CAMBRIDGE SYMPOSIUM ON ECONOMIC CRIME
ECONOMIC CRIME - THE FINANCIAL SYSTEM AS A VICTIM
Director General JFSC
Public Speech - 15th September, 2003
Economic crime, of course, has many victims. People are its victims. They lose their homes, their businesses, and their livelihoods. A regulator like me sees many cases of victims of financial crime. Sometimes we can help (where the perpetrator has acted with the help of a financial institution). Sometimes it is more of a matter for the police and the Courts.
Economic criminals use the financial system both to commit the crime and to hide the proceeds. Economic crime can thereby inhibit the ability of the financial system to contribute to wealth creation. Economic crime can certainly have an adverse effect on financial centres.
But at the same time, economic crime generates profits for participants in the financial system (not all entirely unworthy). Financial institutions have also benefited from the improvements in management practices that have been pressed on financial institutions by regulators and law enforcement agencies as part of the fight against economic crime - although I recognise that such measures have substantial costs as well.
So on balance, my own view is that the damage that economic crime does to the financial system is not necessarily reflected in the cost to individual institutions. There is a case for redressing this balance and ensuring that financial institutions have stronger incentives to act in a way that minimises the damage economic crime does to the financial system.
Clearly the prime purpose of the financial system is to deliver increased prosperity by bringing savers and borrowers together and matching the myriad of different terms and conditions on which those participants are willing to save and borrow. In order to do that job, it depends very heavily on a high degree of trust by the participants in the markets of the institutions that make up those markets. For the financial markets to work properly, it is necessary that people believe that banks will look after their funds and pay a reasonable rate of interest. They need to believe that insurance companies from whom they are hoping to receive a pension in twenty or thirty years time will still be around in order to deliver that (and will not have run off with the money in the meantime). They must believe that the transactions designed to translate risk from one form into another does so without losing too much value on the way and they must believe that the prices of the financial instruments they buy (in particular the stocks that they buy) bear a close relationship to the true value of those instruments, given the state of knowledge generally available at any one time.
An IMF paper on Financial System Abuse written February 12 2001 emphasises that:
"the effective functioning of financial markets relies heavily on the expectation that high professional legal and ethical standards are observed and enforced. A reputation for integrity - soundness, honesty, adherence to standards and codes - is one of the most valued assets by investors, financial institutions and jurisdictions".
Clearly the loss of that trust can weaken the financial system. It is widely assumed that the financial scandals that became manifest in the Enron and World Com cases undermined the confidence of the investor particularly in the US, that the publicly available information was sufficiently reliable to base a decision to buy or sell stocks. To what extent the weakness in the financial markets was affected by that it is difficult to say. But it is generally assumed that there has been some effect.
In addition, since it is often hard to find any individual victims of such crimes as insider dealing and market manipulation, it is generally regarded that these crimes undermine the efficiency of markets by reducing the trust of market participations that the price that they are paying (or receiving) represents true value in the light of the available knowledge in the world at any one time.
If people do not use the financial markets (because they prefer to keep their money under the bed or even in the bank) then those markets cannot be so efficient in allocating resources in such a way as to maximise the creation of wealth.
This argument rests on the assumption that as people lose confidence in financial markets, they do not use them so much.
However, we should be cautious about the extent to which this is so. A US gallop poll in February 2000 that found that only 20% of people had confidence in the securities systems used when companies sell goods on line. However 50% of people use those self same systems. Perhaps this raises some doubts about the extent to which lack of confidence prevents the use of financial services when they are convenient and can create a profit.
Nevertheless, there clearly is a point at which public mistrust of financial institutions and the financial system damages confidence. This undermines the effectiveness of the financial system.
Economic Crime and Financial Institutions
The PriceWaterhouseCoopers Global Economic Survey says that 54% of banks report economic crime - more than any other sector. The average for all institutions is 37% worldwide. This suggests an enormous damage arising from economic crime worldwide - particularly as most of them report that they get very little of the money back when economic crime is discovered.
