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Combating Money Laundering and the Financing of Terrorism

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 2002
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Money laundering and terrorist financing can threaten financial stability and economic prosperity, adding to the gravity of the underlying crimes. The IMF, working closely with the global community, is stepping up its efforts to fight these abuses.

MONEY laundering and terrorist financing are not typically linked to financial instability, but they should be. These activities are not just the by-products or precursors to often serious criminality and even acts of barbarism; they also taint otherwise unaffected people and institutions. When a financial institution is used unwittingly by criminal elements or terrorists, it risks damage to its reputation. If its staff colludes with criminal elements to launder funds or channel financing to terrorists, the damage can be much greater. Those that do business with an institution found to be engaged in money laundering may also suffer a loss of reputation, and when a financial center is widely perceived to be vulnerable to money laundering, others will shy away from investing there. The most serious dangers arise when important financial institutions are controlled by criminals, because in these circumstances the integrity and operations of the whole financial system can be compromised.

For some countries and jurisdictions, the economic and financial impact could be significant. Once the integrity of an institution or financial center is brought into question, its long-term viability is at risk, with potentially serious economic consequences. Moreover, where there is a lack of integrity in financial systems, decisions on the allocation of resources are corrupted and investment is misallocated, dampening economic growth.

Money laundering involves transforming the proceeds of crime into usable form and disguising their illegal origins. After the criminal proceeds are introduced to the financial system, they are hidden—laundered—through a variety of transactions and financial vehicles and finally invested in financial and related assets. These operations often involve international transactions as a means of “layering”—that is, of obscuring the source of the funds (Box 1).

Indeed, money laundering is intrinsically global. If one country or jurisdiction tightens its regulations on money laundering and the financing of terrorism, these activities will quickly shift to a less regulated environment. Even a country with little crime and little money laundering may have to take action to avoid the “immigration” of the problem.

Terrorist financing can be defined as the processing of property from any source (perhaps a legitimate one) to be used to finance terrorist activity that has been or will be committed. It is thought to use many of the same techniques as money laundering, and, therefore, many of the possible countermeasures are similar. Furthermore, several terrorist organizations are known to finance their activities out of the proceeds of crime. Nonetheless, terrorist financing differs from money laundering in several ways that affect public policy. It may be much more difficult to detect than money laundering because it is directed mainly at future activity: it is possible that the only offense that has been committed when the financing takes place is conspiracy to commit a terrorist act. Also, the amounts of money needed to finance terrorism are widely believed to be relatively small—the September 11 attacks on the World Trade Center and the Pentagon were believed to have required less than $1 million—-compared to either normal commercial transactions or typical volumes of money being laundered by, say, large drug trafficking operations, which might total several hundred billion dollars a year.

Box 1An example of money laundering

A recent case of money laundering was revealed when three financial institutions reported similar suspicious transactions. It turned out that drug traffickers were using go-betweens who would deliver the cash proceeds of crime to professionals in travel agencies and import/export businesses. The professionals would place the funds in their bank accounts and, for a fee, transfer them on the basis of fake invoices to bank accounts abroad. An estimated $30 million was laundered this way, but, in the end, prosecutions were brought in two countries.

This case displays many of the common features of money laundering and effective anti-money-laundering measures: cash is introduced into the banking system by people far removed from the predicate criminal activity (the activities that give rise to the cash or other valuables to be laundered); layering is achieved by splitting the funds among many small, seemingly innocuous agents (known as “smurfs”), creating a misleading paper trail, and getting funds abroad as soon as possible. The coordinated analysis of suspicious transaction reports from different sources was instrumental in helping to uncover a money laundering scheme.

Supportive measures

National governments and the international community have long been working to combat both money laundering and terrorist financing. Since the terrorist attacks of September 11, these efforts have redoubled. The countermeasures center on better supervision and regulation at the national level and on filling in critical information gaps, particularly across borders. The effectiveness of anti-money-laundering efforts (AML) and attempts to combat the financing of terrorism (CFT) depends on the creation of a coherent system of countermeasures, which must include a number of critical elements.

As a prerequisite, legislation must be in place that provides the general legal framework and establishes the obligations of financial institutions and other providers of financial services. Such legislation needs to define and criminalize money laundering and terrorist financing with suitably graduated penalties. It has to cover a wide set of predicate crimes and also needs to define the responsibilities and powers of the various government agencies involved. The legislation will typically set out reporting requirements for different categories of institutions: commercial banks are generally obligated to be especially vigilant, given their role in the payment system. However, because criminals exploit loopholes, wide sectoral coverage is needed. Moreover, the layering and eventual placement of funds in the financial system often involves financial institutions other than banks. AML systems erected by banks will be of limited value if it easy to launder money, say, through insurance companies and securities firms. For example, money laundering has occurred through the purchases in cash of single premium life insurance policies, with the encashment values paid through banks’ accounts.

