diamond trade, for instance.
Hence also the involvement of the World Bank and the IMF in fighting
corruption. Both institutions are increasingly concerned with
poverty reduction through economic growth and development. The World
Bank estimates that corruption reduces the growth rate of an
affected country by 0.5 to 1 percent annually. Graft amounts to an
increase in the marginal tax rate and has pernicious effects on
inward investment as well.
The World Bank has appointed last year a Director of Institutional
Integrity - a new department that combines the Anti-Corruption and
Fraud Investigations Unit and the Office of Business Ethics and
Integrity. The Bank helps countries to fight corruption by providing
them with technical assistance, educational programs, and lending.
Anti-corruption projects are an integral part of every Country
Assistance Strategy (CAS). The Bank also supports international
efforts to reduce corruption by sponsoring conferences and the
exchange of information. It collaborates closely with Transparency
International, for instance.
At the request of member-governments (such as Bosnia-Herzegovina and
Romania) it has prepared detailed country corruption surveys
covering both the public and the private sectors. Together with the
EBRD, it publishes a corruption survey of 3000 firms in 22
transition countries (BEEPS - Business Environment and Enterprise
Performance Survey). It has even set up a multilingual hotline for
whistleblowers.
The IMF made corruption an integral part of its country evaluation
process. It suspended arrangements with endemically corrupt
recipients of IMF financing. Since 1997, it has introduced policies
regarding misreporting, abuse of IMF funds, monitoring the use of
debt relief for poverty reduction, data dissemination, legal and
judicial reform, fiscal and monetary transparency, and even internal
governance (e.g., financial disclosure by staff members).
Yet, no one seems to agree on a universal definition of corruption.
What amounts to venality in one culture (Sweden) is considered no
more than hospitality, or an expression of gratitude, in another
(France, or Italy). Corruption is discussed freely and forgivingly
in one place - but concealed shamefully in another. Corruption, like
other crimes, is probably seriously under-reported and underpenalized.
Moreover, bribing officials is often the unstated policy of
multinationals, foreign investors, and expatriates. Many of them
believe that it is inevitable if one is to expedite matters or
secure a beneficial outcome. Rich world governments turn a blind
eye, even where laws against such practices are extant and strict.
In his address to the Inter-American Development Bank on March 14,
President Bush promised to "reward nations that root out corruption"
within the framework of the Millennium Challenge Account initiative.
The USA has pioneered global anti-corruption campaigns and is a
signatory to the 1996 IAS Inter-American Convention against
Corruption, the Council of Europe's Criminal Law Convention on
Corruption, and the OECD's 1997 anti-bribery convention. The USA has
had a comprehensive "Foreign Corrupt Practices Act" since 1977.
The Act applies to all American firms, to all firms - including
foreign ones - traded in an American stock exchange, and to bribery
on American territory by foreign and American firms alike. It
outlaws the payment of bribes to foreign officials, political
parties, party officials, and political candidates in foreign
countries. A similar law has now been adopted by Britain.
Yet, "The Economist" reports that the American SEC has brought only
three cases against listed companies until 1997. The US Department
of Justice brought another 30 cases. Britain has persecuted
successfully only one of its officials for overseas bribery since
1889. In the Netherlands bribery is tax deductible. Transparency
International now publishes a name and shame Bribery Payers Index to
complement its 91-country strong Corruption Perceptions Index.
Many rich world corporations and wealthy individuals make use of
off-shore havens or "special purpose entities" to launder money,
make illicit payments, avoid or evade taxes, and conceal assets or
liabilities. According to Swiss authorities, more than $40 billion
are held by Russians in its banking system alone. The figure may be
5 to 10 times higher in the tax havens of the United Kingdom.
In a survey it conducted last month of 82 companies in which it
invests, "Friends, Ivory, and Sime" found that only a quarter had
clear anti-corruption management and accountability systems in
place.
Tellingly only 35 countries signed the 1997 OECD "Convention on
Combating Bribery of Foreign Public Officials in International
Business Transactions" - including four non-OECD members: Chile,
Argentina, Bulgaria, and Brazil. The convention has been in force
since February 1999 and is only one of many OECD anti-corruption
drives, among which are SIGMA (Support for Improvement in Governance
and Management in Central and Eastern European countries), ACN
(Anti-Corruption Network for Transition Economies in Europe), and
FATF (the Financial Action Task Force on Money Laundering).
Moreover, The moral authority of those who preach against corruption
in poor countries - the officials of the IMF, the World Bank, the
EU, the OECD - is strained by their ostentatious lifestyle,
conspicuous consumption, and "pragmatic" morality.
II. What to do? What is Being Done?
Two years ago, I proposed a taxonomy of corruption, venality, and
graft. I suggested this cumulative definition:
(a) The withholding of a service, information, or goods that, by
law, and by right, should have been provided or divulged.
(b) The provision of a service, information, or goods that, by law,
and by right, should not have been provided or divulged.
(c) That the withholding or the provision of said service,
information, or goods are in the power of the withholder or the
provider to withhold or to provide AND That the withholding or the
provision of said service, information, or goods constitute an
integral and substantial part of the authority or the function of
the withholder or the provider.
(d) That the service, information, or goods that are provided or
divulged are provided or divulged against a benefit or the promise
of a benefit from the recipient and as a result of the receipt of
this specific benefit or the promise to receive such benefit.
(e) That the service, information, or goods that are withheld are
withheld because no benefit was provided or promised by the
recipient.
There is also what the World Bank calls "State Capture" defined
thus:
"The actions of individuals, groups, or firms, both in the public
and private sectors, to influence the formation of laws,
regulations, decrees, and other government policies to their own
advantage as a result of the illicit and non-transparent provision
of private benefits to public officials."
We can classify corrupt and venal behaviours according to their
outcomes:
(a) Income Supplement - Corrupt actions whose sole outcome is the
supplementing of the income of the provider without affecting the
"real world" in any manner.
(b) Acceleration or Facilitation Fees - Corrupt practices whose sole
outcome is to accelerate or facilitate decision making, the
provision of goods and services or the divulging of information.
(c) Decision Altering Fees - Bribes and promises of bribes which
alter decisions or affect them, or which affect the formation of
policies, laws, regulations, or decrees beneficial to the bribing
entity or person.
(d) Information Altering Fees - Backhanders and bribes that subvert
the flow of true and complete information within a society or an
economic unit (for instance, by selling professional diplomas,
certificates, or permits).
(e) Reallocation Fees - Benefits paid (mainly to politicians and
political decision makers) in order to affect the allocation of
economic resources and material wealth or the rights thereto.
Concessions, licenses, permits, assets privatized, tenders awarded
are all subject to reallocation fees.
To eradicate corruption, one must tackle both giver and taker.
History shows that all effective programs shared these common
elements:
(a) The persecution of corrupt, high-profile, public figures,
multinationals, and institutions (domestic and foreign). This
demonstrates that no one is above the law and that crime does not
pay.
(b) The conditioning of international aid, credits, and investments
on a monitored reduction in corruption levels. The structural roots
of corruption should be tackled rather than merely its symptoms.
(c) The institution of incentives to avoid corruption, such as a
higher pay, the fostering of civic pride, "good behaviour" bonuses,
alternative income and pension plans, and so on.
(d) In many new countries (in Asia, Africa, and Eastern Europe) the
very concepts of "private" versus "public" property are fuzzy and
impermissible behaviours are not clearly demarcated. Massive
investments in education of the public and of state officials are
required.
(e) Liberalization and deregulation of the economy. Abolition of red
tape, licensing, protectionism, capital controls, monopolies,
discretionary, non-public, procurement. Greater access to
information and a public debate intended to foster a "stakeholder
society".
(f) Strengthening of institutions: the police, the customs, the
courts, the government, its agencies, the tax authorities - under
time limited foreign management and supervision.
Awareness to corruption and graft is growing - though it mostly
results in lip service. The Global Coalition for Africa adopted
anti-corruption guidelines in 1999. The otherwise opaque Asia
Pacific Economic Cooperation (APEC) forum is now championing
transparency and good governance. The UN is promoting its pet
convention against corruption.
The G-8 asked its Lyon Group of senior experts on transnational
crime to recommend ways to fight corruption related to large money
flows and money laundering. The USA and the Netherlands hosted
global forums on corruption - as will South Korea next year. The
OSCE is rumored to respond with its own initiative, in collaboration
with the US Congressional Helsinki Commission.
The southeastern Europe Stability Pact sports its own Stability Pact
Anti-corruption Initiative (SPAI). It held its first conference in
September 2001 in Croatia. More than 1200 delegates participated in
the 10th International Anti-Corruption Conference in Prague last
year. The conference was attended by the Czech prime minister, the
Mexican president, and the head of the Interpol.
The most potent remedy against corruption is sunshine - free,
accessible, and available information disseminated and probed by an
active opposition, uncompromised press, and assertive civic
organizations and NGO's. In the absence of these, the fight against
official avarice and criminality is doomed to failure. With them, it
stands a chance.
Corruption can never be entirely eliminated - but it can be
restrained and its effects confined. The cooperation of good people
with trustworthy institutions is indispensable. Corruption can be
defeated only from the inside, though with plenty of outside help.
It is a process of self-redemption and self-transformation. It is
the real transition.
Money Laundering in A Changed World
Israel has always turned a blind eye to the origin of funds
deposited by Jews from South Africa to Russia. In Britain it is
perfectly legal to hide the true ownership of a company. Underpaid
Asian bank clerks on immigrant work permits in the Gulf states
rarely require identity documents from the mysterious and wellconnected
owners of multi-million dollar deposits. Hawaladars
continue plying their paperless and trust-based trade - the transfer
of billions of US dollars around the world. American and Swiss banks
collaborate with dubious correspondent banks in off shore centres.
