Bank Shots

How freewheeling bankers used offshore secrecy jurisdictions to escape regulation and contribute to the global economic crisis.

On August 13,
AI editor Adam Garfinkle spoke with Jack A. Blum, chairman of Tax Justice Network USA and one of the world’s premier experts on tax evasion, money laundering, banking and real estate scams, and corporate fraud. Mr. Blum, a Washington, D.C. lawyer in solo practice, also served as Special Counsel to the
Senate Foreign Relations Committee from January 1987 to May 1989.

AI: By now we’ve heard a range of explanations for the current financial-economic meltdown. Some are narrow and some are broad, but few mention the role that offshore secrecy jurisdictions for banks and other financial operations have played in all this. Before asking for your assessment, however, I want to convey a sense of scale here. In our September/October 2008 issue, Robert Morgenthau, the District Attorney of New York City, wrote:

Liechtenstein reports having 161 billion in Swiss francs (equal to about $158 billion at current rates) on deposit in 2006. The Bahamas reportedly has about $200 billion in deposits. By contrast, the Cayman Islands boasted that it had over $1.9 trillion on deposit as of September 2007. . . . Total deposits in the Caymans now amount to four times the total deposits in all the banks in New York City.

Now, most Americans, I think, would be amazed at numbers like these, despite having become a bit jaded by the large bailout sums disbursed over the past year or two. How did these numbers get so large? Is this an old problem that has lately gotten much worse, and if so why?

Jack Blum: There’s no way to make sense of the offshore problem without getting your head around the numbers you mentioned. And those numbers leave out financial assets held by corporations and trusts. Trying to understand the role of offshore secrecy and regulatory havens in the financial crisis is like the problem a doctor has treating a metabolic disease with multiple symptoms. Diabetes, for instance, causes high cholesterol, high blood pressure and all sorts of other problems. You can treat several symptoms and still not cure the disease. Similarly, there are plenty of discrete aspects of the meltdown to talk about and many possible treatments for symptoms, but offshore is at the heart of this metabolic disorder. Its roots reach back decades, in bankers’ attempts to escape regulation and taxation and make banking a highly profitable growth business that mimics the industrial economy.

AI: What’s the relevant history here?

Jack Blum: I’ll begin with an anecdote: In the mid-1970s, when I investigated international banking for the Senate Foreign Relations Committee, I had a long conversation with the cashier of Bank of America, a man named Lee Prussia. He explained that until he arrived, Bank of America hadn’t been very profitable because it specialized in making a lot of little loans to average people, the same kind of business it did when Amadeo Giannini founded it in 1904 as the Bank of Italy. Underwriting those small loans was expensive, he told me, because a loan officer had to sit face-to-face with each borrower, ask all kinds of questions and then turn the borrower down as often as not. To improve the bank’s profitability, he wanted to make a much smaller number of much bigger loans, and he discovered that Third World countries were the ideal borrowers. As he said to me, smiling, over lunch at the top of the Bank of America tower, “We all know governments don’t default.”

AI: Famous last words.

Jack Blum: Well, yes, of course governments do default, and that soon became all too clear. But the point is that the bank was trying to escape the basics of banking, and so were many others in the late 1970s and early 1980s, all in an effort to have profits keep pace with rising corporate profits in general—as increasingly expressed in share prices more than dividend yields or productivity increases. To make their institutions ultra-hot stocks on the market, bankers called in consulting firms like Booz Allen Hamilton to figure out why investment bankers were making so much more money than they were. The answer was that their way of doing business was still too expensive. This led to a trend in which bankers sought to escape the cost grind by farming real banking out to unregulated entities and mostly dealing with the products of their unregulated activity. They also successfully lobbied Congress to relax a range of regulations starting in 1980. Then they focused increasingly on moving financial products from those who created them to those who wanted to buy them. As middlemen, the new breed of bankers could take on less risk and employ very little of their own capital. It worked: They made a lot of money.

But things did not stop there. To make even more money, bankers invented financial instruments that no one understood, and so couldn’t be properly priced by the market. They could get a hell of a mark-up on that and lay it on the customer. So it was the inability or unwillingness of bankers to stick to their business that led them to try to get out from under regulatory supervision.

AI: So now we’re in a position to bring in the offshore piece. What’s the connection between the sort of dynamics you’ve just described and places like the Caymans?

