In the aftermath of 9/11, a pitched battle emerged between the American banking industry and the U.S. Congress. The month before the attacks, in August 2001, Senator Carl Levin (D-MI) placed a far-reaching anti-money laundering (AML) bill before the Senate Banking Committee chaired by Senator Phil Gramm (R-TX). Gramm ignored Levin’s proposed legislation just as over the past six years he had prevented no fewer than 11 AML bills from emerging from the committee. But the 9/11 terror attacks changed the political landscape. As Congress began work in October on the U.S.A. PATRIOT Act, Levin pleaded that his draft AML bill be included in the new act on the grounds that money laundering had helped and would otherwise continue to help fund terrorist groups intent on the mass-murder of Americans.

Enter Citibank. Supported by the American Bankers Association and other financial institutions, Citibank mounted a campaign bitterly opposing inclusion of strengthened AML provisions in the PATRIOT Act. A central point of contention was the phenomenon of shell banks that hide behind nominees and trustees so that no one can know who their real owners and managers are. Citibank had for years offered such trustee services to all sorts of rogues through Caribbean subsidiaries, and they desperately wanted to continue this lucrative business. The risk that their subsidiaries might be handling terrorist money seemed hardly to matter to Citibank directors.

Levin and other Senators were equally resolute in their determination to win the fight against illicit money. Civility collapsed; shouting matches between Citibank officers and congressional staffers erupted in the halls of Congress. Levin finally had to insist to his more reluctant colleagues that without an AML package there would not be a PATRIOT Act. Supported particularly by Senators Chuck Grassley (R-IA), John Kerry (D-MA), Paul Sarbanes (D-MD), Bill Nelson (D-FL), Jon Kyl (R-AZ) and Mike DeWine (R-OH), Title III, the International Money Laundering Abatement and Anti-Terrorist Financing Act, was signed into law with the PATRIOT Act on October 26, 2001.

Among its provisions, Title III decrees that no bank registered in the United States can receive a transfer from a foreign shell bank and that no foreign bank can transfer money to the United States that it has received from a foreign shell bank, including wire transfers that might only momentarily touch New York City before speeding off elsewhere. Violation of this prohibition can cause funds to be seized in retribution from “correspondent accounts”, or accounts established in the United States on behalf of foreign banks.

Very few banks could risk such penalties, not just because of the amounts of money involved but because of the huge reputational damage that would ensue. With startling speed, therefore, almost all shell banks went out of business. The thousands of shell banks that used to run loose have been reduced to perhaps a few dozen. Of these, a handful still operate in Europe and a few masquerading front men still make a living dissembling, but all are extremely careful to avoid having their transactions go through American correspondent banking accounts. With a stroke of the legislative pen, a major threat to economic integrity has been almost completely removed from the global financial system.

This story illustrates three central points: eliminating secrecy instantly curtails serious financial risks; the banking community will oppose eliminating secrecy with all the ruckus it can muster; and elected officials nonetheless have the power to require transparency in the global financial system if they choose. The critical importance of these points remains because a welter of shady though not always illegal practices still goes on in domestic U.S. and international banking—notwithstanding the success of the International Money Laundering Abatement and Anti-Terrorist Financing Act. These practices abet not just the financing of terrorism but also incentivize paroxysms of greed that ultimately jeopardize the international financial system on which global economic growth depends.

A G-20 Tale

In their November 2008 Washington meeting, the leaders of the new G-20 ranked transparency in the global financial system ahead of reliance on regulation and oversight as the most important element of reform. Paragraph nine of the group’s joint communiqué pledged to strengthen financial market transparency, require increased disclosure on complex products, and ensure complete and accurate information on the condition of major firms. Later paragraphs proposed five specific actions to promote transparency and accountability (regulation garnered only one).

Talk, however, is cheap, even when it comes from communiqués from august bodies of world leaders. The real test comes when such promises are translated into action, and here is where the story gets interesting. The November 2008 G-20 meeting established four working groups to propose specific recommendations aimed at implementing the principles outlined by the heads of state. Of the more than one hundred people involved in these four groups, the vast majority were drawn from central banks and finance ministries, with only a handful representing multilateral organizations and accounting bodies. In effect, the international financial establishment presumed that it could right its own wrongs.