Multinationals shift money through tax free territories in what is
euphemistically known as "tax planning". Internet gambling outfits
and casinos serve as fronts for narco-dollars. British Bureaux de
Change launder up to 2.6 billion British pounds annually. The 500
Euro note will make it much easier to smuggle cash out of Europe. A
French parliamentary committee accuses the City of London of being a
money laundering haven in a 400 page report. Intelligence services
cover the tracks of covert operations by opening accounts in obscure
tax havens, from Cyprus to Nauru. Money laundering, its venues and
techniques, are an integral part of the economic fabric of the
world. Business as usual?
Not really. In retrospect, as far as money laundering goes,
September 11 may be perceived as a watershed as important as the
precipitous collapse of communism in 1989. Both events have forever
altered the patterns of the global flows of illicit capital.
What is Money Laundering?
Strictly speaking, money laundering is the age-old process of
disguising the illegal origin and criminal nature of funds (obtained
in sanctions-busting arms sales, smuggling, trafficking in humans,
organized crime, drug trafficking, prostitution rings, embezzlement,
insider trading, bribery, and computer fraud) by moving them
untraceably and investing them in legitimate businesses, securities,
or bank deposits. But this narrow definition masks the fact that the
bulk of money laundered is the result of tax evasion, tax avoidance,
and outright tax fraud, such as the "VAT carousel scheme" in the EU
(moving goods among businesses in various jurisdictions to
capitalize on differences in VAT rates). Tax-related laundering nets
between 10-20 billion US dollars annually from France and Russia
alone. The confluence of criminal and tax averse funds in money
laundering networks serves to obscure the sources of both.
The Scale of the Problem
According to a 1996 IMF estimate, money laundered annually amounts
to 2-5% of world GDP (between 800 billion and 2 trillion US dollars
in today's terms). The lower figure is considerably larger than an
average European economy, such as Spain's.
The System
It is important to realize that money laundering takes place within
the banking system. Big amounts of cash are spread among numerous
accounts (sometimes in free economic zones, financial off shore
centers, and tax havens), converted to bearer financial instruments
(money orders, bonds), or placed with trusts and charities. The
money is then transferred to other locations, sometimes as bogus
payments for "goods and services" against fake or inflated invoices
issued by holding companies owned by lawyers or accountants on
behalf of unnamed beneficiaries. The transferred funds are reassembled
in their destination and often "shipped" back to the point
of origin under a new identity. The laundered funds are then
invested in the legitimate economy. It is a simple procedure - yet
an effective one. It results in either no paper trail - or too much
of it. The accounts are invariably liquidated and all traces erased.
Why is it a Problem?
Criminal and tax evading funds are idle and non-productive. Their
injection, however surreptitiously, into the economy transforms them
into a productive (and cheap) source of capital. Why is this
negative?
Because it corrupts government officials, banks and their officers,
contaminates legal sectors of the economy, crowds out legitimate and
foreign capital, makes money supply unpredictable and
uncontrollable, and increases cross-border capital movements,
thereby enhancing the volatility of exchange rates.
A multilateral, co-ordinated, effort (exchange of information,
uniform laws, extra-territorial legal powers) is required to counter
the international dimensions of money laundering. Many countries opt
in because money laundering has also become a domestic political and
economic concern. The United Nations, the Bank for International
Settlements, the OECD's FATF, the EU, the Council of Europe, the
Organisation of American States, all published anti-money laundering
standards. Regional groupings were formed (or are being established)
in the Caribbean, Asia, Europe, southern Africa, western Africa, and
Latin America.
Money Laundering in the Wake of the September 11 Attacks
Regulation
The least important trend is the tightening of financial regulations
and the establishment or enhancement of compulsory (as opposed to
industry or voluntary) regulatory and enforcement agencies.
New legislation in the US which amounts to extending the powers of
the CIA domestically and of the DOJ extra-territorially, was rather
xenophobically described by a DOJ official, Michael Chertoff, as
intended to "make sure the American banking system does not become a
haven for foreign corrupt leaders or other kinds of foreign
organized criminals." Privacy and bank secrecy laws have been
watered down.
Collaboration with off shore "shell" banks has been banned. Business
with clients of correspondent banks was curtailed. Banks were
effectively transformed into law enforcement agencies, responsible
to verify both the identities of their (foreign) clients and the
source and origin of their funds. Cash transactions were partly
criminalized. And the securities and currency trading industry,
insurance companies, and money transfer services are subjected to
growing scrutiny as a conduit for "dirty cash".
Still, such legislation is highly ineffective. The American Bankers'
Association puts the cost of compliance with the laxer anti-moneylaundering
laws in force in 1998 at 10 billion US dollars - or more
than 10 million US dollars per obtained conviction. Even when the
system does work, critical alerts drown in the torrent of reports
mandated by the regulations. One bank actually reported a suspicious
transaction in the account of one of the September 11 hijackers -
only to be ignored.
The Treasury Department established Operation Green Quest, an
investigative team charged with monitoring charities, NGO's, credit
card fraud, cash smuggling, counterfeiting, and the Hawala networks.
This is not without precedent. Previous teams tackled drug money,
the biggest money laundering venue ever, BCCI (Bank of Credit and
Commerce International), and ... Al Capone. The more veteran, NewYork
based, El-Dorado anti money laundering Task Force (established
in 1992) will lend a hand and share information.
More than 150 countries promised to co-operate with the US in its
fight against the financing of terrorism - 81 of which (including
the Bahamas, Argentina, Kuwait, Indonesia, Pakistan, Switzerland,
and the EU) actually froze assets of suspicious individuals,
suspected charities, and dubious firms, or passed new anti money
laundering laws and stricter regulations (the Philippines, the UK,
Germany). A tabled EU directive would force lawyers to disclose
incriminating information about their clients' money laundering
activities. Pakistan initiated a "loyalty scheme", awarding
expatriates who prefer official bank channels to the much maligned
(but cheaper and more efficient) Hawala, with extra baggage
allowance and special treatment in airports.
The magnitude of this international collaboration is unprecedented.
But this burst of solidarity may yet fade. China, for instance,
refuses to chime in. As a result, the statement issued by APEC last
week on measures to stem the finances of terrorism was lukewarm at
best. And, protestations of close collaboration to the contrary,
Saudi Arabia has done nothing to combat money laundering "Islamic
charities" (of which it is proud) on its territory.
Still, a universal code is emerging, based on the work of the OECD's
FATF (Financial Action Task Force) since 1989 (its famous "40
recommendations") and on the relevant UN conventions. All countries
are expected by the West, on pain of possible sanctions, to adopt a
uniform legal platform (including reporting on suspicious
transactions and freezing assets) and to apply it to all types of
financial intermediaries, not only to banks. This is likely to
result in ...
The decline of off shore financial centres and tax havens
By far the most important outcome of this new-fangled juridical
homogeneity is the acceleration of the decline of off shore
financial and banking centres and tax havens. The distinction
between off-shore and on-shore will vanish. Of the FATF's "name and
shame" blacklist of 19 "black holes" (poorly regulated territories,
including Israel, Indonesia, and Russia) - 11 have substantially
revamped their banking laws and financial regulators. Coupled with
the tightening of US, UK, and EU laws and the wider interpretation
of money laundering to include political corruption, bribery, and
embezzlement - this would make life a lot more difficult for venal
politicians and major tax evaders. The likes of Sani Abacha (late
President of Nigeria), Ferdinand Marcos (late President of the
Philippines), Vladimiro Montesinos (former, now standing trial,
chief of the intelligence services of Peru), or Raul Salinas (the
brother of Mexico's President) - would have found it impossible to
loot their countries to the same disgraceful extent in today's
financial environment. And Osama bin Laden would not have been able
to wire funds to US accounts from the Sudanese Al Shamal Bank, the
"correspondent" of 33 American banks.
Quo Vadis, Money Laundering?
Crime is resilient and fast adapting to new realities. Organized
crime is in the process of establishing an alternative banking
system, only tangentially connected to the West's, in the fringes,
and by proxy.
This is done by purchasing defunct banks or banking licences in
territories with lax regulation, cash economies, corrupt
politicians, no tax collection, but reasonable infrastructure. The
countries of Eastern Europe - Yugoslavia (Montenegro and Serbia),
Macedonia, Ukraine, Moldova, Belarus, Albania, to mention a few -
are natural targets. In some cases, organized crime is so allpervasive
and local politicians so corrupt that the distinction
between criminal and politician is spurious.
Gradually, money laundering rings move their operations to these
new, accommodating territories. The laundered funds are used to
purchase assets in intentionally botched privatizations, real
estate, existing businesses, and to finance trading operations. The
wasteland that is Eastern Europe craves private capital and no
questions are asked by investor and recipient alike.
The next frontier is cyberspace. Internet banking, Internet
gambling, day trading, foreign exchange cyber transactions, e-cash,
e-commerce, fictitious invoicing of the launderer's genuine credit
cards - hold the promise of the future. Impossible to track and
monitor, ex-territorial, totally digital, amenable to identity theft
and fake identities - this is the ideal vehicle for money
launderers.
This nascent platform is way too small to accommodate the enormous
amounts of cash laundered daily - but in ten years time, it may. The
problems is likely to be exacerbated by the introduction of smart
cards, electronic purses, and payment-enabled mobile phones.
In its "Report on Money Laundering Typologies" (February 2001) the
FATF was able to document concrete and suspected abuses of online
banking, Internet casinos, and web-based financial services. It is
difficult to identify a customer and to get to know it in
cyberspace, was the alarming conclusion. It is equally complicated
to establish jurisdiction.
Many capable professionals - stockbrokers, lawyers, accountants,
traders, insurance brokers, real estate agents, sellers of high
value items such as gold, diamonds, and art - are employed or coopted
by money laundering operations. Money launderers are likely to
make increased use of global, around the clock, trading in foreign
currencies and derivatives. These provide instantaneous transfer of
funds and no audit trail. The underlying securities involved are
susceptible to market manipulation and fraud. Complex insurance
policies (with the "wrong" beneficiaries), and the securitization of
receivables, leasing contracts, mortgages, and low grade bonds are
already used in money laundering schemes. In general, money
laundering goes well with risk arbitraging financial instruments.
