The actual and potential use of unregulated financial instituitons for transnational crime


The problems of hedge funds, mortgage brokers, and finance companies have several common themes. First a lack of prudential supervision; second, an ability to abort anti money-laundering legislation using cross-border transactions; third, a common escape clause of “natural market forces” being used by regulators; and fourth, benefits accruing to the originators. In view of the potential of these types of non-bank financial institutions (NBFI’s) to generate systemic crisis by avoiding the new Operating Risk requirements of Basel II, the effectiveness of the new capital adequacy regime is now highly questionable. Unregulated NBFIs by offering a regulatory black hole, appear to have become the home of the new transnational criminal.

1.0 History of the Sub-Prime Crisis and the Role of Hedge Funds, Finance Companies and Planners, and Mortgage Brokers

According to a recent analysis  the subprime mortgage crisis in the USA had its roots in operational risk (OR) problems. Although credit risk played a significant role, Pennington (2007) defines subprime mortgages as loans to consumers with low credit scores at higher interest rates than prime credits . She claims that the high rate of default made in the first eight months of the loan’s life is not just due to bad credit risk factors but totally to OR factors such as  :

  1. An influx of mortgage lenders during the period 2000-2006  due to high economic growth, overcapitalization of banks, low interest rates and rising house prices. This led to a deterioration in standards relating to documentation, disclosure of the true cost of the loans and increasing competitive loan products – such as low interest rates for two years (ARM or adjustable rate mortgages).
  2. The growth of the secondary market, whereby mortgage lenders were quick to onsell their mortgages to investment banks to be securitized, which would later help spread the systemic risk.
  3. Failure to price for volatility and risk leading to incorrect interest rate calculations.
  4. Relationship problems intertwined with questionable corporate governance practices at the top of the firm  making the primary transaction.
  5. Staff hired with insufficient or no training, as the industry expanded quickly .
  6. Fraud was also an issue – “either from external parties such as brokers seeking to push loans through, or from borrowers who take advantage of the (meager) documentation and stressed system to tender fraudulent applications” (Pennington, 2007, p.37).
  7. Unscrupulous underwriters, brokers and financial planners who were incentivised and in some cases forced by their employers to push through questionable mortgage applications or originators who exaggerated the income of some clients to allow them to qualify for the loan.
  8. Lack of diversification of the loan portfolios of the mortgage lenders.
  9. Slack controls by the mortgage insurers such as Fannie Mae and Freddie Mac.
  10. Lack of stress testing models with an integrated risk management system, which could have softened the crisis through anticipation, hence setting risk management in process well before the crunch.


Although the government of the USA has put in place several measures to help the mortgage industry – namely mitigation programs to curb foreclosures – the fallout has spread globally through the investment banks which lent to and created the brokers, through the finance companies and hedge funds lending and investing in the subprime sector.  Examples are Bear Stearns and Goldman Sachs – the former selling off large tranches of High-Grade Structured Credit Strategies Enhanced Leverage Funds, and other funds backed by subprime mortgages, which was insufficient to prevent being placed under an official rescue program. Many other international banks that were lending to mortgage lenders, finance companies investing in property, and hedge funds specializing in subprime have experienced a similar run on their share price. The Swiss bank UBS is closing its Dillon Road Capital Management hedge fund following a loss of US$123 million.

The long delayed introduction of Basel II, introducing new credit and OR standards for banks, was caused by the very US regulators who are now having to deal with the results of their own prevarications and stalling mechanisms. Until recently the Federal Reserve after lobbying by the banking industry adopted the line that Basel II in its most advanced form was only to be applied to the largest four banks. As recently as June, 2007, a senior US regulator was reported as saying “divergence between the US plan to implement Basel II and the original version of the Accord being adopted internationally will not unfairly disadvantage American Banks”.  Only one month later, a leading Reuters journalist slammed Basel II for its regulatory deficiencies, loopholes and black holes -

"Shock losses at some of the world's biggest banks have left some people asking whether new global bank risk rules have failed their first test of fire. So as big banks line up to reveal massive losses on risky investments, critics are asking aloud whether the Basel accord rewrite -- the biggest change to global banking rules in a generation -- has failed before it has started. ‘Questions are being raised whether Basel II is out of touch with the markets’, said analyst Luis Maglanoc at bank UniCredit in a recent note. Banks have been preparing for its implementation for years. Yet it appears that the Basel II framework has been limping behind the innovative power of the structured credit markets.”  

Another major contributor to the accompanying fallout of the subprime crisis in the USA was the role of commission based financial planners.