Jack Blum: The connection is fundamental: Banks and other financial institutions that go offshore get out from under regulation and from their reserve requirements. Offshore banks and affiliates have no reserve requirements. The appalling aspect of the offshore world has been that the banks and other financial companies that fit into the world of shadow banking (hedge funds, insurance giants and others) have an unlimited ability to create money. Normally money creation by ordinary banks is limited by reserve requirements—loan loss and liquidity reserves. Without those limitations, their ability to lend goes through the roof. The more crazy financial instruments they produce and sell on money they lend the more money they make. The beauty of this is that the more they lend, the more the junk derivatives they sell increase in value. It works beautifully until the bottom falls out.

AI: And crazy instruments have a way of generating scandals. The Caymans was the nominal home of Long Term Capital, the giant hedge fund that collapsed in 1998. Enron Corporation used 441 Caymans affiliates to hide $2.9 billion in losses. Bear Stearns and especially AIG are interesting cases in this regard, too, are they not?

Jack Blum: AIG’s entire credit-default-swap-cum-insurance policy business was offshore, because AIG would have been required to have reserves against possible losses onshore. The credit-default swap is a perfect scheme: You write insurance, in many cases for deals in which no assets or equity is involved, and then all you have to do is nakedly pass out contracts saying, “We’ll repay you if this thing goes bad.” You don’t have to keep money on hand; you just keep writing those policies and collecting the premiums.

AI: The assumption being that not many will go bad, and that if they do—

Jack Blum: —you’ll cover it either out of cash flow, or you’ll retire and leave the U.S. Treasury to pick up the pieces. The whole thing represented a threat to the stability of the financial system, and it couldn’t possibly have reached the scale it did without the offshore secrecy jurisdictions which gave AIG the ability to hide the risk as a contingent liability.

AI: That’s just one side of the picture, right? A lot of these offshore shenanigans were technically legal despite being so pernicious, like systematic efforts at tax avoidance.

Jack Blum: Right, and tax is the aspect people usually overlook. These financial games were played in a tax-free environment. So not only will banking businesses onshore be more expensive because they have to keep reserves, making their cost of money higher; they will be taxed while transactions offshore won’t be. The perfect world offshore consists of three parts: No one is watching your activities, it’s at low cost, and you’re not paying taxes.

An enormous amount of super-charged money is what took us over the precipice. Until that super-charged money-creation machine is brought under control and taxed, we haven’t fixed anything. Some people are now yelling “Hallelujah, the recovery cometh!”, but the underlying problem, the bankers’ attempt to get out from under their basic function, remains.

AI: The offshore sector has become so large that one wonders about a boomerang effect back onshore. Is there one?

Jack Blum: Oh, yes. American financial regulators have for some years tilted toward loosening regulation so that onshore businesses could compete with offshore ones. You may remember the series of discussions in 2005–06 about how the Securities and Exchange Commission was making American securities offerings non-competitive in global markets. There have been many excuses for the loosening banking and financial regulations over the past quarter century, some ideological, others more simply venal, but the argument of having to compete with less-regulated sectors in a global marketplace has been key.

AI: But that justification hasn’t satisfied everyone. Well before the meltdown, some people tried to warn us about the toxicity of the offshore sector, including then-Senator Obama and Senator John Kerry. And after the meltdown, Senator Carl Levin introduced the Stop Tax Haven Abuse Act (S. 681). We witnessed the secrecy cork pop in Liechtenstein—something you’ve been involved in—and we saw President Sarkozy read out a list of secrecy jurisdiction havens at a G-8 meeting.

But of course none of these efforts ever seems to make it over the political wall. The Levin bill hasn’t passed, whistle-blowers in Liechtenstein got in more trouble than the crooks, and Sarkozy’s list was highly selective. You worked 14 years in the Senate so you’re no stranger to the sausage factory. What does the game board look like now?

Jack Blum: The problem is that when you bring up the issue of offshore tax avoidance and evasion and regulation with the Democratic leadership in the House, they’ll tell you that if you legislate against individual offshore criminal evasion, maybe they can pass something, but they say stay away from the corporate avoidance side of this, because that would scare too many people off, and they would get too much pushback from the members.

AI: So they’re telling you, in essence, to act like a bunch of Keystone cops, rushing around but being ineffectual.

Jack Blum: That’s one of the problems. The second is that the coveted committee slots on Capitol Hill are Financial Services and Ways and Means in the House, and Finance and Banking, Housing and Urban Affairs in the Senate. Why is that? It’s where big money can be raised. The role of campaign money in all this is huge: The major financial companies have contributed about $4.5 billion to campaigns for both parties since 2000. It’s a non-ideological issue.

AI: Has anyone asked the President about this? He campaigned against the K Street transactional culture. You couldn’t ask for a better example of it than the one you just gave.