For primary legislation to be operational, regulations and supervision must be implemented. First, financial institutions must make efforts to avoid dealing with criminal elements. Checks have to be made on the identity and legitimacy of clients, especially new clients and those acting on behalf of others. The “know your customer” or “due diligence” obligation is partly a matter of establishing that potential clients are who they say they are, but can also involve elaborate background checks. In a globalizing world, it can be quite difficult to distinguish when a foreign business is entirely honest and when it is involved in a scam to launder money, although there are circumstances that should prompt close scrutiny, such as when a counterpart comes from a jurisdiction known to have weak AML/CFT systems.

Second, these provisions must be backed by measures to ensure that criminals do not gain control of financial institutions. If that happens, it will be very difficult to detect and root out money laundering (or the financing of terrorism). Therefore, it is important that major shareholders and senior managers in financial institutions demonstrate that they are “fit and proper” to hold these positions of control and oversight. These requirements apply at the initial licensing stage but need to be maintained as shareholdings change hands and management turns over.

Third, financial institutions must establish systems of identifying and reporting unusual or suspicious transactions. The financial institutions themselves need to be aware of the threat of money laundering and terrorist financing, to train their staff to spot activities that raise a suspicion of money laundering, and to have clear processes in place for reporting back to the authorities. Elaborate AML/CFT systems are irrelevant if the people who deal with clients are not able to identify and report suspicious transactions. (As an example of what can go wrong, in a recent case, a bank hired more staff to handle the increased volume of new, large-denomination banknotes being deposited by one client before considering that the transactions might be related to money laundering. In the end, the deposits turned out to be from criminal sources.)

Fourth, both the reporting of unusual transactions and “know your customer” rules need to be supported by adequate record keeping. When a suspicious transaction is investigated, a financial institution needs to be able to help the authorities establish an audit trail going as far back as five years.

Institutions need to be established by governments and given the power and resources to ensure that the relevant commercial enterprises follow the laws and regulations and that any suspected cases of money laundering or terrorist financing can be monitored. Typically, financial sector regulators are responsible for supervising AML/CFT procedures followed by financial institutions and for checking that their managers and owners meet the “fit and proper” test. Much of this supervision is not separable from other aspects of prudential supervision, and there are clearly economies of scale. For example, a bank supervisor will have to review a commercial bank’s internal control procedures to prevent internal fraud or imprudent behavior and, at the same time, can check whether the bank has in place the means to limit vulnerability to money laundering. The banking supervisors in different countries also normally institute arrangements to exchange information and cooperate on the supervision of internationally active institutions. These arrangements must be well suited to support AML/CFT measures (for example, for checking on “fit and proper” owners and managers).

Many countries have also set up specialized agencies called financial intelligence units (FIUs). These agencies investigate, analyze, and pass on to the appropriate authorities financial and related information concerning suspected proceeds of crime. A key component of an FIU’s work is to share information about suspicious transactions across borders. The Egmont Group, set up in 1995, serves as an association of FIUs and promotes best practice among its members.

The above initiatives have to be supported with a general raising of awareness of the issues; appropriate training of regulators and staff in financial institutions to ensure appropriate vigilance; and domestic and international sharing of information on known criminals and terrorists. Institutions such as the Financial Action Task Force (FATF) on Money Laundering contribute importantly to these supportive measures, for example, through their typologies of money laundering and terrorist financing techniques.

Where the IMF fits in

The IMF has for some time emphasized that a sound financial system is a precondition for macroeconomic stability and sustainable economic growth, not to mention a healthy international financial system. It therefore promotes sound financial sector policies and helps countries build the needed institutions to prevent financial crises. As part of these efforts, the IMF began to include AML issues in its work on financial systems, and, in April 2001, the IMF’s Executive Board approved a series of initiatives in this area.

After the terrorist attacks of September 11, the IMF moved quickly to reexamine how it could contribute to stepped-up global AML/CFT efforts within its areas of responsibility and specialization. It was recognized that, while the main responsibility for these activities rests with governments, financial institutions, and citizens of individual countries, the IMF could play a facilitating role—focusing on the integrity and stability of the international financial system and working closely with the FATF, other standard setters, and the World Bank. The IMF’s focus would be on those areas that are macroeconomically relevant and pose a significant risk of money laundering and terrorist financing. However, the IMF would not become involved in law enforcement issues.

