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[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

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs

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                            WASHINGTPON : 2005

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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

                              ----------                              

                         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.

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