2.0 The current prudential regulatory system governing NBFIs

The resulting fallout from the subprime credit crisis on hedge funds, and the knock on effect on the whole mortgage lending and property finance industry, has revealed pre-existing flaws in the regulatory models governing a country’s financial system. That is, these NBFIs escape the regulatory controls such as the OR requirements of Basel II. Given this situation it is not surprising that the subprime crisis spread, affecting the ability of property financiers to borrow in the wholesale market and thus spreading contagion in a knock-on effect to related sectors. The principal role of hedge funds in this crisis merits examination.

2.1 The role of hedge funds

The term “hedge funds” lacks a precise definition. It commonly refers to identify:

  1. An entity that holds a pool of securities and perhaps other assets. In the USA hedge funds do not register their securities offerings under the Securities Act and hence are not registered as an investment company under the Investment Company Act (SEC, 2003) . In Australia the term refers to managed funds that use a wider range of financial instruments and investment strategies than traditional managed funds do, including the use of short selling and derivatives to create leverage, with the aim of generating positive returns regardless of overall performance.
  2. An entity whose fee structure typically compensates the adviser based upon a percentage of the hedge fund’s capital gains and capital appreciation.
  3. An entity whose advisory personnel often invest significant amounts of their own money into the hedge funds that they manage.

Although similar to hedge funds, there are other unregistered pools of investments, including venture capital funds, private equity funds and commodity pools that generally are not categorized as hedge funds. The investment goals of hedge funds vary among funds, but many hedge funds seek to achieve a positive, absolute return rather than measuring their performance against a securities index or other benchmark.

Hedge funds utilize a number of different investment styles and strategies and invest in a wide variety of financial instruments. Hedge funds invest in equity and fixed income securities, currencies, over-the-counter derivatives, futures contracts and other assets. Some hedge funds may take on substantial leverage, sell securities short and employ certain hedging and arbitrage strategies. Hedge funds typically engage one or more broker-dealers to provide a variety of services, including trade clearance and settlement, financing and custody services.

The Securities and Exchange Commission in 2003 when reporting on “Implications of the Growth of Hedge Funds” concluded that investors in hedge fund assets, anticipated to exceed $1 trillion in the next 5 to 10 years , suffered from a lack of information about these investment pools.
The growth in such funds has been fuelled primarily by the increased interest of institutional investors such as pension plans, endowments and foundations seeking to diversify their portfolios with investments in vehicles that feature absolute return strategies – flexible investment strategies which hedge fund advisers use to pursue positive returns in both declining and rising securities markets, while generally attempting to protect investment principal. In addition, funds of hedge funds (“FOHF”), which invest substantially all of their assets in other hedge funds, have also fuelled this growth.

The SEC study (2003, p. vii) commenced with a review of 65 hedge fund advisers (both registered and unregistered) managing approximately 650 different hedge funds with over $160 billion of assets. It focused on a number of key areas of concern – “including the recent increase in the number of hedge fund enforcement cases, the role that hedge funds play in our financial markets and the implications of the Commission’s limited ability to obtain basic information about hedge funds.” The study also examined the emergence of FOHFs that register under the Investment Company Act of 1940 (“Investment Company Act”) and the Securities Act of 1933 (“Securities Act”) so that they may offer and sell their securities in the public market. Finally, the study reviewed hedge fund disclosure and marketing practices, valuation practices and conflicts of interest” (SEC, 2003, p.x).

The SEC concluded that “Hedge funds often provide markets and investors with substantial benefits. For example, based on our observations, many hedge funds take speculative, value-driven trading positions based on extensive research about the value of a security. These positions can enhance liquidity and contribute to market efficiency. In addition, hedge funds offer investors an important risk management tool by providing valuable portfolio diversification because hedge fund returns in many cases are not correlated to the broader debt and equity markets.” (SEC, 2003, p.xi)

However the valuation practices were queried – “The broad discretion that these advisers have to value assets and the lack of independent review over that activity gives rise to questions about whether some hedge funds’ portfolio holdings are accurately valued”.  Other concerns of the SEC were the effect on systemic stability.

A number of strategies that may be used by hedge fund managers include:

  1. Global Asset Allocation, which involves the use of research to exploit movements in different industry sectors, currencies and stockmarkets. This strategy tends to be highly geared and uses derivatives.
  2. Event Driven, which involves taking advantage of event or transaction specific situations. eg mergers, distressed debt, natural disasters.
  3. Relative Value which exploits temporary arbitrage opportunities eg where there are price differences in the shares of one company listed in two different markets.
  4. Equity Hedge whereby equity hedge managers buy undervalued securities and short sell overvalued securities.
  5. Short Selling whereby short sellers borrow, then sell, overvalued shares anticipating a decline whereupon the shares are bought back.


