Bank Shots: How the Financial System Can Isolate Rogues

Rachel L Loeffler. Foreign Affairs. Volume 88, Issue 2. March/April 2009.

Over the last five years, U.S. national security policy and the international banking system have become inextricably intertwined. With terrorism and nuclear proliferation at the top of the United States’ foreign policy agenda and few diplomatic or military levers left to pull, Washington has increasingly turned to the private sector for help in confronting some of its biggest international challenges. That has meant, above all, an effort to work with banks to put pressure on states and other international actors that the United States otherwise has little ability to influence.

This effort is defined by a careful dance between the U.S. government and the global banking industry. Through targeted financial measures, Washington has signaled to banks situations in which it sees dangerous actors intersecting with the international financial system. Banks, for the most part, have acted on these signals, and the two most recent chapters in this unfolding story—Iran and North Korea—suggest that using global finance to shape the behavior of international actors can be remarkably powerful.

But financial measures are only as effective as the banks that implement them. Given the role that banks, rather than governments, now play as agents of international isolation, policymakers must develop a more sophisticated and accurate understanding of what this new tool of statecraft can and cannot do. In its bid to curb Iran’s and North Korea’s destabilizing efforts to develop or expand their nuclear programs, the U.S. government has, in recent years, financially targeted not only Tehran and Pyongyang but also the individuals, companies, and associations that front their illicit activities. These measures have depended on a diplomatic campaign aimed at the world’s financial centers.

In the immediate aftermath of 9/11, financial diplomacy meant lobbying foreign governments to freeze assets. Now, U.S. financial diplomacy increasingly involves global financial institutions in addition to governments. Traditionally, Washington has worked with compliance departments in global banks to combat terrorism, weapons proliferation, the narcotics trade, and corruption. Governments issue watch lists that banks use to block suspected assets and transactions, thereby cutting individuals and organizations off from the world’s financial system. The benefit of compliance strategies is that banks do not have to make the difficult determination about whether to handle certain clients on their own. Surprisingly, these restrictions have reached beyond the boundaries of legal jurisdiction. Banks outside the United States often adhere to U.S. watch lists even when they are not required by domestic or international law to do so.

Aware of this response, the United States has begun to pursue high-level financial diplomacy with global banks directly to foster a shared sense of risk. For banks, this risk often comes down to questions of reputation. In the global financial marketplace, a brand name is a valued asset, one that takes time to build and virtually no time at all to destroy. The risk of an alarmist headline announcing that a bank has facilitated terrorism or nuclear weapons proliferation abroad, even unwittingly, is not worth any potential return for a major global bank. Accordingly, the underlying business imperative of banks—to understand and assess risk—has begun to encourage cooperation between the public and the private sector against threats posed to global security.

In 2007, the United States accounted for half of the global investment banking and brokerage markets and half of the diversified-financial services market, leading most global financial institutions to forgo potentially profitable opportunities in other regions before risking a brand-name malfunction in the U.S. market. With the dollar in steep decline, the dispersion of financial activity away from one center to many, and the U.S. financial system in crisis, it is very possible that the United States’ financial prowess will wane over time. That makes it all the more critical for the new financial statecraft to foster a shared sense of risk between U.S. policymakers and global bankers.

Pulling the Plug on Pyongyang

By the middle of 2005, the North Korean nuclear crisis had been going on, in its usual fits and starts, for over two years, since Pyongyang had kicked out inspectors and resumed its nuclear weapons program in late 2002. The six-party talks had been through four rounds, and North Korea had declared that it had produced nuclear weapons and had fired a short-range missile into the Sea of Japan.

Meanwhile, the U.S. Treasury Department had been conducting an investigation into North Korea’s widespread illicit activities. In September 2005, the Treasury Department designated the Macao-based Banco Delta Asia (BDA) a “primary money laundering concern” under the U.S.A. Patriot Act. This measure had two elements. First, it publicly highlighted the misconduct of the bank, which included a host of questionable activities, such as accepting large deposits of cash from North Korean officials (some of it counterfeit U.S. currency) and agreeing to place that currency into circulation, drawing a fee from North Korea for access to the banking system with little oversight or control, and conducting business with a known North Korean front company involved in international drug trafficking. Second, the Treasury Department indicated that after 30 days of the designation, the United States could at any time cut BDA off completely from the U.S. financial system.

