[Senate Hearing 108-752]
[From the U.S. Government Publishing Office]
S. Hrg. 108-752
OVERSIGHT OF THE EXTENDED
CUSTODIAL INVENTORY PROGRAM
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED EIGHTH CONGRESS
SECOND SESSION
ON
THE RECENT EVENTS INVOLVING THE UNION BANK OF SWITZERLAND-
ZURICH WHICH VIOLATED ITS ECI AGREEMENT WITH THE FEDERAL RESERVE BANK
OF NEW YORK BY ENGAGING IN U.S. DOLLAR BANKNOTE TRANSACTIONS WITH
COUNTRIES SUBJECT TO SANCTIONS BY THE U.S. DEPARTMENT OF THE TREASURY'S
OFFICE OF FOREIGN ASSETS CONTROL, WHICH ADMINISTERS AND ENFORCES
ECONOMIC SANCTIONS AGAINST TARGETED FOREIGN COUNTRIES
__________
MAY 20, 2004
__________
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
RICHARD C. SHELBY, Alabama, Chairman
ROBERT F. BENNETT, Utah PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky EVAN BAYH, Indiana
MIKE CRAPO, Idaho ZELL MILLER, Georgia
JOHN E. SUNUNU, New Hampshire THOMAS R. CARPER, Delaware
ELIZABETH DOLE, North Carolina DEBBIE STABENOW, Michigan
LINCOLN D. CHAFEE, Rhode Island JON S. CORZINE, New Jersey
Kathleen L. Casey, Staff Director and Counsel
Steven B. Harris, Democratic Staff Director and Chief Counsel
Douglas R. Nappi, Chief Counsel
Mark F. Oesterle, Counsel
Skip Fischer, Professional Staff
Stephen R. Kroll, Democratic Special Counsel
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
(ii)
C O N T E N T S
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THURSDAY, MAY 20, 2004
Page
Opening statement of Chairman Shelby............................. 1
WITNESSES
R. Richard Newcomb, Director, Office of Foreign Assets Control,
U.S. Department of the Treasury................................ 2
Thomas C. Baxter, Jr., Executive Vice President and General
Counsel, Federal Reserve Bank of New York...................... 3
Prepared statement........................................... 18
(iii)
OVERSIGHT OF THE EXTENDED CUSTODIAL INVENTORY PROGRAM
----------
THURSDAY, MAY 20, 2004
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:08 a.m., in room SD-538, Dirksen
Senate Office Building, Senator Richard C. Shelby (Chairman of
the Committee) presiding.
OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY
Chairman Shelby. The hearing will come to order.
The purpose of today's hearing is to conduct oversight of
the Federal Reserve's operation of its Extended Custodial
Inventory, or ECI, program.
This program, which is administered by the Federal Reserve
Bank of New York, was established to address the significant
issues associated with the fact that a huge amount of U.S.
currency circulates outside of the United States.
By partnering with United States and foreign banks at
various locations throughout the world, the program is intended
to enhance the ability of the Federal Reserve to deal with
counterfeiting, to promote repatriation of old U.S. banknotes,
to recirculate fit new U.S. banknotes, and to facilitate the
international distribution of U.S. currency.
Unfortunately, recent events make it abundantly clear that
the oversight of this program deserves a good portion of this
Committee's time and attention.
Last week, the Federal Reserve announced that it was
imposing a $100 million fine against the Union Bank of
Switzerland, or UBS, as punishment for serious transgressions
the Swiss Bank committed in its capacity as an ECI program
participant.
Apparently, from the time UBS began working with the Fed in
1996 until sometime last year, UBS employees were conducting
business through the ECI program with entities from nations
restricted by the Office of Foreign Asset Control or OFAC.
While these activities were strictly prohibited under the
terms of the ECI contract, UBS employees were able to engage in
this deceptive conduct for a prolonged period by falsifying
documents they were required to provide to the Federal Reserve.
Ultimately, UBS used the Federal Reserve to conduct
billions of dollars worth of transactions with entities in
Cuba, Iran, Libya, and Yugoslavia. Billions to Cuba, Iran,
Libya, and Yugoslavia.
While we will never know the full extent of the damage, we
do know that our national security and economic interests were
significantly compromised by these despicable acts.
This morning, we will look at the circumstances that made
it possible for the Federal Reserve to be repeatedly and
systematically deceived by UBS, as well as the operation and
oversight of the overall program.
In consideration of the amounts of money involved, we must
be sure that the Federal Reserve employs the appropriate
procedural safeguards, and perhaps more importantly, we must be
sure that the staff of the Federal Reserve have the requisite
frame of mind to aggressively and consistently apply those
safeguards.
In the end, I believe we must look to the matter of ECI
contract compliance as something requiring far more
consideration than it seems to have been given in the past.
This morning we have as our witnesses, Richard Newcomb,
Director, Office of Foreign Assets Control, U.S. Department of
the Treasury, and Thomas C. Baxter, General Counsel and
Executive Vice President of the Federal Reserve Bank of New
York, and we have a number of people accompanying them, but Mr.
Newcomb and Mr. Baxter, I believe will testify.
We will start with you, Mr. Newcomb.
STATEMENT OF R. RICHARD NEWCOMB
DIRECTOR, OFFICE OF FOREIGN ASSETS CONTROL
U.S. DEPARTMENT OF THE TREASURY
Mr. Newcomb. Thank you, Mr. Chairman. I want to thank you
for inviting me to testify today about the Extended Custodial
Inventory program. It is a pleasure to be here again to work
with you and with your staff as we have over the years, and to
discuss the Office of Foreign Assets Control and its
relationship with the Federal Reserve Bank.
As you know, the primary mission of the Office of Foreign
Assets Control is to administer and enforce economic sanctions
against targeted foreign countries and groups and individuals,
including terrorists, terrorist organizations, and narcotics
traffickers which pose a threat to the national security,
foreign policy, and economy of the United States. We act under
general Presidential wartime and national emergency powers, as
well as specific legislation to prohibit transactions and
freeze assets subject to U.S. jurisdiction. Economic sanctions
are intended to deprive the target of the use of its assets and
deny the target access to the U.S. financial system, and the
benefits of trade, transactions, and services involving U.S.
markets. These same authorities have also been used to protect
assets within U.S. jurisdiction of countries subject to foreign
occupation and to further important U.S. nonproliferation
goals.
We currently administer and enforce some 28 economic
sanctions programs pursuant to Presidential and Congressional
mandates. These programs are a crucial element in preserving
and advancing the foreign policy and national security
objectives of the United States, and are usually taken in
conjunction with diplomatic, law enforcement, and occasionally
military action.
Enforcement of these programs is defined by our
jurisdiction, which extends to all U.S. citizens and permanent
resident aliens, regardless of where they are located, all
persons and entities within the United States and all U.S.
incorporated entities and their foreign branches. In the case
of Cuba, we also have jurisdiction with regard to foreign
subsidiaries owned or controlled by U.S. companies. For the
purposes of our discussion, let us call these ``U.S. persons.''
OFAC has always had an outstanding relationship with the
Federal Reserve, especially with the Federal Reserve Bank of
New York. Because of this outstanding relationship, in early
July 2003, the Federal Reserve Bank of New York contacted us to
indicate that it had learned that U.S. dollar banknotes held in
the Union Bank of Switzerland-Zurich, or UBS, may have been
illegally bought or sold to sanctioned countries by UBS in
violation of their Extended Custodial Inventory agreements with
the Federal Reserve Bank of New York. I understand that the
Federal Reserve Bank of New York has not previously been aware
of the situation because officers and employees of UBS in
Zurich had submitted deliberately falsified statistical
reporting data.
We kept in touch with the Federal Reserve Bank of New York
while UBS, at the Fed's insistence, and under the oversight of
the Swiss banking authorities, initiated an internal
investigation into this matter. UBS issued an initial report of
findings on December 1, 2003, and a supplemental report dated
January 26 of this year. The initial report was provided to the
Federal Reserve Bank with a request that it be shared with
OFAC. OFAC received it electronically on January 20 of this
year with the supplemental report received on the January 29.
We immediately reviewed the material and initiated an
enforcement investigation into any possible activities on the
part of ``U.S. persons'' over whom we would have jurisdiction.
The UBS/Zurich ECI contract was terminated for breach on
October 28, 2003, and UBS, as you know, has paid a significant
fine to the Federal Reserve Bank of New York for deception. We
have met with all of the key players of the Federal Reserve
Bank of New York and understand that the Bank, through new
contracts made effective in February of this year, has taken
very substantial steps to enhance controls over all remaining
ECI's with respect to sanctions compliance. We applaud the Fed
for these efforts.