The next section considers the contagion effects that could result from other unregulated NBFIs borrowing from and lending to both sophisticated and unsophisticated entities.

2.2 The Potential for systemic risk and contagion from hedge funds, mortgage lenders and unregulated finance companies

Financial or systemic crises can be attributed to regulatory failure, which allow a shock, usually price volatility, to enter the financial system raising systemic risk levels and lowering systemic efficiency. For instance in 1987 failure to supervise banks credit risk led to uncontrolled lending to entrepreneurs, margin loans and property developments which resulted in several years of price instability and eventually bank failures in some OECD nations. In 1997 the net result of a similar failure to supervise loans to emerging nations and lending within those nations impacted on all layers of the financial system. In the USA in 2002 regulatory failure of the corporate reporting of some large high profile non financial institutions has resulted in international security price volatility. Hence we need a definition of the severity of regulatory failure which can precipitate financial crises. The scale used herein is the author’s own rating system – an arithmetic scale from 1 to 10 where the series represents an escalation in severity as follows:

  1. Volatile security and asset prices, resulting from failure by central banks to target inflation and prudentially supervise the risk behaviour of financial institutions,
  2. Failure in major corporates, and/or a minor bank and/or a major non bank financial institutions,
  3. Removal of funds from minor banks and/or non bank financial institutions to major banks or to alternative investments such as prime corporate securities,
  4. Removal of funds from corporate securities to major banks, precipitating further volatility or at worst a stock market crash,
  5. Removal of funds from major banks to government guaranteed securities, such as postal savings accounts in Japan,
  6. Flight to cash and or gold,
  7. Contraction in lending leading to lower economic growth, disruption to savings and  investment,
  8. Failure in major non financial institutions, and  failure in major non bank financial institutions,
  9. Failure in major banks,
  10. All of the above together with a currency crisis leading to rapid depreciation, rescheduling of external country debt, higher inflation and negative economic growth.

Hedge funds appear to have contributed to the subprime crisis and its ongoing effects. To understand how and why we need to appreciate the rate of growth of these funds and the attraction that they have offered to investors, which in 2007-8 may have reversed, except for those funds which short sell. Australia has been relatively immune from subprime loans due to the strict application of Basel II capital adequacy to mortgage loans, but has suffered fallouts in share values due to short selling and some notable financial collapses. Hence it is taken as a case study. The growth of these funds in Australia compared to overseas trends is illustrated by McNally’s comparative study (2004, pp. 57-8). This shows that the pattern is similar. Global hedge funds both doubled number form 1999 to 2004, which was mirrored in Australia. However the assets under global management showed a 1000% increase, while the Australian assets only doubled. Globally the number of funds grew from 500 to 1000, while assets under managed increased from US$500 billion to US$10billion. In Australia in the number of funds increased from 8 to 15, while assets controlled grew from US48billion to US$15billion. The industry in Australia, shows a high degree of concentration evidenced by the top five hedge fund managers accounting for 47% of total funds under management, while the top 10 managers make up 66% of the market. Only a third had a track record of three years of more, with 7-10% ceasing operations each year.

The leverage of these funds  means that performance can be significantly higher than average but also highly variable, exposing such funds to severe diminutions in value when credit and market risk increase systemically. Returns compiled by McNally (2004, p. 62) are only for three years and embodies the effect of 911 in the USA which puts Australian hedge funds at the top of the performance table. As pointed out by Dimensional Funds Managers, a US firm whose portfolio management is directed out of the Chicago School of Economics based on the work of efficient market theorists such as Fama and French , the only true time frame to assess is over a 15 year period. Similarly the data in 2004 is hardly a representative sample (McNally, 2003, p. 63).

The global meltdown effect on banks which had lent or invested in hedge funds affected by the subprime credit crisis, scores a rating of 9/10 rating on the Currie scale described above. Major bank crashes have been averted by Federal Reserve intervention in providing liquidity through the discount window, lowering of both the discount and overnight official cash rate, accepting subprime securities, specific liquidity lines, loosening rules governing the mortgage insurers, and by “jawboning”. This is evident by examining the series of events which have led to such a ranking of this crisis, described in Table 1’s timeline.

