Where did the money go?

Where did the money go? Endogenous money creation for international fraudulent purposes The case of the 2015 Moldovan banking scandal

Abstract: We investigate the biggest banking scandal ever in the History of the Republic of Moldova, based on the Kroll Report published in 2015, which focuses on three commercial banks that account for a third of the country's banking sector. Despite the opacity of the web of complex transactions that led to the scandal, rarely have we been in possession of so much quality information about actual banking operations involving billions of dollars (or the equivalent in foreign currency). What are the learning lessons of this banking scandal in the Republic of Moldova for Post-Keynesian monetary theory? Part 1 presents a brief synopsis of the 2015 Moldovan banking scandal. In part 2, we investigate the under-explored issues of corporate governance structures of both lenders and borrowers as well as the impact of transnational financial engineering practices in the context of endogenous money theory. Part 3 sketches out the implications of the 2015 Moldovan banking scandal for post-Keynesian monetary theory by, on the one hand, rehabilitating Palley's concept of endogenous finance, and on the other hand, by demonstrating how the scandal is best conceptualized by elaborating a new framework focusing on the interface between transnational financial elites and the shadow banking system in transition economies.

Introduction

On Monday 4 May 2015, the speaker of Parliament of the Republic of Moldova decided to publish the Kroll Report on his Internet blog after thousands of people rallied on Sunday 3 May in the capital, Chisinau, to protest against endemic corruption in the country, and demand recovery of the missing billions in the so-called Ilan Shor group scandal. The Kroll report investigates the apparent theft of nearly one-fifth of the country's annual GDP. In a spectacular lender-of-last resort move, the Moldovan central bank was forced to issue some 16 billion lei ($870 million) in emergency loans to keep the economy afloat. The Kroll report focuses on three commercial banks that account for a third of the country's banking sector. These banks were subject to significant shareholder change, which had the effect of transferring ownership to a series of apparently unconnected individuals and entities in Russia, Ukraine, the UK and Moldova with various actors linked to notorious tax havens such as Seychelles or the Marshall islands. Despite the opacity of the web of complex transactions that led to the scandal, rarely have we been in possession of so much quality information about actual banking operations involving billions of dollars (or the equivalent in foreign currency). What are the learning lessons of this gigantic banking scandal in the Republic of Moldova for Post-Keynesian monetary theory? Part 1 presents a brief synopsis of the 2015 Moldovan banking scandal. In part 2, we investigate the under-explored issues of corporate governance structures of both lenders and borrowers as well as the impact of transnational financial engineering practices in the context of endogenous money theory. Part 3 sketches out the implications of the 2015 Moldovan banking scandal for post-Keynesian monetary theory by rehabilitating Palley's concept of endogenous finance, and in addition demonstrating how the scandal is best conceptualized by elaborating a new framework focusing on the interface between transnational financial elites and the shadow banking system in transition economies.

I) A brief synopsis of the 2015 Moldovan banking scandal A) The methodological approach adopted by the Kroll report The Kroll report The present paper would have been impossible without the release of the Kroll report on Monday, 4 May 2015, by the speaker of Parliament after thousands of people rallied in the capital Chisinau the previous day to protest against endemic corruption in the country, and demand recovery of the missing billions.1 The Kroll Report focuses on three commercial banks accounting for almost a third of the country's banking sector, namely Unibank, Banca Sociala, and Banca de Economii, (whose chairman was Ilan Shor himself). These banks "were 1

The scandal was named by some Moldovan media the “theft of the century”. As we will see, the terminology is slightly misleading. Money being endogenous, that is credit-driven, the creation of money for fraudulent purposes through credit intermediation only indirectly amounts to welfare losses for the economy. Fragile banks as a result of dubious billion-dollar loans will probably be less capable of financing the investment expenditures of the economy, which constitute the real welfare losses (that is the real theft) entailed by the scandal.

consecutively subject to significant shareholder change, which had the effect of transferring ownership to a series of apparently unconnected individuals and entities" in Russia, Ukraine, and Moldova (Kroll report, 2015, p 8). The scoping phase of investigation (ibid., p.6) aimed (1) to identify the irregular transactions since January 2013 and prioritize those of largest value, (2) to identify linkages (transactions, related parties, banks insiders) (3) to detect potential anomalies in the transactions (lack of sound business rationale and/or non-compliance with international banking norms and regulatory requirements). (4) to assess the likelihood of recovery of the missing sums of money and the need for intervention of foreign jurisdictions. With these initial objectives in mind, briefing discussions and interviews were conducted with experts of the National Bank of Moldova, special administrators and relevant stakeholders in the scandal. The Kroll report relied on source data provided by the NBM and “further external investigative research has been conducted into relevant individuals and entities as the investigation has progressed, in order to identify the extent to which transactions might be associated, individuals linked, as well as the likely legitimacy of beneficiaries of transactions” (Kroll report, 2015, p.7). B) The facts : what we know as of May 2015 Who is Ilan Shor? Ilan Shor is an Israeli-born, Moldovan businessman barely 28 years old at the time of writing, who possesses a duty-free concession at Chisinau airport, a fleet of expensive cars, a football club in the town of Orhei, several TV stations, and even a Russian pop-star wife named Jasmin. Until the 2015 Moldovan banking scandal, he had, against the odds, managed to escape public scrutiny. Shor is head of the so-called Shor group headquartered in the Republic of Moldova. What is the Shor Group? The seminal article by Ronald Coase (1937) asked the question of why intense formal activity exists within firms (i.e., formal organizations) if we agree with the neoclassical premises that market forces necessarily ensure the most effective allocation of scarce resources. Following Coase (1937), who emphasized the role of transaction costs and imperfect information, Williamson (1975, 1979, 1985) pursued this research program, by putting the search for efficiency at the heart of the definition of the boundaries of the firm as well as the idea that “every transaction can be mapped into a most efficient institutional arrangement” (Holmström and Roberts, 1998, p.78). Organization design will also be strongly influenced by information and knowledge that will challenge both markets and firms (Ibid., p. 90). Yet, it seems to us that further analytical steps are strongly needed to understand why complex economic structures, such as the Shor group, may actually come into existence. In fact, the Shor group is