At this stage, all the United States had done with the designation was publicly highlight BDA s role in North Korea’s illicit financial operations and warn U.S. financial institutions that stronger measures could follow. Still, even this had an effect. Although global banks were not required to take any particular action, many responded to the Treasury Department’s move in important and far-reaching ways. In the year that followed this ruling, non-U. S. banks across Asia voluntarily cut back or terminated their business with BDA and, in some cases, with North Korea itself.

In short, the mere announcement of a possible regulatory measure that would apply only to U.S. institutions caused banks around the world to refrain from dealing with BDA and North Korea. By March 2007, when Washington actually made it illegal for U.S. banks to maintain relationships with BDA, many in the global financial community had already cut ties with BDA on their own. To be sure, the jury is still out on the degree to which North Korea will uphold its end of the bargain that emerged from the six-party talks. But the fact that financial measures have raised the costs for North Korea to engage in illicit activity is already evident.

The final stage of the BDA affair was especially revealing. In the spring of 2007, North Korea demanded that roughly $25 million funds frozen by the Macanese authorities, not the United States—be transferred from BDA to another bank of their choosing. The funds were available for immediate physical withdrawal, but the issue was not the availability of the money. Pyongyang seemed to understand that what was at stake was not just $25 million but also ongoing and unfettered access to the international financial system. Ultimately, thanks to the unwillingness of global banks to deal with BDA or the North Korean regime, the $25 million in frozen assets had to travel from Macao, through the U.S. Federal Reserve system and the Bank of Russia, and finally to a small bank in Russia’s Far East. As a result of the U.S. regulatory action, North Korea could achieve this simple money transfer only through an unlikely route that involved two central banks working through days of negotiations. Washington’s action had significantly increased the costs of being a rogue state.

Unenriching Iran

The case of Iran followed closely on the heels of the experience with North Korea. Iran’s nuclear diplomacy escalated with the election of President Mahmoud Ahmadinejad in mid-June 2005. Three months after the election, Iran said that it had resumed uranium conversion at its Isfahan plant, and the International Atomic Energy Agency found Iran in violation of the Nuclear Nonproliferation Treaty. By midsummer 2006, Iran had declared its successful enrichment of uranium. After several months of intensive diplomacy, China, France, Germany, Russia, the United Kingdom, and the United States offered a package of incentives to Iran to curb its nuclear program. But neither that package nor a UN Security Council resolution in July 2006 could forestall the progress of Iran’s nuclear program.

For years, the United States had had in place an expansive sanctions program against Iran that barred all but the most minimal financial relations. In September 20o6, Washington went further and targeted Bank Saderat—one of Iran’s biggest state-owned banks—for supporting terrorism. To do so, U.S. policymakers did not resort to a dramatic expansion of the already broad sanctions program. Instead, they eliminated a small but significant exception to the program, the so-called U-turn authorization, for Bank Saderat. Few foreign-policy watchers noticed this barely perceptible development in world affairs, but bankers engaged in the day-to-day work of clearing international transactions knew exactly what it meant: Bank Saderat could no longer process dollar transactions through the United States. For a bank in a country that still had at least 20 percent of its foreign reserves in dollars and for which the oil trade, also denominated in dollars, is its primary livelihood, being rejected by Wall Street was serious business.

Four months later, the United States targeted another of Iran’s most important financial institutions, Bank Sepah, for its involvement in Iran’s nuclear weapons development. This time, the U.S. government used its asset-freezing authority to deny Bank Sepah ongoing access to the U.S. financial system. Two months after that, the United Nations registered its agreement with the measure and listed Bank Sepah in Security Council Resolution 1747, which toughened sanctions against Iran.

International action did not stop there. In October 2007, the Financial Action Task Force (FATF)—a group of experts from the world’s leading economies (including, notably, China, Russia, and states in the Gulf Cooperation Council)—issued a striking statement telling member countries to advise their banks about Iran’s worrisome financial practices. The statement demanded that Iran address its deficient anti-money-laundering and anti-terrorist-financing structure “on an urgent basis.” The U.S. Treasury Department also engaged in what Stuart Levey, the undersecretary for terrorism and financial intelligence, called “unprecedented, high-level outreach to the international private sector,” meeting with more than 40 banks worldwide to discuss Iran. These talks involved U. S. Treasury Secretary Henry Paulson himself. In September 2006, Paulson even led a discussion with executives of major global banks at the annual meeting of the World Bank and the International Monetary Fund.