I would like to thank you once again, and the Committee,
for the opportunity to speak here this morning, and when we
conclude we will be happy to answer any questions you may have.
Chairman Shelby. Thank you, Mr. Newcomb.
Mr. Baxter.
STATEMENT OF THOMAS C. BAXTER, JR.
EXECUTIVE VICE PRESIDENT AND GENERAL COUNSEL
FEDERAL RESERVE BANK OF NEW YORK
ACCOMPANIED BY:
RICHARD ASHTON, ASSOCIATE GENERAL COUNSEL AND
MICHAEL LAMBERT, FINANCIAL SERVICES MANAGER, CASH SECTION,
DIVISION OF RESERVE BANK OPERATIONS AND PAYMENT SYSTEMS
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
Mr. Baxter. Thank you, Mr. Chairman.
Chairman Shelby, distinguished Members of the Committee, my
name is Thomas Baxter and I am the General Counsel and
Executive Vice President of the Federal Reserve Bank of New
York.
At the New York Fed, I have responsibility for the law
function, security, and the Corporate Secretary's Office. I
appreciate your
invitation, and I am honored to appear before you to discuss
the Federal Reserve's operation of our Extended Custodial
Inventory program, and our response to UBS's misconduct in
operating one of our ECI facilities.
The U.S. dollar is the most desired form of money in the
world. In many ways our dollar represents the strength of the
American economy. The dollar is so desired around the world
because it is a stable, always reliable medium of exchange and
store of value.
Today, I will be speaking about the Federal Reserve's
operation of our ECI program. I should start by describing it.
In operation since 1996, when the Treasury, Secret Service, and
Federal Reserve collectively decided to launch it, the ECI
program has been a great success. The program sustains the
quality of the U.S. dollar banknote, helps to deter
counterfeiting, and provides an efficient and effective
mechanism for the distribution of those notes in what is our
largest market, the market outside of the United States.
We estimate that up to two-thirds of our currency
circulates outside of the United States. The ECI program
involves the use of
financial institutions, mainly commercial banks, that are
highly active in the international currency distribution
business as Federal Reserve contractors. They agree to extend
the Federal Reserve's reach into major financial centers of
other countries, and hold inventory of our most popular
product, the Federal Reserve note. They do this by holding in
custody for us in their vaults U.S. dollar notes that we expect
to distribute abroad, or old and unfit notes that we wish to
repatriate.
The Extended Custodial Inventory facility helps to assure
the quality of our product and its efficient distribution. With
respect to quality, the ECI facility performs two important
functions. First, it positions us to better monitor and better
control the quality of our product by identifying counterfeit
notes. The ECI's are well situated to detect such notes, to
remove them from circulation, to provide intelligence to law
enforcement authorities here and abroad, and to distribute new
authentic notes. They perform similar functions with respect to
what we call ``unfit'' notes, which is a cash processing code
word for worn and dirty.
As for the efficiency of our distribution network, through
our ECI contract partners we are positioned in the high volume
wholesale banknote markets. Currently these markets are located
in London, Frankfurt, Zurich, Hong Kong, and Singapore. Our ECI
contractors are the market makers in those markets. At the
present time we have ECI contracts with American Express, Bank
of America, HSBC, Royal Bank of Scotland, and United Overseas
Bank. Our ECI contractors bring into the markets they serve new
fit notes quickly, and with similar expedition they repatriate
unfit or old design notes to the United States for destruction.
With respect to repatriation, let me highlight one
technical but very important point. Before the ECI program,
wholesale dealers in U.S. dollars had a financial incentive to
recirculate the unfit and old design notes that came into their
possession, because the time to transport those notes to the
United States carried a corresponding delay in credit. The ECI
program changed that, and as a consequence, the unfit and old
design notes move into our custody much sooner. A credit for
those notes passes from the Federal Reserve to the ECI
contractor earlier, providing a financial incentive for quality
control. Finally, our ECI contractors have ready a substantial
inventory of banknotes to satisfy the periodic spikes in supply
and demand encountered in a world full of uncertainties.
Because these notes are Federal Reserve property, the ECI
contractors do not have to finance the inventory when it is not
needed.
This leads me to my first point. The experience that we
have had with UBS does not change the fact that the ECI program
is a success. I hasten to add that I am in no way trying to
minimize what UBS did. The breach by UBS of our contract was
wrongful, and the concerted acts of deception by UBS, carried
out over a long period of time, violated our laws. The Federal
Reserve terminated the contract with UBS in October 2003, and
we assessed a $100 million civil money penalty against UBS on
May 10 of this year, thereby remedying the breach and punishing
the deception.
This leads me to my second point, which looks at how we
respond when someone doing our business performs badly. The
prompt corrective action taken to terminate the Federal
Reserve's contractual relationship with UBS and to punish
deception by UBS with a large monetary penalty, demonstrates a
resolve that Federal Reserve operations will be conducted to
the highest standards and in full compliance with U.S. legal
requirements. In this regard it is noteworthy that our ECI
contracts, in essence, export U.S. legal requirements including
OFAC restrictions to offshore facilities.
When the Federal Reserve learned that UBS had breached its
contractual obligations to abide by the restrictions of the
U.S. sanctions program and engaged in U.S. dollar transactions
with impermissible jurisdictions, we acted swiftly and surely.
We terminated our contract with UBS and debited UBS's account
with us for the entire inventory maintained in the Zurich
vault. In a day, UBS lost an entire business line that had been
profitable throughout the 8 years that UBS served as an ECI
contractor.
The forfeiture of a profitable business is a financial
consequence. UBS also suffered a reputational injury. Through
the related action of our colleagues at the Swiss Federal
Banking Commission, UBS is forbidden from reentering the
wholesale external banknote business without the permission of
that Commission.
This leads to my third point. The Federal Reserve will not
tolerate deception. We will not tolerate deception from those
banking organizations that we supervise, and we will not
tolerate deception from those with whom we contract to execute
important Federal programs. The ECI program is one such
program. To transact business out of the Zurich facility with
Iran, Cuba, Libya, and Yugoslavia, UBS personnel needed to act
covertly and to hide
their activity from the Federal Reserve. For a time they
succeeded in their deceptive scheme, but we put a stop to it
just about a year ago.
The people who engaged in such conduct in Switzerland have
lost their jobs. The business franchise is no more. In the
civil money penalty that we announced on May 10, UBS paid a
heavy price for the deceit of the banknote personnel which it
formerly employed.
Turning for just a moment back to the ECI program, the
imposed penalty gave our remaining ECI contractors 100 million
reasons to remain truthful.
And on top of all of that, the Swiss Federal Banking
Commission issued a formal public reprimand to the largest bank
in Switzerland. The banknote personnel of UBS deceived people
at the Banking Commission just as they deceived us. Our
colleagues at the Banking Commission joined with us in finding
such deception inexcusable and warranting reprimand.
This brings me to my fourth and final point. At the Federal
Reserve we are dedicated to continuous improvement, and we know
that all internal controls can be bolstered through the lessons
of experience, including our own unfortunate experience with
the UBS case.
That experience has shown that our primary control for
compliance with country restrictions, truthful monthly
reporting of
currency transactions by country, was just not sufficient.
Since
February of this year, our ECI contracts have a number of new
features that enhance the control environment. One is the
requirement that management of our ECI contractors attest
yearly on
contract compliance and on accurate reporting, and that an
independent public accounting firm certifies to the Federal
Reserve
that the management attestation is fairly stated. This
Sarbanes-Oxley inspired change shows our commitment to
continuous
improvement.
Let me also acknowledge a lesson learned. With the country
reports we receive from UBS, we did not follow the old audit
admonition, ``trust but verify.'' Going forward, verification
of the accuracy in reporting by our ECI contractors will come
from the certifications of those attestations from public
accounting firms.
In summing up, let me restate my four points. The ECI
program is important and successful because it fosters the
excellent quality of U.S. currency and its efficient
distribution outside the United States. When someone performs
poorly in the ECI program you can be assured that the Federal
Reserve will respond with prompt corrective action. If there is
deception in addition to poor performance, as was the case with
UBS, the consequences will be severe. Finally, we will strive
to continuously improve our internal controls by borrowing the
best ideas and by learning lessons from our experiences.
Thank you for your attention and I look forward to
answering any questions you may have.
Chairman Shelby. Thank you. I would like to acknowledge the
presence of Richard Ashton, Associate General Counsel, and
Michael Lambert, Financial Services Manager, Cash Section,
Division of Reserve Bank Operations and Payment Systems, Board
of Governors of the Federal Reserve. Welcome to both of you
gentlemen.
