Abstract
This background paper explores the impact of ML and related predicate crimes on banking sector stability. The paper identifies potential short- and medium-term impacts of financial integrity failures on individual banks’ performance and systemic stability, and outlines a framework piloted by Fund staff for the quantification of such impacts. Finally, the paper puts forth some proposals for deepening the engagement on financial integrity—financial stability nexus through the Fund’s core functions.
Background Paper II: AML/CFT Risk-Based Supervision of Banks—The Impact of Financial Integrity Failures on Financial Stability
Executive Summary
This background paper explores the impact of ML and related predicate crimes on banking sector stability. The paper identifies potential short- and medium-term impacts of financial integrity failures on individual banks’ performance and systemic stability, and outlines a framework piloted by Fund staff for the quantification of such impacts. Finally, the paper puts forth some proposals for deepening the engagement on financial integrity—financial stability nexus through the Fund’s core functions.
A. Background1
1. ML and its predicate crimes (tax evasion, corruption, drug trafficking, fraud, etc.) can have significant impact on the stability of the financial sector and broader economy.2 These effects can manifest in jurisdictions where illicit proceeds originate, where they transit, and where they are integrated. Macro-critical impacts of ML and its predicate crimes can be grouped into (i) de-stabilizing effects on the financial sector, (ii) adverse impacts on the broader economy, and (iii) inward and outward spillover effects. The effective operation of a country’s financial system depends heavily on trust and the expectation that the highest professional, legal, and ethical standards are observed. Financial and external stability may be undermined by the act of ML or TF itself but also by the associated crimes (i.e., predicate crimes).
2. Failures or weaknesses in countries’ AML/CFT regimes and risk-based supervision of banks can threaten financial sector stability.3 The adverse effects of ML and its predicate crimes are commonly channeled through the banking sector. For instance, volatile inflows/outflows from the injection or withdrawal of large amounts of criminal proceeds from predicate crimes could de-stabilize the banking sector. Regulatory sanctions for financial integrity failures in banks can increase credit, solvency, and liquidity risks, with potential de-risking of the concerned institution in the medium-term which may be transmitted to other banks through interconnectedness of assets and liabilities or contagion effects. Large-scale predicate crimes, such as financial sector frauds, may also cause bank insolvencies, with potential systemic impacts within the sector. Further, assessed or perceived weaknesses in AML/CFT frameworks or perceived high levels of ML and economic crimes within a jurisdiction can result in curtailed/reduced access to global financial markets, through correspondent banking relationships pressures.4
3. A spate of ML scandals in the financial sector during the review period5 has highlighted the need for increased focus on potential impacts of such failures on systemic stability in the banking sector. These high-profile AML/CFT failings6 involving banks with significant cross-border activities have led to revocation of banking licenses and termination of CBRs with affected banks (Box II.3). While these events resulted in increased international scrutiny of AML/CFT supervision, there has been limited analysis of the possible effects of such events on systemic soundness in the banking sector. This paper explores the nexus between financial integrity failures and financial stability, to set out proposals to guide the Fund’s future work on financial stability implications arising from AML/CFT failings.
B. ML/TF Risks and Vulnerabilities in the Banking Sector
4. Although non-bank institutions and VAs are growing sectors with financial integrity risks, banks continue to be the main gatekeepers of the financial system and are vulnerable to misuse as a conduit to launder illicit proceeds. In the global financial system, banks continue to be the main intermediary through which illicit funds flow. Banks are particularly attractive for criminals to conceal illicit proceeds and are at higher threat for several reasons: they have a global reach domestically and through branches and subsidiaries, high levels and widespread of activity, broad range of products/services such as correspondent banking and trade finance (that present high levels of ML risks), lower cost, combined with their ease of access and speed of transactions.
5. Banks are required to implement AML/CFT systems and controls. In line with the FATF recommendations, banks are required to implement AML/CFT systems and controls in order to prevent ML, underlying crimes, and TF. When AML/CFT preventive measures—such as CDD measures, record keeping, policies and procedures, customer and entity-level ML/TF risk assessments, internal control systems, transaction monitoring and suspicious transaction reporting—are effectively implemented, they could significantly reduce the risk of laundering of proceeds of crimes or TF going through the banking sector. The cost of implementing those compliance measures by banks is often high requiring constant adjustments to evolving risks, technical tools, and financial and well-trained human resources.