As foxes are not known to respect the security interests of chickens, so the financial community is not known to cherish transparency. Rather more often it holds the principle of secrecy dear and only grudgingly accepts even the need for regulation. They and their political allies and associates have come to expect financial affairs to be shrouded in mist, and regulatory regimes to do their jobs out of sight. So it was no surprise that when the working groups presented their reports to the April 2009 London follow-on meeting, regulation and oversight had re-assumed a primary place in the reform agenda and transparency was virtually banished. Among the six pledges in the opening section of the meeting’s communiqué, transparency is not even mentioned. The word appears only twice in the lengthy text, both times buried deep within otherwise innocuous language.

Clearly, the official regulatory establishment had trumped the laudable intentions of the G-20. Given the way these things usually work, with senior political leaders lacking the time and specific experience to see new ideas through to implementation, they never knew what hit them in the five-month interstice between the Washington and London meetings. The result is that instead of a new focus that could have had genuinely systematic reform consequences, a bureaucratic juggernaut managed to keep things within its own professional comfort zone, essentially restoring the system that had just failed, merely redecorating it with a few new rules of uncertain significance.

This is not just a semantic quibble. There is a vast difference in practice between a conception of reform based on regulation and oversight, as those terms are commonly understood, and one based on transparency. Legislation can establish regulatory regimes with substantial oversight structures, or it can establish, though a mix of prohibitions and obligations, transparency requirements that in most cases lack substantial oversight structures because they do not need them. The regulatory and oversight approach operates largely within the norms of the community being regulated. The transparency approach establishes norms on the basis of an authority above and beyond that of the community being regulated, and it relies on the bright light of day to enforce those norms.

There are advantages and disadvantages to both approaches, in theory at least. Regulation and oversight regimes offer some efficiencies, but they are also more vulnerable to regulatory capture. Transparency-based regimes generate more political friction as they rely on what amounts to behavior modification, but they are capable of generating more ambitious reforms and are less vulnerable to both regulatory capture and well-funded lobbying efforts. When a system of governance fails spectacularly, or when new circumstances demand new design parameters for governance, the transparency approach is almost always the better option.

Title III of the PATRIOT Act, which banished the shadowy world of shell banks, is a stellar example of transparency-based reform. The law says, simply put, don’t do business with shell banks or you’ll get clobbered. There is no Office Overseeing the Elimination of Shell Banks, no multimillion-dollar budget to people and house such an office, no new congressional subcommittee to oversee it, and no new private “associations” renting space on K Street to lobby it either. Possible violations of the law can be investigated through already-existing bank examination protocols, but the law’s persuasive power lies less in its specific enforcement mechanisms than in the arresting character of its clear, categorical prohibition and its large penalties.

It is, after all, in the nature of oversight under a regulatory regime that malefactors—chronically uncertain about their chances of getting caught but more or less assured that they can survive whatever penalty they receive—will think of violating the law as an exercise in probability. In a transparency regime, they are forced to think in categorical, not probabilistic, terms. Thus one almost always tempts more violations with the former approach than with the latter. Uncertainty breeds lawlessness.

The financial community hates the clear, blunt enforcement approach of a transparency-based regime because it works. It much prefers a complicated system of regulation and oversight, which lends itself to plausible deniability and regulatory arbitrage. The more intricate the statute or regulation, the easier it is to circumvent. If you are caught walking a little over the line of some regulation, you can argue that the best lawyers advised you to do so. If you are still worried about potential violations, you can shop for an offshore jurisdiction that will provide little or no information about your activities to national regulators or law enforcement officials. The more complex the law and the more likely its implementation is expected to take place behind closed doors, the more opportunities there will be to circumvent both the letter and the intent of the law. The more space for corruption that exists, the more respect for the law in general will be debased. That sort of system was perhaps tolerable for the world that Al Capone and Eliot Ness lived in, but it’s neither sensible nor tolerable for the world’s largest economy, one that seeks to be leader, stabilizer and validating agent of a global economic architecture that benefits not just American society but the global commons as well.

The range of current ideas for correcting flaws in national and global financial systems through regulation and oversight is extensive, as the list at the end of this article illustrates. The operational complexity and diversity of these proposals intimidate even legislators who are themselves lawyers by training, because they recognize the difficulties of selecting among such a wide variety of options to create a single regulatory regime.