Mr. Baxter, if you could, walk us through how the ECI
program should have ideally worked from the Fed's perspective
by walking us through a buy and sell order. Explain, if you
could, how it was used and operated by UBS in contravention of
your agreement and how they deceived you. Can you do that, just
slowly?
Mr. Baxter. The first way they deceived us, Chairman, was
by not telling the truth. We will start out with the breach of
the
contract, and the contract exported the restrictions that
Director Newcomb spoke about in his testimony this morning. We
export those restrictions from the United States to our ECI
facilities, and one was in Zurich.
One of the restrictions was that the UBS facility could not
send cash from our ECI vault to Iran. That provision in the
contract was breached, so that is the first provision that
would have prevented this that was violated by UBS. The control
on that particular contract provision is the monthly reports
that the contract also requires be rendered by an ECI operator.
Chairman Shelby. Were those reports false?
Mr. Baxter. You will not be surprised to hear, Chairman,
that the reports rendered by UBS's facility never showed Iran,
and so, yes, sir, they were false. We had the breach and the
doing of the business of Iran and then we have the deception
with respect to the falsification of the monthly reports. Had
the reports been truthful, then the activity would have been
revealed to us and we would have addressed it immediately.
Chairman Shelby. How much money was involved here,
billions, was it not?
Mr. Baxter. Between $4 and $5 billion aggregate for the
jurisdictions that it should not have done business with.
Chairman Shelby. Was the deception facilitated to some
degree by failure to audit primary documentation that would
have evidenced OFAC violations? In other words, from your
standpoint, you cannot just trust somebody in a blanket way,
can you?
Mr. Baxter. In some of your contractual dealings, Chairman,
with respect to some contractual provisions, it is customary to
rely on reps and warranties from your counterparty, and there
is a basic business principle that your counterparty will tell
you the truth.
Here we did not entirely trust our counterparty because we
did audit the cash in the vaults to be sure. We went over with
our auditors to make sure that the money in the vaults
belonging to the Federal Reserve was accurate in count.
With respect to the representation concerning OFAC
restrictions, which was breached, there we did not audit for
compliance. Instead we relied in the past on the monthly
reporting information from the ECI operator. Of course, that
has changed. That has changed because going forward we are
going to receive the management attestation and then the
independent check of the public accounting firm that will have
to assure us in a certification that there is a fair basis for
that attestation.
Chairman Shelby. Under the terms of the ECI agreement, in
addition to receiving statistical data, reports for money
laundering, and OFAC compliance, the Federal Reserve Bank
retained the right to enter, ``the ECI operation on an
announced or unannounced basis to conduct audits of the Bank's
assets as well as
request,'' in this case UBS, ``to account for and reconcile in
the Bank's presence,'' in your presence, ``all other United
States currency on the books at UBS.'' This is from the
document.
What was the purpose of this provision? Why were these
rights necessary?
Mr. Baxter. We wanted to have the ability of our audit
personnel to go in and assure themselves and us----
Chairman Shelby. Unannounced too.
Mr. Baxter. Unannounced or announced, that the cash that
was expected to be in the vault was there, and that we did.
What we did not do is----
Chairman Shelby. Did you ever go unannounced? Did the Fed
ever conduct unannounced audits of the ECI?
Mr. Baxter. I do not believe so, Chairman.
Chairman Shelby. Will you check for the record? You think
not?
Mr. Baxter. I think they always knew we were coming.
Chairman Shelby. Did the Federal Reserve ever request or
conduct a review of U.S. currency transactions on UBS's books
over the course of the contract? You acknowledged a minute ago
you went in and counted the money, but did you ever conduct a
review of U.S. currency transactions on the UBS books over that
contract?
Mr. Baxter. Let me answer it in this way, Chairman, because
there are really two steps. There is the transaction between
UBS and our vault, and of course, that is closely monitored,
and then there is the next layer of transaction between UBS and
its counterparties, and it was the next layer we never actually
looked at that segment, but we certainly were looking----
Chairman Shelby. You wish you had though, do you not?
Mr. Baxter. Now I do.
Chairman Shelby. Mr. Baxter, what about an oversight regime
seemingly dependent upon the voluntary compliance of the banks
which you contracted to hold U.S. currency? In other words, you
are basically voluntary.
It is my understanding that the Federal Reserve Bank did
not suspect that there could be a problem with at least one of
its contractors because of the false reports filed with the Fed
by those contractors. In other words, you relied on them.
Are you comfortable with a compliance system that relies so
heavily on voluntary compliance with the integrity of a major
U.S. international economic program; that is, our ability to
combat counterfeiting, our ability to enforce sanctions against
rogue regimes and a heck of a lot of cash here at stake? What
measures has the Fed taken or do you plan to take so that it is
less reliant on an apparently flawed compliance system? In
other words, you just told us that you did not go the second
layer. You did not go to examine what they were doing, what UBS
was doing. You counted the money, so to speak.
Mr. Baxter. Yes, Chairman.
Chairman Shelby. What is the Fed doing now?
Mr. Baxter. First, let me part company with the word
``voluntary'' because there was a contract. The contract
required the rendering of monthly reports, then and now. So it
was not that it was voluntary. It was required, and the failure
to provide those reports would be a breach. I would not
characterize the reporting as voluntary. It was mandatory, then
and now.
The problem with the reporting is we trusted the
truthfulness of our reporter, and our reporter here was being
deceptive, and that we have addressed through the public
accounting firm certification. What we have not done, and it
would be very, very difficult to do, would be to go to the next
layer and say, ``Okay,'' with an institution, for example, the
size of HSBC, ``we want to see every currency transaction
between HSBC anywhere it is in the world and all of its
counterparties'' because it has branches in many, many
different jurisdictions, there are currency transactions
between HSBC and many, many other banks. So, to take it to that
level would be very, very difficult.
And that gets into one of the fundamental problems here,
trying to trace banknotes, once they are outside of the United
States, from hand-to-hand. And in an organization the size of
an HSBC or a Bank of America, that becomes extremely difficult.
Chairman Shelby. Were the monthly reports basically just
computer spreadsheets that you were getting?
Mr. Baxter. What the monthly reports would show is a
listing of all of the countries that you either received cash
into our ECI facility from or you sent cash from our ECI
facility to. You have all of those countries, and then you
would have amounts for shipments out and receipts. That is what
those reports show.
That is exactly why the reports rendered by UBS were false
because they were missing countries, first, and, second, the
amounts that were shown for those countries were being placed
in a different place on the reports.
Chairman Shelby. Totally fraud, in a sense.
Mr. Baxter. Deception, no question.
Chairman Shelby. Mr. Baxter, I understand that the banknote
trading business was supposed to be kept operationally separate
from the extended custodial inventory program. There does seem
to be some confusion regarding the extent to which these two
activities may have been blurred together.
Were the same people who traded the banknotes for the ECI
program also involved in, for example, UBS's proprietary
banknote trading operation?
Mr. Baxter. The ECI facility----
Chairman Shelby. Do you understand my question?
Mr. Baxter. I do understand, Chairman.
The ECI facility in Zurich was run out of the airport
there. In the airport, there were operational personnel who
prepared the monthly reports that were deceptive, that contain
false entries, and then there were trading personnel. And there
was a form of Great Wall of China between those two operations.
Chairman Shelby. Could you see through it?
Mr. Baxter. Not only could you see through it, Chairman,
not only was there deception, but there was also a conspiracy
among the deceivers who were preparing the reports and also who
were doing the trading. So you had the worst of all worlds. You
had deceptive activity, and you had conspiracy between people
on the operational side and people on the trading side.
Chairman Shelby. What has happened to these people who were
involved in this conspiracy at UBS? In other words, I know you
fined them $100 million, but have they violated Swiss law here?
Have they violated our laws or what have they done? Are you
looking at it closely?
Mr. Baxter. Let me answer this in two ways. First, the
people have been fired. Second, there are continuing
investigations with respect to potential actions against those
people not only here in the United States, but also in
Switzerland. And as I said in my opening statement, there was
deception not only to the Federal Reserve, but also to the
Swiss Federal Banking Commission.
Chairman Shelby. Mr. Newcomb, I believe it is your
responsibility at the Treasury to enforce the U.S. economic
sanctions against countries like Cuba, Iran, Libya, and under
its old regime of Yugoslavia, what used to be Yugoslavia. These
have been some of the key countries I think have been a concern
for the United States in other words, for Treasury for many
years.
Notwithstanding changes with respect to U.S. relations with
Yugoslavia and Libya, has the integrity of the sanction regimes
that have been an essential and important tool of U.S. foreign
policy been harmed by UBS's conduct and Los Angeles oversight
on the part of the Federal Reserve?