composed of numerous business entities, with Ilan Shor being a common connection between all of them (some direct, some looser, albeit evidenced by business research conducted by the authors of the Kroll report). Ownership and/or control by Ilan Shor having devised a metastrategic plan, is thus a necessary and sufficient condition to define the boundaries of the Shor Group.

Source: Kroll Report, 2015, p.14

Given the prominent role of Ilan Shor in the definition of the Shor group, one may wonder whether the latter comes down to the decisions of a single individual, or rather consists of a nexus of contracts forming a coherent corporate strategy serving his interests. In order to answer this difficult question, we resort to the landmark paper by Jensen & Meckling (1976, p.9, emphasis added), with their conception of the firm as a nexus of contracts. Viewing the firm as the nexus of a set of contracting relationships among individuals also serves to make it clear that the personalization of the firm implied by asking questions such as “what should be the objective function of the firm?” or “does the firm have a social responsibility” is seriously misleading. The firm is not an individual. It is a legal fiction which serves as a focus for a complex process in which the conflicting objectives of individuals (some of whom may “represent” other organizations) are brought into equilibrium within a framework of contractual relations. In this sense the “behavior” of the firm is like the behavior of a market that is the outcome of a complex equilibrium process.

With hindsight, the corporate strategy of the Ilan Shor group certainly spurred the subsequent losses of the three Moldovan banks, which likewise may be viewed as the outcome of a “complex equilibrium process” (ibid.). As a matter of fact, creditors of the Ilan Shor group (and at large the Moldovan society) have been deeply affected by the banking scandal, thereby questioning the enthusiasm of Jensen and Meckling (1976, p.71), regarding the greatness of the publicly held business corporation. The publicly held business corporation is an awesome social invention. Millions of individuals voluntarily entrust billions of dollars, francs, pesos etc. of personal wealth to the care of managers on the basis of a complex set of contracting relationships which delineate the rights of the parties involved. The growth in the use of the corporate form as well as the growth in market value of established corporations suggests that at least, up to the present, creditors and investors have by and large not been disappointed with the results, despite the agency costs in the corporate form.

Contrary to the above profession of faith, more than just the incumbents of agency costs, it is likely that a number of stakeholders (the State, the Central Bank, the creditors of Shor, the banks’ other clients, society at large) were substantially disappointed by the unfolding of events.

Graph 1 Total Shor Group Loan Exposure to all Moldovan bank between 2010 and 2014

The exposure of companies of the Shor Group between 2012 and 31 October 2014 A substantial increase in the combined value of credit assets was witnessed (from Mld Lei 1.1 Billion to Mld Lei 8 Billion), while an abnormally high level of connectivity between the structures characterized these three banks (Kroll Report, 2005, p.11). Such a significant level of interrelated lending within three, apparently independent banks would have required a significant level of co-ordination within and control of each of them. Control is implied by the significant connectivity identified between the shareholders of each of the banks, whilst coordination is reflected by the number of common management between UB, BS and BEM.

November 2014 A dramatic twist of events occurred in November with the unfolding of a web of complex operations coordinated by one person, Ilan Shor, possibly aided by a small set of collaborators (2015, p.8). The Kroll report (ibid., p.12) that surfaced these operations, refers to a coordinated effort between the three banks (testifying that bank corporate governance is of utmost relevance), in order to extract as much loan finance from the bank with disregard for any business rationale of the underlying activities.: By 24 November, all but four of outstanding loans on 31 October 2014 had been paid down. These credit assets were replaced by higher value loans issued by BEM to four entities belonging to the Shor group. On 24 November, the balance owned by these entities to BEM was MDL 13.2 billion. The dramatic turning point occurred between 24 and 26 November. During these three days, the loans issued by BEM to these four entities2 were repaid. This massive influx of liquidities enabled BEM to deposit an equivalent sum of money at BS, 2

Namely Provolirom SRL, Dracard SRL, Caritas SRL and Voximar SRL

which was further used to issue new loans to five Shor Group companies up to MDL 13.7 billion3. Following a request from seven shareholders based in Russia and Ukraine, a meeting was convened on 26 November, which allowed the sale by BS of the totality of the loans outstanding to a company called Fortuna United LP (this is the first step in the transnational financial engineering chain that will be elaborated upon in Part 3).

C) Research question : Despite the opacity of the web of transactions that led to the scandal, rarely have we been in possession of this much quality information about actual banking operations involving billions of dollars (or the equivalent in foreign currency). What are the learning lessons of this banking scandal in the Republic of Moldova for PostKeynesian monetary theory?