Trust-based, globe-spanning, money transfer systems based on
authentication codes and generations of commercial relationships
cemented in honour and blood - are another wave of the future. The
Hawala and Chinese networks in Asia, the Black Market Peso Exchange
(BMPE) in Latin America, other evolving courier systems in Eastern
Europe (mainly in Russia, Ukraine, and Albania) and in Western
Europe (mainly in France and Spain).
In conjunction with encrypted e-mail and web anonymizers, these networks are virtually impenetrable. As emigration increases, diasporas established, and transport and telecommunications become ubiquitous, "ethnic banking" along the tradition of the Lombards and the Jews in medieval Europe may become the the preferred venue of money laundering. September 11 may have retarded world civilization in more than one way.
Hawala, or the Bank that Never Was
I. OVERVIEW
In the wake of the September 11 terrorist attacks on the USA,
attention was drawn to the age-old, secretive, and globe-spanning
banking system developed in Asia and known as "Hawala" (to change,
in Arabic). It is based on a short term, discountable, negotiable,
promissory note (or bill of exchange) called "Hundi". While not
limited to Moslems, it has come to be identified with "Islamic
Banking".
Islamic Law (Sharia'a) regulates commerce and finance in the Fiqh Al
Mua'malat, (transactions amongst people). Modern Islamic banks are
overseen by the Shari'a Supervisory Board of Islamic Banks and
Institutions ("The Shari'a Committee").
The Shi'a "Islamic Laws according to the Fatawa of Ayatullah al
Uzama Syed Ali al-Husaini Seestani" has this to say about Hawala
banking:
"2298. If a debtor directs his creditor to collect his debt from the
third person, and the creditor accepts the arrangement, the third
person will, on completion of all the conditions to be explained
later, become the debtor. Thereafter, the creditor cannot demand his
debt from the first debtor."
The prophet Muhammad (a cross border trader of goods and commodities
by profession) encouraged the free movement of goods and the
development of markets. Numerous Moslem scholars railed against
hoarding and harmful speculation (market cornering and manipulation
known as "Gharar"). Moslems were the first to use promissory notes
and assignment, or transfer of debts via bills of exchange
("Hawala"). Among modern banking instruments, only floating and,
therefore, uncertain, interest payments ("Riba" and "Jahala"),
futures contracts, and forfeiting are frowned upon. But agile Moslem
traders easily and often circumvent these religious restrictions by
creating "synthetic Murabaha (contracts)" identical to Western
forward and futures contracts. Actually, the only allowed transfer
or trading of debts (as distinct from the underlying commodities or
goods) is under the Hawala.
"Hawala" consists of transferring money (usually across borders and
in order to avoid taxes or the need to bribe officials) without
physical or electronic transfer of funds. Money changers
("Hawaladar") receive cash in one country, no questions asked.
Correspondent hawaladars in another country dispense an identical
amount (minus minimal fees and commissions) to a recipient or, less
often, to a bank account. E-mail, or letter ("Hundi") carrying
couriers are used to convey the necessary information (the amount of
money, the date it has to be paid on) between Hawaladars. The sender
provides the recipient with code words (or numbers, for instance the
serial numbers of currency notes), a digital encrypted message, or
agreed signals (like handshakes), to be used to retrieve the money.
Big Hawaladars use a chain of middlemen in cities around the globe.
But most Hawaladars are small businesses. Their Hawala activity is a
sideline or moonlighting operation. "Chits" (verbal agreements)
substitute for certain written records. In bigger operations there
are human "memorizers" who serve as arbiters in case of dispute. The
Hawala system requires unbounded trust. Hawaladars are often members
of the same family, village, clan, or ethnic group. It is a system
older than the West. The ancient Chinese had their own "Hawala" -
"fei qian" (or "flying money"). Arab traders used it to avoid being
robbed on the Silk Road. Cheating is punished by effective excommunication
and "loss of honour" - the equivalent of an economic
death sentence. Physical violence is rarer but not unheard of.
Violence sometimes also erupts between money recipients and robbers
who are after the huge quantities of physical cash sloshing about
the system. But these, too, are rare events, as rare as bank
robberies. One result of this effective social regulation is that
commodity traders in Asia shift hundreds of millions of US dollars
per trade based solely on trust and the verbal commitment of their
counterparts.
Hawala arrangements are used to avoid customs duties, consumption
taxes, and other trade-related levies. Suppliers provide importers
with lower prices on their invoices, and get paid the difference via
Hawala. Legitimate transactions and tax evasion constitute the bulk
of Hawala operations. Modern Hawala networks emerged in the 1960's
and 1970's to circumvent official bans on gold imports in Southeast
Asia and to facilitate the transfer of hard earned wages of
expatriates to their families ("home remittances") and their
conversion at rates more favourable (often double) than the
government's.
Hawala provides a cheap (it costs c. 1% of the amount transferred),
efficient, and frictionless alternative to morbid and corrupt
domestic financial institutions. It is Western Union without the hitech
gear and the exorbitant transfer fees.
Unfortunately, these networks have been hijacked and compromised by
drug traffickers (mainly in Afganistan and Pakistan), corrupt
officials, secret services, money launderers, organized crime, and
terrorists. Pakistani Hawala networks alone move up to 5 billion US
dollars annually according to estimates by Pakistan's Minister of
Finance, Shaukut Aziz. In 1999, Institutional Investor Magazine
identified 1100 money brokers in Pakistan and transactions that ran
as high as 10 million US dollars apiece. As opposed to stereotypes,
most Hawala networks are not controlled by Arabs, but by Indian and
Pakistani expatriates and immigrants in the Gulf. The Hawala network
in India has been brutally and ruthlessly demolished by Indira
Ghandi (during the emergency regime imposed in 1975), but Indian
nationals still play a big part in international Hawala networks.
Similar networks in Sri Lanka, the Philippines, and Bangladesh have
also been eradicated.
The OECD's Financial Action Task Force (FATF) says that:
"Hawala remains a significant method for large numbers of businesses
of all sizes and individuals to repatriate funds and purchase
gold.... It is favoured because it usually costs less than moving
funds through the banking system, it operates 24 hours per day and
every day of the year, it is virtually completely reliable, and
there is minimal paperwork required."
(Organisation for Economic Co-Operation and Development (OECD),
"Report on Money Laundering Typologies 1999-2000," Financial Action
Task Force, FATF-XI, February 3, 2000, at
http://www.oecd.org/fatf/pdf/TY2000_en.pdf )
Hawala networks closely feed into Islamic banks throughout the world
and to commodity trading in South Asia. There are more than 200
Islamic banks in the USA alone and many thousands in Europe, North
and South Africa, Saudi Arabia, the Gulf states (especially in the
free zone of Dubai and in Bahrain), Pakistan, Malaysia, Indonesia,
and other South East Asian countries. By the end of 1998, the overt
(read: tip of the iceberg) liabilities of these financial
institutions amounted to 148 billion US dollars. They dabbled in
equipment leasing, real estate leasing and development, corporate
equity, and trade/structured trade and commodities financing
(usually in consortia called "Mudaraba").
While previously confined to the Arab peninsula and to south and
east Asia, this mode of traditional banking became truly
international in the 1970's, following the unprecedented flow of
wealth to many Moslem nations due to the oil shocks and the
emergence of the Asian tigers. Islamic banks joined forces with
corporations, multinationals, and banks in the West to finance oil
exploration and drilling, mining, and agribusiness. Many leading law
firms in the West (such as Norton Rose, Freshfields, Clyde and Co.
and Clifford Chance) have "Islamic Finance" teams which are familiar
with Islam-compatible commercial contracts.
II. HAWALA AND TERRORISM
Recent anti-terrorist legislation in the US and the UK allows
government agencies to regularly supervise and inspect businesses
that are suspected of being a front for the ''Hawala'' banking
system, makes it a crime to smuggle more than $10,000 in cash across
USA borders, and empowers the Treasury secretary (and its Financial
Crimes Enforcement Network - FinCEN) to tighten record-keeping and
reporting rules for banks and financial institutions based in the
USA. A new inter-agency Foreign Terrorist Asset Tracking Center
(FTAT) was set up. A 1993 moribund proposed law requiring US-based
Halawadar to register and to report suspicious transactions may be
revived. These relatively radical measures reflect the belief that
the al-Qaida network of Osama bin Laden uses the Hawala system to
raise and move funds across national borders. A Hawaladar in
Pakistan (Dihab Shill) was identified as the financier in the
attacks on the American embassies in Kenya and Tanzania in 1998.
But the USA is not the only country to face terrorism financed by
Hawala networks.
A few months ago, the Delhi police, the Indian government's
Enforcement Directorate (ED), and the Military Intelligence (MI)
arrested six Jammu Kashmir Islamic Front (JKIF) terrorists. The
arrests led to the exposure of an enormous web of Hawala
institutions in Delhi, aided and abetted, some say, by the ISI
(Inter Services Intelligence, Pakistan's security services). The
Hawala network was used to funnel money to terrorist groups in the
disputed Kashmir Valley.
Luckily, the common perception that Hawala financing is paperless is
wrong. The transfer of information regarding the funds often leaves
digital (though heavily encrypted) trails. Couriers and "contract
memorizers", gold dealers, commodity merchants, transporters, and
moneylenders can be apprehended and interrogated. Written, physical,
letters are still the favourite mode of communication among small
and medium Hawaladars, who also invariably resort to extremely
detailed single entry bookkeeping. And the sudden appearance and
disappearance of funds in bank accounts still have to be explained.
Moreover, the sheer scale of the amounts involved entails the
collaboration of off shore banks and more established financial
institutions in the West. Such flows of funds affect the local money
markets in Asia and are instantaneously reflected in interest rates
charged to frequent borrowers, such as wholesalers. Spending and
consumption patterns change discernibly after such influxes. Most of
the money ends up in prime world banks behind flimsy business
facades. Hackers in Germany claimed (without providing proof) to
have infiltrated Hawala-related bank accounts.
