An address by Avinash Persaud

1.  I would like to begin with a short story of what happened in another industry not such a long time ago with a number of parallels for our topic today.

2.  On October, 16th, 2002, six years before the collapse of Lehman Brothers, an article appeared in the Financial Times opinion page, with the esoteric title, “Banks put themselves at risk in Basle”. The article made three hitherto unconnected points that may seem obvious now, but was not then. The first, was that the bankers had captured their regulators. Not in every country. Back then the Basle Committee of bank supervisors and regulators was an exclusive, self-appointed body, dominated by the US, European countries and Japan – not dissimilar from FATF. They were the rule setters; the rest of the world, rule takers. If you were not Basle compliant there were severe consequences.

3.  The second point was that the evidence for capture was not in brown paper bags, but in the peculiar turn that bank regulation had taken. The author showed that If you used history and logic to determine what bank regulation should be about, you would come up with something that on examination, was diametrically opposed to the rules being set in Basle.

4.  For instance, experience tells us that bank regulation should be most onerous on large, connected, institutions whose failure would tear down the financial system and less burdensome on smaller, less pivotal firms. Over eight hundred years of financial folly tells us that banks are pro-cyclical, lending too much in the boom, too little in the crash, and so regulators should not let bank safety rest too heavily on internal risk assessments. And logic tells us that evidence of poor credit decisions, should be penalised with higher capital adequacy to incentivise better understanding of their risks.

5.  But instead, the effect of Basle was that the most systemically important banks had the lowest capital requirements, helping to push smaller ones out of business. To get lower capital adequacy what they had to do was not to make better credit decisions, but buy bigger databases. The more data and sophisticated the computer models, the more they were allowed to use their internal risk calculations. It was all about process, not evidence of getting it right. Large banks with torrid credit histories could always out-compete smaller banks that may have been better at credit risk, but could not spend as much on processes and data. Making less credit mistakes brought no reward.

6.  The third point the article made was that regulation which favoured process over effectiveness, large over small, internal compliance over objective measures of risk, would fail at the very job it was supposed to do. That system was destined to lead to a liquidity crisis with banks holding concentrations of previously highly rated assets that they would all want to sell at the same time when the computer models told them so. What followed was no fluke. The very same Basle Committee countries that had smugly lectured on the importance of a sound banking system, which could only be achieved, they said, by following their standards, could not have made a bigger (foul) up if they tried. Before destruction, the heart of man is haughty.

7.  There are striking parallels between what happened in banking regulation and what is happening in international rules on money laundering and the evasion of taxes.

8.  Let me make my point, not with rhetoric but by asking you to participate in a simple scientific experiment in which you have to jot down three separate lists of about a dozen countries each.

a.  The first is the list of countries we know we should be worried about with regards to money laundering and tax evasion. To arrive at this list we need to begin with the products that make money laundering and tax evasion possible, namely shell companies, where the beneficial owners are untraceable. We then need to consider not just the rules on shell companies, but their effectiveness. In this regard we have been immensely helped by a field experiment by Findlay, Nielson and Sharman of almost 180 jurisdictions, originally carried out in 2010 and recently updated. In this experiment they present themselves as those that would appear to be a high risk of being a money launder and see how hard it is to actually get a company with untraceable owners set up in different jurisdictions.

9.  We also need to add to the mix our understanding that money launderers seek financial sectors that have as much depth, diversity and sophistication as possible, to assist in the laundering and its camouflage. In the words of Brigitte Unger’s 2007 study, giants wash more. The list of countries in which shell companies are easiest to set up and which also have the largest financial sectors is led by the US, Canada, UK, Australia, Poland, Ireland – all OECD and FATF members.

10.  Now jot down the second list, this one based on a very different set of criteria.

a.  We are looking for countries which are avowedly anti US, or sufficiently small or poor to be unable to respond to sanctions by others or, with a financial system with a small number of international linkages, The more of these traits a country exhibits the more it should be on this list and so at the top would probably be North Korea and Syria. Cuba, Bolivia, Ecuador and Yemen would also be there and I would venture Iran as well.

11.  The third list I would like you to jot down is that list that used to be called the “black list”, but today is more formally a list of those countries the Global Forum have warned, need to strengthen their anti-money laundering processes, and that other countries need to defend themselves against with sanctions.

12.  I now ask you, of these three lists,

a.  the first list of countries the evidence tells us we should be worried about when it comes to tax evasion and money laundering,
b.  the second list of small, unconnected, countries unable to respond to sanctions and
c.  the third, Global Forum’s list,

13.  Which two are closest? You don’t need the conclusive rank correlations to know the answer. The Global Forum process is intellectually bankrupt.

14.  If the OECD and G20 were really concerned about limiting money laundering and tax evasion the effort would be focused on products not countries; effectiveness not processes.

a.  When it came to countries, they would be targeting a set of OECD and G20 countries that we know will never be targeted and listed, not a set of small, unconnected countries unable to afford strong response to a deeply political process.

15.  But it is worse than that.

a.  The consequence of the politicisation of efforts against money laundering and tax evasion is dangerous because it facilitates money laundering and tax evasion.
b.  It is just like the consequences of the earlier capture of bank regulators.
c.  The very countries that objectively present the greatest risk of money laundering and tax evasion, where establishing a shell company is three times easier than in your average small international financial centre, are the very set of OECD countries that feel no fear of being black listed, and have never been so.