Mr. Newcomb. Mr. Chairman, let me answer that question in
this way. Whenever we find hemorrhaging like this, it is
significant to----
Chairman Shelby. It is a lot of money, is it not?
Mr. Newcomb. It is a lot of money.
Chairman Shelby. It evens it out.
Mr. Newcomb. It affects the ability of us to administer
sanctions programs.
We have unilateral sanctions programs.
Chairman Shelby. I know.
Mr. Newcomb. It is unilateral on Iran, it is unilateral on
Cuba, and it was, for a time, on Yugoslavia unilateral. So you
cannot, other than jawboning foreign governments to go along
with your programs, it is very difficult in all instances to
get cooperation. Some governments, in fact, have blocking
statutes prohibiting their nationals from cooperating in
administering sanctions programs.
I think what we have here is a very significant event and,
as Mr. Baxter has pointed out, lessons learned. Though we do
not have jurisdiction over UBS Zurich--there is no enforcement
action that we can take against that bank--we do have other
matters open that I cannot comment about to determine if there
is U.S. jurisdiction and if U.S. laws have been violated. But
we do look forward to cooperating with the Fed. We have met
with them twice in the last month and anticipate next week to
continue to see, though we do not have jurisdiction, to see
what further steps we can take to ensure that these and other
agreements for distribution of dollars are consistent with our
goal in implementing the sanctions programs.
Chairman Shelby. Mr. Newcomb, when entities are sanctioned
for OFAC violations, how much money is usually involved in the
underlying transaction? Does it vary?
Mr. Newcomb. It depends on what the country is and the
timing of the sanctions program. If it is an oil-rich country,
where there is an element of surprise, there can be billions
and sometimes tens of billions of dollars involved. In other
situations where relationships have deteriorated, there usually
is a very small amount blocked, but the size of transactions
can be anywhere in the hundreds of dollars up to the billions
of dollars, depending on the particular facts and circumstances
of the country program and point in time.
Chairman Shelby. Did you rely on the same reporting
requirements to check compliance in your areas that they did?
Mr. Newcomb. Well, we are not involved in the ECI program.
It goes to banks over which we do not have jurisdiction. Any
reliance we would have would be on the contractual relationship
that the Fed would have with its ECI counterparties to control
what is taking place within those institutions. But we have no
jurisdiction, for example, to go and look in a foreign bank, so
there would be no way we could oversee the activities.
Chairman Shelby. But to help coordinate your job, do you
rely, in this case, on some of their information?
Mr. Newcomb. Yes, we do.
Chairman Shelby. And obviously a lot of it was false, was
it not?
Mr. Newcomb. The information that UBS had given to the Fed
was false. I will say, as soon as the Fed was aware of it last
July, they notified us immediately, and as developments
occurred in July, I think again in October, and then in
January, gave us a reporting. As I mentioned since, in recent
weeks, we have met twice and are looking forward to the
cooperation of the Fed to see what steps we might be able to
bootstrap, recognizing that we do not have jurisdiction over
foreign banks, but we are very concerned about the sanctions
program implementation.
Chairman Shelby. Sure.
Mr. Baxter, if one of the purposes behind the distribution
of new dollars in the ECI program was to curtail
counterfeiting, why was a Swiss location used? In other words,
the contracts require cooperation with the New York Federal
Reserve and the Secret Service in investigating counterfeits.
Was there a concern that Swiss Bank secrecy law would inhibit
the Secret Service access to useful information for combatting
counterfeiting on a real-time basis? And was there any explicit
or implicit agreement with the Swiss authorities regarding
access to information that would be necessary to investigate
counterfeiting in Switzerland, for example?
Mr. Baxter. Originally, in 1996, UBS was selected in Zurich
as one of our ECI counterparties and for a very specific
reason, Chairman. At the time, the United States was
introducing a new $100 note, and one of the places that note
was going to be most highly prized was the former Soviet Union.
The key point for shipment of dollars into the former
Soviet Union was Zurich. UBS was an institution that was very
interested in the Russian business. So it was for those reasons
that we originally started our ECI operation in Zurich with
UBS.
With respect to counterfeiting, we get excellent
cooperation from the Swiss government. There is an
international convention that deals with the counterfeiting of
another state's currency within your territory, and that is one
of the things that is highly useful in these matters.
In addition, what we have with respect to the ECI program
is a capability, when a counterfeit note is detected in a place
like Zurich, to alert the Secret Service in the United States
as to the country of origin for that counterfeit note, and that
was also another key factor because, with respect to terrorism,
there was a concern, with respect to the $100 note, that
certain countries were active in supporting counterfeiting of
our currency really to call into question the strength of the
dollar.
Another aspect of this, in quartering a facility in a place
like Zurich, was to get into the market that would lead to the
early detection of the counterfeiting and the possible use of
money as a hostile attack on the U.S. dollar. So those were all
considerations.
Swiss secrecy law, which was also in your question, was
certainly acknowledged as an issue, but an issue that we did
not think would interfere with our getting the country
information, and the country information was seen to be most
important, then and now.
Chairman Shelby. Mr. Baxter, the opinion letter of UBS's
counsel makes it clear that the New York Fed would have
absolutely no recourse, under Swiss law, if it became necessary
to obtain customer-specific information. As a matter of fact,
under paragraph 10(2) of the original 1996 contract, the New
York Fed stipulated that it was not acting ``as a foreign
government body,'' arguably giving up what limited recourse
might be available to foreign governments, like us, for law
enforcement information through the Swiss judicial system.
Don't these limitations in some way diminish the value of
the Zurich ECI with respect to law enforcement efforts. I know
you wanted to launch your new $100 bill there, but you did have
to give up some other things, did you not?
Mr. Baxter. You are correct, Chairman, that to conduct
Governmental activity on the soil of Switzerland would be a
violation of the Swiss penal law. However, with respect to
secrecy, I have yet to meet, in my 24-year career as a lawyer,
a secrecy law that did not have some weaknesses in it, and one
of them--and you can see it here, Chairman--is you can find a
gateway usually through a supervisor. That is why, on July 22,
I went to Bern, Switzerland, and I met with people who I have
known for years at the Swiss Federal Banking Commission, and I
asked for their assistance in getting information through them,
not directly, because there are legal prohibitions to get it
directly, but if you get it through the supervisory authority,
you can find a gateway through secrecy, and that is exactly
what I was looking for on January 22. That is exactly what the
Federal Reserve got because we received the information that we
needed to take the action, and the action was taken in October
and May.
So secrecy laws did not stand in the way because the
Federal Reserve knew how to find the gateway.
Chairman Shelby. But that was after 7 years of violations,
was it not?
Mr. Baxter. And the violations resulted from the deception,
no question, Chairman.
Chairman Shelby. Seven years. Were you or the Secret
Service ever alerted by UBS of counterfeit evidence over the
course of the contract?
Mr. Baxter. I do not know, Chairman.
Chairman Shelby. Can you check that out for the record?
Mr. Baxter. Yes.
Chairman Shelby. Mr. Baxter, why would you use a foreign
bank as an ECI contractor? Would the Fed not have useful
leverage over the U.S. bank with foreign operations? In other
words, we have huge banks headquartered here. I could name, you
could name them all, that do business all over the world. We
have Citicorp, we have Bank of America, you can go on and on,
and you would have some jurisdiction over these U.S. banks, as
opposed to a foreign bank to deal with U.S. dollars,
distribution, repatriating, and so forth. The merits of it.
Could you discuss the relative merits of using UBS, as opposed,
say, to Citicorp or Bank of America or, gosh, you name it, JP
Morgan Chase. I better name them all.
[Laughter.]
Mr. Baxter. Chairman, two points. First, with respect to
the selection of an ECI contractor, we look at the place, and
we look at who can make markets or make markets in those
places. So you have to be active in the banknote business, and
there are only about 30 banks worldwide that are active in that
business. Not all of them are American banks.
Chairman Shelby. Are some of the American banks active in
the banknote business?
Mr. Baxter. Yes. In fact, three of our ECI operators are
American. We have American Express, we have Bank of America,
and HSBC, our contract is with HSBC USA.
Chairman Shelby. A British bank, right?
Mr. Baxter. Well, our contract is with the American
subsidiary. So three of our five are American.
Chairman Shelby. Have you had trouble with HSBC? Are you
auditing HSBC?
Mr. Baxter. Well, remember, we audit all of our facilities
with respect to the cash in the vault.
Chairman Shelby. Is your auditing going to the second-tier
audit now? You did not with UBS, but are you looking at the
others more thoroughly now? And if not, why not?