The problem is that banks and financial institutions - and not only
in dodgy offshore havens ("black holes" in the lingo) - clam up and
refuse to divulge information about their clients. Banking is
largely a matter of fragile trust between bank and customer and
tight secrecy. Bankers are reluctant to undermine either. Banks use
mainframe computers which can rarely be hacked through cyberspace
and can be compromised only physically in close co-operation with
insiders. The shadier the bank - the more formidable its digital
defenses.
The use of numbered accounts (outlawed in Austria, for instance,
only recently) and pseudonyms (still possible in Lichtenstein)
complicates matters. Bin Laden's accounts are unlikely to bear his
name. He has collaborators.
Hawala networks are often used to launder money, or to evade taxes.
Even when employed for legitimate purposes, to diversify the risk
involved in the transfer of large sums, Hawaladars apply techniques
borrowed from money laundering. Deposits are fragmented and wired to
hundreds of banks the world over ("starburst"). Sometimes, the money
ends up in the account of origin ("boomerang").
Hence the focus on payment clearing and settlement systems. Most
countries have only one such system, the repository of data
regarding all banking (and most non-banking) transactions in the
country. Yet, even this is a partial solution. Most national systems
maintain records for 6-12 months, private settlement and clearing
systems for even less.
Yet, the crux of the problem is not the Hawala or the Hawaladars.
The corrupt and inept governments of Asia are to blame for not
regulating their banking systems, for over-regulating everything
else, for not fostering competition, for throwing public money at
bad debts and at worse borrowers, for over-taxing, for robbing
people of their life savings through capital controls, for tearing
at the delicate fabric of trust between customer and bank (Pakistan,
for instance, froze all foreign exchange accounts two years ago).
Perhaps if Asia had reasonably expedient, reasonably priced,
reasonably regulated, user-friendly banks - Osama bin Laden would
have found it impossible to finance his mischief so invisibly.
Straf - Corruption in Central and Eastern Europe
The three policemen barked "straf", "straf" in unison. It was a
Russianized version of the German word for "fine" and a euphemism
for bribe. I and my fiancée were stranded in an empty ally at the
heart of Moscow, physically encircled by these young bullies, an
ominous propinquity. They held my passport ransom and began to drag
me to a police station nearby. We paid.
To do the fashionable thing and to hold the moral high ground is
rare. Yet, denouncing corruption and fighting it satisfies both
conditions. Such hectoring is usually the preserve of well-heeled
bureaucrats, driving utility vehicles and banging away at wireless
laptops. The General Manager of the IMF makes 400,000 US dollars a
year, tax-free, and perks. This is the equivalent of 2,300 (!)
monthly salaries of a civil servant in Macedonia - or 7,000 monthly
salaries of a teacher or a doctor in Yugoslavia, Moldova, Belarus,
or Albania. He flies only first class and each one of his air
tickets is worth the bi-annual income of a Macedonian factory
worker. His shareholders - among them poor and developing countries
- are forced to cough up these exorbitant fees and to finance the
luxurious lifestyle of the likes of Kohler and Wolfensohn. And then
they are made to listen to the IMF lecture them on belt tightening
and how uncompetitive their economies are due to their expensive
labour force. To me, such a double standard is the epitome of
corruption. Organizations such as the IMF and World Bank will never
be possessed of a shred of moral authority in these parts of the
world unless and until they forgo their conspicuous consumption.
Yet, corruption is not a monolithic practice. Nor are its outcomes
universally deplorable or damaging. One would do best to adopt a
utilitarian and discerning approach to it. The advent of moral
relativism has taught us that "right" and "wrong" are flexible,
context dependent and culture-sensitive yardsticks.
What amounts to venality in one culture (Slovenia) is considered no
more than gregariousness or hospitality in another (Macedonia).
Moreover, corruption is often "imported" by multinationals, foreign
investors, and expats. It is introduced by them to all levels of
governments, often in order to expedite matters or secure a
beneficial outcome. To eradicate corruption, one must tackle both
giver and taker.
Thus, we are better off asking "cui bono" than "is it the right
thing to do". Phenomenologically, "corruption" is a common - and
misleading - label for a group of behaviours. One of the following
criteria must apply:
(a) The withholding of a service, information, or goods that, by
law, and by right, should have been provided or divulged.
To have a phone installed in Russia one must openly bribe the
installer (according to a rather rigid tariff). In many of the
former republics of Yugoslavia, it is impossible to obtain
statistics or other data (the salaries of senior public
officeholders, for instance) without resorting to kickbacks.
(b) The provision of a service, information, or goods that, by law,
and by right, should not have been provided or divulged.
Tenders in the Czech Republic are often won through bribery. The
botched privatizations all over the former Eastern Bloc constitute a
massive transfer of wealth to select members of a nomenklatura.
Licences and concessions are often granted in Bulgaria and the rest
of the Balkan as means of securing political allegiance or paying
off old political "debts".
(c) That the withholding or the provision of said service,
information, or goods are in the power of the withholder or the
provider to withhold or to provide AND That the withholding or the
provision of said service, information, or goods constitute an
integral and substantial part of the authority or the function of
the withholder or the provider.
The post-communist countries in transition are a dichotomous lot. On
the one hand, they are intensely and stiflingly bureaucratic. On the
other hand, none of the institutions functions properly or lawfully.
While these countries are LEGALISTIC - they are never LAWFUL. This
fuzziness allows officials in all ranks to usurp authority, to trade
favours, to forge illegal consensus and to dodge criticism and
accountability. There is a direct line between lack of transparency
and venality. Eran Fraenkel of Search for Common Ground in Macedonia
has coined the phrase "ambient corruption" to capture this complex
of features.
(d) That the service, information, or goods that are provided or
divulged are provided or divulged against a benefit or the promise
of a benefit from the recipient and as a result of the receipt of
this specific benefit or the promise to receive such benefit.
It is wrong to assume that corruption is necessarily, or even
mostly, monetary or pecuniary. Corruption is built on mutual
expectations. The reasonable expectation of a future benefit is, in
itself, a benefit. Access, influence peddling, property rights,
exclusivity, licences, permits, a job, a recommendation - all
constitute benefits.
(e) That the service, information, or goods that are withheld are
withheld because no benefit was provided or promised by the
recipient.
Even then, in CEE, we can distinguish between a few types of corrupt
and venal behaviours in accordance with their OUTCOMES (utilities):
(a) Income Supplement
Corrupt actions whose sole outcome is the supplementing of the
income of the provider without affecting the "real world" in any
manner.
Though the perception of corruption itself is a negative outcome -
it is so only when corruption does not constitute an acceptable and
normative part of the playing field. When corruption becomes
institutionalised - it also becomes predictable and is easily and
seamlessly incorporated into decision making processes of all
economic players and moral agents. They develop "by-passes" and
"techniques" which allow them to restore an efficient market
equilibrium. In a way, all-pervasive corruption is transparent and,
thus, a form of taxation.
This is the most common form of corruption exercised by low and midranking
civil servants, party hacks and municipal politicians
throughout the CEE.
More than avarice, the motivating force here is sheer survival. The
acts of corruption are repetitive, structured and in strict
accordance with an un-written tariff and code of conduct.
(b) Acceleration Fees
Corrupt practices whose sole outcome is to ACCELERATE decision
making, the provision of goods and services or the divulging of
information. None of the outcomes or the utility functions are
altered. Only the speed of the economic dynamics is altered. This
kind of corruption is actually economically BENEFICIAL. It is a
limited transfer of wealth (or tax) which increases efficiency. This
is not to say that bureaucracies and venal officialdoms, overregulation
and intrusive political involvement in the workings of
the marketplace are good (efficient) things.
They are not. But if the choice is between a slow, obstructive and
passive-aggressive civil service and a more forthcoming and
accommodating one (the result of bribery) - the latter is
preferable.
Acceleration fees are collected mostly by mid-ranking bureaucrats
and middle rung decision makers in both the political echelons and
the civil service.
(c) Decision Altering Fees
This is where the line is crossed from the point of view of
aggregate utility. When bribes and promises of bribes actually alter
outcomes in the real world - a less than optimal allocation of
resources and distribution of means of production is obtained. The
result is a fall in the general level of production. The many is
hurt by the few. The economy is skewed and economic outcomes are
distorted. This kind of corruption should be uprooted on utilitarian
grounds as well as on moral ones.
(d) Subversive Outcomes
Some corrupt collusions lead to the subversion of the flow of
information within a society or an economic unit. Wrong information
often leads to disastrous outcomes. Consider a medical doctor or an
civil engineer who bribed their way into obtaining a professional
diploma.
Human lives are at stake. The wrong information, in this case is the
professional validity of the diplomas granted and the scholarship
(knowledge) that such certificates stand for. But the outcomes are
lost lives. This kind of corruption, of course, is by far the most
damaging.
Unfortunately, it is widespread in CEE. It is proof of the collapse
of the social treaty, of social solidarity and of the fraying of the
social fabric.
No Western country accepts CEE diplomas without further
accreditation, studies and examinations. Many "medical doctors" and
"engineers" who emigrated to Israel from Russia and the former
republics of the USSR - were suspiciously deficient professionally.
Israel was forced to re-educate them prior to granting them a
licence to practice locally.
(e) Reallocation Fees
Benefits paid (mainly to politicians and political decision makers)
in order to affect the allocation of economic resources and material
wealth or the rights thereto. Concessions, licences, permits, assets
privatised, tenders awarded are all subject to reallocation fees.
Here the damage is materially enormous (and visible) but, because it
is widespread, it is "diluted" in individual terms. Still, it is
often irreversible (like when a sold asset is purposefully undervalued)
and pernicious. a factory sold to avaricious and criminally
minded managers is likely to collapse and leave its workers
unemployed.
Corruption pervades daily life even in the prim and often hectoring
countries of the West. It is a win-win game (as far as Game Theory
goes) - hence its attraction. We are all corrupt to varying degrees.
But it is wrong and wasteful - really, counterproductive - to fight
corruption in CEE in a wide front and indiscriminately.