Quite aside from the complexity of devising an improved system out of all these options, the politics of doing so gives one pause. The financial community can take advantage of the current hyper-partisan political environment to divide and delay, spreading around millions of lobbying dollars to nitpick, dilute and subvert every single regulatory measure that is proposed. Wall Street and its allies would have the home-field advantage in any such contest, having already successfully fended off regulation of the very products and practices that directly contributed to the worst economic crisis since the Great Depression.1 And they’re doing so using the same scoundrel’s argument they’ve used before: Others do “it”, whatever it is, and if we don’t do it too we’ll be at a disadvantage. Thus we hear in Washington that Wall Street dare not fall behind the City of London in financial competitiveness; meanwhile in London, we hear them say that they dare not fall behind Wall Street. If we have so much trouble stopping this obvious “race to the bottom” in our domestic politics, we can forget about arrangements enabling a global financial regulator such as the Bank for International Settlements or the Financial Stability Board to have any say whatsoever over American and other banks operating around the world.

The regulatory reforms on or near the table today are not in themselves futile, and they’re certainly not all bad. Most of them make sense on the merits, but trying to move reform forward on a piecemeal basis will take years that we can’t spare if we want to avoid the next financial crisis. Legislative fatigue and lobbyist sabotage will invariably led to incremental changes that will leave holes big enough for the global economy to fall through yet again.

“Transparency Does a Lot of Work For You”

There is a better way, and Andrew Cuomo, Democratic Attorney General of New York, as quoted above, gets it: Transparency-based reform accomplishes far more, far faster, than regulation and oversight. We need to adopt the tactic employed to enact fast-track trade legislation and the military base closures of the 1990s: Legislators can vote up or down on a package of reforms, but they cannot pick it apart by amendment or delay it by filibuster. We also need to make sure that the reform effort is based on a principle so fundamental that ordinary citizens can easily understand and support it to offset the power of professional lobbyists. Transparency is such a principle. Indeed, the reform campaign’s slogan might be: “Hey Wall Street: If you really have nothing to hide, then why are you hiding it?”

Secrecy and calculated obscurity have been gaining ground in the financial system for decades. Almost $600 trillion, ten times global GDP, in over-the-counter derivatives, primarily interest rate swaps, had accumulated with hardly anyone taking notice. To escape notice (and taxes), hedge funds by the hundreds incorporated in the Cayman Islands, where there are no accounting, filing or reporting requirements. And the Caymans is just one of more than sixty secrecy jurisdictions around the world, most of which allow nominees and trustees to front for shell corporations, trust accounts and foundations, leaving beneficial owners nameless. Such disguised entities now number in the millions. To America’s great shame, they include entities incorporated in Delaware, Wyoming and Nevada.²

Estimates suggest that perhaps half of global trade and capital movements pass through secrecy jurisdictions at some point between origination and completion. Utilizing the global shadow financial system, mispricing of imports and exports for the purpose of shifting capital unrecognizably across borders is routine both within multinational corporations and in person-to-person transactions. Anti-money laundering efforts are a victim of this structure: U.S. Treasury Department officials estimate that 99.9 percent of the drug, terrorist and corrupt money that our laws try to stop is accepted into U.S. accounts on first presentation. The U.S. response to money laundering and abusive transfer pricing has been, frankly, pathetic. We remain legally open to money generated abroad from handling stolen property, counterfeiting, commercial contraband, environmental crimes, tax evasion and more. This fact, as much as the U.S.-born financial crash, has gradually weakened America’s image around the world as a responsible moral actor.

The globe-spanning structure of secrecy instruments and entities also had a major role in accelerating the economic crisis to every corner of the planet. Part of the reason the meltdown became so severe is that no one knew how big the crisis could get. Commercial banks had developed major off-the-books trading operations for their own anticipated profits, tucking away securitized bad paper in off-balance-sheet accounts, special purpose vehicles and over-the-counter derivatives. Financial institutions could not discern the quality of assets in other institutions, or in many cases even in their own portfolios, and so stopped lending to one another. Bear Stearns’ demise took root after the implosion of two major clients, hedge funds incorporated in the impenetrable Caymans. As unseen losses kept mounting, it took four cash infusions into AIG over six months and three into Citibank over five months to stabilize just these two players in the U.S. economy. We now know that the key subprime-peddling instrument at the heart of the Securities and Exchange Commission’s case against Goldman Sachs, Abacus, was incorporated in the Caymans. Deliberate opacity, largely in offshore form, was at the very heart of the contagion.