Table 1 : Subprime credit crisis timeline

2005: Boom ended August 2005. The booming housing market halted abruptly for many parts of the U.S. in late summer of 2005.
2006: Continued market slowdown. Prices are flat, home sales fall, resulting in inventory buildup. U.S. Home Construction Index is down over 40% as of mid-August 2006 compared to a year earlier.
2007: Home sales continue to fall. The plunge in existing-home sales is the steepest since 1989. In Q1/2007, S&P/Case-Shiller house price index records first year-over-year decline in nationwide house prices since 1991. The subprime mortgage industry collapses, and a surge of foreclosure activity (twice as bad as 2006 and rising interest rates threaten to depress prices further as problems in the subprime markets spread to the near-prime and prime mortgage markets. The U.S. Treasury secretary calls the bursting housing bubble "the most significant risk to our economy."
February–March: Subprime industry collapse; more than 25 subprime lenders declaring bankruptcy, announcing significant losses, or putting themselves up for sale.
April 2: New Century Financial, largest U.S. subprime lender, files for chapter 11 bankruptcy.
July 19: Dow-Jones closes above 14,000 for the first time in its history.[7]
August: worldwide "credit crunch" as subprime mortgage backed securities are discovered in portfolios of banks and hedge funds around the world, from BNP Paribas to Bank of China. Many lenders stop offering home equity loans and "stated income" loans. Federal Reserve injects about $100B into the money supply for banks to borrow at a low rate.
August 6: American Home Mortgage files for chapter 11 bankruptcy.
August 7: Democratic presidential front-runner Hillary Clinton proposes a $1 billion bailout fund to help homeowners at risk for foreclosure.
August 16: Countrywide Financial Corporation, the biggest U.S. mortgage lender, narrowly avoids bankruptcy by taking out an emergency loan of $11 billion from a group of banks.
August 17: Federal Reserve lowers the discount rate by 50 basis points to 5.75% from 6.25%.
August 31: President Bush announces a limited bailout of U.S. homeowners unable to pay the rising costs of their debts. Ameriquest, once the largest subprime lender in the U.S., goes out of business;
September 1–3: Fed Economic Symposium in Jackson Hole, WY addressed the housing recession that jeopardizes U.S. growth. Several critics argued that the Fed should use regulation and interest rates to prevent asset-price bubbles, blamed former Fed-chairman Alan Greenspan's low interest rate policies for stoking the U.S. housing boom and subsequent bust, and Yale University economist Robert Shiller warned of possible home price declines of fifty percent.
September 13, British bank Northern Rock applied to the Bank of England for emergency funds caused by liquidity problems.[41] Concerned customers produced "an estimated £2bn withdrawn in just three days".
September 14: A run on the bank forms at the United Kingdom's Northern Rock bank precipitated by liquidity problems related to the subprime crisis.
September 17: Former Fed Chairman Alan Greenspan said "we had a bubble in housing" and warns of "large double digit declines" in home values "larger than most people expect."
September 18: The Fed lowers interest rates by half a point (0.5%) in an attempt to limit damage to the economy from the housing and credit crises.
September 28: Television finance personality Jim Cramer warns Americans on The Today Show, "don't you dare buy a home—you'll lose money," causing a furor among realtors.
September 30: Affected by the spiraling mortgage and credit crises, Internet banking pioneer NetBank goes bankrupt, the first FDIC-insured bank to fail since the savings and loan crisis,  and the Swiss bank UBS announced that it lose US$690 million in the third quarter.
October 5, Merrill Lynch announced a US$5.5 billion loss as a consequence of the subprime crisis, which was revised to $8.4 billion on October 24, a sum that credit rating firm Standard & Poor's called "startling
October 15–17: A consortium of U.S. banks backed by the U.S. government announced a "super fund" of $100 billion to purchase mortgage backed securities whose mark-to-market value plummeted in the subprime collapse. Both Fed chairman Ben Bernanke and Treasury Secretary Hank Paulson expressed alarm about the dangers posed by the bursting housing bubble; Paulson said "the housing decline is still unfolding and I view it as the most significant risk to our economy. … The longer housing prices remain stagnant or fall, the greater the penalty to our future economic growth."
October 31: Federal Reserve lowers the federal funds rate by 25 basis points to 4.5%.
November 1: Federal Reserve injects $41B into the money supply for banks to borrow at a low rate. The largest single expansion by the Fed since $50.35B on September 19, 2001.
December 6: President Bush announced a plan to voluntarily and temporarily freeze the mortgages of a limited number of mortgage debtors holding adjustable rate mortgages (ARM). He also asked Members Of Congress to pass legislation to modernize the FHA, to temporarily reform the tax code to help homeowners refinance during this time of housing market stress, and to pass funding to support mortgage counseling, as well as to pass legislation to reform Government Sponsored Enterprises (GSEs) like Freddie Mac and Fannie Mae.
March 14, 2008: Bear Stearns gets Fed funding as shares plummet.
March 16, 2008: Bear Stearns gets acquired for $2 a share by JPMorgan Chase in a fire sale avoiding bankruptcy. The deal is backed by Federal Reserve providing up to $30B to cover possible Bear Stearn losses.