Mr. Baxter. What our first line of defense is, is the
public accounting certification of both contract compliance and
accuracy in reporting. So we are not doing it using our own
personnel, Chairman. We are using the personnel of public
accounting firms for that purpose.
Chairman Shelby. I hope they are accurate.
Mr. Baxter. The other point about UBS, Chairman, that I was
going to offer, I know it is commonplace to think of UBS as a
Swiss institution, and it does have a Swiss license, but it is
a trillion-dollar bank with $600 billion of its assets in the
United States and 22,000 employees in the United States.
Chairman Shelby. We understand that. We know they are a
good bank, but we also know that they have done some awful
things for the Fed to fine them $100 million. That is not just
a slap on the wrist, monetarily speaking, right?
Mr. Baxter. Correct, Chairman.
Chairman Shelby. Now, you are not trying to defend their
conduct, are you?
Mr. Baxter. Absolutely not, Chairman.
Chairman Shelby. In light of the fact that we now know that
UBS falsified records relating to OFAC issues, has there ever
been a question as to their records with respect to
counterfeiting and money laundering? In other words, if they
would falsify the records dealing with rogue nations, what
about counterfeiting and money laundering? What about terrorist
financing, you know, or anything? I think these questions
should be followed anyway. In other words, if you do those
kinds of things what else would you do? Do you see my question?
Mr. Baxter. I do, Chairman.
Chairman Shelby. Is anybody looking at that?
Mr. Baxter. I know that the Swiss Federal Banking
Commission has looked at those issues with respect to Swiss
banks, generally, and with respect to UBS, specifically, and
that is one of its charges, as the home country supervisor of
UBS, and I know the people there carry that out quite
seriously. I also know, Chairman, from the testimony of others,
like David Aufhauser, Juan Zarate, that there is an opinion in
the Government today that the Swiss are doing more than ever
before not only in the antimoney laundering area, but also in
the terrorist finance area.
Chairman Shelby. Are they doing enough?
Mr. Baxter. I do not know if any of us are doing enough,
Chairman.
Chairman Shelby. It begs the question here, I think, if
they would falsify dealing with rogue nations, what else would
they do? Maybe nothing. Maybe this is all they did, but it
makes you wonder--it does me, and I am sure it does others that
deal with money laundering, terrorist financing, everything
else--because if you are dealing with some of these rogue
nations in that regard, would you be dealing with them in other
respects? I do not know that question, I do not know the answer
to it.
Mr. Baxter, the operations manual for UBS, Union Bank of
Switzerland, makes continued reference to the Avix computer
system. What is the AVIX system?
Mr. Baxter. My belief is the AVIX system that we use with
respect to counterfeit identification, and that is one of the
purposes of an ECI is the early detection of the counterfeit
market.
Chairman Shelby. Does it provide a real-time relay of
information to the New York Fed? Is that part of it?
Mr. Baxter. I do not know that, Chairman, as I sit here.
Chairman Shelby. Can counsel answer that? Does the AVIX
computer system provide a real-time relay of information to the
New York Fed?
Mr. Lambert, do you want to answer that?
Mr. Lambert. Yes, Mr. Chairman. That system is a real-time
system that will convey information from the ECI facilities
back to New York on payment and receipt activity. So it is a
real-time system.
Chairman Shelby. So this system would provide a field for
designating the source of a deposit or a request for cash?
Mr. Lambert. It is basically the payment to and receipt
from information.
Chairman Shelby. Do all ECI contractors use the same
program and manual for controls and operations here, do you
know?
Mr. Lambert. Yes, they do.
Chairman Shelby. Who insures the integrity of the data that
the New York Fed receives from the ECI operators? Is Mr.
Lambert the proper one to answer that?
Mr. Lambert. I think perhaps Mr. Baxter may be able to.
Chairman Shelby. Mr. Baxter.
Mr. Baxter. With respect to cash into or out of an ECI
vault, there would be records that would be maintained on both
the credit and the debt side, and there would be records on the
custody side, which is out at the ECI facility itself. And when
our audit personnel go out to an ECI to do an audit, that is
exactly what they are looking at, Chairman.
Chairman Shelby. Mr. Baxter, we are talking about trust,
but you know you can trust too much sometimes. You have to
verify, you have to check, especially when significant amounts
of money are involved, and there were $4 or $5 billion--I
believe that was your number--involved here. Is there a
cultural issue at the New York Federal Reserve that made it
difficult for you to adopt a rigorous verification program. In
other words, why did you not have a rigorous verification
program?
Mr. Baxter. Mr. Chairman, with respect to the culture at
the Federal Reserve Bank of New York, our culture has always
been rigorous with respect to compliance and with respect to
the enforcement of U.S. sanctions regime.
I can tell you, Chairman, as a very young lawyer, I started
my career in the summer of 1980 at the New York Fed working on
the Iranian hostage crisis. I am one of the very few people
probably
left who has actually been involved with sanctions longer than
Director Newcomb, who I think started in 1981. I learned from
my seniors then, and I have carried with through today, a very
healthy respect for that regime of sanctions. It is part of
our culture. It is part of my being, I believe in it, and part
of the culture of compliance.
Chairman Shelby. But this undermines the sanctions.
Mr. Baxter. Absolutely, and that is why we responded
swiftly and surely, sir.
Chairman Shelby. You responded that--I understand that--and
I commend you for that. But an overarching concern that a lot
of us have is that it took the discovery of a $600-million cash
hoard in Iraq, as reported by The New York Times, to make you
aware of what could be characterized as a fairly significant
and material fraudulent conduct here and this, after at least
two major revisions of the contract and numerous other
amendments of the contract terms, over the course of the life
of the contract from 1996 through 2003.
You significantly altered the terms of your contracts after
this discovery. Are you confident, Mr. Baxter, that such
conduct could be detected in the future from other banks that
you have contracted with? And if so, how? In other words, how
has your compliance changed in your examination? In other
words, if you have not changed, how are you, other than
somebody discovering it for you or alerting you to it, how are
you going to find out what is really going on with your
contract banks in this regard?
Mr. Baxter. I think the first thing that you need, and this
gets to the culture question, Chairman, is you need to be
attentive and responsive, and if you look at how this started,
it started on Sunday, April 20, 2003, when I saw in The New
York Times this reference to our money being found in Baghdad.
And, of course, the first question was how could that happen
not only with U.S. sanctions, but also with UN sanctions? How
could that happen?
The beginning of the tracing exercise was symptomatic of a
culture that we cannot sit still when we see problems. That is
exactly what you see in the chronology of the Federal Reserve's
response.
Chairman Shelby. But a thorough audit might have prevented
those problems early on, could it? Maybe, maybe not.
Mr. Baxter. Truthfulness by our ECI contractor would have
prevented it, and that is why I think it is so important, when
we see deception, that we respond not only swiftly and surely,
but we also respond aggressively, and that is what happened
here. That is what we did.
Chairman Shelby. How many foreign banks--even if they are
based somewhere, if they are based in London, they are based in
Zurich, they are based in Frankfurt, or wherever or Tokyo or
you name it in the world--are your contractors in this regard?
Mr. Baxter. Two--Royal Bank of Scotland and United Overseas
Bank.
Chairman Shelby. I thought HSBC was one you----
Mr. Baxter. Our contract is with the American subsidiary.
Chairman Shelby. Now, what has changed in your audit, in
other words your compliance, since last year to now is what I
am getting at or is it the same procedure you had?
Mr. Baxter. We first added, in both the contract and the
manual of procedures, many more provisions dealing with
antimoney laundering and OFAC compliance, including having a
compliance program for OFAC compliance, appointing a compliance
officer. So there is a much more robust control environment
imposed by contract. That is the first point.
Chairman Shelby. But that is a contract.
Mr. Baxter. That is correct.
Chairman Shelby. But what are you doing yourself to make
sure that contract is complied with?
Mr. Baxter. And then the second thing----
Chairman Shelby. In other words, a thorough audit.
Mr. Baxter. --is the management attestation of two things,
Chairman. First is contract compliance. So all of those new
provisions now are going to get a management official who is
going to attest to compliance with all of those new provisions,
and that management official is also going to attest to
truthful, accurate reporting.
And, the third level, we have a public accounting firm that
is going to come in, and here they are essentially doing the
inspection in place of us, and they are looking at those
management attestations with respect to compliance and with
respect to accurate reporting, and they are saying directly to
the Fed, ``You can rest comfortably, you can take assurance----
''
Chairman Shelby. Were they doing this before? Were they
doing this a year ago, these accounting firms? Were they doing
the----
Mr. Baxter. They were not, Chairman. This was put into
place in February of this year.