Jack Blum:Well I don’t know if anyone has asked him, but I do know that Rahm Emanuel, his Chief of Staff, comes out of the hedge fund business, and his largest bundler, I’m told, was the head of the U.S. division of the financial services company UBS.

AI: We’ll get back to UBS in a minute, but are you suggesting that the President is either insincere or that his hands are tied?

Jack Blum: Neither, really. It’s a situation where nobody is overtly corrupt, but everybody is more than influenced. And the ideological dimension comes to play here as well. We’ve just been through a twenty- to thirty-year period in which the message—regulation is bad, taxation is bad, and capital should not be taxed because it is job-creating—has been hammered into an entire generation.

AI: But after the past year and half, who could possibly still believe that financial markets are perfectly self-regulating?

Jack Blum: Lots of people, evidently. Three generations of economists and business school graduates have come to embrace market fundamentalism as a kind of religion. That god is dead, but the priests and the acolytes have not yet let go of the hymnal.

AI: There’s an institutional legacy of this inside the government, too, is there not? I have heard that some officials in the Department of the Treasury worry that if they don’t turn a blind eye to the ebb and flow of dirty money, the United States will lose access to a vast sum that would then be of use to, for example, British bankers via the Isle of Man, Gibraltar, the Caymans or “the City” itself.

Jack Blum: There is some of that. For example, the Treasury set up a program called “Qualified Intermediary” in which it said a foreign bank in a tax haven can open accounts in the United States in the name of its corporation or bank, or a corporation it controls, without identifying the beneficial owner. The only obligations they had was to be audited and not to take in U.S. persons. Why did we do that? Simple: We wanted investment incoming from people outside the United States who were evading taxes in their own countries, but we didn’t want to receive information that we might be obligated to report to the foreign government under our tax-exchange information agreements. That kind of cynical double-play is nauseating at best.

And this, by the way, brings us to UBS. UBS had the same wealth management system going all around the world. It had a Latin American division. The banker who was arrested was coming back to the United States from Brazil; he wasn’t in Brazil to take the waters. The Financial Times identified him as Martin Liechti, head of UBS’s wealth management operations in North and South America. Wealth management is the core of UBS’s private banking operations, and Liechti was held as a “material witness.” The real issue here is, why does the Swiss government encourage its banks to go out of their way to seek this kind of business? Why does it protect them when they get jammed or caught red-handed?

AI: Well, they might respond that, as you have just illustrated, the U.S. government does things that are just about as cynical.

Jack Blum: True enough. We have a Delaware corporate form that hides beneficial ownership. It is used by gangsters from all over the world. The United States gets mutual legal assistance requests by the thousands—

AI: In Delaware? And those guys charge those outrageous tolls on I-95, to boot? That’s not fair.

Jack Blum: These requests pour in from all over the world, and they end up in the “miscellaneous” docket in Delaware district court, and we can’t do anything about them because we don’t know who owns the company. So on the one hand, as with UBS, we’re victims; on the other hand, we’re the perps. What this shows, to me at least, is that we can’t solve the problem, and deal with the potential for financial meltdown it poses, without addressing the systemic issues. And no one is doing that. Instead, the Treasury and the Fed are obsessed with what they take to be a much more profound problem.

AI: Which is?

Jack Blum: The status of the U.S. dollar as a reserve currency. This, above all, is what the Treasury wants to protect because it is the ultimate source of power. It’s what makes the American banking system dominant in the world. Protecting the dollar as the reserve currency has become a very important base-line objective for the Treasury Department, which is why it has bailed out not only U.S. banks but foreign banks as well. Few people understand or even know about this. Last November, the Federal Reserve offered unlimited swap lines to foreign central banks that were in trouble with their bad investments in dollar debt.

AI: Like in Switzerland?

Jack Blum: Yes. UBS had many billions of U.S. dollars invested but in derivatives. These investments went south. It is not well understood that a central bank can only print money in its own currency; so the Swiss national bank can print Swiss francs, but not dollars. If that central bank had printed Swiss francs and then sold them in the international market to buy the dollars needed to bail out UBS, the Swiss franc would have been the functional equivalent of used tissue paper. So we came and said to the Swiss: We’ll swap you dollars for Swiss francs at the current rate, as much as you need to bail out UBS.

AI: Very generous of us.

Jack Blum: Indeed, and we asked nothing in return.

AI: Nothing? Might that generosity have influenced UBS’s recent agreement to cooperate with the IRS and the Justice Department investigation of their American clients suspected of tax evasion?