6. Given banks’ inherent exposure to ML risks, there is a need for the implementation of strong and robust AML/CFT preventive measures and risk management systems. Despite heightened focus (e.g., inclusion of AML/CFT as a key priority in banks’ strategies and increased compliance costs) on the effectiveness of banks’ preventive measures, banks often (wittingly or unwittingly) become vulnerable and a channel for IFF (for example, to conceal the proceeds of fraud, corruption, and tax crimes).
7. In order to ensure that these controls are fit for purpose and operating as designed, effective oversight—i.e., effective AML/CFT risk-based supervision—is required. AML/CFT supervisors are required to ensure that banks properly implement robust AML/CFT preventive measures including effective systems and controls to adequately mitigate risks. Supervisors are required to assess and analyze banks’ AML/CFT frameworks and promote and enforce their effectiveness through risk-based supervisory activities.
8. Both banks’ AML/CFT systems and controls, and AML/CFT supervisory efforts often fall short and present significant vulnerabilities. Box II.1 below sets out (at country level) FATF’s assessment of the effectiveness of preventive measures and AML/CFT supervision. These results indicate—notwithstanding the important efforts made in the last two decades—that in most instances countries (overall) struggle to put in place robust preventive measures and rarely implement effective risk-based AML/CFT supervisory frameworks. In addition, although supervisors are imposing fines and penalties—that have increased in size overall during the last decade—for banks’ weak AML/CFT controls, global trends show that regulators continue to face challenges in their governance, resources, and capacity structures, and have vulnerabilities in their AML/CFT functions and in exercising their responsibilities in an effective manner.
9. There are several ways in which ML, related predicate crimes, and TF can undermine the stability of a country’s financial system. Overall, three financial stability risk components are important to assess: (i) the threat of domestic and cross-border illegal proceeds layered or integrated in the banking sector (e.g., volume, trends and channels); (ii) vulnerabilities of the banks in preventing those proceeds to be laundered, and the vulnerabilities of the AML supervisors of banks in ensuring compliance; and (iii) impact on financial stability often resulting from the high threats and high vulnerabilities in the banking sector. Specific financial system effects could be related to:
Loss of access to global financial markets: The failure of a member to deal effectively with ML or TF may result in a loss of access of its financial system to global financial markets, with potentially negative consequences for financial stability and the economy as a whole. It is becoming a more frequent practice for national supervisors to prohibit their banks from dealing with financial institutions from countries with weak AML/CFT frameworks, or to at least subject transactions with institutions from such countries to stricter conditions. Even in the absence of specific guidance from the relevant national authorities, financial institutions in some countries may prove reluctant to deal with banks from jurisdictions where ML or TF is a major concern.
Destabilizing inflows and outflows: ML or TF activities may give rise to significant levels of criminal proceeds (e.g., arising from tax crimes or proceeds of corruption) or—hot money—flowing into and out of individual financial institutions in the country in ways that are destabilizing for these institutions. Such inflows or outflows can be either cross-border or domestic in nature and, where transactions in illegal markets or criminal proceeds are significant in relation to the size of the country’s formal sector, these flows can affect the entire financial system.
Financial sector fraud: ML may also be associated with broader problems of financial sector fraud. The potentially adverse effects on financial stability that may arise from large-scale Ponzi schemes in the financial sectors of small island economies have been well-publicized. Financial fraud may undermine a country’s financial system in many different ways—through large-scale bank insolvencies that ensue when banks’ balance sheets are properly valued, by large outflows of capital from the banking system as the scale of the fraud becomes known, or by the loss of access to international financial markets arising from the deterioration in the jurisdiction’s reputation.