Chairman Shelby. They were not. So this is a change you
have brought about.
Mr. Baxter. Yes, Chairman.
Chairman Shelby. And what level of management is involved
in the oversight of this at the Fed?
Mr. Baxter. Well, I am at the executive vice president
level. I am essentially second level down from the first vice
president and the president. So you have it at my attention,
and I am on the Management Committee. I am a very senior person
at the New York Fed.
Chairman Shelby. Do you feel like this is not going to
happen again? You cannot predict that, can you?
Mr. Baxter. Well, I have learned in my career never to say
never, Chairman. I certainly will use my best efforts to assure
that it does not happen again.
Chairman Shelby. We appreciate your appearance here today.
Senator Sarbanes has a number of questions for the record. We
will leave that open if others do. There are a lot of meetings
going on, but we think this is important to hold this
oversight.
Thank you a lot.
The hearing is adjourned.
[Whereupon, at 11:07 a.m., the hearing was adjourned.]
[Prepared statements supplied for the record follow:]
PREPARED STATEMENT OF THOMAS C. BAXTER, JR.
Executive Vice President and General Counsel
Federal Reserve Bank of New York
May 20, 2004
Introduction
Chairman Shelby, Senator Sarbanes, and Members of the Committee, I
am pleased to be here this morning to discuss certain recent events
relating to the Federal Reserve's Extended Custodial Inventory (ECI)
program. More specifically, I will focus on conduct by one of the
former operators of an ECI facility, namely UBS, a Swiss banking
organization. UBS operated a site in Zurich, Switzerland until late
October 2003 when the Federal Reserve Bank of New York (New York Fed)
terminated its contract with UBS for serious breaches. More recently,
the Federal Reserve assessed a $100 million civil money penalty against
UBS for deceptive conduct both in connection with its performance under
the ECI contract, and with respect to the investigation into that
performance.
My remarks today will cover four topics. First, I will provide some
background regarding the ECI program. Second, I will review the
chronology surrounding our discovery that UBS had violated its ECI
Agreement with the Federal Reserve Bank of New York by engaging in U.S.
dollar (USD) banknote transactions with countries subject to sanctions
by the U.S. Department of the Treasury's Office of Foreign Assets
Control (OFAC), and, moreover, that certain former officers and
employees of UBS had intentionally deceived the Federal Reserve Bank of
New York in order to conceal those transactions. Third, I will explain
the rationale behind our decision to assess a civil money penalty in
the amount of $100 million and will distinguish this punitive action
from the earlier action for breach of contract and the remedial action
of the Swiss supervisor, the Swiss Federal Banking Commission (referred
to as the ``EBK''). Fourth, I will discuss the steps the New York Fed
has taken with respect to its remaining ECI operators so as to improve
the controls relating to OFAC compliance.
Background on the ECI program
Let me now begin with some background on the ECI program.
The ECI program serves as a means to facilitate the international
distribution of U.S. banknotes, permit the repatriation of old design
banknotes, promote the recirculation of fit new-design currency, and
strengthen the U.S. information gathering capabilities on the
international use of U.S. currency and sources of U.S. banknote
counterfeiting abroad. ECI facilities function as overseas cash depots
operated by private sector commercial banks. These banks hold currency
for the New York Fed on a custodial basis.
It is estimated that as much as two-thirds of the value of all
Federal Reserve notes in circulation, or over $400 billion of the $680
billion now in circulation, is held abroad. The billions of dollars
held overseas represent a financial benefit to U.S. taxpayers. While
many financial institutions trade U.S. dollars in the foreign exchange
markets, no more than thirty institutions worldwide participate in the
wholesale buying and selling of physical USD banknotes. At the present
time, the principal hubs for the distribution of U.S. banknotes are:
Frankfurt, London, Zurich, Hong Kong, and Singapore. Wholesale banknote
dealers purchase approximately 90 percent of the U.S. banknotes that
are exported to international markets from the New York Fed.
Working with the U.S. Department of the Treasury, the Federal
Reserve introduced the ECI program as a pilot in 1996 to aid in the
introduction of the $100 new currency design note, and in recognition
that an assured supply of U.S. currency abroad would help to alleviate
any uncertainty that might have been associated with a new design. The
pilot program succeeded in ensuring the orderly introduction of the new
design banknotes by providing ready supplies of such notes,
particularly in the European and former Soviet Union markets.
After the successful introduction of the new design $100 banknote,
the primary purpose of the ECI program shifted to enhancing the
international banknote distribution system. The ECI program was placed
into full operation in January 1998 with ECI facilities in London,
Frankfurt, and Zurich, and soon thereafter, Hong Kong. In 2000, an ECI
facility was established in Buenos Aires, but the site was closed in
February 2002 because of unpredictable economic and political
conditions. The Singapore ECI started operation in 2002. Currently, a
total of eight ECI facilities are operated in five cities by five
banks: American Express Bank (London), Bank of America (Hong Kong,
Zurich), HSBC (London, Frankfurt, Hong Kong), Royal Bank of Scotland
(London), and United Overseas Bank (Singapore).
The New York Fed manages the ECI program and provides management
oversight and monitoring of it. We coordinate the shipment and receipt
of currency between our offices and the ECI's. All banknotes contained
within an ECI vault and while being transported between the New York
Fed and an ECI vault, remain on the books of the New York Fed. When
banknotes are withdrawn from the ECI vault to fill a banknote order to
third parties, or for an ECI operator's use, the ECI operator's account
at the New York Fed is debited accordingly. When banknotes are
deposited into the ECI vault to augment the New York Fed inventory, the
operator's account at the New York Fed is credited.
The relationship between ECI operators and the New York Fed is
governed by an ECI Agreement and a Manual of Procedures for the ECI
program (Manual of Procedures). From the start of the ECI program, the
ECI Agreement has specifically prohibited ECI operators from engaging
in transactions affecting ECI inventory with OFAC sanctioned entities.
In addition, since the beginning of the program, the ECI Agreement and
the Manual of Procedures have required ECI operators to provide the New
York Fed with monthly reports showing all countries that engaged in
U.S. dollar transactions with the operator during the preceding month
and the volume of those transactions.
The ECI program facilitates the international distribution of U.S.
currency by maintaining sufficient inventory of Federal Reserve Notes
in strategically located international distribution centers. The ECI's
also are a key part of the Federal Reserve's and Treasury's efforts to
distribute currency to the major global financial markets during times
of crises. In the wake of the September 11 attacks, when air
transportation was seriously disrupted, having U.S. currency already
positioned at the ECI facilities helped enable the Federal Reserve to
continue satisfying international demand for U.S. currency in the major
financial markets without any interruption of service.
In addition to its role in international currency distribution, the
ECI program is critical to ensuring the quality of U.S. currency
abroad. ECI's are required to sort currency purchased from market
participants both by currency design (old and new) and into fit and
unfit notes. These requirements ensure that old design and unfit notes
are removed from circulation in a timely fashion. ECI's are also
responsible for authenticating banknotes purchased in the market.
Therefore, the ECI's detect counterfeit notes as they circulate in
significant offshore money markets, and quickly report information on
the geographic sources of these counterfeit notes to the Secret
Service.
Finally, the information provided by the ECI's to the New York Fed
regarding country level flows of payments, and receipts of U.S.
dollars, has given the U.S. Government a valuable tool for estimating
stocks and flows of U.S. currency abroad, particularly for countries
about which little information was available previously.
The Chronology
I will now turn to the chronology of events surrounding the
discovery that UBS had engaged in ECI transactions with OFAC sanctioned
countries and had concealed those transactions from the New York Fed.
On April 20, 2003, the Sunday New York Times reported that U.S.
armed forces had discovered, in Baghdad, approximately $650 million in
United States currency. According to the article, the wrapping on the
currency indicated that it originated, in part, from the New York Fed.
Upon reading this article, I sent an e-mail directing staff at the New
York Fed to attempt to determine how currency bearing the mark of the
Federal Reserve Bank of New York might have traveled from our offices
to Baghdad. Around the same date, staff from the Board of Governors of
the Federal Reserve System (Board of Governors) in Washington were
contacted by the Treasury Department and asked to assist in tracing the
same currency. Also at this time, staff at the New York Fed and other
Reserve Banks received telephone calls from agents of the United States
Customs Service seeking information regarding the discovered banknotes.
