Colossal Bailouts, Monetary Policy, or Drug Money: What Saved the Global Economy in 2008?

What came to be known as the Great Recession started in 2006, when sales of new homes, having risen steeply since the turn of the millennium, began to weaken. The downturn accelerated in 2007 and, in March, it had ensnared two notable hedge funds that were heavily invested in complex securities linked to mortgages.

Sales of new single-family homes in the US (thousands of units)
Source: Federal Reserve Bank of St. Louis

They were managed by Bear Stearns, one of Wall Street’s leading investment banks at the time. The bank tried to save the funds but was undermined by collapsing securities prices as fears about the fallout from a distressed US housing sector spread rapidly through both US and international markets.

While Bear Stearns was rescued and bought for a fraction of its pre-crisis value by J.P. Morgan in March 2008, Lehman Brothers, another big Wall Street firm, was not so lucky. Grossly over-exposed to the same mortgage-backed securities, Lehman Brothers declared bankruptcy in September 2008 owing USD 613 billion, the largest bankruptcy in US history to date. This, in turn, has sent a shockwave of terror through financial markets worldwide.

Lehman Brothers and Bear Stearns had trading relationships with leading banks around the world, but none of those counterparties knew which of their peers were exposed to the two failed institutions, nor to what degree. The worldwide financial system froze; banks became frightened of lending to each other and could no longer access the liquid assets that were the medium for such interbank funding.

Number and total assets of bank failures in the United States from 2001 to 2023
Source: Statista

What Was the Capital Flowing From During the ‘Liquidity Crunch’?

In December 2009, Antonio Maria Costa, executive director of the United Nations Office on Drugs and Crime from 2002 to 2010, spoke to a British newspaper. In the interview, he claimed that some banks during the financial crisis had been saved by a surprising source: billions of dollars that ‘originated from the drugs trade and other illegal activities.’

These sums amounted to the majority of the cartels’ USD 352 billion in profits from their illegal trade in cocaine and marijuana, according to Mr. Costa. He named neither the banks nor the countries in which they were located. He did not even say how he had arrived at his figure for the cartels’ profits.

Interbank loans were funded by money that originated from the drugs trade and other illegal activities […] There were signs that some banks were rescued that way.
— Antonio Maria Costa, Executive Director of the United Nations Office on Drugs and Crime, 2002-2010

The theory is that this timely cash infusion was made possible by the drug barons having changed their modus operandi for handling the ballooning cash proceeds of their trade. Due to strict money-laundering controls, cartels had previously struggled to deposit money with regulated banks, though they were able to work with banks in less-strictly regulated offshore financial centers.

The American housing boom and burst changed all that and, in 2007, the cartels embarked on a ‘buying spree of assets.’ To that end, they deposited substantial amounts in banks in markets that had previously been heavily regulated. The cartels were taking advantage of those banks’ growing disregard for money laundering controls as the US liquidity crisis engulfed them. With their usual depositors increasingly wary of all banks, their need for liquid reserves became acute.

So it was, claimed Mr. Costa, that the banks used the deposited proceeds of the trade in illicit drugs to climb out of the financial abyss in which they found themselves.

‘Drug Money Saved the World’s Financial System From Collapse’ – Rumor or Reality?

There are a number of difficulties with Mr. Costa’s analysis. First, while USD 352 billion is a substantial amount of money in most circumstances, it was minuscule compared to the liquidity needs of the financial system in 2008. In just a few months of that year, between September and November, the US Federal Reserve had to inject close to USD 1.3 trillion of liquidity into the system in order to prevent its complete collapse.

That alone is 3.7 times the amount representing the supposed deposits from drug cartels. However, that was only the beginning of the support given to the financial markets by central banks in the US and elsewhere.

The chart below shows the growth in the balance sheets of selected central banks, namely, the Swiss National Bank (‘SNB in the chart’), the US Federal Reserve (‘Fed’), the European Central Bank (‘ECB’), the Bank of England (‘BoE’), and the Bank of Japan (‘BoJ’).

Cumulative central banks' balance sheets (in USD trillion)
Source: TopForeignStocks.com

In all, over the ten years following the Global Financial Crisis, central banks spent more than USD 14 trillion in what is termed ‘quantitative easing’ (QE). That entailed the selling of government bonds and other financial securities to support market liquidity and drive down interest rates. The hope, which proved to bear out, was that QE would prevent The Great Recession from becoming another Great Depression.

In comparison with that unprecedented ocean of financial support, whatever drug money was included by the banks themselves was little more than a single drop of water.

Why, then, did Antonio Maria Costa, a respected United Nations official who was also an experienced economist, claim that at least some banks were saved by hundreds of billions of dollars that “originated from the drugs trade and other illegal activities”?

Final Thoughts

It was significant that Mr. Costa voiced his claim to a British newspaper. At the time, as the article notes, police in the UK were launching a new anti-drug campaign amid signs that cocaine use was rising among its youth. The UN official’s claim was, therefore, both a timely and authoritative endorsement of that initiative and also useful publicity for his own organization’s efforts to curtail the international trade in illicit drugs.

Nonetheless, evidence for the validity of at least part of his claim later emerged when, in March 2010, criminal proceedings were brought against Wachovia, one of the largest US banks, owned by Wells Fargo since 2008. The bank was accused of failing to apply effective anti-money-laundering checks on the transfer of USD 378.4 billion by Mexican currency exchanges over a period of years that began in 2004.

The case never came to court; Wachovia paid USD 110 million in forfeiture to US federal authorities as well as a fine of USD 50 million. As the federal prosecutor remarked at the time, the bank’s negligence “gave international cocaine cartels a virtual carte blanche to finance their operations.”

Judging by the large fines and penalties banks continue to incur, it appears that, if banks are offered a substantial amount of business, compliance might sometimes take second place to profit.