What this timeline illustrates is the failure of regulators to protect the financial system from the instability caused by incorrect Operating Risk controls, not by credit risk procedures, for all the reasons highlighted in Section 1 of this paper.

2.3 The lack of protection of borrowers and lenders exposed by the subprime credit crisis

The subprime crisis has affected average investors and corporations which now face a variety of risks due to the inability of mortgage holders to pay. These vary by legal entity. Some general exposures by entity type include:

  1. Bank corporations: The earnings reported by major banks are adversely affected by defaults on mortgages they issue and retain. Mortgage assets (receivables) are revalued based on estimates of collections from homeowners resulting in increased bad debt reserves and reducing earnings. Rapid or unexpected changes in mortgage asset valuation can lead to volatility in earnings and stock prices. The ability of lenders to predict future collections is a complex task subject to a multitude of variables.
  2. Mortgage lenders and Real Estate Investment Trusts: These entities face similar risks to banks. In addition, they have business models with significant reliance on the ability to regularly secure new financing through CDO or commercial paper issuance secured by mortgages. Investors have become reluctant to fund such investments and are demanding higher interest rates. Such lenders are at increased risk of significant reductions in book value due to asset sales at unfavorable prices and several have filed bankruptcy.
  3. Special purpose entities (SPE), such as hedge funds: Like corporations, SPE are required to revalue their mortgage assets based on estimates of collection of mortgage payments. If this valuation falls below a certain level, or if cash flow falls below contractual levels, investors may have immediate rights to the mortgage asset collateral. This can also cause the rapid sale of assets at unfavorable prices. Other SPE called special investment vehicles (SIV) issue commercial paper and use the proceeds to purchase securitized assets such as CDO. These entities have been affected by mortgage asset devaluation. Several major SIV are associated with large banks.
  4. Investors: The stocks or bonds of the entities above are affected by the lower earnings and uncertainty regarding the valuation of mortgage assets and related payment collection.

Due to the fact that only the first type of entity is prudentially supervised, the other types in Australia only being required to register with ASIC and lodge reports as well as satisfy listing requirements if publicly owned with a large spread of investors numbering over 50, the potential not only for a systemic crisis but for a significant portion of the small investment community to be affected is huge. The US regulatory model leaves financial system participants unprotected, in a similar manner, despite the SEC in 2003 as a result of their study of hedge funds, making recommendations regarding the operations of Hedge Fund Advisers, Funds of Hedge Funds and Hedge Funds. These recommendations were never put in place. They were:

  • Advisers be required to register as Investment Advisers under the Advisers Act, with strict disclosure requirements;
  • Standards be introduced regarding Valuation, Suitability and Fee Disclosure Issues relating to registered FOHFs;
  • The SEC should consider permitting general solicitation in fund offerings to be limited to qualified purchasers;
  • The staffs of the SEC and the NASD should monitor closely capital introduction services provided by brokers;
  • Encouragement of unregulated industries to embrace and further develop best practices;
  • The SEC should continue its efforts to improve investor education.


3.0 Mechanisms for Transnational crime

In an effort to combat international organised crime, now known by the term “Transnational crime”, the United Nations in December 2000, after eight years of negotiation, opened for signature the ‘Convention against Transnational Organised Crime (2001)’, also known as The Palermo Convention. Transnational crime was defined as including:

“theft of cultural property, trafficking in arms, illegal gambling, smuggling of illegal migrants, trafficking in women and children for sexual slavery, extortion, violence against the judiciary and journalists, corruption of government and public officials, trafficking in radioactive material, trafficking in body parts, trafficking in endangered species, transantional auto theft, money laundering and computer related crime.”

The Palermo treaty is supplemented by three protocols on trafficking in persons, smuggling of migrants, and trafficking in firearms and ammunition.  It has been criticised by Schloenhardt (2005, p. 353)  for failing in one of its main goals to establish a universal concept of organised crime – “the lack of a comprehensive definition of the term and the ambiguities arising from the elements of the organized criminal group definition will allow criminal organisations to continue to take advantage of the discrepancies between legal systems”. Other criticisms are that extradition procedures are still faulty, the failure to recognise the root cause of organised crime – the demand side. A further fault is the lack of enforcement measures and a central authority – “it is still unclear how the signatories and the United Nations will respond to countries that fail to live up to expectations or that are found harbouring or collaborating with criminal organisations”. 

