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Backgrounder #1323 on Russia

September 22, 1999

Russian Money Laundering: Questions Congress Should Ask

By and

The U.S. Federal Bureau of Investigation (FBI), the New York Federal Reserve Board, the New York Banking Commission, and British law enforcement and national security agencies are undertaking a massive investigation of money laundering and diversion of international financial assistance. The investigation is currently addressing the diversion of between $4.5 billion and $10 billion that originated in Russia and involved some ten thousand transactions since October 1998.1 It is possible that still more money was laundered earlier. In addition, Swiss authorities are investigating hundreds of millions of dollars in Swiss bank accounts, some of the money allegedly embezzled funds from Russian state companies and bribes taken by Russian officials on the highest level.2

According to Russian law enforcement officials, capital flight from the USSR and Russia between 1985 and 1999 was over $120 billion, possibly topping $200 billion--that is more than the entire foreign debt of the Russian Federation and up to 10 times more than the total foreign investment in Russia. A significant part of that money was plundered by federal and local government officials. It is high time to shed light on this unsavory and pervasive practice which harms the Russian economy and defrauds the Russian people.

In recent weeks, the Wall Street Journal, New York Times, and USA Today have reported that the Bank of New York, the Republic Bank of New York, and possibly other financial institutions were embroiled in a massive money laundering scam involving billions of dollars. According to these reports, International Monetary Fund (IMF) money earmarked for Russia was funneled out of Moscow and mixed with the profits from activities such as prostitution in Eastern Europe and illegal weapons sales. Moreover, a Lugano-based engineering and construction company, Mobitex, allegedly opened credit cards and deposited large sums in private accounts for the benefit of President Boris Yeltsin, as well as members of his family and close associates, according to Swiss authorities.

As the details of this scandal are revealed, they are leading to difficult questions about the policy toward Russia that was pursued by both the Clinton Administration and the IMF. The situation has also cast light on the lax standards applied by the U.S. government and international financial institutions in disbursing financial assistance to the opaque economies of post-communist and developing countries.

Earlier this year, the IMF and the Russian Central Bank admitted that IMF assistance had been diverted to offshore companies, such as the Finance Investment Management Company (FIMACO), which is controlled by the Russian Central Bank. Senior Russian officials claimed repeatedly that the IMF knew about FIMACO, and other similar arrangements, and did nothing to stop them.3 There also are reports that World Bank loans were misused or embezzled by Russian officials. One such admission, concerning the Bank's coal industry restructuring loan of $250 million, was made by Viktor Chernomyrdin, who was Prime Minister of Russia and a close ally of Boris Yeltsin at the time.

The House Banking Committee should be commended for undertaking hearings on these issues. It and other congressional committees may well be called upon to play a key role in addressing both the failed Russia lending policies that have been exercised by the G-7 governments, the IMF, and the World Bank, as well as the lax banking standards applied to financial transfers from countries of the former Soviet Union involving funds obtained from illicit activities.

U.S. POLICY FAILURE: TWO SCENARIOS

The massive abuse of Western financial assistance could not have occurred had not President Bill Clinton, Vice President Al Gore, and other senior Administration officials aggressively advocated multi-billion dollar credits to keep Boris Yeltsin afloat. Questioned about the money-laundering scandal, senior officials at the IMF repeatedly stated that without pressure from the White House, loans to Russia and Ukraine would not have been granted.4 Two scenarios have been advanced to explain this policy failure.

One scenario is that the IMF and Clinton Administration officials turned a blind eye not only to the reports coming from the intelligence community and the FBI, but also to the unprecedented financial mismanagement that characterized the post-communist countries of the former Soviet Union. Russia and Ukraine were the largest recipients of Western assistance, but, in both the public and private sectors, corruption and embezzlement have been and continue to be widespread. Under these conditions, the massive inflow of U.S. and international financial aid has led to unintended and harmful macroeconomic outcomes:

  • It facilitated the delays of much-needed market reforms, hindered deregulation, and allowed "crony" privatization by financiers closely allied with political leaders, thus minimizing the economic efficiency of the reforms;

  • It increased the foreign debt liabilities of Russia, Ukraine, and other New Independent States (NIS) and increased the tax burden on the populations of these countries to service the debt; and

  • It undermined the legitimacy of Western advice and assistance, allowed reform opponents to accuse the multilateral financial institutions of being a tool for perpetuating dependency on the West, and shifted the blame for the failure of reforms from local political and economic leaders to Western lenders, donors, advisors, and policymakers.

A second, less benign scenario that needs to be considered involves the potential personal and political benefit to some of the key players. Between 1995 and 1998, some U.S. banks and hedge funds made billions in the highly lucrative and volatile Russian short-term bond market (the so-called gosudarstvennye kaznacheyskie obligatsii, or GKO, in Russian). The profit margins on these instruments reached a staggering 250 percent annually. Hence, some U.S. and European financial institutions had a direct interest in riding the Russian market for as long as possible, reaping the highest profits they could. For this scenario to work, however, IMF money as well as G-7 credits had to keep pouring into Russia. It is possible that political pressure was placed on Washington to continue lending.

QUESTIONS FOR CONGRESS

The House Banking Committee has an opportunity to stop the abuse associated with Russian aid. The Committee needs to assess the damage to the U.S. and Western banking systems, and examine whether violations of law and procedure were committed by U.S. officials (specifically, the Department of the Treasury) and by the IMF. Below are questions that need to be considered by the Committee in the course of its investigations:

  1. What were the sources and destinations of the funds deposited in the Bank of New York, Republic Bank of New York, and the Swiss Banks that are under investigation by the Swiss authorities in Bern?
    The reported volume of funds is considerable: $4.5 billion to as high as $15 billion. Did these funds come from Russian crime organizations? Was Russia a transit point for money from drug-trafficking that originated elsewhere, such as Latin America, Central Asia, or the Far East? Were some of these funds used as kickbacks to high-level Russian officials, as the Swiss authorities have alleged? Were any funds transferred to the personal accounts of American or other Western officials serving in either national governments or multilateral financial institutions?