II) Why the ownership structure of lenders and borrowers matters 1) Bank ownership structure : a review of literature The Group of Thirty (G30, 2012, emphasis added) states that In the wake of the crisis, financial institution (FI) governance was too often revealed as a set of arrangements that approved risky strategies (which often produced unprecedented short-term profits and remuneration), was blind to the looming dangers on the balance sheet and in the global economy, and therefore failed to safeguard the FI, its customers and shareholders, and society at large (G30, 2012, p.5).

This statement resonates with the advent of the 2015 Moldovan banking scandal. One may reflect on the link between the quasi failures of these three Moldovan banks and their corporate governance structure in the run-up to the scandal and the disappearance of the funds. Drawing on the findings of Berger and Bouwman (2013) regarding the role of capital on bank performance during financial crises, one may acknowledge the relative small size of these three Moldovan banks, and their resulting financial fragility. The fact that they were undercapitalized weakened their performance, and slashed their probability of survival during what appeared as a bank crisis (ibid., p.176) caused by an exogenous event triggering systemic risk. But besides under-capitalization of banks (a factor which proved paramount as the global financial crisis unfolded in 2008), why do banks fail? This has arguably been the central question at the heart of concerns by regulators and by extension all stakeholders of the global banking system in the aftermath of the global crisis (Berger et al., 2014) 3

We do not imply that deposits make loans, which would be a negation of endogenous money theory; rather, a substantial improvement in a bank’s liquidity position increases its ability to issue new loans. See some of the writings on the preference for liquidity of commercial banks with an emphasis on emergent economies ( Khemraj (2013), and Khemraj, (2014, Chap 2)) “Bank liquidity preference and the investment demand constraint,” Economic Modelling, Vol. 33 (July), 2013. Money, Banking and the Foreign Exchange Market in Emerging Economies, Cheltenham, UK and Northampton, MA, USA: Edward Elgar, 2014.

investigate this question, acknowledging that many aspects remain unresolved to date. What does post-Keynesian theory have to say in this respect? First and foremost, the seminal contribution by Moore (1988a, 1998b, 1989) has acknowledged that money creation is driven by credit and determined by demand. In this sense, only the effective demand by creditworthy borrowers (Wolfson, 1996) will preside over the distribution of new bank loans, and therefore the endogenous creation of money. The debate between horizontalists and structuralists was raging during the 1990s and the early 2000s. It both highlighted and questioned the relevance of the principle of increasing risk (associated with a positive slope of the money supply curve) in a macroeconomic setting, with horizontalist economists, such as Lavoie (2003) usually criticizing the mere microeconomic stance adopted by structuralists. Likewise, Piegay (2003, p.250) argues that the main difference between horizontalism and structuralism is at the adopted level of analysis: horizontalists focusing more on the macroeconomic level, while structuralists concerned with microeconomic issues. For Dimsky (1988, p.505), banks pool risks and provide liquidity to depositors; they also gather private information regarding the creditworthiness of potential borrowers, and act as credit intermediaries so as to transfer purchasing power to bank-funded borrowers. For Dimsky (ibid., p.517), decisions regarding the volume and the loan rates in the current period depend on the anticipations of bank liquidity in the next period. One is tempted to revisit this analysis through the 2015 Moldovan banking scandal. However, let us remember that Dimsky’s emphasis on microlevel bank behavior was strongly criticized by Wray (1989, p.152), who lamented over the erroneous ideas held by Dimsky, and his non-Keynesian banks in contradiction with endogeneity and the non-scarcity of money (Parguez, 2001). However, the actual determinants of borrowers’ creditworthiness have been underexplored by post-Keynesian economists, as pointed out by Ramskogler (2011, p.74), whose critical question is not the microeconomic assessment of the creditworthiness of a particular borrower by an individual bank, but rather, how the extension of credit to a particular borrower may impact the bank’s solvency in the eyes of credit rating agencies and the public at large. In this sense, the assessment of the structure of bank assets (as in the Basel framework) and the bank balance sheet is paramount (Dimsky, 1988, p.517) regarding expected bank liquidity. In mainstream economics, solvency has usually been apprehended through a battery of regression tests conducted on key accounting variables, such as capital ratios (as previously highlighted), non-performing loans ratios, and earnings (Martin, 1977; Pettway and Sinkey, 1980; Espahbodi, 1996; Helwege, 1996, Schaek, 2008, Cole and White, 2012). Yet, as pointed out by Berger et al. (2014, p.1), “no research to date has empirically analyzed the influence of corporate governance characteristics, such as ownership structure or management structure, on a bank’s probability of default”. The same goes for Post-Keynesian monetary theory, wherein the weight of the corporate governance structure of both lenders and borrowers has been an oft-neglected issue with perhaps the notable exception of Marangos’ writings on transition economies (Marangos, 2006). The present paper constitutes a step in this hopefully fruitful direction.