Within days, the New York Fed received serial numbers for a small
sample of the banknotes found in Iraq. By April 24, 2003, our cash
staff in East Rutherford, New Jersey had determined, using serial
number records, that the sampled notes were part of twenty-four
shipments that had been sent from our offices to three of our ECI
facilities: HSBC in London, Bank of America in Zurich, and UBS in
Zurich. Over the next few weeks, we received additional serial numbers
from other samples of the discovered currency as well as serial numbers
from samples of an additional $112 million that was discovered shortly
after the initial hoard. We successfully traced those serial numbers to
the same three ECI facilities, as well as to HSBC's ECI facilities in
Frankfurt and London; to the Royal Bank of Scotland's ECI facility in
London; to a number of commercial banks in the United States and
abroad; and to several foreign central banks.
In an effort to follow the currency trail further, in early May
2003 we contacted each of the ECI operators, and one of the commercial
banks that had done a large volume of relevant currency purchases, and
asked them to provide us with information regarding the counterparties
to whom they sold the identified banknotes. By the end of May, we had
received responses from HSBC and Bank of America that included, for
HSBC, specific counterparty information, and for Bank of America, more
general country information, for the relevant shipments. No
transactions with Iraq or any other OFAC sanctioned countries were
contained in these responses. Our investigative efforts to follow the
trail of the currency discovered in Iraq are continuing.
UBS responded to our inquiry by advising that it did not track
serial numbers for its banknote sales. In the alternative, UBS agreed
to provide information regarding shipments of currency from the ECI
that corresponded closely to the dates on which the notes found in Iraq
had been shipped from the New York Fed's New Jersey office to the UBS
ECI. UBS also informed the New York Fed that Swiss law considerations
precluded the sharing of specific counterparty names. Accordingly, only
country destinations could be provided. On June 25, 2003, UBS provided
a report to one of our cash officers, who was in Zurich for a periodic
site inspection. The report purported to list the relevant shipments by
date and included the countries to which the banknotes were sold and
the amounts in each shipment. While no transactions with Iraq were
identified, included in this report were entries representing eight
shipments of banknotes to Iran. Of course, we had not expected such a
disclosure as currency transactions with Iran were expressly prohibited
by the ECI Agreement.
Upon learning that UBS had sold banknotes to Iran, we asked UBS to
explain how these Iranian transactions could have occurred in view of
the clear contractual prohibition in the ECI Agreement against shipping
currency to countries that are the subject of regulations issued by
OFAC. We also inquired as to why these transactions had not appeared on
the monthly dollar transaction reports that UBS was required to provide
to the New York Fed pursuant to the ECI Agreement. UBS responded that
the transactions with Iran were done by mistake. Further, with respect
to our specific questions directed at the false monthly reports, UBS
banknote personnel provided a facially plausible, but false,
explanation. The explanation was that the reports were the result of an
innocent mistake and not an intentional
deception.
In early July 2003, New York Fed management concluded that the
transactions by our ECI operator, UBS, with Iran constituted a material
event that needed to be reported. Consequently, on July 11, 2003, I
sent a memorandum reciting the facts known then to the New York Fed's
Board of Directors, which, under Section 4 of the Federal Reserve Act,
exercises ``supervision and control'' of the Bank management. In
addition, the New York Fed disclosed what we knew to senior staff at
OFAC, the Board of Governors, and the Department of the Treasury. On
July 17, 2003, the UBS situation was discussed with the New York Fed's
Board of Directors at its July meeting. The directors concurred in the
management recommendation to more fully understand the facts by
involving UBS' home country supervisor, the EBK, and when the facts
were fully understood, to make a decision with respect to contract
termination.
On July 22, 2003, I met with representatives of the EBK in
Switzerland to discuss how to move forward with an inquiry. I explained
to the representatives that, to avoid termination of its ECI contract,
UBS would have to provide the New York Fed with reassurance as to its
compliance. I emphasized that the New York Fed would not tolerate a
repeat violation. I also told the EBK that I was not satisfied with the
explanation proffered by UBS concerning the monthly reports. It was
agreed that the New York Fed would draft questions regarding UBS'
compliance with OFAC regulations in the operation of the ECI and that
Ernst and Young (E&Y), UBS' outside auditor, would review the operation
and prepare responses to our questions.
In late July 2003, E&Y began its review of UBS' ECI operation.
During the course of this review, E&Y learned that in addition to the
transactions with Iran, UBS had also engaged in banknote purchase
transactions with Cuba, another country on the OFAC list, and that the
banknotes had been deposited into the ECI. E&Y also learned that, in
preparing the monthly dollar transaction reports, personnel in UBS'
banknotes operation had concealed the Cuban transactions from the New
York Fed. E&Y informed senior UBS personnel of its findings and
encouraged UBS to disclose the information to the EBK and to the New
York Fed.
In mid-October, UBS disclosed to the EBK that, in addition to the
transactions with Iran, it had engaged in USD banknote transactions
with Cuba that involved the ECI. The EBK advised UBS to disclose the
transactions to the New York Fed. Late on Friday, October 24, 2003,
representatives of UBS met with me at the New York Fed. They told me
that UBS had engaged in transactions not only with Iran, but also with
Cuba, and Libya, yet another country on the OFAC list. On Tuesday,
October 28, 2003, the New York Fed terminated its ECI Agreement with
UBS for breach of Articles 8 and 9 of the Agreement which dealt with,
respectively, UBS' monthly reporting obligations and its OFAC
compliance obligations. Within a week of the termination, UBS disclosed
that it had also engaged in transactions with Yugoslavia (the Republics
of Serbia and Montenegro) during the time that Yugoslavia was subject
to OFAC sanctions. On November 10, 2003, I provided a written report on
the termination decision to New York Fed Board of Directors, and
reviewed it with the Board at their meeting on November 20.
After terminating the contract for breach, the New York Fed needed
UBS' continuing cooperation in the investigation of the facts regarding
the breach and the false reports. Senior management of UBS did
cooperate with us in these specific matters. Further, we received
extraordinary assistance from our supervisory colleagues at the EBK.
Following the termination of the ECI Agreement, UBS appointed an
investigative steering committee and retained two respected law firms
to conduct a full investigation into the operation of the Zurich ECI.
The internal and external auditors of UBS were asked to assist. The EBK
agreed to allow UBS to share the results of this investigation with the
New York Fed on a confidential basis.
Over the next 6 months, the investigative team interviewed forty-
eight UBS employees, many on multiple occasions, and reviewed several
thousand documents, including e-mails. On December 3, 2003, the first
report from the investigation was provided to the New York Fed. Between
delivery of the first report and April 2004, I, along with other New
York Fed officers, met with representatives of UBS on three occasions
and had numerous telephone conversations. We reviewed the status of the
investigation, and requested that more work be done on specific issues.
During this same time period, the UBS investigative team also provided
us with numerous supplemental responses, documents, and updated
chronologies. True to its commitment during the summer of 2003, the EBK
enabled UBS to make full disclosure of the investigative results, and
also enabled the New York Fed to interview members of the E&Y team that
had reviewed UBS' ECI operations. On April 16, 2004, UBS provided the
New York Fed with its final supplement to the December report.
The investigation confirmed that UBS engaged in USD banknote
transactions, through the ECI, with four OFAC sanctioned countries:
Cuba, Libya, Iran, and the former Yugoslavia. UBS consistently engaged
in these transactions from the inception of the ECI program,
notwithstanding the fact that the UBS personnel involved clearly
understood that the ECI Agreement prohibited such transactions.
Moreover, UBS personnel took affirmative steps to conceal these
transactions from the New York Fed, including, but not limited to,
falsifying the monthly U.S. dollar transaction reports that it was
contractually obligated to submit. UBS personnel continued their
efforts to conceal these transactions even after the investigation was
underway. The banknote personnel of UBS also affirmatively misled the
EBK.
In early May 2004, the New York Fed engaged the EBK in discussions
regarding the appropriate supervisory response to UBS' conduct. Our
goal was for the EBK to take remedial action in its capacity as UBS'
home country supervisor, and for the Federal Reserve to take punitive
action against UBS for its deceptive conduct with respect to an
important U.S. program--our sanction regime. On May 10, 2004, the EBK
publicly reprimanded UBS for the failures in internal control that
permitted both the breach of contract and the deception. The EBK's
decision acknowledged that UBS planned to discontinue its banknotes
trading business, and forbade UBS from restarting this business without
the EBK's consent. Simultaneous with the EBK's announcement of its
supervisory decision, the Federal Reserve announced the assessment of a
$100 million civil money penalty against UBS.
The Civil Money Penalty Assessment
I now turn to my third topic and focus on the amount of the civil
money penalty assessed by the Federal Reserve Board against UBS. At the
outset let me emphasize that the civil money penalty is directed at
deception and the violation of U.S. laws relating to deception. The
remedy for breach of contract was contract termination, and that
occurred more than 6 months ago.