Yet despite the damage this opaque structure has done, most bankers and financial executives still embrace elements of it and fight to keep them functioning. When they speak of “transparency”, they attempt to hijack the word, limiting it to disclosure on documents and instruments. Systemic transparency is in truth their greatest fear.

So what does legislating transparency mean in practice? It means implementing three major and three supplemental steps to transform the accident-prone structure we have.

First, eliminate secrecy of ownership.

It is ridiculous that, in this era of drug trafficking, corruption and terrorism, any financial institution accepts business from any entity with unknown owners. Wall Street bankers retort, “Do you have any idea how much it would cost us to determine the beneficial owners of all our accounts?” But the answer is that it would cost nearly nothing if we put the shoe on the other foot: We can notify each non-individual-owned account that we must know within a certain period the names and addresses of the flesh-and-blood beneficial owners of the account, or the listed company on a stock exchange that controls the account. Failing that, the account will be closed and the balance returned to the last known address. Filing a false statement on beneficial ownership can at any subsequent date lead to the account being blocked.

If we do this, we will see how, with startling speed, disguised entities fall from the millions to perhaps a few thousand, just as was the case with shell banks. Knowing with whom you are doing business is a necessary step in reforming the global financial system. This is already a recommendation of the Financial Action Task Force in Paris, the global anti-money laundering body. It should become law in every jurisdiction.

Second, cross-border financial institutions and multinational corporations should report their results on a country-by-country basis.

The wholesale disguise of income statements and balance sheets simply has to end for all major entities. Companies must be required to report sales, profits and taxes paid for each jurisdiction where a subsidiary or branch exists. If this were required today, financial institutions and corporations would be forced to reveal huge profits in secrecy jurisdictions where they do no business, a revelation that would shame these companies into reform. Country-by-country reporting directed at extractive industries is beginning within the European Union and is under consideration in the U.S. Congress, and these efforts will no doubt generate much greater transparency in this important sector.

Third, we must automatically exchange tax information across borders.

It is unacceptable that one state jurisdiction can legally participate in depriving another of its revenues. The European Union figured this out and entered into a Savings Tax Directive that requires the automatic exchange of tax data among 24 members, with the remaining three (Austria, Luxembourg and Belgium) likely to join soon. Automatic tax information exchange means that secret money has no place to hide. This must become the norm for all states, including developing countries, which may take some time to put such data to effective use. Curtailing global tax evasion is tantamount to curtailing global financial secrecy. Equally important, it is crucial to reducing our frightfully large budget deficits and, in poorer countries, to lifting the siege on development and poverty alleviation budgets.

Three additional steps would complement these fundamental measures. We should harmonize anti-money laundering laws across all cooperating countries. It is no less unacceptable that the United States welcomes many forms of criminal money from abroad than that other countries turn a blind eye to drug and terrorist money. Furthermore, knowingly receiving tax-evading money across borders should be included in the list of barred proceeds. Illicit flows like these, worth trillions of dollars annually, destabilize the security of nations and the global financial system. Regulatory arbitrage in money laundering needs to stop.

We must also face the issue of trade mispricing. Despite legal guidelines and conventions, manipulation of prices for the purpose of shifting disguised and usually tax-evading capital transfers across borders is standard practice in international commerce. Virtually every multinational corporation uses this technique to break the laws of one or more countries in order to squirrel money away in others. Much of the global financial secrecy structure serves this business. Yet it can be curtailed with just two signatures: those of the seller and the buyer, under a short paragraph in the commercial invoice stating that there is no mispricing for the purpose of avoiding VAT taxes, customs duties or income taxes, and no violation of the exchange control laws or banking statutes of the exporting or importing countries. The great majority of corporations will not ask employees to manipulate trade prices and then sign a document saying they did no such thing; all it would take is one whistleblowing employee to bring down the whole operation.