Jack Blum: That remains to be seen. In any event, we offered similar swap lines to all the major European central banks, dollars for euros. The euro, in a funny way, is a bogus currency, because the mandate of the European Central Bank, which is in charge of printing euros, is only to control inflation, not to provide liquidity to banks in a jam. That function still resides with the national central banks, but of course they can’t print euro currency. They can only borrow euros to restore the solvency of distressed banks. But what if they need dollars? Then the national bank has to go out and buy dollars, which amounts not to printing currency but to real money flowing out of the national treasury. So here’s where the Fed and its swap lines come in: We take the euros and give dollars, and they take the dollars to bail out the bank. As a result, the dollar remains the key currency of exchange.

AI: Why is this so important to the Treasury?

Jack Blum: Its view is that if people lose faith in the dollar as a reserve currency—meaning a currency convertible into any and all other currencies and used to conduct and value most of the world’s trade—the United States would lose its dominant position in world trade and finance. We also want to keep foreigners wanting greenbacks under their mattresses. This, too, is not well understood: The dollar bill represents Treasury debt, of course, but it’s completely interest-free. We have managed to get some $600 billion of interest-free debt floating around the world because people have faith in the dollar. The Treasury and the Fed are desperately afraid that if that faith erodes, they’ll have to pay interest on that debt, to the tune of $4–5 billion a year, or who-knows how much.

AI: Let’s get back to offshore tax evasion, shall we? How does it typically work, and to what extent is the U.S. government itself a witting or unwitting enabler of it?

Jack Blum: Let me give you the flavor of the problem. Financial institutions are required to withhold tax money unless there’s a certification on file that the account is foreign. This is a form called a W-8, filed by a foreign entity or individual that claims ownership of the account and exemption from U.S. taxation. The instructions on the W-8 and the instructions to withholding agents say that if you know that the person who owns the account is a U.S. citizen but filed a W-8 anyway, you have to withhold or else be subject to paying the interest, principal and penalties associated with the failure to withhold. The regulations as written, however, create an enormous loophole that allows institutions to accept the W-8 at face value. Anyone can write practically anything on the W-8, and banks are not obligated to verify it, and so taxes are not withheld.

How did this happen? The regulation-writing procedure at the IRS is so arcane that average people, including most public interest groups, have no idea when a regulation has been proposed or what it means once it is written. This regulatory language leaves banks off the hook; they practice a kind of “don’t ask, don’t tell” policy with respect to the W-8 forms. So how can the IRS go after violators if the banks don’t bother to collect and verify the proper information? Nobody at the IRS knows where or how to look for them.

AI: Especially if they only have a fraction of the agents they need to do it.

Jack Blum: That’s another problem. The main problem, however, is that the entire structure of the tax enforcement system is based on the premise that what’s important appears on your tax return. You fill out a paper or electronic return and file it with the IRS, where agents run it through some number-crunching machine so that they’ll be able to say, “Aha! Your deductions are out of line with your income; we’re auditing you.” And then you have to justify your deductions to the auditor. But in the world we’re talking about, what’s important isn’t on your return.

The second part of the tax enforcement process comes when the agent has looked at your receipts, finds the bogus ones, recalculates the return and sends you a bill. You can then challenge or appeal it. The problem with offshore forms of tax evasion is that, if it isn’t on the return to start with—even if the agent has found out about a hidden account in the Cayman Islands—how does he reconstruct the return in order to create a bill? He can demand information, but he won’t often get it. The most he can usually do is penalize the person for not having reported the account. The IRS can threaten criminal prosecution, but there are both legal and practical limitations to that. The system simply isn’t set up to catch people enmeshed in corporate enterprises who have a big offshore stash that they haven’t reported.

AI: Can it be set up differently, set up better?

Jack Blum: In theory, yes. In practice, it is extremely difficult. Let’s start with the obvious: The banks now operate seamlessly on a global scale. This was not always the case, so again we need to fill in a little more of the history here.

In 1978, a Citibank trader was busted in Brussels for trading currencies, which at the time was tightly regulated. Each state said, in essence, you can only trade our currency within our borders, and each bank was required to balance its books at the end of each trading day so they couldn’t get into long-term exposure in a particular currency. This guy in Brussels broke all the rules in the book. When the cops came, he said the trades were in the Bahamas. They said, “That’s nonsense! You’re here, the records are here, and you’re just mailing them to the Bahamas where they’re posted weeks later.” So they began the prosecution, but in the middle of it Citibank’s worldwide computer went up, and suddenly all the transactions could be booked in the Bahamas concurrently. That ended the prosecution. Nowadays, obviously, all banks have central computers and accounting systems and it makes no difference where a trader operates. It is now impossible to apply national rules to commercial entities that can move accounts and processes around the world at will, and in mere seconds.

AI: Does that mean that the first principle of any solution is that it has to be international?