So how and why can transnational crime continue to exist and why might it shelter behind hedge funds investing in subprime credits, or finance companies raising monies from the public for property investment, or in the specialised mortgage houses themselves?

3.1 Tax Havens

In a globalised market place competition extends to the tax system, so that transactions with a tax havens can often be used to avoid paying tax elsewhere (ATO, 2004, p. 2).  A tax haven is defined by the OECD according to three criteria – none, or only nominal taxes, lack of effective exchange of information, and lack of transparency. The OECD recognises a total of 38 tax havens, three of which have committed to eliminating harmful tax practices. There are also countries which are not tax havens, but by virtue of their bank secrecy arrangements may be exploited for tax haven purposes. Despite a number of treaties to reduce bank secrecy and tax havens, in particular the Financial Action Task Force, in 2002-3, A$3.8billion (A$5billion in 2001-2, flowed from Australia to tax havens (ATO, 2004, p. 4). The fact that many of the hedge funds, and other entities discussed in this paper use tax havens as their corporate base means that the checks and balances on them to ensure they are not being used by transnational criminals is deficient. As can be seen from Table 2 below, 46.7% of funds are domiciled in the Caribbean according to the Global Data Feeder (higher for other DataFeeders). 

In Switzerland, bank secrecy is described as still “unassailable in the case of fiscal offences”  and despite Switzerland seeking to protect its reputation as the world’s leader in the management of offshore wealth by prohibiting its bankers from assisting in the flight of capital and tax evasion, the country still rates as a save haven for illegally got gains. In fact as pointed out by Chaikin, (2000), when grand corruption occurs, and the dictator is overthrown, “this does not mean that the stolen monies will be recovered. Indeed, the modern experience is that dictators are able to keep their loot, which is deposited, outside their country. The mobility of wealth prevents effective recovery of the assets and the sheer size of the stolen monies has major economic consequences for development”.  Given the use of tax havens by the unregulated institutions involved in the subprime crisis, there are other mechanisms that have been used to hide and conceal the true purposes of transactions.

Table 2  Distribution of Funds (Source: The Barclay Group)


Global DataFeeder

Hedge Fund DataFeeder

Single-Hedge Fund Manager DataFeeder

CTA DataFeeder

Number of reporting funds





Number of reporting management companies










Managers domiciled in USA





Managers domiciled in Europe





Managers domiciled in Caribbean





Managers domiciled in Rest of World





Funds domiciled in USA





Funds domiciled in Europe





Funds domiciled in Caribbean





Funds domiciled in Rest of World






3.2 The use of corporate groups and nominee companies

As pointed out by the OECD (2001) the misuse of corporate entities for transnational crime, such as money laundering, bribery and corruption, shielding assets from creditors, illicit activities, has been on the increase. The systemic side effects on financial stability has been evident in the subprime crisis, so that despite measures put in place to obtain beneficial ownership statistics, such use of corporate vehicles still occurs – “ money launderers exploit cash-based businesses and other legal vehicles to disguise the source of their illicit gains, bribe-givers and recipients conduct their illicit transactions through bank accounts opened under the names of corporations and foundations, and individuals hide or shield their wealth from tax authorities and other creditors through trusts and partnerships, to name a few examples”.

Mechanisms for obtaining beneficial ownership and control information fall into three types – up front disclosure to the authorities, primary reliance on intermediaries, and primary reliance on investigative system. Not all options are suitable for all jurisdictions – investigative systems only work for instance with adequate investigative mechanisms to effectively monitor compliance by corporate service providers , where there is a sufficient number of such providers with suitable experience and resources and where there is a strong enforcement mode with good transparency and governance mechanisms. Unfortunately such methods of obtaining beneficial ownership have fallen far short of expectations. This can be seen in the case of nominee shareholders in Australia, let alone attempting to penetrate foreign nominees.

The original justification for nominee shareholdings was that it provided “an efficient mechanism for the administration of assets held on behalf of another person, and that it secured the financial privacy of persons who did not wish to appear on the company registry.”  However nominee companies can be used for illicit purposes, particularly money laundering. In Australia the failure of the corporate regulator to trace powers to penetrate the Swiss nominees in ASC v Bank Leumi has created a precedent  which has undermined the strategic enforcement objective of detecting insider trader and other abusive market conduct . All of these types of mechanisms have left any financial system that fails to prudentially supervise all deposit taking institutions, such as hedge funds, mortgage lenders and finance companies specializing in property investment, open to abuse by transnational criminals.

