The Other Banking Drama: Those Secret Swiss AccountsPublished: March 04, 2009 in Knowledge@Wharton
While world markets are teetering in a global banking meltdown, another banking drama is playing out in Switzerland that could end the way private banking has been done there for centuries.
U.S. tax authorities have challenged long-standing Swiss banking secrecy laws, demanding that UBS AG release the names of 52,000 Americans suspected of opening secret accounts to evade taxes. The bank agreed to release client information on 250 U.S. citizens and pay a $780 million fine as part of a settlement, but that decision has put the entire Swiss banking system in jeopardy, according to Wharton faculty.
"Swiss banking as we have known it is dead," says Wharton professor of operations and information management Maurice Schweitzer.
Even though UBS has balked at releasing the full 52,000 names, turning over the 250 client names put a "chink" in the system that will destroy the trust of wealthy people around the world in Swiss bank accounts, he says. "Secrecy is at the heart of Swiss banking. This UBS case shakes that foundation of trust that clients had placed in Swiss banks regarding the secrecy [of] those accounts."
If the release of individual names triggers a run on UBS, the already fragile global banking system could be further endangered, according to Wharton finance professor Franklin Allen. "UBS is one of biggest banks in the world, and it's not clear the Swiss government could save it. If UBS were to fail, this would be a huge problem." He says U.S. authorities will have to engage in careful "brinksmanship" with UBS to balance their goal of apprehending tax cheats with the goal of preserving the stability of global finance systems.
Secret banking in Switzerland dates back to 1713 when the Council of Geneva passed a law preventing banks from sharing client information. In the 1930s, after France and Germany tried to negate that ruling in order to prevent capital flight, the Swiss responded by making the release of banking information a crime. The system was reaffirmed in 1984 when 73% of Swiss voters agreed to preserve secret banking.
The combination of its secret banking laws and a stable government gave Switzerland a competitive advantage in private banking, allowing it to attract capital from overseas. Today, one-third of the world's total offshore assets of $7 trillion are in Swiss banks, according to Reuters.
The current dispute pits U.S. tax law against Swiss law which still makes the release of banking clients' names a crime -- unless there is a specific client suspected of evasion and the client has the opportunity to answer to Swiss authorities. The U.S. Internal Revenue Service (IRS) has filed a civil lawsuit in U.S. District Court in Miami to force UBS to disclose the identities of U.S. customers who have secret Swiss bank accounts holding cash and securities valued at almost $15 billion as of the middle of this decade.
According to Wharton finance professor Richard Marston, the U.S. takes tax evasion seriously, and the IRS has long been frustrated by the Swiss private banking system. The current action, however, comes in response to a concerted effort by UBS to solicit private banking clients in the United States. As a result, U.S. tax authorities threatened to indict the firm's U.S. subsidiary, a move that would have endangered UBS's sizable legitimate financial services business in the U.S. The bulk of UBS's U.S. business is highly reputable, Marston adds.
"UBS management was really tone-deaf in terms of U.S. tax policy," says Marston. "The one thing that distinguishes investors in the U.S. from many European countries is the concern that they don't violate tax laws. It's taken seriously by the IRS, and everyone clearly knows this."
UBS has already replaced the management team that agreed to the settlement. That team, Schweitzer speculates, must have been under enormous pressure to agree to release the 250 names. "The difference between 250 and 52,000 is small. The levy has been breached. They have given up names, which to my understanding, no Swiss bank has ever done before," Schweitzer says. "As a result, no Swiss banker can approach [a potential client] and say with a straight face that his or her banking will be completely secret."
To much of the world, Swiss bank accounts are viewed as a tool for certain individuals -- from ultra-rich Americans and Europeans to African despots and Russian oligarchs -- to hide vast wealth.
Wharton finance professor Marshall Blume says that, for obvious reasons, it's not exactly clear what kind of person makes up the bulk of clients at Swiss private banks. "Certainly people who have ill-gotten gains find it attractive to hide them there. For the U.S., it's tax evasion, but for other countries it's more a place to hide money."
If the Swiss system were to collapse, Blume suggests, other havens, such as the Cayman Islands, might see an increase in business. He adds, however, that other countries willing to shield investors are not as stable, nor are they immune to the same pressure from U.S. tax authorities. Confidence in the security of Lichtenstein's bank privacy laws was shaken last year when a former Lichtenstein bank executive handed over client names to U.S. authorities and testified before the U.S. Senate.
Philip M. Nichols, Wharton professor of legal studies and business ethics acknowledges that the lack of transparency and accountability invites abuse. "When I talk with people involved in corruption all around the world, the phrase 'Swiss bank account' almost always comes up."
The importance of Swiss bank accounts varies, Nichols says. For many individuals in emerging countries, they provide the chance to maintain safe accounts in a stable currency and shield holdings from currency controls that limit how much money an individual can take in or out of the country. "There are still plenty of countries in the world that are somewhat authoritarian, in which the government basically takes money from the rich and keeps it to themselves. To wealthy persons, [secret accounts] are an invaluable tool for legitimate purposes." But for those government or NGO (non-governmental organization) officials who are trying to aggregate and mobilize capital for development purposes in emerging economies, "they are somewhat frustrating because we wish the capital would stay in the home country."
Blume and other faculty members say the timing of the case against UBS has nothing to do with the current global banking meltdown or the recent election of U.S. President Barack Obama. They note that U.S. tax authorities have been building this case for some time, and it has only now come to point where it was ready to go before a judge.
Governments around the world, adds Schweitzer, tolerated the Swiss private banking system as an historic holdover. UBS is now suffering because it tried to integrate its private bank services with its traditional U.S. business. "UBS initially hoped they could have it both ways. When they realized they couldn't, they chose to continue their ordinary banking services in the U.S."
How will it all turn out?
Blume isn't sure. "I don't know why the Swiss gave in [to U.S. demands] in the first place, unless there is a lot of behind the scenes pressure that you and I don't know about." Marston predicts that while the Swiss have the right to establish their own laws, the tax case will become a "serious tug of war" between two conflicting philosophies -- one supporting secret accounts and the other opposing tax evasion regardless of the legal framework. He notes that the issue has not come to a head until now because more of the cases were isolated incidents in which an individual taxpayer slipped up and gave the IRS an opening. "It's only when a major bank tries to create a program that builds up the secret accounts -- that's when you run into trouble," he says.
The U.S. and Switzerland are now on a collision course, according to Marston, although the U.S. will be reluctant to hurt its relations with an important European country. "It's going to be difficult, and I'm not sure what will happen," he says, "but when push comes to shove, I don't think the Swiss will allow the general release of names" beyond the 250.
Allen, too, notes that UBS is pushing back hard. A U.S. indictment of the firm would amount to "Armageddon." He advises U.S. tax authorities to continue to apply pressure to force the Swiss banks and U.S. taxpayers to break away from one another. If U.S. tax authorities "can do this at the right level so that it scares [the banks] -- without killing them -- they will be successful."
Tax evasion, he adds, is a serious issue, and the entire global community should be organizing against outlier nations that provide bank secrecy to "put very heavy pressure on all these horrible dictators who hide money. The world would be a lot better place if bank secrecy were eliminated."
Schweitzer agrees that the Swiss will fight the IRS case vigorously. "This is not over. It's going to be long and drawn out, but the precedent has been set. A Swiss bank has agreed that it will disclose account information."
UBS agreed to release names only to avoid criminal indictment, he says, "but I really think the door's been opened here. Even if it is just UBS, and even though there are just 250 names, that's enough to set the precedent that secret Swiss banking as it used to happen cannot continue."