Deficiencies in financial sector supervision or regulatory capture: Financial integrity failures may serve as evidence of deeper problems regarding the integrity of a country’s framework for financial sector supervision. Where important financial institutions within a country are owned or controlled by criminals with elements of regulatory capture, and weak fit and proper requirements are in place, the authorities may encounter difficulties in supervising these institutions or in identifying and addressing problems before domestic financial stability is undermined. The quality of the overall AML/CFT supervisory framework would entail, among other things, the autonomy of the supervisory agency which could undermine its ability to identify and manage financial integrity risks.
TF and economic paralysis: Incidents of terrorism, and TF may also undermine the stability of a country’s financial system—either because of a history of terrorist incidents or through the effect of a single but significant incident. These circumstances may make key sectors of the economy vulnerable to declines in economic activity to the point where the stability of individual banks may be threatened. More broadly, banks that are regarded as serving as a conduit for TF may be subjected to international sanctions or, more generally, may encounter difficulties in finding counterparts with which to deal in ways that undermine their own stability.
Tax fraud: ML may be associated with tax fraud that can undermine financial or macroeconomic activity in important ways.7 Significant levels of tax fraud may affect the government’s revenue stream to a point where its fiscal balance is significantly undermined. By limiting opportunities for the banking system to be used to launder the proceeds of tax evasion, a robust framework of AML/CFT controls can serve as an effective instrument in combating tax evasion.
10. In most cases of ML, these problems will be transmitted through a country’s financial system. Criminal proceeds and TF will generally have to be placed within a country’s financial system and may either remain there or may be transferred abroad to the financial systems of other countries. However, there are circumstances in which the predicate crimes to which ML or TF relate will have an adverse effect on the stability of the broader economy without necessarily directly involving the financial system. This will particularly be the case in countries with only rudimentary banking systems where illegal transactions are conducted in cash or informality and the proceeds of crime are never introduced into the banking system.
11. When banks fail to prevent ML, there can be significant repercussions that raise financial stability concerns. For example, banks scandals triggered by financial crimes could lead to a bank run and their collapse, sanctions by the domestic and foreign regulators or the judiciary, loss of their CBRs, and criminal prosecutorial actions and/or their resolution and liquidation. In egregious cases, the banking sector as a whole could be affected due to lack of proper AML/CFT supervision and the banking sector failing to ensure that laundering of proceeds of crimes is not taking place at a large scale through the sector.
Compliance with FATF Immediate Outcomes 3 (Effectiveness Ratings on AML/CFT Supervision) and 4 (Effectiveness Ratings on AML/CFT Preventive Measures)
LE = Low Level of Effectiveness
ME = Moderate Level of Effectiveness
SE = Substantial Level of Effectiveness
HE = High Level of Effectiveness
Compliance with IO.3 and IO.4
Citation: Policy Papers 2023, 053; 10.5089/9798400260438.007.A002
12. The central role of banks in the global financial ecosystem, overlayed with the high level of exposure to ML/TF risks means that these institutions and their safeguards require particular attention. This attention spans from the implementation of robust AML/CFT preventive frameworks, effective risk-based supervision, to identify the banks that are most vulnerable and ensuring that measures are in place to protect the financial stability of these banks.
C. AML/CFT Failures and Banking Sector Stability
Financial integrity issues could potentially present risks to financial stability for banks in the short- and medium-term, including through contagion effects.
Short-Term Impact
13. In the short-term, banks facing financial integrity issues could face tensions related to wholesale funding and liquidity. In the short term, the impact on the affected bank can crystallize through higher credit risk resulting in higher funding costs (including in foreign currencies), lower liquidity (due to outflows and a possible decline in counterbalancing capacity), higher refinancing risk (due to outflows and a reduction in wholesale funding), and a lower equity price (possibly raising the cost of equity). Stress stemming from entities on a standalone basis could also spread to the financial group, either through direct linkages (such as direct exposures) or indirect effects via reputational effects.8
14. Short-term stress affecting one bank could also be potentially transmitted to other banks through direct and indirect effects. Financial integrity issues related to one bank can have an impact on other banks via direct exposures. For example, other banks holding shares in a bank affected by financial integrity issues could face substantial market-to-market losses due to the decline in stock prices for the affected bank. Indirect effects via market confidence could also propagate shocks, especially if other banks have similar exposures and/or comparable business models. Other banks with similar exposures to the affected bank might experience qualitatively similar shocks, as market participants and clients could expect those banks to be facing similar issues. In contrast, banks which are perceived as “safer” might see deposits inflows as clients move away from the affected bank (or similar banks) to other banks. In some cases, high profile ML cases can increase market-based funding costs for all banks, even those with no direct connections to the case at hand. Figure II.1 summarizes the main short-term transmission channels identified.
