The attacks on New York City and the Pentagon on September 11 set the United States and its allies on a new, and unprecedented, war footing. Like previous global conflicts, the battle against terrorism will be waged on many fronts. Initially, much of the press and public attention has rightly focused on the military front in Afghanistan. Other crucial theatres of operation received attention as well, including the financial front.

 

ince September 11, policymakers have focused resources on developing the means to anticipate and prevent such incidents in the future. And across the board, experts and politicians agree that more resources must be devoted to gathering and analyzing intelligence. As a result, the Central Intelligence Agency, the Federal Bureau of Investigation, and military intelligence units are likely to receive greater funding.

Ironically, the discussion has not focused quite as much on financial intelligence. After all, authorities could – and should – use financial systems to cut off the air supply of terrorists. Even though the attacks of September 11 were reportedly carried out on a relatively modest budget – about $300,000 – they could not have been carried out without adequate and timely funding. And just as the terrorists took advantage of our relatively open and porous educational, aviation, and immigration systems to plan and execute their attacks, they also took advantage of our financial system.

Indeed, there is now plenty of evidence to suggest that terrorists, and those who support them, are using the global financial network as a conduit for funding mayhem. There have been reports of financial support to extremist organizations from businessmen and companies in a number of countries. And one of the more intriguing – and bizarre – trails of the September 11 attacks focused on the unusual activity prior to the attacks in financial instruments such as put options on the stocks of airline and insurance companies. The value of these instruments appreciated considerably as stock market indexes and the stock prices of severely-impacted companies fell after September 11. There remains a suspicion that some associates of the terrorists were, in fact, aware of the impending attack and its possible financial market consequences.

"Just as the terrorists took advantage of our relatively open and porous educational, aviation, and immigration systems to plan and execute their attacks, they also took advantage of our financial system."

Regardless of the scope and ambition of their goals, terrorists need financial secrecy to achieve their aims. Of course, virtually all legitimate businesses need financial secrecy as well. In fact, secrecy forms an integral part of the market for all banking and financial services, fiduciary relationships, and regulatory structures. Secrecy is a “product” that has intrinsic value, and that can be bought and sold separately or in conjunction with other financial services. This means that as we activate troops on the financial front, we must distinguish between the need to penetrate the secrecy needed by terrorists from the imperative to protect the financial secrecy needed by other users of the financial system, most of whom are totally legitimate. Since terrorism-related financial flows are most likely a drop in the ocean of legitimate financial flows, they need to be triangulated, attacked and throttled with least possible damage to the financial system as a whole.

The longstanding desire for financial secrecy stems from several powerful imperatives, and the phenomenon has several different manifestations. Personal financial secrecy usually remains in substantial compliance with applicable laws and regulations, and in many countries has been well served by long-standing traditions of banking confidentiality. Likewise, business financial secrecy involves the generally legitimate withholding financial information from competitors, suppliers, employees, creditors and customers. Such financial information is proprietary and capitalized in the value of a business to its shareholders.

Other forms of financial secrecy skate closer to the edge of the law. Capital flight normally refers to an unfavorable change in the risk/return profile associated with a portfolio of assets held in a particular country thought sufficient to warrant redeployment of assets. Capital flight may or may not violate the law, but is usually done in secret. Tax evasion – illegally avoiding payment of fiscal levies – is a classic source of demand for financial secrecy, and requires varying degrees of financial secrecy to work. Finally, there’s criminal activity. Drug traffickers and smugglers not only accumulate large amounts of cash, but also regularly deal in a variety of financial instruments and foreign currencies. So do gun runners and terrorists. All require ways to launder funds and eliminate paper trails that might be taken as evidence of criminal activity; their ill-gotten gains need to disappear and stay hidden.

egardless of the motivation, the value of secrecy depends on what may happen if the cover is blown and the probability of subsequent exposure of the parties and transactions concerned. Damage can range from criminal prosecution, exile, and political ostracism to confiscation of assets, fines, taxes and penalties, social opprobrium, and familial tension. The avoidance of damage is what the secrecy-seeker is after. And since damage usually is a matter of probabilities, the attitude toward the risk of exposure is a critical factor in how this benefit is valued. In the case of terrorism, a serious financial system reform can affect these odds and change the perpetrators’ attitudes to undertaking such activity.

In order to combat terrorism-related financial flows, we must uncover the financial conduits being used and then close them. This is an admittedly ambitious goal. And it is more than likely that the measures law enforcement authorities and financial institutions employ cannot possibly be granular enough to identify only the targeted flows. Consequently, they are likely to pull in a lot of financial “by catch.” Some of these efforts will produce collateral dividends, such as rooting-out criminal financing in the drug business or the illicit arms trade. And some will make tax evasion much more difficult, and improve tax compliance – especially in countries with poorly structured fiscal regimes.

If governments now get serious about going after the terrorists’ secret financing channels – and governments have plenty of leverage on banks and other financial firms if they decide to use it – everyone else involved in the illicit funds flows (estimated to be $1.5 trillion annually) will start squirming. Chances are the dragnet will come up with much more that the authorities bargained for. Secrecy-seekers of the world should fasten their seat-belts!

To be sure, there will be negative outcomes on the financial front. The new campaign will impose costs on people who want to move funds to less risky political or economic regimes, who want to keep things confidential for business or family reasons, or who simply consider their own financial situation to be nobody else’s business. These costs are hard to measure, but they are doubtless significant and have to be considered “collateral damage” in the war on global terrorism.

As always, the trick is to limit that damage by using finely-honed, “surgical” regulatory techniques. Unfortunately, we are in uncharted territory here. So as they design the new anti-terrorism financial weaponry, policymakers must try to devise financial early-warning systems that bolster the public interest while limiting the adverse consequences.

It is clear that we need to develop techniques that can monitor terrorist activities as well as enforce securities laws and combat drug-related crime. Any anti-terrorism task force certainly needs the kind of manpower, financial and technical, that is fully up to the task and capable of coping with the inevitable unintended consequences. Looking for needles in a haystack rarely leaves the haystack the same.

Marti Subrahmanyam is Charles E. Merrill professor of finance, economics, and international business at NYU Stern.

Ingo Walter is Charles Simon Professor of international business, economics, and finance at NYU Stern.