2) Transnational financial engineering and the need to explore the ownership structure of the recipients of bank credit a) Transnational Financial Engineering It seems that at the heart of the Moldovan banking scandal, there is a transnational financial nexus involving opaque Russian, Ukrainian, Latvian, and British actors. A tentative explanation of the financial set-up Affiliations amongst shareholders of one of the banks of the consortium (BEM) all related to the Shor group (Kroll Report, 2015, p.11). For instance, SSI4 was financing its increase in share capital via its Russian parent company, registered as OOO5 Konstanta, which received funding from Daniell Invest LTD, a shell company registered in the UK (incorporated on 21 March 2012) and SKIF LLP (a Moscow-based entity), which also provided funding arrangements for other BEM shareholders6. The financial set-up also entailed an intensification of interbank lending (between the banks of the consortium) designed to enable increased liquidity of balance sheets and therefore increased lending (ibid.). As a consequence of this intensified lending activity on the part of the consortium, the Shor group exposure (i.e. the sum of credits assets resulting from loans made to the Shor group) increased to MDL 4.8 billion by the end of 2013. The higher exposure was concentrated mostly within one of the three banks of the consortium (i.e. Unibank). As we explained in Part 1, 26 November was a key date marked by highly unusual events taking place within the banks of the consortium. A stunning reversal of loan exposure occurred when loans issued by BEM to four Shor group-related entities were repaid. The balances held on deposit between BEM and Russian banks automatically cleared down. Some very complex transactions immediately followed the reversal of exposure, resulting in new loans granted for MDL 13.7 billion by BS to five entities based in Moldova. The funds were immediately transferred to a company registered in the UK with accounts in a Latvian bank (i.e., Privatbank). The loans were then sold to Roseau Alliance LLP7, a UK registered shell company for nominal value and accrued interest (for MDL 4.7 billion) to be paid in five annual installments until November 2019. Were the suspicious transactions documented? From a regulatory standpoint, this is an obligation. In the case at hand, all loan documentation had been channeled to a motor vehicle managed by a third-party company Klassica Force SRL. The vehicle was found to be stolen and burned out, thereby eliminating (by means of criminal 4

The full denomination of SSL is “Întreprinderea cu Capital Străin "SISTEME INFORMAŢIONALE INTEGRATE" S.R.L”, meaning literally “Enterprise with foreign capital "SISTEME INFORMAŢIONALE INTEGRATE" limited liability enterprise”. 5 Общество с ограниченной ответственностью in Russian (literally: Enterprise with limited responsibility) 6 Tintel Project Ltd, Wall Trend Ltd, Canmondean Development Ltd, Calteco Prim SRL, and Viadox Grup SRL (Kroll Report, 2005, p.11) 7 Roseau Alliance is a Limited Liability Partnership incorporated in 2012 in Birmingham, UK in the vaguely defined field of investment services.

masquerade?) all relevant loan documentation. Regarding the role played by Roseau Alliance, it is not the first time that the name of this entity appeared, as it had already signed with BEM a cession agreement in 2013, which resulted in the transfer of all claims relating to a list of non-performing loans for a nominal value of almost MDL 1 billion (Kroll Report, 2015, p.31). These non-performing loans corresponded to the historical commercial lending activity of BEM, and had been on its books for several years (see table below).

Source: The Kroll Report (2015, p.31)

The Kroll Report (ibid.) ostensibly questions the reason why this company registered in the UK would be willing to acquire a series of non-performing credit assets with no discount applied, in order to replenish Moldovan banks with cash; yet, further research (ibid., p.32) has shown that Roseau Alliance was only incorporated one year prior to the transaction. Its general partners are based in the Marshall Islands 8. The representative of Roseau Alliance, who signed the agreement is known as Ilya Gribkov, a common Russian name, who is related to Elena Gribkova, who is simply the spokesperson for Ilan Shor9. By all means, the financial set-up is made of a transnational financial nexus involving opaque Russian, Ukrainian, Latvian and British actors. The shareholding structure of Unibank, one of the banks of the consortium presents some very idiosyncratic features. From 2007 until 2012, it was operated under the ownership of Austria-based Vienna Capital Partners Unternehmensberatungs AG. A restructure took place on 17 August 2012 when all of the banks shares were sold and transferred to twenty one new shareholders with a stake comprised between 4.5% and 4.99%.

8

“The Republic of the Marshall Islands is an incorporation haven. Its legislation is very similar to that of Liberia although more recent. The name of the corporation may be written in any language which uses the Latin alphabet with any of the following suffixes indicating that it is a corporation: Corporation, Corp., Company, Co., Limited, Ltd., Société Anonyme, S.A., Sociedad Anonima, Incorporated, Inc., Limitada, Ltda., Aktiengesellschaft, AG, NV, A/S, Société par actions.” See https://www.offshore-manual.com/224_3.html 9 See http://skandaly.ru/2013/10/03/shoryi-ilana-shora/

This is significant, as the 5% threshold under Moldovan legislation, defines a significant shareholder, whose acquisition requires the formal approval of the central bank (Kroll report, 2015, p.16). The new shareholders of Unibank comprised eight companies registered in the UK, twelve Moldovans and one Russian citizen. The Kroll Report (2015, p.16) evidenced that among all the shareholders some are connected to Moldovan political parties, and government institutions. The set-up is of utmost complexity, and the report shows that some of the beneficiaries of the UK shareholders include individuals based in Latvia and Cyprus, linked to money laundering allegations (ibid.). Another disturbing fact is that Roseau Alliance LLP, the abovementioned UK registered shell company, which acquired BEM’s non-performing loans in 2013 in exchange for cash is also the owner of the headquarters of PPCD, which presents itself as the oldest political party in the Republic of Moldova10. Roseau also owns a building, where an association that belongs to the latter party, is registered11.