It is the kind of corruption whose evil outcomes outweigh its
benefits that should be fought. This fine (and blurred) distinction
is too often lost on decision makers and law enforcement agencies in
both East and West.
ERADICATING CORRUPTION
An effective program to eradicate corruption must include the
following elements:
(a) Egregiously corrupt, high-profile, public figures,
multinationals, and institutions (domestic and foreign) must be
singled out for harsh (legal) treatment and thus demonstrate that no
one is above the law and that crime does not pay.
(b) All international aid, credits, and investments must be
conditioned upon a clear, performance-based, plan to reduce
corruption levels and intensity. Such a plan should be monitored and
revised as needed. Corruption retards development and produces
instability by undermining the credentials of democracy, state
institutions, and the political class. Reduced corruption is,
therefore, a major target of economic and institutional
developmental.
(c) Corruption cannot be reduced only by punitive measures. A system
of incentives to avoid corruption must be established. Such
incentives should include a higher pay, the fostering of civic
pride, educational campaigns, "good behaviour" bonuses, alternative
income and pension plans, and so on.
(d) Opportunities to be corrupt should be minimized by liberalizing
and deregulating the economy. Red tape should be minimized,
licensing abolished, international trade freed, capital controls
eliminated, competition introduced, monopolies broken, transparent
public tendering be made mandatory, freedom of information
enshrined, the media should be directly supported by the
international community, and so on. Deregulation should be a
developmental target integral to every program of international aid,
investment, or credit provision.
(e) Corruption is a symptom of systemic institutional failure.
Corruption guarantees efficiency and favourable outcomes. The
strengthening of institutions is of critical importance. The police,
the customs, the courts, the government, its agencies, the tax
authorities, the state owned media - all must be subjected to a
massive overhaul. Such a process may require foreign management and
supervision for a limited period of time. It most probably would
entail the replacement of most of the current - irredeemably corrupt
- personnel. It would need to be open to public scrutiny.
(f) Corruption is a symptom of an all-pervasive sense of
helplessness. The citizen (or investor, or firm) feels dwarfed by
the overwhelming and capricious powers of the state. It is through
corruption and venality that the balance is restored. To minimize
this imbalance, potential participants in corrupt dealings must be
made to feel that they are real and effective stakeholders in their
societies. A process of public debate coupled with transparency and
the establishment of just distributive mechanisms will go a long way
towards rendering corruption obsolete.
Russia's Missing Billions
Russia's Audit Chamber - with the help of the Swiss authorities and
their host of dedicated investigators - may be about to solve a long
standing mystery. An announcement by the Prosecutor's General Office
is said to be imminent. The highest echelons of the Yeltsin
entourage - perhaps even Yeltsin himself - may be implicated - or
exonerated. A Russian team has been spending the better part of the
last two months poring over documents and interviewing witnesses in
Switzerland, France, Italy, and other European countries.
About $4.8 billion of IMF funds are alleged to have gone amiss
during the implosion of the Russian financial markets in August
1998. They were supposed to prop up the banking system (especially
SBS-Agro) and the ailing and sharply devalued ruble. Instead, they
ended up in the bank accounts of obscure corporations - and, then,
incredibly, vanished into thin air.
The person in charge of the funds in 1998 was none other than
Mikhail Kasyanov, Russia's current Prime Minister - at the time,
Deputy Minister of Finance for External Debt. His signature on all
foreign exchange transactions - even those handled by the central
bank - was mandatory. In July 2000, he was flatly accused by the
Italian daily, La Reppublica, of authorizing the diversion of the
disputed funds.
Following public charges made by US Treasury Secretary Robert Rubin
as early as March 1999, both Russian and American media delved
deeply over the years into the affair. Communist Duma Deputy Viktor
Ilyukhin jumped on the bandwagon citing an obscure "trustworthy
foreign source" to substantiate his indictment of Kremlin cronies
and oligarchs contained in an open letter to the Prosecutor General,
Yuri Skuratov.
The money trail from the Federal Reserve Bank of New York to Swiss
and German subsidiaries of the Russian central Bank was
comprehensively reconstructed. Still, the former Chairman of the
central bank, Sergei Dubinin, called Ilyukhin's allegations and the
ensuing Swiss investigations - "a black PR campaign ... a lie."
Others pointed to an outlandish coincidence: the ruble collapsed
twice in Russia's post-Communist annals. Once, in 1994, when Dubinin
was Minister of Finance and was forced to resign. The second time
was in 1998, when Dubinin was governor of the central bank and was,
again, ousted.
Dubinin himself seems to be unable to make up his mind. In one
interview he says that IMF funds were used to prop up the ruble - in
others, that they went into "the national pot" (i.e., the Ministry
of Finance, to cover a budgetary shortfall).
The Chairman of the Federation Council at the time, Yegor Stroev,
appointed an investigative committee in 1999. Its report remains
classified but Stroev confirmed that IMF funds were embezzled in the
wake of the 1998 forced devaluation of the ruble.
This conclusion was weakly disowned by Eleonora Mitrofanova, an
auditor within the Duma's Audit Chamber who said that they
discovered nothing "strictly illegal" - though, incongruously, she
accused the central bank of suppressing the Chamber's damning
report. The Chairman of the Chamber of Accounts, Khachim Karmokov,
quoted by PwC, said that "the audits performed by the Chamber
revealed no serious procedural breaches in the bank's performance."
But Nikolai Gonchar, a Duma Deputy and member of its Budget
Committee, came close to branding both as liars when he said that he
read a copy of the Audit Chamber report and that it found that
central bank funds were siphoned off to commercial accounts in
foreign banks.
The Moscow Times cited a second Audit Chamber report which revealed
that the central bank was simultaneously selling dollars for rubles
and extending ruble loans to a few well-connected commercial banks,
thus subsidizing their dollar purchases. The central bank went as
far as printing rubles to fuel this lucrative arbitrage. The dollars
came from IMF disbursements.
Radio Free Europe/Radio Liberty, based on its own sources and an
article in the Russian weekly "Novaya Gazeta", claims that half the
money was almost instantly diverted to shell companies in Sydney and
London. The other half was mostly transferred to the Bank of New
York and to Credit Suisse.
Why were additional IMF funds transferred to a chaotic Russia,
despite warnings by many and a testimony by a Russian official that
previous tranches were squandered? Moreover, why was the money sent
to the Central Bank, then embroiled in a growing scandal over the
manipulation of treasury bills, known as GKO's and other debt
instruments, the OFZ's - and not to the Ministry of Finance, the
beneficiary of all prior transfers? The central bank did act as
MinFin's agent - but circumstances were unusual, to say the least.
There isn't enough to connect the IMF funds with the money
laundering affair that engulfed the Bank of New York a year later to
the day, in August 1999 - though several of the personalities
straddled the divide between the bank and its clients. Swiss efforts
to establish a firm linkage failed as did their attempt to implicate
several banks in the Italian canton of Ticino. The Swiss - in
collaboration with half a dozen national investigation bureaus,
including the FBI - were more successful in Italy proper, where they
were able to apprehend a few dozen suspects in an elaborate
undercover operation.
FIMACO's name emerged rather early in the swirl of rumors and
denials. At the IMF's behest, PricewaterhouseCoopers (PwC) was
commissioned by Russia's central bank to investigate the
relationship between the Russian central bank and its Channel
Islands offshoot, Financial Management Company Limited, immediately
when the accusations surfaced.
Skuratov unearthed $50 billion in transfers of the nation's hard
currency reserves from the central bank to FIMACO, which was
majority-owned by Eurobank, the central bank's Paris-based daughter
company. According to PwC, Eurobank was 23 percent owned by "Russian
companies and private individuals".
Dubinin and his successor, Gerashchenko, admit that FIMACO was used
to conceal Russia's assets from its unrelenting creditors, notably
the Geneva-based Mr. Nessim Gaon, whose companies sued Russia for
$600 million. Gaon succeeded to freeze Russian accounts in
Switzerland and Luxemburg in 1993. PwC alerted the IMF to this
pernicious practice, but to no avail.
Moreover, FIMACO paid exorbitant management fees to self-liquidating
entities, used funds to fuel the speculative GKO market, disbursed
non-reported profits from its activities, through "trust companies",
to Russian subjects, such as schools, hospitals, and charities -
and, in general, transformed itself into a mammoth slush fund and
source of patronage. Russia admitted to lying to the IMF in 1996. It
misstated its reserves by $1 billion.
Some of the money probably financed the fantastic salaries of
Dubinin and his senior functionaries. He earned $240,000 in 1997 -
when the average annual salary in Russia was less than $2000 and
when Alan Greenspan, Chairman of the Federal Reserve of the USA,
earned barely half as much.
Former Minister of Finance, Boris Fedorov, asked the governor of the
central bank and the prime minister in 1993 to disclose how were the
country's foreign exchange reserves being invested. He was told to
mind his own business. To Radio Free Europe/Radio Liberty he said,
six years later, that various central bank schemes were set up to
"allow friends to earn handsome profits ... They allowed friends to
make profits because when companies are created without any risk,
and billions of dollars are transferred, somebody takes a (quite
big) commission ... a minimum of tens of millions of dollars. The
question is: Who received these commissions? Was this money
repatriated to the country in the form of dividends?"
Dubinin's vehement denials of FIMACO's involvement in the GKO market
are disingenuous. Close to half of all foreign investment in the
money-spinning market for Russian domestic bonds were placed through
FIMACO's nominal parent company, Eurobank and, possibly, through its
subsidiary, co-owned with FIMACO, Eurofinance Bank.
Nor is Dubinin more credible when he denies that profits and
commissions were accrued in FIMACO and then drained off. FIMACO's
investment management agreement with Eurobank, signed in 1993,
entitled it to 0.06 percent of the managed funds per quarter.
Even accepting the central banker's ludicrous insistence that the
balance never exceeded $1.4 billion - FIMACO would have earned $3.5
million per annum from management fees alone - investment profits
and brokerage fees notwithstanding. Even Eurobank's president at the
time, Andrei Movchan, conceded that FIMACO earned $1.7 million in
management fees.