The private financial community responded to these signals by scaling back its business ties with Iran. The big Swiss banks UBS and Credit Suisse were among the first to draw down their business with Iran, in January 2006. By the summer of 2007, several large German banks, including Deutsche Bank, Dresdner Bank, and Commerzbank, had curtailed their business ties with Tehran. French banks, including Société Générale and Le Crédit Lyonnais, and the British banks HSBC and Barclays also pulled back. Even the National Bank of Fujairah, a Dubai-based institution, recently stated that it would no longer support commercial operations with Iran.

This public-private positive-feedback loop continued. In October 2007, the United States targeted 23 more Iranian entities, including three banks. Bank Melli, Iran’s oldest and largest bank, had provided financial services for Iran’s nuclear and ballistic missile programs and had helped the Quds Force—the arm of Iran’s Islamic Revolutionary Guard Corps that supports the Taliban and Hezbollah—obtain $100 million over a four-year period. Washington singled out Bank Melli not only for the fact of its support for the programs and the Quds Force but also for its efforts to disguise its involvement. BankMellat, another of Iran’s state-owned financial institutions, was caught in the October 2007 financial strike for facilitating what the Treasury Department called “the movement of millions of dollars for Iran’s nuclear program since at least 2003.” And Bank Saderat, the original target of the small regulatory measure, had its assets frozen as well.

With a now familiar one-two punch, the United Nations bolstered the United States’ and the FATF’s gestures with a Security Council resolution in March 2008 calling for member states to “exercise vigilance over the activities of financial institutions in their territories with all banks domiciled in Iran, in particular with Bank Melli and Bank Saderat.” After that came a mid-March financial advisory issued by the U.S. government’s financial intelligence unit stating that the Central Bank of Iran and other Iranian banks had specifically requested the removal of their names from global transactions so that counterparties could not detect the banks’ involvement in proliferation and terrorist activities. This two-year sweep of financial diplomacy reached a high point in June 2008, when British Prime Minister Gordon Brown announced that the European Union would impose sanctions against Bank Melli. This was particularly powerful given London’s preeminent role in global capital markets. Rejection from London and the rest of Europe would cripple the bank’s global image and operating ability.

In the final days of the Bush administration, the United States made two last financial incursions. First, in October 2008, the United States froze the assets of the Export Development Bank of Iran for providing financial services that helped advance Iran’s weapons of mass destruction program. And finally, the United States revoked the entire U-turn provision for Iran, which had previously been revoked only for Bank Saderat. This final action, according to the U.S. Treasury Department, essentially closed the “last general entry point for Iran to the U.S. financial system.”

Insecure Transactions

In the case of Iran, the question of impact can be considered from two perspectives. From the vantage point of Iranian businesspeople seeking a friction-free financial relationship with the outside world, the costs of financial pressure have been high and unwelcome. Costs associated with Iranian trade have reportedly gone up by between 10 and 30 percent. The vice president of the Dubai-based Iranian Business Council has stated that no one is accepting Iranian letters of credit anymore, which is why Iranians are moving out of Iran in order to establish relationships with other foreign banks. In June, The Washington Post reported that the honorary president of the private German-Iranian Chamber of Commerce said that the financial sanctions against Iran’s international banking network have made it nearly impossible to pay for goods.

The banking squeeze has also put a hold on foreign investment. Chinese banks reportedly have scaled back ties with Iranian companies at a time when Iran is looking to China as part of its great reorientation eastward. This is to say nothing of the numerous oil and gas deals that have hobbled along erratically as companies and their banks retreat from doing business with Iran. According to the UN Conference on Trade and Development’s 2007 World Investment Report, Iran kept company with Iraq, Kuwait, the Palestinian territories, Syria, and Yemen in attracting the lowest levels of foreign investment in the Middle East.

