Corruption And The Global Financial Crisis

The financial debacle has many causes and implications, but it would be wrong to underestimate systemic corruption

By Daniel Kaufmann*

Forbes 
January 27, 2009

It would be very convenient to start this article by stating that corruption is a challenge mainly for public officials in developing countries and that it is unrelated to the current global crisis. I also wish I could claim that corruption has declined worldwide as a result of the global anti-corruption and awareness-raising campaign, the many effective anti-corruption commissions, and the recognition that poverty and culture are the reasons why corruption prevails.

But none of it is true. For starters, corruption is not unique to developing countries, nor has it declined on average. Some developing countries, such as Chile and Botswana, exhibit lower levels of corruption than some fully industrialized nations. And countries like Colombia and Liberia have made gains in recent years, while others, such as Zimbabwe, have deteriorated. Bribery remains rife in many countries, totaling about $1 trillion globally every year. In truth, anti corruption commissions, revised laws and awareness-raising campaigns have had limited success. Focus on petty or administrative bribery has been misplaced at the expense of high-level political corruption. One neglected dimension of political corruption is "state capture," or just "capture." In this scenario, powerful companies (or individuals) bend the regulatory, policy and legal institutions of the nation for their private benefit. This is typically done through high-level bribery, lobbying or influence peddling. The cost to society of bribing a bureaucrat to obtain a permit to operate a small firm pales in comparison with, say, a telecommunications conglomerate that corrupts a politician to shape the rules of the game granting it monopolistic rights, or an investment bank influencing the regulatory and oversight regime governing them. As a country becomes industrialized, its governance and corruption challenges do not disappear. They simply morph and become more sophisticated: Transfer of a briefcase stashed with cash is less frequent. Instead, subtler forms of capture and "legal corruption" exist: an expectation of a future job for a regulator in a lobbying firm, or a campaign contribution with strings attached. In many countries this may be legal, even if unethical. In industrialized nations undue influence is often legally exercised by powerful private interests, which in turn influence the nation's regulations, policies and laws.

This has dire consequences: Witness the various forms of corruption underlying the current global financial crisis that started in the U.S.

There are multiple causes of the financial crisis. But we can not ignore the element of "capture" in the systemic failures of oversight, regulation and disclosure in the financial sector. Concrete examples abound. First, the way Freddie Mac (nyse: FRE - news - people ) and Fannie Mae (nyse: FNM - news - people ) spent millions of dollars lobbying some influential members of Congress in exchange for, among other things, lax capital reserve requirements for these mortgage giants. 
Second, how AIG's (nyse: AIG - news - people ) "small" derivatives unit located in London managed to obscure its accounts, be governed by lax regulatory oversight, and take inordinate risks that effectively brought down AIG's empire of 100,000 employees in 130 countries, accelerating the global financial crisis. 
Third, how giant mortgage lenders such as Countrywide Financial switched regulators so to fall under the lax oversight of the Office of Thrift Supervision, which was funded by fees paid by the regulated banks (and which also supervised AIG's derivative unit). 
Fourth, how in April 2004, during a 55-minute-long meeting at the Securities and Exchange Commission, the largest investment banks persuaded the SEC to relax its regulatory stance and allow them to take on much larger amounts of debt. 
Finally, Madoff's giant Ponzi scheme, some of which appears to be plain fraud, though system-wide irregularities also point to subtler forms of corruption and capture. Years ago the SEC knew that Madoff, who had served on the commission's own advisory committee, had multiple violations and was misleading it in how he managed the funds of his customers. Yet the SEC failed in unmasking the Ponzi scheme. 
Consequently, the study of corruption ought to include acts that may be legal in a strict narrow sense but where the rules of the game have been bent. Would this broader view of corruption result in different corruption ratings? Absolutely.

Let's look at the U.S. Over the past few years, traditional measures of corruption, such as the Corruption Perceptions Index by Transparency International, have placed the U.S. among the least corrupt nations in the world, currently ranking No. 18 among 180 rated countries.

In stark contrast, when in 2004 I calculated an index of "legally corrupt" manifestations (measured through the extent of undue influence through political finance and powerful firms influencing politicians and policy making), the U.S. rated in the bottom half among the 104 countries surveyed. Countries like the Netherlands, Norway, Denmark and Finland exhibited low levels of "legal corruption" (ranking Nos. 1 through 4, respectively). Yet the U.S. was rated 53rd, a few ranks below Italy. Chile rated 18th. Also rating better than the U.S. were countries like Botswana, Colombia and South Africa. 
Corruption and capture are important causes of the crisis. But it is also urgent to face up to the consequences of "new world order." There is a rapid--unprecedented in peacetime--expansion in the role and scope of government in "market economies.” This new overarching role of government, taking place in the U.S. and other large economies, is occurring at five levels. 
First, the public sector is reshaping regulation; second, the government is becoming an owner of financial institutions; third, it is bailing out selected private concerns through a quick and massive infusion of funds; fourth, it is to provide almost a huge fiscal stimulus into infrastructure; and fifth, it intends to extend the social (and housing) safety net for millions of vulnerable citizens. 
There are governance and corruption risks in each of these areas. Lobbyists are already at the door. These new risks are not exclusive to the U.S., but apply to other G-7 countries: Russia and China, among others. With the U.S. leading, current global estimates of disbursed and planned bailout funds approach $3 trillion, while cumulative global plans for fiscal stimulus near $2 trillion. 
The new U.S. administration has stated its intention to address the challenges of transparency and accountability in its stimulus plan. The devil will be in the details. Merely creating an oversight institution will not do; system-wide reforms in incentives are required. Deep-seated transparency reforms need to be a cornerstone in the government's plan, and should apply to U.S. public agencies as well as domestic and international financial institutions. Regulations supporting effective disclosure, as well as improved audit, accounting and risk-rating standards, should be preferred to restrictive regulatory controls that block innovation and growth. 
Humbly learning from other nations will also go a long way. The situation in the U.S. warrants studying other countries--for instance, Sweden and Chile, which successfully addressed their financial crises long ago. Chile also offers guidance on how to structure less corrupt and effective concessions in infrastructure, where the U.S. is a novice.

In order to restore confidence, citizens, entrepreneurs and bankers need to have renewed trust in the financial system. That way they can be persuaded that it is no longer a giant Ponzi scheme. Transparency is the key.

About the Author: Daniel Kaufmann, a Chilean citizen, is senior fellow at the Brookings Institution, formerly director of governance at the World Bank. Read his blog at www.thekaufmannpost.net.