The IMF insisted that the PwC reports exonerated all the
participants. It is, therefore, surprising and alarming to find that
the online copies of these documents, previously made available on
the IMF's Web site, were "Removed September 30, 1999 at the request
of PricewaterhouseCoopers".
The cover of the main report carried a disclaimer that it was based
on procedures dictated by the central bank and "... consequently, we
(PwC) make no representation regarding the sufficiency of the
procedures described below ... The report is based solely on
financial and other information provided by, and discussions with,
the persons set out in the report. The accuracy and completeness of
the information on which the report is based is the sole
responsibility of those persons. ... PricewaterhouseCoopers have not
carried out any verification work which may be construed to
represent audit procedures ... We have not been provided access to
Ost West Handelsbank (the recipient of a large part of the $4.8 IMF
tranche)"
The scandal may have hastened the untimely departure of the IMF's
Managing Director at the time, Michel Camdessus, though this was
never officially acknowledged. The US Congress was reluctant to
augment the Fund's resources in view of its controversial handling
of the Asian and Russian crises and contagion.
This reluctance persisted well into the new millennium. A
congressional delegation, headed by James Leach (R, Iowa), Chairman
of the Banking and Financial Services Committee, visited Russia in
April 2000, accompanied by the FBI, to investigate the persistent
contentions about the misappropriation of IMF funds.
Camdessus himself went out of his way to defend his record and
reacted in an unprecedented manner to the allegations. In a letter
to Le Mond, dated August 18, 1999 - and still posted on the IMF's
Web site, three years later - he wrote, inadvertently admitting to
serious mismanagement:
"I wish to express my indignation at the false statements,
allegations, and insinuations contained in the articles and
editorial commentary appearing in Le Monde on August 6, 8, and 9 on
the content of the PricewaterhouseCoopers (PWC) audit report
relating to the operations of the Central Bank of Russia and its
subsidiary, FIMACO.
Your readers will be shocked to learn that the report in question, requested and made public at the initiative of the IMF ... (concludes that) no misuse of funds has been proven, and the report does not criticize the IMF's behavior ... I would also point out that your representation of the IMF's knowledge and actions is misleading. We did know that part of the reserves of the Central Bank of Russia was held in foreign subsidiaries, which is not an illegal practice; however, we did not learn of FIMACO's activities until this year--because the audit reports for 1993 and 1994 were not provided to us by the Central Bank of Russia. The IMF, when apprised of the possible range of FIMACO activities, informed the Russian authorities that it would not resume lending to Russia until a report on these activities was available for review by the IMF and corrective actions had been agreed as needed ... I would add that what the IMF objected to in FIMACO's operations extends well beyond the misrepresentation of Russia's international reserves in mid-1996 and includes several other instances where transactions through it had resulted in a misleading representation of the reserves and of monetary and exchange policies. These include loans to Russian commercial banks and investments in the GKO market."
No one accepted - or accepts - the IMF's convoluted post-facto
"clarifications" at face value. Nor was Dubinin's tortured sophistry
- IMF funds cease to be IMF funds when they are transferred from the
Ministry of Finance to the central bank - countenanced.
Even the compromised office of the Russian Prosecutor-General urged
Russian officials, as late as July 2000, to re-open the
investigation regarding the diversion of the funds. The IMF
dismissed this sudden burst of rectitude as the rehashing of old
stories. But Western officials - interviews by Radio Free
Europe/Radio Liberty - begged to differ.
Yuri Skuratov, the former Prosecutor-General, ousted for undue
diligence, wrote in a book he published two years ago, that only c.
$500 million of the $4.8 were ever used to stabilize the ruble. Even
George Bush Jr., when still a presidential candidate accused
Russia's former Prime Minister Viktor Chernomyrdin of complicity in
embezzling IMF funds. Chernomyrdin threatened to sue.
The rot may run even deeper. The Geneva daily "Le Temps", which has
been following the affair relentlessly, accused, two years ago,
Roman Abramovich, a Yeltsin-era oligarch and a member of the board
of directors of Sibneft, of colluding with Runicom, Sibneft's
trading arm, to misappropriate IMF funds. Swiss prosecutors raided
Runicom's offices just one day after Russian Tax Police raided
Sibneft's Moscow headquarters.
Absconding with IMF funds seemed to have been a pattern of behavior
during Yeltsin's venal regime. The columnist Bradley Cook recounts
how Aldrich Ames, the mole within the CIA, "was told by his Russian
control officer during their last meeting, in November 1993, that
the $130,000 in fresh $100 bills that he was being bribed with had
come directly from IMF loans." Venyamin Sokolov, who headed the
Audit Chamber prior to Sergei Stepashin, informed the US Senate of
$2 billion that evaporated from the coffers of the central bank in
1995.
Even the IMF reluctantly admits:
"Capital transferred abroad from Russia may represent such legal
activities as exports, or illegal sources. But it is impossible to
determine whether specific capital flows from Russia-legal or
illegal-come from a particular inflow, such as IMF loans or export
earnings. To put the scale of IMF lending to Russia into
perspective, Russia's exports of goods and services averaged about
$80 billion a year in recent years, which is over 25 times the
average annual disbursement from the IMF since 1992."
The Enrons of the East
Hermitage Capital Management, an international investment firm owned
by HSBC London, is suing PwC (PricewaterhouseCoopers), the biggest
among the big four accounting firms (Andersen, the fifth, is being
cannibalized by its competitors).
Hermitage also demands to have PwC's license suspended in Russia. All this fuss over allegedly shoddy audits of Gazprom, the Russian energy behemoth with over $20 billion in annual sales and the world's largest reserves of natural gas. Hermitage runs a $600 million Russia fund which is invested in the shares of the allegedly misaudited giant.
The accusations are serious. According to infuriated Hermitage, PwC falsified and distorted the 2000-1 audits by misrepresenting the sale of Gazprom's subsidiary, Purgaz, to Itera, a conveniently obscure entity. Other loss spinning transactions were also creatively tackled. Stoitransgaz - partly owned by former Gazprom managers and their relatives - landed more than $1 billion in lucrative Gazprom contracts.
These shenanigans resulted in billions of dollars of losses and a depressed share price. AFP quotes William Browder, Hermitage's disgruntled CEO, as saying: "This is Russia's Enron". PwC threatened to counter-sue Hermitage over its "completely unfounded" allegations.
But Browder's charges are supported by Boris Fyodorov, a former Russian minister of finance and a current Gazprom independent director. Fyodorov manages his own investment boutique, United Financial Group. Browder is a former Solomon Brothers investment banker. Other investment banks and brokerage firms - foreign and Russian - are supportive of his allegations. They won't and can't be fobbed.
Fyodorov speculates that PwC turned a blind eye to many of Gazprom's shadier deals in order to keep the account. Gazprom shareholders will decide in June whether to retain it as an auditor or not. Browder is initiating a class action lawsuit in New York of Gazprom ADR holders against PwC.
Even Russia's president concurs. A year ago, he muttered ominously about "enormous amounts of misspent money (in Gazprom)". He replaced Rem Vyakhirev, the oligarch that ran Gazprom, with his own protégé. Russia owns 38 percent of the company.
Gazprom is just the latest in an inordinately long stream of companies with dubious methods. Avto VAZ bled itself white - under PwC's nose - shipping cars to dealers, without guarantees or advance payments. The penumbral dealers then vanished without a trace. Avto VAZ wrote off more than $1 billion in "uncollected bills" by late 1995. PwC did make a mild comment in the 1997 audit. But the first real warning appeared only three years later in the audit for the year 2000.
Andrei Sharonov, deputy minister in the federal Ministry of Economics said, in an interview he granted "Business Week" last February: "Auditors have been working on behalf of management rather than shareholders." In a series of outlandish ads, published in Russian business dailies in late February, senior partners in the PwC Moscow office made this incredible statement: "(Audit) does not represent a review of each transaction, or a qualitative assessment of a company's performance."
The New York Times quotes a former employee of Ernst&Young in Moscow as saying: "A big client is god. You do what they want and tell you to do. You can play straight-laced and try to be upright and protect your reputation with minor clients, but you can't do it with the big guys. If you lose that account, no matter how justified you are, that's the end of a career."
PwC should know. When it mentioned suspicious heavily discounted sales of oil to Rosneft in a 1998 audit report, its client, Purneftegaz, replaced it with Arthur Andersen. The dubious deals dutifully vanished from the audit reports, though they continue apace. Andersen claims such transactions do not require disclosure under Russian law.
How times change! Throughout the 1990's, Russia and its nascent private sector were subjected to self-righteous harangues from visiting Big Five accountants. The hectoring targeted the lack of good governance among Russia's corporations and public administration alike. Hordes of pampered speakers and consultants espoused transparent accounting, minority shareholders' rights, management accessibility and accountability and other noble goals.
That was before Enron. The tables have turned. The Big Five - from disintegrating Andersen to KPMG - are being chastised and fined for negligent practices, flagrant conflicts of interests, misrepresentation, questionable ethics and worse. Their worldwide clout, moral authority, and professional standing have been considerably dented.
America's GAAP (Generally Accepted Accounting Practices) - once considered the undisputable benchmark of rectitude and disclosure - are now thought in need of urgent revision. The American issuer of accounting standards - FASB (Financial Accounting Standards Board) - is widely perceived to be an incestuous arrangement between the clubby members of a rapacious and unscrupulous profession. Many American scholars even suggest to adopt the hitherto much-derided alternative - the International Accounting Standards (IAS) recently implemented through much of central and eastern Europe.
Russia's Federal Commission for the Securities Market (FCSM) convened a conclave of Western and domestic auditing firms. The theme was how to spot and neutralize bad auditors. With barely concealed and gleeful schadenfreude, the Russians said that the Enron scandal undermined their confidence in Western accountants and the GAAP.