The trade picture also has shifted notably. Whereas Japan, the United Kingdom, and the United States were Iran’s top export markets 14 years ago, China and Turkey had taken second and third place by 2006. Even Germany, which was Iran’s top import supplier from 1994 to 2006, has seen its exports to Iran drop by roughly a quarter in just the last two years. This shift reflects not just the inevitable “rise of the rest” that is affecting the trade portfolios of many countries but also the pressure many European governments have put on their domestic industries to reconsider pursuing contracts with Iran.

The rising costs of letters of credit and trade realignment will not cripple the Iranian economy; anyway, President Ahmadinejad is managing to do that by himself. But they do make life more cumbersome and expensive for Iranian importers. Rising costs create pressures that may be felt in Iran’s business and political power structures.

Still, the risk of evasion continues to be an issue. Just as the United States and its partners have found a new and targeted way to hurt Iran financially, Iranian institutions have learned and will continue to learn how to innovate and evade the resulting restrictions. And in some cases, large global banks have been willing to help. On January 9, Robert Morgenthau, the Manhattan district attorney, announced that the British bank Lloyds TSB would be fined $350 million for its “systematic process of altering wire-transfer information to hide the identity of its clients.” Although Lloyds voluntarily curtailed this practice, the Iranian banks Sepah, Melli, and Saderat had managed to push more than $300 million through the financial system before it was all over. Ultimately, the question is not whether Iran’s businesspeople will find a way around financial restrictions but how much they will, how quickly, and at what cost? The United Arab Emirates has long been a central reexport point for Western-origin goods going to Iran. Although UAE officials have begun to crack down more seriously on suspect trade, this multibillion-dollar trade relationship allows Iran to blunt the impact of financial restrictions.

The ultimate policy impact of these measures remains an open question. There is no sign that Iran has suspended or given up its efforts to develop a nuclear weapons program. Tehran has rebuffed or ignored multilateral overtures and incentive packages multiple times. But in this context, financial gamesmanship is but one of the many tools in the arsenal of policy tactics. The moment has not yet come for a final assessment of the new financial statecraft, but it clearly provides a lever of influence where fewer and fewer seem to exist.

Risks of Business

To better foster a shared sense of risk among the public and private sectors, the United States should use financial tools in select cases when doing so could provide a reasonable chance of compelling others in the international community to take similar measures. The case of the Iranian banks has been a noteworthy success. Patient, graduated U.S. actions motivated international commitment, creating over time the kind of pressure and legitimacy necessary to have a lasting impact. The scope of those actions raised awareness and affected risk assessments in the global banking industry. But all targeted financial actions are not created equal. Although some deliver surprisingly powerful effects, every targeted financial action may not produce the same response. The potential risk is that if they are used routinely or seemingly indiscriminately, financial measures could eventually lose their effectiveness. Financial tools have the capacity to isolate world actors, but they also have the capacity to discredit the user.

The financial system s relevance to a reported threat must also be clearly demonstrated. Global financial institutions are much more likely to share the U.S. government’s perspective if a risky country, person, or set of circumstances clearly intersects at some identifiable point with the global financial system. Highlighting the Central Bank of Iran’s role in the deceptive financial practices of that country is a perfect example of this relationship. If governments use financial measures when the connection is less obvious, they will risk alienating the very banks that must implement them.

Finally, the geography of global banking must be well understood. Iran and North Korea make up only a fraction of a percent in the overall earnings for most global banking institutions, whereas Europe, North America, and other countries in Asia contribute the vast majority of those earnings. Those banks that publish geographic breakdowns rarely even show a category for the Middle East, let alone Iran. But what would happen if the target in question made up five percent of a bank’s income? In such a case, the interests of the public and private sectors could potentially diverge.

Although the risk that financial tools could lose their effectiveness is real, the success of the interaction between the public and the private sector to date gives a sense of the powerful possibilities that lie ahead. It is hard to imagine any serious foreign policy issue down the line in which financial tools would not be or should not be considered a part of a comprehensive strategy. The management of this dynamic remains the crucial challenge. So far, Washington has maintained a balance between issuing compliance mandates and engaging in high-level financial diplomacy that respects the autonomy of banks and their decision-making processes. If the United States can continue to nurture this public-private relationship and take action in disciplined and selective ways, the tools of U.S. foreign policy will at once be significantly augmented and usefully refined.