b) The ownership structure of bank credit recipients: an underexplored issue in PostKeynesian economics Marangos (2006, p.669) is a vehement critic of the rapid privatization decisions following neoclassical prescriptions in post-communist countries. For Marangos (ibid.), the “implementation of the neoclassical privatization process resulted in a cruel deception, in which many individuals colluded, a few profited, and the public at large was the great loser”. Pilkington (2005, p.14) regrets the lack of emphasis on institutions by neoclassical economists: “The recent example of Russia illustrates the crucial role of institutions, and the lack thereof that might account for the problematic transition towards a market-oriented economy”. Marangos (2006, p. 669) rejects the idea that privatization in transition economies during the 1990s resulted in efficient private ownership structures. Contrariwise, it favored corruption practices and inefficiency. Marangos (ibid.) points to the breaking down of firms into numerous entities under the form of joint stock or limited liability companies (SRL in Moldova). The common objective for colluding bankers and managers was to reap the benefits of the most profitable parts of the business while transferring the losses to the State (ibid.), a phenomenon reminiscent of the privatization of profits and the socialization of losses in advanced economies in the aftermath of the global financial crisis. The reflection on corporate governance is not absent from the post-Keynesian literature. The founding fathers can be found with the likes of Galbraith (1967), Wood (1975), Eichner & Kregel (1975) and Eichner (1976). In the 1990s, Crotty (1990, p.534), and Lavoie (1992, p.94-118) made important contributions; and more recently, Dallery (2008), Stockhammer (2005-6) and Hein (2008). Yet, what has been missing so far, following the research program initiated by Marangos, is an objective assessment, based on real-world examples, of the creditworthiness of bank credit recipients whenever the latter take the form of a constellation of firms in post-communist countries in light of their idiosyncratic corporate governance structures.

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http://www.ppcd.md/ro/despre-noi.html http://www.zdg.md/editia-print/investigatii/locuintele-de-lux-si-afacerile-de-familie-ale-liderilor-electorali

III)

Learning lessons for post-Keynesian monetary theory

1) Revisiting Palley’s concept of endogenous finance We have already referred to the post-Keynesian debate between horizontalists (or accomodationists) and structuralists in Part 2. In this section, we push the issue of money creation further by rehabilitating the concept of endogenous finance developed more than two decades ago by Tom Palley (1992), a well-known structuralist postKeynesian, Contrastingly [to horizontalists], structuralists emphasize the private initiatives of banks in arranging loan finance, while at the same time retaining a critical role for the monetary authority. The wider significance of this debate lies in the fact that the structuralist approach incorporates elements of nascent endogenous finance. If Post Keynesians are to adopt this perspective, it is important that the debate be resolved in favor of the structuralist position (Palley, 1992, p.2)

In this paper, we consider the Shor group scandal that lends itself to microeconomic analysis with a substantial role devoted to the private initiatives of the three Moldovan banks of the consortium. This story is therefore best apprehended through the lenses of the structuralist position, in phase with the concept of endogenous finance that we hope to extend to the macroeconomic level. The channel of financing of investment expenditure by banks has often been circumscribed to bank credit in the postKeynesian literature. For Palley, this is most unfortunate, as bank credit is far from constituting the sole source of financing for productive firms. In a monetary economy, banks represent one element in the financial system, and in principle there is room for substitution in the manner in which payments are arranged. This means that it is necessary to move the analysis beyond the confines of the banking system, and include other forms of financing. It is this feature that prompts the notion of moving beyond endogenous money and toward endogenous finance (Palley, 1992, p.18)

Other sources that ought to be considered include issues of new equity shares financed by hard-to-trace off-shore companies, as in the Moldovan case. All in all, a striking parallel exist between Palley’s creative finance (ibid.) and the Shor group’s financial engineering practices, Lastly, business cycles tend to be marked by the adoption of “creative” financing, a process which may also be viewed as part of endogenous finance. Thus, as the financial system’s ability to finance transactions becomes strained over the course of the upswing, there may be shifts in the medium of settlement. For instance, when it comes to purchase of large real assets such as office towers, payment may take the form of title to notes and bonds rather than transfer of title to bank deposits. By taking transactions out of the banking system, this helps circumvent any emerging liquidity shortage that may characterize the banking system.

Finally, endogenous finance à la Palley is contingent on the institutional context (Palley, 1992, p.20), which also pertains to the Moldovan case: “more generally, this illustrates the significance of the institutional context for the operation, of the

endogenous finance perspective, since institutional arrangements affect the capacity for and pattern of financial accommodation”.

2) Endogenous money creation, but for whom and for what? The unfolding of the Moldovan banking scandal seems to vindicate Palley’s claims on endogenous finance. It also echoes the idea that modern banking systems may be entering a new phase (partly anticipated by Chick) wherein money is endogenous for reasons that have little to do with production or real economic activity and quite a lot to do with what we shall call transactions in assets or (less formally) ‘speculative’ activity (Howells, 2000, p.1)12.

Howells (ibid., p.7) is critical of the orthodox approach to endogenous money propounded by Moore and Davidson : Consider what one might call the ‘orthodox’ approach to endogenous money. Loans create deposits and endogeneity results from the fact that loan demand depends upon events elsewhere in the economy – on firms’ demand for working capital according to the dominant view (Davidson, 1988; Moore, 1988, pp. 221-32). An increase in economic activity (and/or the price level) requires firms to increases their working capital and this is supplied, often on overdraft, by banks. Clearly then, the money supply is demand-determined, but notice that the demand which is immediately responsible is the demand for credit.