The Institute of Corporate Law and Corporate Governance (ICLG), having studied the statements of a few major Russian firms, concluded that there are indications of financial problems, "not mentioned by (mostly Western) auditors". They may have a point. Most of the banks that collapsed ignominiously in 1998 received glowing audits signed by Western auditors, often one of the Big Five.
The Russian Investor Protection Association (IPA) and Institute of Professional Auditors (IPAR) embarked on a survey of Russian investors, enterprises, auditors, and state officials - and what they think about the quality of the audit services they are getting.
Many Russian managers - as avaricious and venal as ever - now can justify hiring malleable and puny local auditors instead of big international or domestic ones. Surgutneftegaz - with $2 billion net profit last year and on-going dispute with its shareholders about dividends - wants to sack "Rosexperitza", a respectable Russian accountancy, and hire "Aval", a little known accounting outfit. Aval does not even make it to the list of 200 largest accounting firms in Russia, according to Renaissance Capital, an investment bank.
Other Russian managers are genuinely alarmed by the vertiginous decline in the reputation of the global accounting firms and by the inherent conflict of interest between consulting and audit jobs performed by the same entity. Sviazinvest, a holding and telecom company, hired Accenture on top of - some say instead of - Andersen Consulting.
A decade of achievements in fostering transparency, better corporate governance, and more realistic accounting in central and eastern Europe - may well evaporate in the wake of Enron and other scandals. The forces of reaction and corruption in these nether lands - greedy managers, venal bureaucrats, and anti-reformists - all seized the opportunity to reverse what was hitherto considered an irreversible trend towards Western standards. This, in turn, is likely to deter investors and retard the progress towards a more efficient market economy.
The Big Six accounting firms were among the first to establish a presence in Russia. Together with major league consultancies, such as Baker-McKinsey, they coached Russian entrepreneurs and managers in the ways of the West. They introduced investors to Russia when it was still considered a frontier land. They promoted Russian enterprises abroad and nursed the first, precarious, joint ventures between paranoid Russians and disdainful Westerners.
Companies like Ernst&Young are at the forefront of the fight to include independent directors in the boards of Russian firms, invariably stuffed with relatives and cronies. Together with IPA, Ernst&Young recently established the National Association of Independent Directors (NAID). It is intended to "assist Russian companies to increase their efficiency through introduction of best independent directors' practices."
But even these - often missionary - pioneers were blinded by the spoils of a "free for all", "winner takes all", and "might is right" environment. They geared the accounts of their clients - by minimizing their profits - towards tax avoidance and the abolition of dividends. Quoting unnamed former employees of the audit firms, "The New York Times" described how "... the auditors often chose to play by Russian rules, and in doing so sacrificed the transparency that investors were counting on them to ensure."
The Typology of Financial Scandals
I. Overview
Also published by United Press International (UPI)
The recent implosion of the global equity markets - from Hong Kong
to New York - engendered yet another round of the semipternal
debate: should central banks contemplate abrupt adjustments in the
prices of assets - such as stocks or real estate - as they do
changes in the consumer price indices? Are asset bubbles indeed
inflationary and their bursting deflationary?
Central bankers counter that it is hard to tell a bubble until it
bursts and that market intervention bring about that which it is
intended to prevent. There is insufficient historical data, they
reprimand errant scholars who insist otherwise. This is
disingenuous. Ponzi and pyramid schemes have been a fixture of
Western civilization at least since the middle Renaissance.
Assets tend to accumulate in "asset stocks". Residences built in the
19th century still serve their purpose today. The quantity of new
assets created at any given period is, inevitably, negligible
compared to the stock of the same class of assets accumulated over
decades and, sometimes, centuries. This is why the prices of assets
are not anchored - they are only loosely connected to their
production costs or even to their replacement value.
Asset bubbles are not the exclusive domain of stock exchanges and
shares. "Real" assets include land and the property built on it,
machinery, and other tangibles. "Financial" assets include anything
that stores value and can serve as means of exchange - from cash to
securities. Even tulip bulbs will do.
In 1634, in what later came o be known as "tulipmania", tulip bulbs
were traded in a special marketplace in Amsterdam, the scene of a
rabid speculative frenzy. Some rare black tulip bulbs changed hands
for the price of a big mansion house. For four feverish years it
seemed like the craze would last forever. But the bubble burst in
1637. In a matter of a few days, the price of tulip bulbs was
slashed by 96%!
Uniquely, tulipmania was not an organized scam with an identifiable
group of movers and shakers, which controlled and directed it. Nor
has anyone made explicit promises to investors regarding guaranteed
future profits. The hysteria was evenly distributed and fed on
itself. Subsequent investment fiddles were different, though.
Modern dodges entangle a large number of victims. Their size and
all-pervasiveness sometimes threaten the national economy and the
very fabric of society and incur grave political and social costs.
There are two types of bubbles.
Asset bubbles of the first type are run or fanned by financial
intermediaries such as banks or brokerage houses. They consist of
"pumping" the price of an asset or an asset class.
The assets concerned can be shares, currencies, other securities and
financial instruments - or even savings accounts. To promise
unearthly yields on one's savings is to artificially inflate the
"price", or the "value" of one's savings account.
More than one fifth of the population of 1983 Israel were involved
in a banking scandal of Albanian proportions. It was a classic
pyramid scheme. All the banks, bar one, promised to gullible
investors ever increasing returns on the banks' own publicly-traded
shares.
These explicit and incredible promises were included in prospectuses
of the banks' public offerings and won the implicit acquiescence and
collaboration of successive Israeli governments. The banks used
deposits, their capital, retained earnings and funds illegally
borrowed through shady offshore subsidiaries to try to keep their
impossible and unhealthy promises. Everyone knew what was going on
and everyone was involved. It lasted 7 years. The prices of some
shares increased by 1-2 percent daily.
On October 6, 1983, the entire banking sector of Israel crumbled.
Faced with ominously mounting civil unrest, the government was
forced to compensate shareholders. It offered them an elaborate
share buyback plan over 9 years. The cost of this plan was pegged
at $6 billion - almost 15 percent of Israel's annual GDP. The
indirect damage remains unknown.
Avaricious and susceptible investors are lured into investment
swindles by the promise of impossibly high profits or interest
payments.
The organizers use the money entrusted to them by new investors to
pay off the old ones and thus establish a credible reputation.
Charles Ponzi perpetrated many such schemes in 1919-1925 in Boston
and later the Florida real estate market in the USA. Hence a "Ponzi
scheme".
In Macedonia, a savings bank named TAT collapsed in 1997, erasing
the economy of an entire major city, Bitola. After much wrangling
and recriminations - many politicians seem to have benefited from
the scam - the government, faced with elections in September, has
recently decided, in defiance of IMF diktats, to offer meager
compensation to the afflicted savers. TAT was only one of a few
similar cases. Similar scandals took place in Russia and Bulgaria in
the 1990's .
One third of the impoverished population of Albania was cast into
destitution by the collapse of a series of nation-wide leveraged
investment plans in 1997. Inept political and financial crisis
management led Albania to the verge of disintegration and a civil
war. Rioters invaded police stations and army barracks and
expropriated hundreds of thousands of weapons.
Islam forbids its adherents to charge interest on money lent - as
does Judaism. To circumvent this onerous decree, entrepreneurs and
religious figures in Egypt and in Pakistan established "Islamic
banks". These institutions pay no interest on deposits, nor do they
demand interest from borrowers. Instead, depositors are made
partners in the banks' - largely fictitious - profits. Clients are
charged for - no less fictitious - losses. A few Islamic banks were
in the habit of offering vertiginously high "profits". They went the
way of other, less pious, pyramid schemes.
They melted down and dragged economies and political establishments
with them.
By definition, pyramid schemes are doomed to failure. The number of
new "investors" - and the new money they make available to the
pyramid's organizers - is limited. When the funds run out and the
old investors can no longer be paid, panic ensues. In a classic "run
on the bank", everyone attempts to draw his money simultaneously.
Even healthy banks - a distant relative of pyramid schemes - cannot
cope with such stampedes. Some of the money is invested long-term,
or lent. Few financial institutions keep more than 10 percent of
their deposits in liquid on-call reserves.
Studies repeatedly demonstrated that investors in pyramid schemes
realize their dubious nature and stand forewarned by the collapse of
other contemporaneous scams. But they are swayed by recurrent
promises that they could draw their money at will ("liquidity") and,
in the meantime, receive alluring returns on it ("capital gains",
"interest payments", "profits").
People know that they are likelier to lose all or part of their
money as time passes. But they convince themselves that they can
outwit the organizers of the pyramid, that their withdrawals of
profits or interest payments prior to the inevitable collapse will
more than amply compensate them for the loss of their money. Many
believe that they will succeed to accurately time the extraction of
their original investment based on - mostly useless and
superstitious - "warning signs".
While the speculative rash lasts, a host of pundits, analysts, and
scholars aim to justify it. The "new economy" is exempt from "old
rules and archaic modes of thinking". Productivity has surged and
established a steeper, but sustainable, trend line. Information
technology is as revolutionary as electricity. No, more than
electricity. Stock valuations are reasonable. The Dow is on its way
to 33,000. People want to believe these "objective, disinterested
analyses" from "experts".
Investments by households are only one of the engines of this first
kind of asset bubbles. A lot of the money that pours into pyramid
schemes and stock exchange booms is laundered, the fruits of illicit
pursuits. The laundering of tax-evaded money or the proceeds of
criminal activities, mainly drugs, is effected through regular
banking channels. The money changes ownership a few times to obscure
its trail and the identities of the true owners.
Many offshore banks manage shady investment ploys. They maintain two
sets of books. The "public" or "cooked" set is made available to the
authorities - the tax administration, bank supervision, deposit
insurance, law enforcement agencies, and securities and exchange
commission. The true record is kept in the second, inaccessible, set
of files.
This second set of accounts reflects reality: who deposited how
much, when and subject to which conditions - and who borrowed what,
when and subject to what terms. These arrangements are so stealthy
and convoluted that sometimes even the shareholders of the bank lose
track of its activities and misapprehend its real situation.