3.3 Viewing the sub-prime crisis as a special case of Financial Statement manipulation or a failure of Operating Risk Systems

Another way of viewing the subprime crisis is a special case of financial statement fraud, which is a failure of the operating risk systems in a bank to detect fraud being perpetuated on the bank to induce them to lend. The opportunity is created by the lack of regulation, standards, disclosure, advisor licensing and education detailed in Sections 2 and 3 above. Such a hypothesis fits neatly into the Albrechts’ “perfect fraud storm” theory  containing nine factors – a booming economy (which neatly hides the fraud), moral decay, misplaced executive incentives, unachievable expectations of the market, pressure of large borrowings, US rules-based accounting, opportunistic behaviour of audit firms, greed on the part of a wide variety of groups of people and educator failures.

Using Cressey’s fraud triangle,  the motivation is easy to fill in – high commissions based on reported earnings and/or possibility of timely self redemption given the high degree of manager/advisor investment. Other motivations include :

  • Desire to increase or maintain share or unit prices;
  • The need to meet internal and external forecasts;
  • The desire to minimize tax liabilities;
  • The avoidance of debt covenant violations;
  • The desire to raise further debt and equity cheaply.

The rationalization would be the fact that originators of property finance companies, mortgage lenders, and hedge funds investing or exploiting the subprime credit market believe they are endowing their intelligience on creditors and investors in order to return to them above normal profits .
The methods of committing financial statement fraud defined as “any intentional act or omission that results in materially misleading financial statements”  are fairly common. They can be categorized under four types – changing accounting methods, altering managerial estimates, improperly recognizing revenues and expenses and overstating assets. In the Brennan et al study (2007) of 14 companies that were subject to an official investigation, recording false sales was the most common method, motivated by meeting external forecasts, with mostly incumbent or new management discovering the fraud. In the case of the three types of companies singled out in this report – property financiers, mortgage lenders and hedge funds – the conflict of interest that exists where management can be both an investor and creditor may preclude any discovery until the fraud has produced insolvency, with funds safely banked in a tax haven or bank secrecy haven.

A replication of the Brennan et al (2007) study could be made asking the same six questions using their case study methodology. Questions related to the perpetuators, the method, the motivation, the organizational factors, the mode by which it was detected and the outcome. Obviously such a study would only focus on there fraud is under investigation, that is category 2 above and where information regarding motives and methods is already on public record, with perpetuators publicly identified.

4.0 Conclusion: A Regulatory Black Hole and a Field rife for Future Research

Since the crisis regulators have taken the following actions to manage the crisis:

  • Open market operations to ensure member banks have access to funds (i.e., liquidity). These are effectively short-term loans to member banks collateralized by government securities.
  • Central banks have also lowered the interest rates charged to member banks (called the discount rate in the U.S.) for short-term loans thus providing access to funds for those entities with illiquid mortgage-backed assets. Second, the available funds stimulate the commercial paper market and general economic activity. Lenders and homeowners both may benefit from avoiding foreclosure, which is a costly and lengthy process. Some lenders have taken action to reach out to homeowners to provide more favorable mortgage terms (i.e., loan modification or refinancing). Homeowners have also been encouraged to contact their lenders to discuss alternatives.
  • Reexamination of the credit rating process  to encourage greater transparency to the risks involved with complex mortgage-backed securities and the entities that provide them.
  • Regulatory action regarding lending practices, bankruptcy protection, tax policies, affordable housing, credit counseling, education, and the licensing and qualifications of lenders.   Basel II needs to be enforced in the USA in respect to all institutions.
  • Amendments to disclosure rules governing the nature, transparency and regulatory required for the complex legal entities and securities involved in these transactions.
  • Encouragement by the media to promote investor education and awareness and public debate.

It should be noted that early warning signals were evident as early as the 2003. For instance in the Annual Report issued by Fairfax Financial Holdings Limited, Prem Watsa raised concerns about securitized products:

"We have been concerned for some time about the risks in asset-backed bonds, particularly bonds that are backed by home equity loans, automobile loans or credit card debt (we own no asset-backed bonds). It seems to us that securitization (or the creation of these asset-backed bonds eliminates the incentive for the originator of the loan to be credit sensitive... With securitization, the dealer (almost) does not care as these loans can be laid off through securitization. Thus, the loss experienced on these loans after securitization will no longer be comparable to that experienced prior to securitization (called a ‘‘moral’’ hazard)... This is not a small problem. There is $1.0 trillion in asset-backed bonds outstanding as of December 31, 2003 in the U.S.... Who is buying these bonds? Insurance companies, money managers and banks – in the main – all reaching for yield given the excellent ratings for these bonds. What happens if we hit an air pocket? Unlike..."