From my own experience I can see that economic crime can be damaging to individual institutions and a financial centre. Former President General Abacha used Jersey as part of his campaign to hide some of his ill-gotten gains. Some of his associates in Nigeria at the time did the same. The effect on an institution when this was discovered looks fairly dramatic. In the case of the Jersey institutions, they have had to deal with an extensive investigation by forensic accountants. This investigation they had to pay for themselves. Funds were frozen. There were the threats of legal challenges from those who claimed to have the rightful access to that money. They had to tread an appropriate tightrope while dealing with the demands of the law enforcement agencies as well as their own customers. Moreover, the scope for those financial institutions for selling their customers more financial products - became very limited in respect of those who claimed to be the owners of the money apparently stolen by General Abacha and his associates.
Financial institutions in such circumstances can expect to be on the end of regulatory or criminal action. Many of you will have seen repeated Senate Committee investigations of financial institutions apparently engaged in handling the proceeds of corruption. In the case of Abacha the Swiss Federal Banking Commission issued a report naming and shaming particular banks. The Financial Services Authority in the UK has been aggressive in the fining of particular institutions for failures in their anti money laundering controls (by no means necessarily connected with the Abacha case).
On the face of it, therefore, economic crime can have an effect on institutions within the financial services sector.
However, I wonder how bad this really is. I have often asked myself how many customers have decided not to use those banks that were publicly named and shamed as having some of Abacha's funds. How many can even remember which they were. Moreover, even in respect of fraud committed against the banks themselves, only half of the companies in the PriceWaterhouseCoopers Global Economic Crime Survey had taken out insurance even though it was demonstrated that those which had done so were three times as likely to recover 60% of more of their losses.
Profits for the Financial System
It is an ill wind that blows nobody any good. Financial institutions make profits out of economic crime. I say this not in a particular cynical manner, nor am I accusing the institutions of being unworthy. But the fact of economic crime generates economic opportunity.
Economic criminals frequently use the financial system to launder the proceeds of their activities. They are keen to engage in transactions that have no economic purpose but are designed to hide the connection between the crime and their money. This layering of transaction generates profits within the financial system. Since we have, sadly, to assume that most money laundering of this kind is probably undetected, the net effect must be to provide additional profits - particularly as economic criminals may be relatively indifferent to the cost of their sham transactions. I do not criticise financial institutions. Most of them do their best to frustrate this kind of activity and would not wish to assist it. But the measures they take to prevent it are never going to be 100% effective.
There are services provided by forensic investigators; regulators and those who advise on compliance with regulatory requirements. There are businesses that conduct in depth due diligence of customers of institutions. There are a range of economic opportunities created by economic crime and which provide profits to the financial system.
And of course, if one is going to be more cynical, there remain some businesses that can gain profits from allowing criminals and fraudsters to use their institutions to launder their money. Although we are getting much more vigilant about such things, we cannot maintain that they cease to exist.
Reforms of the Financial System
Perhaps most importantly, the financial system has benefited from the imposition of decent standards of behaviour by legislation and regulation introduced in order to combat economic crime.
Looking at the kind of requirements that the Jersey Financial Services Commission imposes on its businesses (and these are in line with international requirements), one can see that they are the kind of measures that anyone would expect any decent business to maintain. The Commission expects financial businesses to have proper standards of corporate governance, for example. We expect them to have policies on risk management and then internal controls that allow them to implement those policies. They must vet their staff, train them, and keep their continuous professional development up. They must keep their records up to date, deal properly with complaints and be open and transparent with their customers. Above all they must know their customers - we impose this to make sure that they are not dealing with crooks. But it provides another opportunity to understand more about what their customers needs are and hence sell them more products.
I would argue, therefore, that the kind of requirements that we have imposed upon institutions at least partly to defeat economic crime has in fact been a benefit to those institutions by improving standards of corporate governance in the financial services sector and introducing policies and controls that enable them better to manage their risks and develop their business.
I do not wish to overstate this point. There clearly are costs arising from the need to demonstrate that proper controls are in place. Nevertheless I would argue that there is a real sense in which the businesses have benefited from these corporate governance requirements.
For 20 Symposiums, we have been discussing the effects of economic crime on various kinds of victims. I would certainly accept that the financial system as a whole suffers - and when it does, there is a damaging effect on its ability to create wealth. I would also accept that there are some damaging effects on financial institutions. However, sadly, but inevitably, economic crime brings some benefits to financial institutions and other participants in the financial system, by no means all of them unworthy. I believe therefore that there remains work to be done to make sure that the damaging effect on the public interest from economic crime is reflected more directly in the net effect of that crime on individual institutions.
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