Unscrupulous management and staff sometimes take advantage of the
situation. Embezzlement, abuse of authority, mysterious trades,
misuse of funds are more widespread than acknowledged.
The thunderous disintegration of the Bank for Credit and Commerce
International (BCCI) in London in 1991 revealed that, for the better
part of a decade, the executives and employees of this penumbral
institution were busy stealing and misappropriating $10 billion. The
Bank of England's supervision department failed to spot the rot on
time. Depositors were - partially - compensated by the main
shareholder of the bank, an Arab sheikh. The story repeated itself
with Nick Leeson and his unauthorized disastrous trades which
brought down the venerable and veteran Barings Bank in 1995.
The combination of black money, shoddy financial controls, shady
bank accounts and shredded documents renders a true account of the
cash flows and damages in such cases all but impossible. There is no
telling what were the contributions of drug barons, American offshore
corporations, or European and Japanese tax-evaders - channeled
precisely through such institutions - to the stratospheric rise in
Wall-Street in the last few years.
But there is another - potentially the most pernicious - type of
asset bubble. When financial institutions lend to the unworthy but
the politically well-connected, to cronies, and family members of
influential politicians - they often end up fostering a bubble.
South Korean chaebols, Japanese keiretsu, as well as American
conglomerates frequently used these cheap funds to prop up their
stock or to invest in real estate, driving prices up in both markets
artificially.
Moreover, despite decades of bitter experiences - from Mexico in
1982 to Asia in 1997 and Russia in 1998 - financial institutions
still bow to fads and fashions. They act herd-like in conformity
with "lending trends". They shift assets to garner the highest
yields in the shortest possible period of time. In this respect,
they are not very different from investors in pyramid investment
schemes.
II. Case Study - The Savings and Loans Associations Bailout
Also published by United Press International (UPI)
Asset bubbles - in the stock exchange, in the real estate or the
commodity markets - invariably burst and often lead to banking
crises. One such calamity struck the USA in 1986-1989. It is
instructive to study the decisive reaction of the administration and
Congress alike. They tackled both the ensuing liquidity crunch and
the structural flaws exposed by the crisis with tenacity and skill.
Compare this to the lackluster and hesitant tentativeness of the
current lot. True, the crisis - the result of a speculative bubble -
concerned the banking and real estate markets rather than the
capital markets. But the similarities are there.
The savings and loans association, or the thrift, was a strange
banking hybrid, very much akin to the building society in Britain.
It was allowed to take in deposits but was really merely a mortgage
bank. The Depository Institutions Deregulation and Monetary Control
Act of 1980 forced S&L's to achieve interest parity with commercial
banks, thus eliminating the interest ceiling on deposits which they
enjoyed hitherto.
But it still allowed them only very limited entry into commercial
and consumer lending and trust services. Thus, these institutions
were heavily exposed to the vicissitudes of the residential real
estate markets in their respective regions. Every normal cyclical
slump in property values or regional economic shock - e.g., a plunge
in commodity prices - affected them disproportionately.
Interest rate volatility created a mismatch between the assets of
these associations and their liabilities. The negative spread
between their cost of funds and the yield of their assets - eroded
their operating margins. The 1982 Garn-St. Germain Depository
Institutions Act encouraged thrifts to convert from mutual - i.e.,
depositor-owned - associations to stock companies, allowing them to
tap the capital markets in order to enhance their faltering net
worth.
But this was too little and too late. The S&L's were rendered unable
to further support the price of real estate by rolling over old
credits, refinancing residential equity, and underwriting
development projects. Endemic corruption and mismanagement
exacerbated the ruin. The bubble burst.
Hundreds of thousands of depositors scrambled to withdraw their
funds and hundreds of savings and loans association (out of a total
of more than 3,000) became insolvent instantly, unable to pay their
depositors. They were besieged by angry - at times, violent -
clients who lost their life savings.
The illiquidity spread like fire. As institutions closed their
gates, one by one, they left in their wake major financial
upheavals, wrecked businesses and homeowners, and devastated
communities. At one point, the contagion threatened the stability of
the entire banking system.
The Federal Savings and Loans Insurance Corporation (FSLIC) - which
insured the deposits in the savings and loans associations - was no
longer able to meet the claims and, effectively, went bankrupt.
Though the obligations of the FSLIC were never guaranteed by the
Treasury, it was widely perceived to be an arm of the federal
government. The public was shocked. The crisis acquired a political
dimension.
A hasty $300 billion bailout package was arranged to inject
liquidity into the shriveling system through a special agency, the
FHFB. The supervision of the banks was subtracted from the Federal
Reserve. The role of the the Federal Deposit Insurance Corporation
(FDIC) was greatly expanded.
Prior to 1989, savings and loans were insured by the now-defunct
FSLIC. The FDIC insured only banks. Congress had to eliminate FSLIC
and place the insurance of thrifts under FDIC. The FDIC kept the
Bank Insurance Fund (BIF) separate from the Savings Associations
Insurance Fund (SAIF), to confine the ripple effect of the meltdown.
The FDIC is designed to be independent. Its money comes from
premiums and earnings of the two insurance funds, not from
Congressional appropriations. Its board of directors has full
authority to run the agency.
The board obeys the law, not political masters. The FDIC has a
preemptive role. It regulates banks and savings and loans with the
aim of avoiding insurance claims by depositors.
When an institution becomes unsound, the FDIC can either shore it up
with loans or take it over. If it does the latter, it can run it and
then sell it as a going concern, or close it, pay off the depositors
and try to collect the loans. At times, the FDIC ends up owning
collateral and trying to sell it.
Another outcome of the scandal was the Resolution Trust Corporation
(RTC). Many savings and loans were treated as "special risk" and
placed under the jurisdiction of the RTC until August 1992. The RTC
operated and sold these institutions - or paid off the depositors
and closed them. A new government corporation (Resolution Fund
Corporation, RefCorp) issued federally guaranteed bailout bonds
whose proceeds were used to finance the RTC until 1996.
The Office of Thrift Supervision (OTS) was also established in 1989
to replace the dismantled Federal Home Loan Board (FHLB) in
supervising savings and loans. OTS is a unit within the Treasury
Department, but law and custom make it practically an independent
agency.
The Federal Housing Finance Board (FHFB) regulates the savings
establishments for liquidity. It provides lines of credit from
twelve regional Federal Home Loan Banks (FHLB). Those banks and the
thrifts make up the Federal Home Loan Bank System (FHLBS). FHFB gets
its funds from the System and is independent of supervision by the
executive branch.
Thus a clear, streamlined, and powerful regulatory mechanism was put
in place. Banks and savings and loans abused the confusing overlaps
in authority and regulation among numerous government agencies. Not
one regulator possessed a full and truthful picture. Following the
reforms, it all became clearer: insurance was the FDIC's job, the
OTS provided supervision, and liquidity was monitored and imparted
by the FHLB.
Healthy thrifts were coaxed and cajoled to purchase less sturdy
ones. This weakened their balance sheets considerably and the
government reneged on its promises to allow them to amortize the
goodwill element of the purchase over 40 years. Still, there were
2,898 thrifts in 1989. Six years later, their number shrank to 1,612
and it stands now at less than 1,000. The consolidated institutions
are bigger, stronger, and better capitalized.
Later on, Congress demanded that thrifts obtain a bank charter by
1998. This was not too onerous for most of them. At the height of
the crisis the ratio of their combined equity to their combined
assets was less than 1%. But in 1994 it reached almost 10% and
remained there ever since.
This remarkable turnaround was the result of serendipity as much as
careful planning. Interest rate spreads became highly positive. In a
classic arbitrage, savings and loans paid low interest on deposits
and invested the money in high yielding government and corporate
bonds. The prolonged equity bull market allowed thrifts to float new
stock at exorbitant prices.
As the juridical relics of the Great Depression - chiefly amongst
them, the Glass-Steagall Act - were repealed, banks were liberated
to enter new markets, offer new financial instruments, and spread
throughout the USA. Product and geographical diversification led to
enhanced financial health.
But the very fact that S&L's were poised to exploit these
opportunities is a tribute to politicians and regulators alike -
though except for setting the general tone of urgency and
resolution, the relative absence of political intervention in the
handling of the crisis is notable. It was managed by the autonomous,
able, utterly professional, largely a-political Federal Reserve. The
political class provided the professionals with the tools they
needed to do the job. This mode of collaboration may well be the
most important lesson of this crisis.
III. Case Study - Wall Street, October 1929
Also published by United Press International (UPI)
Claud Cockburn, writing for the "Times of London" from New-York,
described the irrational exuberance that gripped the nation just
prior to the Great Depression.
As Europe wallowed in post-war malaise, America seemed to have
discovered a new economy, the secret of uninterrupted growth and
prosperity, the fount of transforming technology:
"The atmosphere of the great boom was savagely exciting, but there
were times when a person with my European background felt alarmingly
lonely. He would have liked to believe, as these people believed, in
the eternal upswing of the big bull market or else to meet just one
person with whom he might discuss some general doubts without being
regarded as an imbecile or a person of deliberately evil intent—some
kind of anarchist, perhaps."
The greatest analysts with the most impeccable credentials and track
records failed to predict the forthcoming crash and the
unprecedented economic depression that followed it. Irving Fisher, a
preeminent economist, who, according to his biographer-son, Irving
Norton Fisher, lost the equivalent of $140 million in today's money
in the crash, made a series of soothing predictions. On October 22
he uttered these avuncular statements: "Quotations have not caught
up with real values as yet ... (There is) no cause for a slump ...
The market has not been inflated but merely readjusted..."
Even as the market convulsed on Black Thursday, October 24, 1929 and
on Black Tuesday, October 29 - the New York Times wrote: "Rally at
close cheers brokers, bankers optimistic".
In an editorial on October 26, it blasted rabid speculators and compliant analysts: ``We shall hear considerably less in the future of those newly invented conceptions of finance which revised the principles of political economy with a view solely to fitting the stock market's vagaries.'' But it ended thus: "(The Fede