16.  This is the adult world we live in.

17.  There have recently been a raft of books by those who feel they are unsung heroes for using the mechanisms of anti-money laundering and tax evasion rules as foreign policy weapons.

18.  The post war agents of multilateralism, the UN, the WTO, have been deliberately made toothless and ineffective and a new colonisation is afoot, based not on gun boats, but the imposition of “standards”, forever changing and subjectively assessed, imposed by those who can retaliate if they are not followed, on to those who cannot.

19.  The issue at hand is how can small states construct their own future in this world, one based on deliberate, responsible behaviour and not leave their future in the hands of an external political process they cannot influence.

20.  I would like to end by offering approaches for these countries to follow that will ensure they are as much Captains of their fate as today’s seas will allow.

a.  The first is to realise the game being played.

• It is not a game where you gather yourself together to comply and the deed is done.
• Local financial sectors would sometimes like to paint that it so, to help persuade cash strapped governments fork out considerable sums to ensure that their jobs are protected.
• But those who think so will be lulled into a false sense of security and frequently confounded.
• Every time they think they have compiled, the rules will change in a manner that discriminates against the powerless.
• The latest iteration of the game is this foolish idea that the number of convictions you have is a measure of enforcement.
• On that bizarre logic, Mexico is doing better than Monaco when it comes to murder because Mexico has far more convictions than Monaco which has hardly any convictions – or murders for that matter.

If you are to stay in the game, you will need to be clever at dealing with financial crime, you will need to sign up to the agreements early and engage the process as much as possible.

In small states there will be real danger that the effort to stay off black lists is so all encompassing that effective financial regulation takes a back seat –}

• Another adverse consequence of the current approach.

b.  The second step, therefore, would be to ensure that the two separate tasks of

• crime prevention and
• financial regulation

are done well by being done separately, through expert institutions, that speak with each other.

I accept the latter may be too much to ask.

c.  If the ground is continuously shifting beneath you, and if you have a broad financial sector covering the waterfront of activities with many thousands of individual clients but you are constrained by size and resources, you cannot easily respond to every false allegation, every empty assertion, every piece of erroneous information, 24 by 7.

• It will be easy to catch you out one day and slap you on a list and watch you bleed dry before the list is updated and you are removed. I think the third step is for small states to find specific niches in which they can be the world expert in and can invest continuously and aggressively in defending and developing that niche.
• I would recommend states with limited resources to dedicate to go deeper and narrower in financial services, not broader; expert rather than generalist; bespoke rather than ready-to-wear.
• If you want to move yourself away from the direct line of fire, focus less on tax efficiency and more on service and regulatory quality. Here is where diversity and breadth makes more sense.

We need more asset managers, risk managers, trust and estate experts, valuers, arbitrators, international courts and exchanges, e-commerce businesses and more.

• To focus more on service and grow the developmental impact of a sector that currently makes a greater contribution in terms of tax revenues than employment and skill transfer, requires greater investment in local human capacity.
• My 2007 proposal for an International Institute of Risk and Regulation in the region, delivering professional qualifications like the CFA, FRM and STEP certificates and using its revenues to fund advocacy for the sector is getting long in the tooth. But there are signs of progress.
• The Caribbean Task Force on financial services which I belong to, met in Nassau in April 2014 and agreed to support collaboration in this regard between an existing Bahamian and Barbadian institution.

d.  Fourth and finally, there remains scope for smart advocacy.

• Although the G20 and OECD initiatives remain deeply political, they are less egregiously so than when OECD countries first began publishing black lists fifteen years ago.
• In those days OECD countries behaved with such impunity that the early lists included countries that did not even exist, or did not have separate fiscal authorities or hardly had a financial sector.
• They saw nothing wrong excluding OECD financial sectors with the longest records of money laundering such as London, New York and Zurich.
• It was only after the financial crisis where faulty regulation in OECD financial centres was laid bare did the process become wider.
• Do not let officials from the OECD or Global Forum imply that whatever modest progress you see today on greater participation and the inclusion of OECD financial centres was freely given or a natural progression of what they were doing.
• It was grudgingly so, after the incontrovertible realities of the crisis and after long debate, often led by those from this region and some in this room.

21.  It is therefore best to plan for the worse with the four steps above,

a.  but there is hope for evidence-based arguments to push us towards a less discriminatory and more effective process.
b.  I continue to believe that the best way to press for this, a way that provides no succour to money launderers and tax evaders, is to raise up the issue of the ineffectiveness of current approach of the Global Forum at curbing money laundering and tax evasion, through for an annual publication of an index covering all financial centres with a STEP presence and sponsored by STEP.
c.  It would be an objective, scientific, rank of actual effectiveness of limiting the tools of money laundering and tax-evasion, following the field study approach of Jason Sharman et al.
d.  It would show that responsible Caribbean financial centres do far, far, better than those imposing the rules and threatening the sanctions.

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Tuesday, May 20 2014 @ 04:00 PM AST
An address by Avinash Persaud