Underworld Bankers Lend to Small Businesses in Transition Economies
by Thomas OrszagLand

Hungary in 1997 introduced landmark legislation to combat the thriving financial institutions of the criminal underworld. Changes to the 1996 Finance Act would make unlicensed financial services, provided for profit or interest payments, a criminal offense, punishable by five years’ imprisonment. The aim is to outlaw money lending by the mafia and thus break organized crime’s hold over thousands of small businesses. Heretofore, these businesses have been exploited with impunity, for money laundering operations. 

Money lending is one of the most popular ways of making tainted cash grow, explains Laszlo Pelikan, chief of the economic crime investigation department at Pest County Police Headquarters. Bankers in the underworld have provided millions of dollars in loans at interest rates up to 30 percent—per week. Such loans usually lead to other serious offenses like blackmail and violence against person and property. The collateral required for such loans often includes the entire wealth of the borrower. A frequent ploy of lenders has been to manipulate the borrower, often by means of violence, in such a way that he cannot meet his obligations in order to secure control of his home and business. Complaints generated by the unofficial financial sector have numbered in the tens of thousands during the past couple of years. But authorities have had great difficulty investigating such offenses because money lending, even at exorbitant rates, has always belonged to the sphere of civil rather than criminal law. The change in the criminal code may thus lead to quick prosecution in many cases that in the past would have escaped sanction. 

Sanctions can be effective only if the root cause of the underworld’s involvement is eliminated. So far, the legitimate banks of the once communist-dominated countries of Europe have failed to meet small enterprises’ needs for startup loans. Economic reforms have led to a significant decline in bank lending over the past years, accompanied by high collateral requirements and extremely high interest rates, implying lack of competition. In the absence of adequate credit facilities, in the case of Hungary, organized crime is thought to have gained as much as a 25 percent share in the financing of small and medium-size businesses, effectively turning such enterprises into operations for laundering tainted cash. That proportion is probably much higher in other countries of the region. 

“It is easier to rob a local bank than to persuade its manager to raise a loan for a new business,” observes Laszlo Arva, an adviser of the Hungarian Privatization Research Institute, in an essay published recently in the financial daily Vilaggazdasag (World Economy). Even when a legitimate bank loan is available, the requirement for high collateral places it beyond the reach of most entrepreneurs. By contrast, “organized crime demands a more easily insurable and more readily collectable deposit,” Arva notes. “It is the life of the borrower.” 

The mafia has also learned to fill many other needs neglected by the fledgling democratic institutions of the region. Entrepreneurs are turning to organized crime for help in many areas—for example, collecting debts or protecting property—at a huge long-term cost to society. “It is possible for someone’s house to be sold out from under him because of the shortcomings of the land registry system,” Arva explains. “And it may take years of legal wrangling before the overburdened judiciary system can sort out a property conflict. Is it surprising then that many aggrieved parties ignore the courts and look to the mafia for justice?” 

Criminal lenders enjoy huge advantages over their legitimate counterparts, observes economist Douglas Keh in a recent study, Drug Money in the Changing World: Economic Reform and Criminal Finance, published by the United Nations’ Vienna-based International Drug Control Program. These underworld bankers do not suffer the heavy cost of non-performing loans that burden the legitimate banks. They have the freedom to discriminate among borrowers, extracting the maximum amount of profit yield that can be collected from each. They can also use violence to ensure compliance with the terms of the loan. In some countries of the region the proliferation of organized gangs is even eroding the difference between legitimate and criminal banks. 

These problems are likely to prove temporary, observes the Organization for Economic Cooperation and Development (OECD) in its analysis of the Hungarian economy. Andrew Burns and Giancarlo Perasso, authors of the OECD analysis, maintain that the excessively high requirement for collateral set by the banks is attributable to the underdeveloped mortgage market and the poor maintenance of the national property registry (though the registry is rapidly improving). The analysis suggests that bankers’ exaggerated prudence in lend-ing is the result of their recent experience with bad loans and lack of expertise in evaluating promising new loan applications. Nonetheless, the banks are increasingly seeking to expand their lending activities, according to the OECD report. Recent legislation on mortgages may also improve individuals’ access to legitimate seed capital.

If Hungary succeeds in ridding itself of the root causes of illegal lending activities, and contains criminal bank-ing, it could help the entire region in the fight against financial crime. That is why Hungary’s neighbors through-out Central and Eastern Europe— whose financial and judicial institutions are undergoing painful, radical reforms as the region adapts to West European standards—are watching with enormous interest. The mafia has profited during the transition process by assuming the role of the state, which has been reduced sharply in many key areas and replaced by the newly emerging institutions of democratic society. When these institutions mature and are able to fulfill their functions properly there will be no room left for organized crime—except in jail cells.

The author, a foreign correspondent stationed in Budapest, writes on global affairs, and contributes regularly to the Christian Science Monitor (Boston) and the Observer (London).