Short-Term Transmission Channels
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Medium-Term Impact
15. In the medium term, banks facing AML/CFT failures might experience higher funding costs, cost of equity and regulatory requirements that can reduce their profitability. As compliance costs increase, affected banks might also face higher capital requirements, which could weigh on medium-term profitability. As a result, affected banks could reduce their exposures to countries where financial integrity issues occurred. Such cutback on activity could result in a sharp reduction of financial services offered to residents resulting in less competition in the banking sector and higher funding costs for the real economy, especially if the domestic banking sector is reliant on those cross-border banking groups.
16. Medium-term effects could also occur at the sectoral or country level via correspondent banks pressures. ML risk crystallizing in one bank may lead to global banks ending relationships with other local banks, up to the point where it becomes impossible to provide payment and settlement services in certain currencies. A reduction or pressures in CBRs could weigh on the financing activity of the banking sector and ultimately reduce the economic activity of domestic entities (Erbenova et al, 2016). A reduction in CBRs has been observed in some European Union (EU) countries such as Cyprus or Malta (IMF, 2020).
Medium-Term Transmission Channels
Citation: Policy Papers 2023, 053; 10.5089/9798400260438.007.A002
17. Banks impacted by financial integrity issues could also face increased costs to preserve financial stability due to higher resolution and liquidation costs for the affected entities. These issues could result in higher liquidation costs as potential buyers might be reluctant to acquire assets of the troubled entity, with a risk for taxpayers if public funds were to be used. Relatedly, liquidation costs might be higher as financial integrity concerns can affect the value of the assets to be disposed of, leading to lower recovery rates for creditors.
D. Assessing the Impact of AML/CFT Failures on the Banking Sector—The Road Ahead
18. The impact of penalties and misconduct on individual banks’ performance has been the main focus of literature so far. Empirical studies find that misconduct and financial penalties have a negative impact on bank performance. From a macroprudential perspective, the European Systemic Risk Board (2015) estimates that misconduct can create uncertainty about banks’ business models and their solvency and lead to a reduction in the provision of financial services. Koster and Pelster (2017; 2018) find that misconduct and financial penalties have a negative impact on individual banks (lower profitability and valuation, higher funding costs, and default risk).
19. Empirical studies on the impact on banks’ liquidity and funding have been scarce, though, and further work is required to deepen the analysis of the impact on financial stability for banks. A few case studies show that financial integrity issues also lead to an increase in funding costs (Danmarks NationalBank (DNB), 2018) and a deterioration in liquidity for banks with offshore activity (IMF, 2019). Financial integrity issues and their nexus with financial stability have been raised as part of Fund surveillance activities.9 However, those risks have not been quantified at regional or country levels.
20. As part of CD activities, staff started to develop an exploratory framework to further calibrate the short-term impact on valuation, credit risk, and liquidity for banks. Data on past financial integrity events could be used to estimate the impact on affected banks and potential contagion effects. The impact can be estimated by comparing changes in financial variables (equity prices, credit default swaps (CDS), spreads, or deposits) around past financial integrity events. Since the observed changes can be due to other factors not related to financial integrity, each financial market variable is to be measured against a benchmark of other banks to control for shocks affecting the banking sector as a whole. This work remains exploratory, and preliminary results laid out in Box II.3 are therefore subject to uncertainty due to the lack of empirical benchmark and the very small sample size of financial integrity events.