Howells (ibid.) draws on the evolutionary view of Victoria Chick (1986) that identifies six banking ‘stages’, and by relying on UK data, makes a case for a seventh one. Howells notes that the demand for credit no longer originates exclusively in the real economy, and the need to finance working capital, but increasingly rests upon speculative and intermediate transactions, which have grown much more rapidly than GDP in the UK. The evolutionary view and notably the idea that money only became endogenous in the last two stages (Chick, 1986, p.115) has not been endorsed by all post-Keynesians, many of them who think that money is endogenous regardless of the historical stage under scrutiny (Rochon and Rossi, 2003, p.xxviii.; Lavoie, 1992). We do not offer to settle this debate here, because the introduction of speculative purposes in money creation has been taken at a further analytical level with the advent of stock-flow consistent models (Godley and Lavoie, 2007). Yet, we retain Howell’s intuition that endogenous money creation is indeed compatible with motives that depart from the workings of the real economy and that might entail, as in the case at hand, a set of international fraudulent purposes through transnational financial engineering practices and possibly involving a so-called shadow banking sector (see Part 3).

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3) The Shor scandal: at the junction between the transnational capitalist class and the shadow banking system? In this final section, we put forward the novel idea that the whole Shor scandal not only helps put back into perspective some of the key theoretical claims in postKeynesian monetary theory, such as endogenous money creation, but also entails a groundbreaking reflection on the true nature of the scandal, which seems to lie at the interface between the workings of the transnational capitalist class and the shadow banking system, for which we provide a revisited definition in the context of transition economies whose banks are poorly regulated.

a) The rehabilitation of a transnational capitalist class We previously alluded to the revival of the concept of endogenous finance developed more than two decades ago by Tom Palley, and that has been crystallized in the more recent shadow banking terminology. Yet, the transnational financial engineering practices observed during the Shor group scandal were only made possible thanks to a complex web of actors, some of them more or less directly linked to opaque and controversial offshore centers, such as the Seychelles or the Marshall islands. We argue here that the transnational capitalist class, akin to the concept of the elite comprising top positions in institutional power structures of the global economy (Murray and Scott, 2012, p.1) has played a pivotal role in ensuring the operations of the Shor scandal. Scott (2012, p.14) has portrayed an interesting (allegedly Marxian) alternative to the managerialist model of business enterprise incarnated by Berle and Means (1932), the latter gaining prominence in business economics research throughout the twentieth century. Berle and Means (ibid.) argued that ownership and control had come to be separated in the 20th century, and the owners (the shareholders) therefore came to rely on the board of directors to represent their interests, incurring what Meckling and Jensen (1976) later labelled agency costs. Berle and Means’ theory states that over time the boards become so dominated by the management that their supervisory role becomes ineffective. This thesis later found support in Minsky’s writings about financial manager capitalism (1986). Contrariwise, based on a number of pioneering works (Zeitlin, 1974; Kotz, 1978; Mintz and Schwartz, 1985; Caroll, 1986, 2004; Scott, 1986, 1997, Murray, 2006), a Marxian alternative to the Berle and Means approach has criticized the managerial revolution (Burnham, 1941) and the strict separation of ownership and control: There has been no separation of ownership and control in the sense described by Berles and Means and no sign of a ‘managerial revolution’ or strict ‘management control’. The situation is one of ‘control through a constellation of interests’ in which there has been no clear-cut disapperance of capitalist classes (Scott, 2012, p.7, emphasis added).

Rejecting the omnipotence of managerial elites, neo-Marxian authors posit the enduring existence of a capitalist class that was given a new impetus through the rise of financial capital, The controllers of finance capital […] are the directors and principal shareholders in the large units of finance capital that dominate the whole credit system. Through the building of extensive networks of interlocking directorships – created when a person is a director of two or more separate companies –finance capitalists can exercise powers of coordination across large sectors of the economy. The key argument put forward was that the interconnections among finance capitalists create large clusters of allied enterprises (Murray and Scott, 2012, p.4 emphasis added).

There are indeed striking similarities between the above explanatory account of finance capital, and what actually occurred during the 2015 Moldovan banking scandal under the aegis of the Shor group company. The similarities with the Moldovan scenario are further strengthened by the fact that the owners of finance capital act in concert with the state apparatus, in order to serve the interests of the capitalist class in a system of state monopoly capitalism (Aaronovitch, 1961; Menshikov, 1969; Murray and Scott). Further, unlike Great Britain, former communist countries did not build upon a small scale entrepreneurship base for their early industrial development (Scott, 2012, p.17). Aleneva (1998) explains that under the Communist era, a complex web of informal transactions and relations structured the economy. Somehow, these informal exchange practices have not disappeared today with the advent of constellations of firms (such as the Shor Group). Scott (2012, p.18) points to the relational, social or even political capital (French, 2011) embedded in these hybrid and sometimes opaque politico-economic structures in transition economies. As Scott (2012, p.18, emphasis in the text) writes: Structures of bargaining and barter have shaped capital mobilization into a truck mechanism of corporate collusion involving complex mixtures of banks, holding companies and former nomenkentura. The mobilization of formal and informal social networks supplements and sometimes supersedes commercial criteria. Access to bank credit, supplies and outlets depends upon the bargain abilities of directors and managers as much as it does on the commercial viability of particular projects.

Strikingly, this description is reminiscent of the Moldovan scenario examined in the present article, with its collusion between banks and managers, and lending activities with disregard for sound business rationales.

b) The role of the shadow banking system in the Republic of Moldova In his account of the global crisis, Rossi (2010, p.414) points to “the creative destructions’ by the shadow banking system that is the result of financial engineering as well as banks’ off-balance-sheet operations”. For Rossi (ibid., p.418, emphasis added), the emergence of the shadow banking system, paramount in the unfolding of the GFC, was the outcome of an inadequate organization of the banking system, and what Rossi terms financial and monetary intermediation (in a Schmittian perspective),

Lacking this structural divide in the real world, banks have rapidly abandoned traditional bank activities (emission of money and financial intermediation) having a close link with production, to establish an alternative (or a shadow) banking system, within which both actors and objects of pure financial-market transactions have nothing to do with value-added creation – whose measure is provided by total income produced in the whole economic system.