Box 2A new instrument in the tool chest

The development of a single comprehensive methodology for assessing a jurisdiction’s AML/CFT regime is well advanced and should be ready for adoption by autumn 2002. It can be thought of as a detailed exposition of the specific steps needed to implement the FATF 40+8 recommendations—the 40 recommendations on money laundering and the additional 8 CFT recommendations issued in October 2001. The completion of the assessment methodology and modalities would form the basis for the go-ahead from the IMF and the World Bank to prepare related reports on standards and codes—documents that summarize the extent to which countries observe certain internationally recognized standards and codes—for the FATF 40+8 recommendations.

A preliminary methodology is already being used on a pilot basis as part of the IMF and World Bank’s Financial Sector Assessment Program and the IMF’s Offshore Financial Center assessments. Between these two activities, the IMF and the World Bank hope to complete some 30 to 40 detailed assessments of countries’ AML/CFT regimes in 2002. The pace of offshore assessments has been accelerated, with the aim of completing all of the assessments by the end of 2003. These centers can be especially vulnerable to money-laundering activities because many of the transactions and financial institutions that operate in them are domiciled elsewhere—complicating customer due diligence and the recognition of suspicious transactions—and because the financial vitality of these centers hinges on maintaining a reputation of financial integrity.

An intensified work program for IMF involvement in AML/CFT efforts was endorsed by the International Monetary and Financial Committee—the IMF’s governing body—in its November 2001 meeting. The program, which is closely coordinated with the complementary activities of the World Bank, helps members identify weakness in their AML/CFT regimes and translates the general approaches to AML/CFT outlined above into specific analysis and recommendations that will be of value to member countries in strengthening their regimes. There are five main elements.

Methodology. The IMF, the World Bank, the FATF, and other standard setters (the Egmont Group, the Basel Committee on Banking Supervision, the International Organization for Securities Commissions, and the international Association of Insurance Supervisors) are preparing a common comprehensive assessment methodology for a global AML/CFT standard (Box 2). The prospective completion of this methodology, which can then be applied in assessments by the FATF, the IMF, and the World Bank, will provide the basis for adding AML/CFT to the list of areas where standards and codes are used in the operational work of the IMF and the Bank.

Assessments. The IMF has stepped up its assessments of members’ AML/CFT regimes as part of its financial sector assessments (usually in collaboration with the World Bank) and its assessments of offshore financial centers. These assessments, which serve to identify potential weaknesses in the AML/CFT regimes and to develop plans for corrective action, have often spurred countries to strengthen their systems, for example, by strengthening their AML/CFT legislation and institutions. The number of these assessments has increased, and the AML/CTT regimes in some 30 to 40 jurisdictions will be covered in 2002.

Technical assistance. The IMF, along with the World Bank, is providing more technical advice in this area. It has been assisting countries in drafting AML/CFT legislation that conforms to international best practices and in strengthening institutions involved in AML/CFT work, such as financial sector supervisors and FIUs. Since September 2001, the IMF and the World Bank have helped some 30 countries in strengthening their AML/CFT regimes. Sometimes this assistance has taken the form of a regional project, such as the IMF’s help with the establishment of an FIU for a group of Pacific island states and the organization of a multidisciplinary regional training seminar on AML/CFT for South America. In addition, the IMF and the World Bank have organized a series of meetings and contacts to facilitate the coordination of technical assistance among the multilateral and regional organizations involved in AML/CFT and major providers of assistance.

Surveillance and policy dialogues. IMF staff and national authorities are discussing AML/CFT policies as part of their Article IV consultations—the regular dialogue between the IMF and each member on economic issues and policies in that country. Such discussions help keep member governments informed of what the IMF is doing in this area and provide them with a sounding board to review their own initiatives. They also provide the country with an opportunity to present to the rest of the international community the strength of its AML/CFT system. For example, during the 2002 Article IV consultation with the United States, the authorities explained that new legislation—the U.S.A Patriot Act—was enacted in October 2001. The legislation established a framework for information sharing between enforcement agencies, regulators, and financial institutions; provided regulators with new powers with respect to terrorist financing; and strengthened and broadened AML reporting requirements.

Research. The IMF and the Bank are conducting research into such issues as the economic consequences of money laundering and the operation of informal systems for transferring funds between various developing and industrial countries. Where such transfer systems are informal, anonymity is an important characteristic that makes them vulnerable to money laundering and terrorist financing.

Conclusion

There has been an extraordinary international effort to fortify defenses globally against money laundering and terrorist financing in response to the tragic events of September 11. Good progress has been made on many fronts: countries worldwide are reassessing the adequacy of their AML/CFT regimes and taking corrective actions. But much remains to be done to build the required institutional and technical capacities. Key challenges will be to maintain the momentum and to eliminate the gaps in defenses so as to detect and deter money laundering and terrorist financing internationally.

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