The Federal Reserve's statutory authority to assess a civil money
penalty is expressly set out in Section 8(i) of the Federal Deposit
Insurance Act (FDI Act). When the Federal Reserve determines that a
financial institution has violated the law, as UBS did here, and that
such a violation justifies the assessment of a civil money penalty, we
look first to Section 8(i) to determine the range of the penalty that
might be imposed. The statute carefully lays out a three-tiered
approach to assessment. The tiers focus on both the likelihood that the
violation will cause financial harm to the institution and on the
degree of willfulness demonstrated by the institution in committing the
violation. The greater the likelihood of harm and the more deliberate
the act, the higher the maximum penalty.
UBS' conduct here constituted a tier two violation. Section
8(i)(2)(B) of the FDI Act provides that any depository institution that
violates any law, which violation is part of a pattern of misconduct,
shall pay a civil money penalty of not more than $25,000 for each day
during which such violation continues. This formula, applied to UBS'
multiple violations of law, permitted the Federal Reserve to assess a
civil money penalty of $100 million.
While UBS is a $1 trillion institution, and has abundant financial
resources, banknote trading was a very small piece of UBS' overall
business. For the years 1999-2003, UBS' banknote trading business for
all currencies with all countries had aggregate net profit of
approximately $87 million. From 1996 through 2003, UBS earned net
profit of slightly less than $5 million from its banknote transactions
with countries subject to OFAC sanctions. Thus, the $100 million civil
money represents a penalty that is approximately twenty times the
amount of the net profit that UBS derived from its wrongful conduct.
Clearly, however, we recognized the severity of UBS' actions. UBS
had deceived us over an 8-year period in several different ways. In
assessing the civil money penalty, however, we were mindful that the
assessment should not be made in a vacuum. Other than the $200 million
penalty the Board of Governors assessed against BCCI, the $100 million
civil money penalty assessed against UBS is equal to the highest
penalty the Federal Reserve has ever assessed against an institutional
respondent. Last year, in conjunction with a criminal disposition by
the U.S. Department of Justice, the Federal Reserve assessed Credit
Lyonnais a $100 million civil money penalty. While no two cases are
alike, Credit Lyonnais engaged in a similar pattern of deliberate and
repeated false statements to the Federal Reserve in connection with its
secret acquisition of the Executive Life Insurance Company.
In considering whether the amount of the civil money penalty was
sufficiently large, it is not enough to look only at the size of UBS'
balance sheet and net profit. It is important to keep in mind that UBS
is a Swiss institution with its own banking supervisor, the EBK, which
has no authority to impose money penalties. A Swiss governmental
reprimand to the largest bank in Switzerland, as occurred in this case
is, to our knowledge, unprecedented in Swiss history. The EBK took that
action, in no small measure, to demonstrate that it would not tolerate
deception any more than we would. We gave special consideration to the
EBK's views also because, as senior Treasury officials have noted in
testimony before Congress, the EBK has demonstrated exceptional
cooperation in matters relating to the global fight against terrorist
financing. As a bank supervisor active in that fight, the Federal
Reserve appreciates the value of global cooperation.
In short, the $100 million civil money penalty that we assessed
against UBS was appropriate. It was within the range permitted by
statute. It was in proportion to the revenues UBS derived from its
unlawful actions. It was in line with the Federal Reserve's history of
civil money penalties. And, it was appropriate because we were able to
act together with the EBK to craft supervisory action that is both
punitive and remedial.
Remedial Measures With Other ECI Operators
I will now turn to my final topic and address the steps the New
York Fed has taken with respect to its remaining ECI operators so as to
improve the controls relating to OFAC compliance.
Immediately following the discovery that UBS had engaged in
transactions with Iran, in July 2003, we directed inquiries toward each
of the five banks with which we continue to maintain an ECI
relationship. The banks responded by detailing for us the procedures
each had in place to ensure their contractual compliance with the OFAC
regulations and various antimoney laundering (AML) statutes and
regulations. These responses gave us sufficient confidence to carry us
through for the period necessary until we could amend our contracts to
strengthen the OFAC and AML compliance provisions.
In the fall of 2003, the New York Fed began a process of amending
its contracts with the remaining ECI banks to incorporate new controls
into the ECI Agreements and add new compliance sections to the ECI
Manual of Procedures. Prior to these amendments, the Federal Reserve
relied on several means of oversight for the ECI program. All ECI
operations were subject to regular audits by (1) the New York Fed's
audit function, (2) the banks' own internal auditors, and (3) the
banks' external auditors. Our primary means of oversight for OFAC
compliance, however, was the monthly dollar transaction reports
required by Article 8 of the ECI Agreement and by the Manual of
Procedures. These reports were reviewed by New York Fed staff to ensure
that the reported numbers corresponded to the amounts shipped from, and
received by, each ECI in the given month. UBS' manipulation of these
reports effectively concealed its transactions with OFAC sanctioned
countries from the New York Fed, and thwarted this oversight mechanism.
In revising the ECI Agreements, two major changes were made to the
OFAC Compliance Section. First, language was added to expressly provide
that the ECI bank ``agrees that ECI Banknote Activity is subject to the
jurisdiction of the U.S. Department of Treasury's Office of Foreign
Assets Control.'' Second, the Agreement was amended to include an
acknowledgement from the operating bank that, with respect to banknote
transactions, it must comply with the provisions of the United States
Trading with the Enemy Act, the International Emergency Economic Powers
Act, the Antiterrorism and Effective Death Penalty Act, and ``any other
similar asset control laws, to the extent that they are implemented by
OFAC regulations.''
Perhaps the most significant changes, however, relate to new audit
requirements for the ECI's. A new section was added to the ECI
Agreement requiring an annual audit of the operating bank's AML and
OFAC Compliance programs. The ECI Agreement provides that a management
representative must attest that the ECI operator is complying with the
contract. Then, the contract requires that a public accounting firm,
hired at the ECI operator's expense, must attest to the management
assertion, and specifically, whether the assertion is fairly stated.
The public accounting firm must also render an opinion on whether the
monthly reports that the ECI bank has provided to the New York Fed are
accurate.
As part of these remedial measures, major changes were also made to
the Manual of Procedures. The Manual of Procedures now contains
sections setting forth specific requirements for AML Compliance and
OFAC Compliance programs. With respect to OFAC Compliance, the ECI
operator must (1) establish a system of internal controls to ensure
compliance with all OFAC regulations; (2) perform and document a
comprehensive OFAC risk assessment of all aspects of ECI Banknote
Activity; (3) designate a Compliance Officer responsible for monitoring
compliance with all OFAC laws and regulations, and an officer
responsible for overseeing any funds blocked as a result of any OFAC
law or regulation; (4) implement an audit program that will provide for
independent testing of all aspects of the OFAC Compliance program, and
for an annual comprehensive audit of each line of business relating to
the ECI Banknote Activity; (5) provide appropriate OFAC Compliance
training for the appropriate employees; (6) maintain the most current
OFAC List of prohibited countries, entities, and individuals; (7)
retain all OFAC related records for a period of not less than 5 years;
and (8) require the OFAC Compliance Officer to develop a program to
screen customers and transactions for OFAC compliance.
Finally, in order to ensure that the New York Fed can react quickly
to any compliance problems that may arise, there is a new procedural
section requiring the ECI operator to notify the New York Fed
immediately of any activity that violates the compliance requirements
of the ECI Agreement.
The new contracts were all executed and became fully effective in
February 2004. I should note that, following the announcement of the
assessment of the $100 million civil money penalty against UBS, we
again directed inquiries to our ECI operators to learn their reactions
to the Federal Reserve's action. All of the ECI operators viewed the
penalty as significant and understood that it reflected the importance
the New York Fed places on both strict compliance with the OFAC
requirements of the ECI Agreement and the Manual of Procedures, and on
the integrity of its ECI operators.
Conclusion
The ECI program serves an important function by ensuring that we
supply USD banknotes to the global market in an efficient manner, and
that the quality of, and confidence in, our currency is maintained at a
high level. UBS' egregious conduct should not overshadow the ECI
program's benefits. In terminating the UBS ECI contract, in assessing a
$100 million civil money penalty against UBS for its deceptive conduct
as a former ECI operator, and in working with the EBK to craft a
coordinated regulatory response, the Federal Reserve acted decisively
and properly to send a message about the importance it places on OFAC
compliance. The remedial measures that have been put into place
underscore that message and, we believe, will promote such compliance
in the future.
I thank you for the opportunity to appear before you today and look
forward to answering any questions you may have.