-Caveat Lector- Dave Hartley http://www.Asheville-Computer.com http://www.ioa.com/~davehart Wall Street Journal Frday, Sept. 24, 1999 Sunshine Disinfects Dirty Money By Martin Mayer, a guest scholar at the Brookings Institution and author of "Risk Reducation in the New Financial Architecture," published by the Levy Institute of Bard College. The Roman Emperor Vespasian, we are told, put a tax on the use of the public toilets, and his son Titus objected. The money, Titus said, is dirty; it smells. Vespasian had the treasurer go to the storehouse and bring back some coins, which had been washed on their receipt. He held them out to his son and declared: "Non olet." It doesn't smell. If you had to choose a banner to hang outside the big banks of the world, that would be the legend woven into its warp and woof: Non olet. Our customers bring us money. Money is fungible. By the time we see it, it doesn't smell. But the truth is that some money stinks. It comes from peddling drugs, or collecting ransom for the kidnapped, or selling worthless debentures to old folks in the lobby of Lincoln Savings & Loan. Or stealing from the Russian state--a matter that drew the attention of the House Banking Committee this week. Russian thieves can be sure of keeping the money only if they can get it out of the country, and for that they need a bank account abroad, denominated in a foreign currency. For Russians, the easiest way to own a bank account abroad is to own a bank in Russia or have friends who owned a bank in Russia. Their bank can then establish "correspondent" relations with, say, the Bank of New York, which has gone after Russian business. Money can then be transferred on the books of the Bank of New York from the Russian bank's correspondent account to an account of some shell company the thieves invented to conceal their ownership. Thus washed, the money is as odorless as Vespasian's coins. And there's not much the Bank of New York can do about it, claims CEO Thomas A. Renyi. "Satisfying ourselves as to the creditworthiness and business-worthiness of any correspondent bank does not give us any knowledge as to the identity or activities of their customers," he told the Banking Committee. He estimated that 30% of the $4 trillion of dollar-denominated payments made through banks every day moved by "book transfer" within banks that kept deposits with each other for that purpose. The money doesn't have to be sent to Antigua, Guernsey, Gibraltar, Cyprus, Belgium or Luxembourg, where the strongest bank-secrecy laws make it impossible to find out even the names of the shell companies. It can be washed first in a "payable through" account inside the American bank. New regulations wouldn't help, Mr. Renyi suggested. "Heightened domestic surveillance in any one country may simply drive would-be wrongdoers to less stringent points of entry into the system." Banking begins, more than half a millennium ago, with correspondent relations. The Medicis, the Fuggers, the Rothschilds and the Morgans built their businesses on the security and competence of their correspondents. In the modern world, more open arrangements took over as clearinghouses were formed to permit participants to net their payments and deliveries. Because these arrangements gave each participant the guarantee of all the members of the clearing house (and often the government, too), banks became much less careful in vetting the reputation of the other banks with which they did business. Recent years have seen a new growth of bank-to-bank transactions that do not pass through the clearinghouses. The most obvious example is the $70 trillion dollar over-the-counter derivatives market, which is entirely bilateral and hidden. Participants pretend to do abstruse mathematical analyses of the risks and rewards of these instruments, but in the absence of a clearinghouse that maintains records of the "open interest"--the number of similar contracts to be settled--no intelligent estimate of probabilities is in fact possible. Banking regulators, seeking to fence off failures that might infect multilateral clearinghouses, have encouraged bilateral netting between banks in their correspondent accounts with each other. The result is a new systemic instability, as the big banks suddenly discover, say, that Long-Term Capital Management is in hock to all of them individually--and that the total money owed under the thousands of private forward foreign exchange contracts by which they and their hedge-fund clients sought to protect their holdings of ruble-denominated instruments has grown so great that the contracts can't possibly be honored. Other derivatives contracts have become convenient ways to launder money. At a conference of derivatives traders in London two weeks ago, where I gave a talk, several dealers complained that nobody was policing the flow of money on the derivatives chassis from Russia, Romania and Bulgaria. Banking regulators could reduce the use of derivatives contracts for money laundering by setting capital-allocation standards that make it cheaper for banks to use exchange-traded contracts than to trade swaps behind closed doors. The Treasury's proposed Money Laundering Act of 1999 will do nothing to slow the spread of correspondent banking settlements. It would expand the list of money handlers required to file "suspicious activity reports" and report large cash payments, and it would fill in holes in the current definitions of what makes an activity the source of a funds transfer that can be prosecuted as money laundering. But it would not move us to greater doses of that sunshine which Justice Louis D. Brandeis long ago called "the best disinfectant." Treasury calls also for a "90-day review to explore what guidance would be appropriate to enhance scrutiny of correspondent accounts." Banking Committee Chairman James Leach (R., Iowa) wants to move now. His bill, with bipartisan support, calls for American banks doing business with foreign banks in jurisdictions where the quality of banking supervision is below U.S. standards to demand identification of the beneficial owners of accounts on whose behalf the American bank is asked to transfer money. If a company with a bank account is publicly traded, no further identification will be necessary; if it isn't, the bank asking the American bank to do business on behalf of the company will have to provide the names of the owners--just as an American bank presumably requires information about ownership from an American seeking to open an account in a corporate name. Such restrictions are workable. Republic Bank of New York, in an April 1999 amendment to its rule book, requires that "use of a foreign correspondent bank's account by its customers will not be permitted without the approval of head office management . . . defined as the unanimous consent to a written submission by the division head, chairman of the board and chairperson of the executive Know Your Customer committee in New York." Like every piece of legislation, the Leach bill should be investigated for the costs it might impose as well as the benefits it might produce. The one argument that should not be honored is the one that will be heard most often--that if you prohibit honest men from doing dishonest things, then dishonest men will do them and we will be worse off. 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