The overarching objective of the framework would be to develop financial integrity stress test analysis to better identify vulnerable banks and support risk-based supervision. Using the transmission channels outlined previously as well as the results of calibration exercises, the scenario can be refined and then run-on sample of banks to assess the impact of financial integrity issues on the banking sector and estimate the resilience of individual entities through direct or contagion channels. The banks in scope could be systemic entities as well as banks for which ML/TF risks are identified as high. Overall, this ongoing work would help further integrate financial integrity issues in risk analysis and banks’ supervision.
Technical Assistance Case Study
A Pilot Exercise for Calibrating the Impact on Liquidity, measured with Deposit Flows
A regional technical assistance project analyzed selected aspects of the Nordic-Baltic region’s AML/CFT regimes.1 It focused on key ML threats resulting from a novel financial flows analysis (based on cross-border payments data), vulnerabilities related to AML/CFT supervision of the banking sector and VASPs, and the potential impact of financial integrity failures on financial stability.
Assessing the impact of ML on liquidity is key, as financial integrity failures in some regions have triggered very large deposit outflows on some (small) banks in the Nordic-Baltic region. While work on the calibration of the impact of ML events on stock prices and credit risk (measured by CDS’ spreads) has been done using commercial data, supervisory information is needed to measure how the liquidity of banks has changed around such events.
Supervisory data includes information on liquidity, funding, and non-resident deposits. Most of the work was focused on the ‘maturity ladder’ template (labelled C66 in European Banking Authority Common Reporting templates used in the EU), which provides detailed information on a monthly basis about potential outflows by contractual maturity (overnight, one to two days etc.), inflows by contractual maturity and counterbalancing capacity (assets that could be mobilized to cover outflows).
The impact of financial integrity events was estimated by comparing deposit levels one month before and after the event. Following an event study approach, data related to the specific month during which a financial integrity event were excluded, and the impact was assessed by comparing deposit information before and after the month when the event occurred. Four financial integrity events occurring in 2018-2019 were chosen.
Supervisory data show that some decline in liquidity—measured by deposits—can be observed around financial integrity events. When a financial integrity event directly affects one bank, the impact on the liquidity is visible. When financial integrity events are related to banks outside of the country participating in the pilot, there could still be some liquidity effects on domestic banks with cross-border exposures to the countries where the ML cases occurred, while other domestic banks did not experience any decline in deposits.
There are several limitations to this study. First, the sample of events is very limited. There is only one event to measure the impact of financial integrity events on the affected bank, which reduces the robustness of the result. This drawback could be addressed if similar analyses were to be performed in countries in the region where banks experienced financial integrity events. While there are more events related to banks outside the country, the sample remains very limited, and some events are overlapping over the estimation window making the identification of the impact of ML events difficult. In addition, changes in liquidity might be driven by other factors than ML events which are not controlled for.
1 Nordic-Baltic Regional Report: Technical Assistance Report-Nordic-Baltic Technical Assistance Project Financial Flows Analysis, AML/CFT Supervision, and Financial Stability (imf.org)21. The work could be extended across several perspectives. First, other dimensions of liquidity could be explored, including changes in inflows and counterbalancing capacity around ML events. Second, the analysis could be applied to a wider sample of data to increase the robustness of estimates. Such extension would be particularly useful for countries where there have been ML cases recently and for countries where small to medium-size banks have been directly targeted (as the liquidity effect on smaller banks is likely to be larger). Third, the potential difference between the run-off rates for resident vs. non-resident depositors could be explored to understand if there are different behaviors/reactions that could then be incorporated into a stress scenario on liquidity. Finally, other reporting information could be used to assess other risks around ML events such as changes to other aspects of liquidity (inflows and counterbalancing capacity assess other risks) and of funding and associated costs.
Calibrating the Short-Term Funding and Liquidity Impacts of Financial Integrity Events on Affected Banks, and Other Banks Through Contagion in the Nordic-Baltic Region
AML/CFT failures are associated with a large drop in equity price for the affected bank, and to a lesser extent other banks from the same country and banks from the region with similar cross-border exposures. Box Figure 1 shows that affected banks experience a large decline in stock prices around the event, with an average decline of 11 percent, a third quartile decline of 18 percent and up to 23 percent. Other banks from the same country also experience a decline in price along with banks from the region with similar cross-border exposures. Large regional banks would be associated with the largest contagion effects.