In many ways, the Shor group seems to have relied on shadow-banking entities, in order to facilitate the disappearance of colossal sums of money from the traditional Moldovan banking system. Below we present the key issues related to the current Moldovan banking sector, in order to better understand the genesis of the Shor scandal.

The Moldovan banking sector: some unresolved issues The biggest issue facing the Moldovan banking sector is probably a lack of transparency, The problems faced by Moldova's banking sector are not performance related, but instead are deeply rooted in a lack of transparency in banks’ shareholder structures. After opaque shareholder changes in the country's two largest banks in 2013, authorities are working on a resolution (Lindhard, 2014).

At first glance, the global picture of Moldovan banks looks healthy: Indeed, the average return on equity across the country’s 14 banks was 9.4% in 2013, the loan-todeposit ratio is below 100% and most foreign currency lending to individuals is forbidden. The rate of bad loans, while higher than in many western European countries, is still below others in the central and Eastern Europe region at 11.6% at the end of 2013 (ibid.).

Quoting Dorin Drăguţanu, the governor of the National Bank of Moldova (NBM), Lindhard writing in The Banker, states that lack of transparency, notably with regard the true identity of banks’ shareholders, is probably the biggest weakness of the Moldovan system at present,13 In the past, shareholders were registered in classical offshore jurisdictions but changes made to the Law on Financial Institutions a few years ago put a ban to that. The new strategy of those smart guys is to use shell companies registered in good jurisdictions – including from the EU – where the ultimate beneficiary remains unknown (Dorin Drăguţanu quoted by Lindhard, 2014).

Quoting Henry Russell, director of financial institutions groups, western Balkans, Belarus, Moldova and Ukraine at the European Bank for Reconstruction and Development (EBRD), Lindhart (ibid.) stresses the legal uncertainty that still prevails in Moldova, and hampers the trust of investors in the effectiveness of the Rule of Law. When foreign investors came [into other eastern European countries] they also brought in best practices […] but if you can’t trust the courts to uphold your property rights, you are not likely to attract foreign investors. [It is this] reputation that Moldova has to improve.

Some important reforms have been engaged over the last few years 13

http://eleonora-lisnic.blogspot.ru/2009/11/dorin-dragutanu-guvernator-al-bnm.html

In July 2013, Moldova established an economic advisory body, the Economic Council, chaired by Prime Minister Iurie Leancă, which is aimed at attracting investment, while improving the business environment and the rule of law. And while Moldova’s rank in the World Bank Doing Business report has improved from 86th place in 2013 to 78th in 2014, the country’s rank for investor protection remained unchanged at 80th in the world (Lindhard, 2014).

The National Bank of Moldova suspects that the ultimate beneficiaries of some opaque share transactions involving the Moldovan banks have not been satisfactorily disclosed to the two regulators (the NBM and the National Commission for Financial Markets (NCFM)), which are in the process of collecting information to clarify some confusing and puzzling economic transactions (ibid.). Quoting Julia Otto, head of the EBRD’s Chisinau office, regulatory loopholes as well as legislative priorities in the Moldovan landscape are singled out, When the voting rights of those minority shareholders were revoked, the raiders used the split of responsibility between the two regulators [the NBM and the National Commission for Financial Markets, or NCFM] in their favor […] There is a need to consolidate regulatory responsibilities under one umbrella to close the loophole […] but this is a large legislative act (ibid.)

Finally, one should address the issue of the ownership of shareholder registers (Lindhard, 2014). Mr Drăguţanu regrets that access to shareholders registers is still a complicated matter in Moldova, and still infringes upon the protection of property rights that characterize a free market economy. Is the Moldovan banking scandal attributable to the shadow banking system? We do not provide a straightforward affirmative answer, and we might even lean towards the opposite stance. Let us invoke hereafter the reasons supporting our claim. Firstly, Adrian Lupusor (quoted by Coalson and Barbarosie, 201514), executive director of the Expert-Grup think tank in Chisinau, argues that the Kroll report has evidenced a sweeping network of illicit financial transactions akin to transnational money laundering activities, “it seems to be a money-laundering scheme with a transnational character, a cross-border character, because it involved several banks and companies from different countries and it definitely involved a large number of people”. At first sight, the above description seems to pertain to opaque schemes designed to escape the vigilance of the regulator. The
term
shadow
banking
system
is
attributed to
PIMCO’s
Managing
Director
Paul Mc Cully (2007) who defined it as “the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures.” Indeed the whole Shor group scandal seems to have been characterized by a web of opaque non-bank (i.e., intra-firm and off-shore) structures, which could arguably be granted a shadow-banking pedigree. Yet, in his initial description of the shadow 14

http://www.rferl.org/content/moldova-banks-audit-links-missing-billion-to-businessman/26996371.html