Meanwhile MarketWatch has cited several economic analysts with Stifel Nicolaus claiming that the problem mortgages are not limited to the subprime niche saying "the rapidly increasing scope and depth of the problems in the mortgage market suggest that the entire sector has plunged into a downward spiral similar to the subprime woes whereby each negative development feeds further deterioration", calling it a "vicious cycle" and adding that they "continue to believe conditions will get worse" . Of the estimated U.S. $1.3 trillion in subprime mortgages 16% were in default as of October 2007, or approximately $200 billion. Considering that $500 billion in subprime mortgages will reset to higher rates over the next 12 months (placing additional pressure on homeowners) and recent increases in the payment default rate cited by the Federal Reserve, direct loss exposure would likely exceed the $200 billion figure. This figure may be increased significantly by "Alt-A" defaults. The impact will continue to fall most directly on homeowners and those retaining mortgage origination risk, primarily banks, mortgage lenders, or those funds and investors holding mortgage-backed securities.

So what have we learnt from this?

First, as the international Financial System enters the third millennium there is a need to resolve challenges such designing regulatory models that promote economic and social development for both emerging and advanced nations. The former are just coming to terms with bank supervision yet may be forced to cope with problems that advanced nations have still not successfully overcome such as supervision of conglomerates, insurance companies, e-commerce and transnational financial crime. Some consider that “correcting regulatory failure requires better regulation – which means setting more appropriate prudential and market conduct standards, improving surveillance and strengthening enforcement. Integrated regulation may help facilitate this process, but it does not, by itself, cause these changes to occur” (Carmichael, 2002, p. 6).

Second, failure in the USA to implement quickly the Operating Risk requirements of Basel II across all financial institutions can be blamed for the lack of regulatory action which could have averted this crisis.

Third, what may help is more research on regulatory failure, its definition, measurement, and causes, and attempts to validate the inputs into the new general theory of regulation developed by the author (Currie, 2005) which is based on a taxonomy, a measurement method and scale. A more precise mathematical exposition of the Currie scale of regulatory failure and taxonomy of regulatory models, together with research as to the exact types of functional relationships that exist between the components of the new general theory of regulation would provide a guide to both national and international policy makers, such as the IMF, in attempting to mould economies in the right direction for growth and stability.

A basis for such initial research would be a classification of regulatory models in advanced and emerging nations, and then an ongoing monitoring of the performance of financial institutions, in order to verify the hypothesis that moving the regulatory model towards one with a Strong Enforcement Mode with strong sanctions and compliance audits, but with weak discretionary and strong institutionalised protective measures, will achieve the desired goals of greater efficiency while maintaining systemic stability. This combined with studies to isolate regulatory black holes, to understand their potential for developing systemic crises, to determine whether they are the result of fraud, or the failure to properly apply the carefully developed operating risk systems of Basel II, would also help solve the problems of transnational crime that help beggar nations.


Currie, C.V., 2000. The Optimum Regulatory Model for the next Millennium - lessons from international comparisons and the Australian-Asian experience in B. Gup (Ed.), New Financial Architecture for the 21st Century.  Quorum/Greenwood Books.
Currie, C.V., 2001. Is the Australian Financial System Prepared for the Third Millennium? in Kantarelis, D., (Ed.),  Global Business and Economics Review - Anthology 2001. Business and Economics Society International.
Currie, C.V., 2002. Regulatory Failure In Emerging And Advanced Markets – Is There A Difference? in  Kantarelis, D. (ed),  Global Business and Economics Review - Anthology 2002 (Business and Economics Society International, ISBN: 0-9659831-5-3; ISSN: 1097-4954)
Diamond, P.W., Dybvig P.H., 1983.  Bank Runs, Deposit Insurance, and Liquidity, Journal of Political Economy, 91(3) 401-19.
Eichengreen, B., Portes R., 1987.  The Anatomy of Financial Crises, in: R. Portes, A.W. Swoboda, (Ed.), Threats to International Financial Stability. Cambridge University Press, New York.
Eichengreen, B., Portes, R., 1986. Debt and Default in the 1930’s: Causes and Consequences, European Economic Review, 30, 599-640.
Flood, R.P., Garber, P.M., 1982. Bubbles, Runs and Gold Monetization in: P. Wachtel (Ed.), Crises in the Economic and Financial Structure. Lexington Books, Massachusetts.
Gup, B., 1995. Targeting Fraud. Quorum Books.
OECD (Organisation for Economic Co-operation and Development), 1991. Systemic Risks in Securities Markets,  OECD Publication, Paris.
….. 1992. Banks under Stress.  OECD Publication, Paris.