Similarly, credit risk increases around financial integrity events for the affected banks and for other banks in the same country or banks from the region with similar cross-border exposures. Box Figure 2 indicates that credit risk—measured by CDS spreads—increased by around 15 basis points for the affected bank and to a lesser extent for banks in the same country or with similar exposures in the region.
Sharp Decline in Stock Prices
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Note: Weekly changes in equity prices (T+3/T-2) relative to EU banks, in percent.Sources: Refinitiv Datastream, IMF staff.Increase in Credit Risk
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Note: Weekly changes in 5Y CDS spreads (T+3/T-2) relative to EU banks, in basis pointsSources: Refinitiv Datastream, IMF staff.Liquidity, as measured by deposit flows, tends to deteriorate around financial integrity events for the affected bank while other domestic banks’ liquidity could benefit from positive substitution effects in the short-term. Box Figure 3 shows changes in deposits between the month before and the month after a financial integrity event.1 Affected banks faced a decline in deposits, with the largest withdrawals from other financial corporations,2 credit institutions and to a lesser extent to non-financial corporates, in line with assumptions used for liquidity stress testing in FSAP (Box Figure 4). In contrast, other domestic banks non-directly affected tend to see an increase in deposits around the event from same categories of depositors, suggesting that depositors moved out of the affected banks towards other domestic banks.3 Those results on liquidity have been obtained during a pilot exercise with one country.
Change in Deposits
Citation: Policy Papers 2023, 053; 10.5089/9798400260438.007.A002
Note: Changes in total deposits (M + 1/M-1) in percent.Sources: Supervisory data, IMF staff.Deposit Run-off Rates
Citation: Policy Papers 2023, 053; 10.5089/9798400260438.007.A002
Note: Monthly decline in deposits, in %. FSAP figures based on IMF (2018).Source: IMF staff.At the regional level, preliminary results tend to indicate possible contagion effects on the liquidity side. Financial integrity events affecting cross-border regional banks with headquarters in another country could be associated with deposits outflows for other banks in the region having similar cross-border exposure to the region where the financial integrity event originated, indicating possible contagion effects. Box Figure 3 indicates that banks in the region similar to the one facing a financial integrity event might also experience a decline in deposits.
Overall, actual deposits run-off rates for other financial corporations experienced by banks were higher than assumptions used for liquidity stress testing in FSAPs. While the actual run-off rates were lower than those used in FSAPs for most depositors, outflows for other financial corporations were substantially higher (Box Figure 4), reflecting the volatile nature of those depositors. Such results can imply that banks relying on other financial corporations for a large portion of their funding might be at higher risk of liquidity issues if AML/CFT failures were to occur, as withdrawals tend to be very large around such events.
A stress scenario was calibrated based on those results. Box Figure 5 shows a possible calibration of the shock. For the affected bank, its equity price would decline by 18 percent, its CDS spreads increase by 15 basis points, and the bank would face deposit outflows of 7 percent (which corresponds to the estimate in Box Figure 5).4 Other banks in the country would also face shocks, with a 6 percent stock price decline, an increase in CDS spreads by five basis points and deposit outflows for 4 percent.5
Shocks in the Stress Scenario
Citation: Policy Papers 2023, 053; 10.5089/9798400260438.007.A002
Note: Shocks to equity (in %), CDS prices (in bps) and deposit outflows (in %).Source: IMF staff.22. Close collaboration between prudential supervisors, AML/CFT supervisors, and financial stability experts is key to understanding the impact of financial integrity on financial stability at national and regional levels. Given potential transmission channels between financial integrity and financial stability, stress tests, and risk analyses in the banking sector could include components related to financial integrity issues. An understanding of ML threats and vulnerabilities in the banking sector, derived from AML/CFT supervisors would be key in selecting banks for deployment of the financial integrity stress test scenario. Entity risk-ratings derived from AML/CFT supervisory risk assessments can facilitate such selection of banks with high ML/TF risk exposure. (Figure II.3).