Jack Blum: It either has to be international, which is very hard, or you have to tell your financial institutions that they can’t operate through offshore subsidiaries off-balance-sheet, and that everything they do within your borders is subject to regulation. You have to be able to say to businessmen and bankers that they can’t do business in countries that reject American regulators. Needless to say, even in the present environment, this is impractical.

Our real issue, it seems to me, is that we refuse to see the problem as a systemic one. Every scandal, every scam, is interpreted as a one-off, an outlier, just the occasional bad apple we can’t do anything about. But when you begin to talk about the underlying instability and the problems that go with them, no one wants to hear it because it interferes with their vision of globalized whatever. So we’re stuck: For purposes of regulation and taxation, national sovereignty is sacred, but for purposes of business operations, banks and corporations are globally seamless.

AI: Sounds like a formula for ultimate regulatory arbitrage.

Jack Blum: It is. Whenever the cops come calling, the banks have a ready response for the particular regulator in each country. No one sees the whole picture, and it’s really no one’s job to even try. When the big and scary stuff happens, the bankers and their friends trot out the Bank for International Settlements or the Financial Stability Forum as proof of effective coordination and regulation. But these things are glorified fig leaves. They have produced absolutely nothing of real value beyond a few minor process quick fixes.

AI: So, then, there’s no clear fix for this problem that’s also politically feasible?

Jack Blum: Perhaps not, in part because the problem of regulatory arbitrage in international banking is just a sub-species of a larger problem, namely the inability of our global governance systems to govern at all. We face the same structural problem with climate change, for example: How do we get at the problem if the Chinese won’t cooperate? Cap-and-trade won’t work if other nations remain aloof. And even if it did, who’s going to regulate a global system that would trade a rainforest in Brazil for pollution in Ohio? We have global problems, but we also have a world we inherited from that fool, Woodrow Wilson, with hundreds of sovereign entities, each of which has to be “respected”—even though the smallest members of the UN have fewer people than an apartment complex in the Bronx.

AI: I have a personal question to ask about people who avoid or evade taxes here and elsewhere. Rich people can be clever, if not necessarily wise, in coming up with rationales for bad behavior. One is that their tax rates amount to extortion; if the government would just curb its voracious appetite, people wouldn’t be forced to shelter their assets and seek out law firms willing to suborn perjury to help them do it. Then there’s the argument, which we’ve alluded to before, that if one guy doesn’t do it, someone else will and gain a competitive advantage in the process. I’m sure you’ve heard such arguments many times, and I’m wondering whether you ever feel any sympathy for them, or if they just piss you off.

Jack Blum:hen individuals make these kinds of arguments—like the typical wealthy guy who’s about to be divorced and wants to hide his money from his soon-to-be ex-wife—it’s the stupidity of the arguments that bothers me. These schemes rarely if ever work out well. Individuals cannot get away with what large banks and hedge funds can get away with. Their oblivious selfishness gets to me, too. The offshore industry lives on the difference between taxes charged and evaded and the fees paid to them. So individuals still pay a “tax”, but to an offshore service provider as opposed to a government. This doesn’t improve the public welfare much, particularly since every dollar not taxed creates a shortfall in revenue or public services that the rest of us have to make up.

AI:Anything else piss you off?

Jack Blum: Sure, the one that irritates the most is the moral illiteracy at work here. It’s bad enough that we never seem to learn anything. Subprime mortgage scams are nothing new. I investigated my first in 1969 and witnessed their second coming twenty years after that. As I said before, when these things happen, we drag out the “bad apple” explanation. But what’s really irritating, and leads me to speak of moral illiteracy, is that the only time we ever really think about all this is when the whole system is on the verge of collapse. And what then? We say the problem is “systemic”, by which we mean that it’s nobody’s fault. And so we proceed to raid the Treasury and give it to the very people who caused the mess in the first place.

AI:What you’ve just said is disturbing. You’re pointing out that in normal times the moral frailty of individuals is excused because it isn’t seen as being connected to some general pathology, but once the moral frailty of individuals accumulates to the point where it’s threatening the system, then there is no moral frailty to be found. It simply disappears into the ether of abnormal times. That’s moral hazard through the looking glass, isn’t it?

Jack Blum: Could be, could be.

Appeared in: Volume 05, Number 2 | Published on: November 1, 2009
Jack Blum is chairman of Tax Justice Network USA and one of the world’s premier experts on tax evasion, money laundering, banking and real estate scams, and corporate fraud. Mr. Blum, a Washington, D.C. lawyer in solo practice, also served as Special Counsel to the Senate Foreign Relations Committee from January 1987 to May 1989.
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