banking system, McCulley (2007) explains that “unlike
regulated
real
banks, which fund themselves with insured deposits backstopped by access to the Fed’s discount window, unregulated shadow banks fund themselves with uninsured commercial paper, which may or may not be backstopped by liquidity lines from real banks”. There are no signs of funding the dubious loans to the Shor group with uninsured commercial paper in the Moldovan case. Likewise, in its Green paper, the European Commission (2012, p.3) reiterated the definition put forward by the Financial Stability Board (2011)15 whereby the shadow banking sector, was defined as "the system of credit intermediation that involves entities and activities outside the regular banking system". Yet, this important definition does not seem to match the initial description of the Shor scandal, which seems to have taken place within the traditional Moldovan banking system, and not outside.
To the question, “is shadow banking really banking?” (Noeth and Sengupta, 2011) provide the following answer, “the credit intermediation process as a whole mimics the function of a bank”16 Yet, mimicking the function and behavior of banks makes sense in a highly regulated banking environment (e.g., the USA), but in a poorly regulated or poorly regulatory effective country, such as the Republic of Moldova, there is no rationale for a shadow-banking system, as pockets of regulatory opacity are easily found within the traditional banking system itself! This leads us to put forward a new proposition that hopefully will spur interesting scholarly discussion. In transition countries wherein the traditional banking system is poorly regulated and/or existing regulation is poorly effective (such as the Republic of Moldova), the shadow banking system is self-contained within the traditional banking system, but it needs not be formally distinguished therewith. By all means, whether the issue at stake is the shadow banking system or a weak regulatory bank environment, we agree with Members of the European Parliament [who] make an attempt to define shadow banking appropriately. They point to the danger of systemic risks caused by the innovative nature and complexity of shadow banking entities, as well as to the problems inherent to the weak regulatory regimes (Henn, 2012)

Before the Moldovan Central Bank initiated its lender-of-last-resort move, systemic risk was palpable in Moldova.

Concluding remarks: In this article, we have analyzed a recent banking scandal that has shaken the Republic of Moldova, and that has served as a stepping stone, in order to revisit some important notions in post-Keynesian monetary theory, but also central mainstream ideas, such as

15 16

www.financialstabilityboard.org/publications/r_111027a.pdf https://www.stlouisfed.org/Publications/Regional-Economist/October-2011/Is-Shadow-Banking-Really-Banking

agency theory and the theory of the firm. As Jensen and Meckling (1976, p.72) argued, any serious theory of the firm ought to account for agency costs, Agency costs are as real as any other costs. The level of agency costs depends, among other things, on statutory and common law and human ingenuity in devising contracts. Both the law and the sophistication of contracts relevant to the modern corporation are the products of a historical process in which there were strong incentives for individuals to minimize agency costs.

In the case at hand, the ingenuity in devising contracts between numerous actors was remarkable; agency costs were kept low as the interests of Ilan Shor were being served, albeit at the expense of creditors and of society at large. For further research, scholars might want to investigate how corporate fraud via transnational financial engineering and the shadow banking system can be the by-products of the minimization of agency costs, while remaining faithful to the theory of endogenous money. The present paper was written in an investigative rather than in a pedagogical fashion. At the time of writing, the time is not ripe for a case-study structured around the Shor scandal. As suggested by the title, we still do not know where the money has gone. Future research should also be geared at a critical discussion of the transactions described in the Kroll Report, using all the tools of accounting and financial analysis. Yet, we believe that the narrative of the Kroll report provides new pedagogical opportunities for teaching endogenous money theory in the classroom. Strictly speaking the phrase ‘theft of the century’, literal translation of the Romanian “furtul secolului”17, is a bit of a misnomer, because bank credits are ex nihilo creations (Schmitt, 1966, p.38) that do not require pre-existing deposits or resources, as explained at length by endogenous money theorists. The role of credit is central to the post-Keynesian theory of endogenous money, as money creation is disturbingly simple (Galbraith, 1975). Yet, the previous terminology does contain some truth: As former Director of the Bank of England Josiah Stamp (1937) once argued, the banking profession is indeed characterized by its immoral nature, Banking was conceived in iniquity and was born in sin. The bankers own the earth. Take it away from them, but leave them the power to create money, and with the flick of the pen, they will create enough deposits to buy it back again.

The ex nihilo creation of money is not merely an automatic accounting operation devoid of socio-economic consequences, as once explained by Yunus (1998, p.234) who regrets that economic science has long failed to grasp the significance of credit, which opens drawing rights on resources, and whose allocation is therefore of societal relevance. This conviction is shared by Maria Nowak (2005), a major microfinance advocate in France and Europe, with her Adie association. Nowak (ibid.) regrets that access to credit remains limited in poor countries. Money propels creativity, and confers a vast transformative power on reality, in order to change it for the better, Countries that successfully develop today are those that manage to integrate the social cohesion of the ancient order with the rise in individualism of the new one, while sometimes resisting the injunctions of international organizations. Opening up the access to credit to all economic actors, 17

http://www.hotnews.ro/stiri-international-20117503-dosarul-furtul-secolului-din-republica-moldova-ilan-shoraudiat-urgenta-procurorii-anticoruptie-dupa-masinile-sale-facut-drumuri-intre-locuinta-aeroportul-chisinau.htm

favors personal success, but also equal opportunities and the preservation of social capital (ibid., p.82, our translation).

In the future, students could be encouraged to reflect on the intersection between endogenous money creation, idiosyncratic legal structures, and ethics, which remains central to the decision to allocate credit to given members of society. In this respect, we hope that a fairer (corruption-free) and creativity-enhancing allocation of credit will help the Republic of Moldova, a small country located in a geopolitically tormented region of the world, pursue its development trajectory in the future.

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