Finally, businesses must be prohibited from maintaining two entirely different sets of accounts—one for shareholders and one for tax authorities. (That this is common practice is an open secret, but few are aware that those obscurely calculated deferred taxes shown on the shareholders’ version of the accounts are rarely paid.) Why should any entity licensed by the state be permitted to show one set of books to shareholders and another to citizens? Are not shareholders also citizens? Are financial institutions and corporations asking shareholders to be complicit in a process that cheats themselves, not to speak of their neighbors? This has gone on long enough.

A one-books standard will indeed lead to banks and corporations paying more taxes, something the financial system has helped them avoid for decades. That might force some companies to lower dividends or trim their mergers-and-acquisitions strategies in order to invest adequately in capital, but that would hardly be tragic for society as a whole. Indeed, it will begin to ease the burden of taxes on wage earners, something much needed, particularly in Western countries. A financial system that caters to duplicity is setting itself up for a fall.

Note that an attack on secrecy is not at the same time an attack on privacy—a red herring that defenders of the present dysfunction like to trot out when it suits them. Each of us would like our financial affairs to be private. That means not available to the public. It does not mean not available to the tax collector, the criminal investigator or the law enforcement official on the trail of terrorists. As citizenship protects our right to privacy, it also imposes a responsibility to cooperate in protecting the security of our financial system, not its secrecy.

Transparency does not diminish financial security; it adds to it. Transparency lets multiple sets of eyes—those of citizens, investors, regulators and watchdog groups—scrutinize systems, institutions, instruments and mechanisms. Regulation and oversight will always be both necessary and porous, but transparency can fill voids and provide a rapid response to events that regulation and oversight cannot react to in good time. It works against the kind of collective delusion that was at the bottom of the recent crisis.

Transparency is also a self-reinforcing phenomenon; the more places that abide by it, the stronger the system overall. Hot money will find the financial system increasingly less hospitable. Legitimate money will flow to places where it feels more secure. Furthermore, transparency is quicker, if not always easier, to legislate; it leaves the financial community with fewer counterarguments. It shifts the theater of operations to the legislators’ turf. And transparency is far less costly than regulation and oversight.

In the final analysis, transparency is the only thing that can keep severe financial crises from occurring again. Smaller events can occur, yes, but threats to the whole global economic system? Not in a world where transparency has replaced secrecy as the guiding principle. We are not going to risk financial suicide with our eyes wide open. We only blunder into that when we literally can’t see what we’re doing.

* * *

Financial instruments proposals

• Establish financial products safety commissions.
• Increase disclosure requirements in interest rate swaps, credit default swaps, equity swaps and derivatives contracts.
• Require trading in such instruments to take place through clearinghouses or exchanges.
• Regulate securitization of asset bundles.

Financial institutions proposals

• Increase capital adequacy ratios across all classes of banking assets.
• Create capital adequacy ratios for investment banks, industrial banks and mortgage lenders.
• Create gross leverage ratio backstops for all financial institutions.
• Create countercyclical capital buffers.
• Adopt liquidity management standards for banks.
• Control maximum sizes of institutions or adopt disincentives for excessive growth.
• Separate commercial and investment banking.
• Regulate insurance companies in a similar manner as banks.
• Regulate credit rating agencies.
• Regulate multinational corporations that pose risks to national economies.
• Require large hedge, private equity and venture capital funds to register with securities authorities and report as required.
• Implement more frequent and intrusive risk reviews of major institutions.
• Regulate executive compensation and bonus deferrals in major institutions.

Proposed macro-prudential reforms

• Align global accounting standards, particularly between the International Accounting Standards Board in London and the U.S.-based Financial Accounting Standards Board.
• Establish systemic risk regulators or colleges of financial supervisors and share information with similar bodies in cooperating countries.
• Give a measure of global regulatory authority to the Bank for International Settlements (BIS) or the Financial Stability Board (FSB).
• Extend national coverage of IMF Financial Sector Assessment Programs and accompanying Financial System Stability Assessments and Reports on Observance of Standards and Codes.

¹See Gretchen Morgenson and Don Van Natta, Jr., “Even in Crisis, Banks Dig in for Battle Against Regulation”, New York Times, June 1, 2009.
²For details, see the Financial Secrecy Index of the Tax Justice Network (www.financialsecrecyindex.com), as well as p. 66 of this issue.