  2. What did the Clinton Administration know about the widespread corruption in the Russian Government and when did it know it?
    When did Administration and IMF officials find out that Russian Central Bank personnel were utilizing falsified promissory notes to embezzle funds? From what source? What action, if any, was taken? To whom was the information reported? What were the dates of such reports? Were the Treasury and IMF officials aware that as early as 1993 some Russian Central Bank officials were involved in massive embezzlement schemes involving hundreds of millions of dollars and utilizing forged financial documents (promissory notes)?

  3. If information about organized crime and widespread corruption was reported, why did the Administration still advocate IMF lending to the Russian government in 1996, 1998, and 1999?
    There have been numerous reports that top Russian government officials, including former Prime Minister Chernomyrdin, were corrupt. No successful prosecution at the Cabinet level ever took place because the Russian legal system was paralyzed. Some of this information was available to the U.S. intelligence community and the media in the early 1990s. What did the Administration do to ascertain what steps the Russian government was taking to safeguard the system which was supposed to handle the credits?

  4. What is the due diligence standard applied to foreign assistance loans?
    "Due diligence" refers to the process of assessing information in order to contain the risks associated with a transaction to an acceptable level. What due diligence standard was applied to the loans to Russia and their disbursement? How does that standard compare to standard best practices in the private sector--was it a higher or a lower due diligence standard than what is normally accepted and exercised by banks?

  5. In view of reports of corruption and embezzlement in the Russian financial sector and in the Russian government, what specific due diligence procedures were applied by the U.S. Treasury Department and the IMF when extending loans to Russia?
    Can copies of the due diligence checklists be supplied to the Committee?

  6. What reporting procedures were used during the period the assistance funds were disbursed?
    What issues were monitored? In the Treasury Department, were law enforcement agencies of the U.S. government involved? Were the national security and intelligence agencies involved? If not, why not? Who wrote the reports on the monitoring of the disbursement of the loans? Can copies of these reports be submitted to the Committee?

  7. Does fiduciary duty (on a level expected of a banker or an investment or financial professional) apply to U.S. government officials and the IMF international civil servants responsible for approving loans to Russia?
    If not, why not? Are U.S. taxpayer funds less protected under these programs than they would be in a bank that extends loans to foreign governments? Would the "reasonable man" standard apply (i.e. "How would you handle your own money in a situation like this?")?

  8. If fiduciary duty does apply, which U.S. Treasury and IMF officials are responsible for exercising this duty in relation to these loans?

  9. If there were violations of U.S. and/or international law on the part of U.S. government officials or international public servants with regard to financial aid to Russia, what is the appropriate agency to investigate these violations?
    Which agencies have the expertise needed to conduct such investigations? Would it be the General Accounting Office, the FBI, the Justice Department, the U.S. Federal Reserve? Which agencies should investigate the IMF? Should international investigating and forensic auditing companies be used more aggressively to get to the bottom of the Russian fiasco? Should the Attorney General appoint a special prosecutor with broad investigative powers?

  10. What is the legal regime governing the administrative and professional responsibility of IMF officials?
    Who has the authority to initiate investigative and legal proceedings against these officials? Are there any plans to initiate such proceedings regarding the Russian policy failure?

  11. Russia currently owes Western creditors about $150 billion. It was supposed to pay back over $17 billion per year. How much is it paying now?
    Why are the U.S. government and the IMF still committed to lending money to Russia? Did the IMF 1998 bailout package significantly improve Russia's economic perform-ance? If the answer is "yes," why is it that the $40 billion GKO market collapsed, the ruble devalued by 75 percent, and the rate of inflation increased from 6 percent annually to 60 percent?

CONCLUSION

The U.S. government and the IMF may have committed one of the largest blunders in the history of international financial assistance by lending to Moscow's corrupt government and the Russian Central Bank. There are strong indications that a significant part of that assistance was abused or embezzled, possibly ending up in bank accounts in the United States and Switzerland. It is also possible that billions of dollars were diverted and laundered through the Bank of New York and other financial institutions. It appears that the U.S. government, especially officials within the Treasury Department, and the IMF either applied lax standards for due diligence and fiduciary duty or did not apply them at all.

Unfortunately, similar scenarios of massive bailout failure are likely to be repeated in future bailouts of countries in Asia, Africa, and Latin America. There is ample evidence of incompetence on the part of decision makers and corruption on the part of recipients; furthermore, these countries lack adequate accounting and administrative safeguards. Congress must ensure that such fiascoes do not happen again.

Dr. Ariel Cohen is Research Fellow in Russian and Eurasian Studies in the Kathryn and Shelby Cullom Davis International Studies Center at The Heritage Foundation.


1. Jack Kelley, "Kremlin Link to Bank Fraud Investigated," USA Today, August 25, 1999, p. 1.

2. Celestine Bohlen, "Yeltsin Aide Denies Report of Secret Cash in Swiss Bank," The New York Times, Friday, August 27, 1999, p. A12.

3. Ariel Cohen, "What Russia Must Do to Recover from its Economic Crisis," Heritage Foundation Backgrounder No. 1296, June 18, 1999, p. 9.

4. Personal interviews with the author, August-September 1999; the IMF officials gave interviews on the condition that their names would not be disclosed.

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