Risk Factors: Threats, Vulnerabilities, and Impact
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23. As part of the determination of Pillar Two Capital Add-Ons, financial integrity scenarios are sometimes captured under the assessment of a Bank’s Operational Risk. These scenarios often relate to serious AML/CFT violations that could generate significant reputational risks. These considerations are often captured on a case-by-case basis and the forward-looking estimation on the impact of an AML/CFT failure on banks is often limited, with the “operational risk event” typically calibrated based on past events overshadowed by these risks given the inadequacy of the weight assigned to ML/TF risks.
24. By deepening the analysis of the impact of financial integrity on financial stability, banks will be positioned to determine whether additional capital buffers are required. Through better analysis and incorporation of these shocks, this, in turn, will allow banks to ensure that required levels of capital are maintained in order to withstand any associated shocks that could potentially impact their stability.
25. Countries require guidance on how to better analyze and mitigate the impact of financial integrity failures on financial stability. Through staff’s development of a framework for the assessment of the impact of financial integrity (including through the incorporation of these considerations into AML/CFT supervision and prudential supervision), countries will be better positioned to safeguard the stability of the financial system. This analysis and policy advice can then be incorporated, in a more detailed manner, across several Fund workstreams.
E. Coverage of AML/CFT in the Fund’s Core Functions
26. Going forward, engagement with countries as part of the FSAP process would provide opportunities to take forward and deepen this analysis. In 2010, the Fund Executive Board made financial sector stability assessments under the FSAP a mandatory part of surveillance under AIV for jurisdictions with systemically important financial sectors.20 FSAPs offer a more in-depth focus on financial sector issues which is a complement to the higher frequency macro-financial surveillance in AIV consultations. This analysis can be brought into FSAPs by expanding the scope of stress testing related to AML/CFT failures. This inclusion could be determined on a case-by-case basis, where there is a country with key financial integrity risks (e.g., high threats from ML/TF, weak AML/CFT supervision and preventive measures). The focus of the analysis could be further determined based on the specific threats the country faces (including use of financial integrity scenarios in other countries/regions, calibrated to the specific circumstances of the country being assessed). Integrating this deepened analysis into FSAPs would also lessen the burden on country authorities, as we confirmed through the pilot exercise that the data used is typically collected as part of an FSAP. Further, FSAPs can inform the analysis of financial sector issues in AIV consultations, especially in the case of mandatory FSAPs.
27. AIV engagements also could cover banking stability impacts from systemic deficiencies in AML/CFT supervisory frameworks when macro-critical.10 Staff can leverage the increased availability of FSAPs coupled with ML/TF risk-relevant information, both from member countries (greater availability of updated national and sectoral risk-assessments) as well as quantitative information (e.g., cross-border payments data) to improve understanding of risks facing the banking sector. This will allow further focus on AML/CFT supervision in the banking sector in cases where the sector is exposed to high risks, and where AML/CFT failures could have potential financial stability impacts.
28. The analysis will also be broadened to assess the impact on other sectors. While banks continue to play a central role in the financial system, new entrants (e.g., VASPs) and other non-bank sectors are also vulnerable to ML/TF risks and further analysis is required to better understand the impact of AML/CFT failures on these sectors. In addition, the analysis will be expanded to further consider cross-border impacts and group structures (including groups that combine banking and other financial sector activities/entities).
29. In line with the demand for the analysis of financial stability impacts of financial integrity failures in advanced economies, it is anticipated that this trend will continue. In a recent regional CD project, the Fund piloted a novel methodology to explore financial stability impacts of financial integrity events jointly with the analysis of cross-border ML/TF risks as well as vulnerabilities in risk-based AML/CFT supervision. This project allowed the development of a methodology to analyze financial stability impacts of AML/CFT failings. Since then, training modules on assessing financial stability impacts have been developed and delivered in regional trainings.
30. This analysis would also be highly relevant to LIC and emerging economies where the banking sector is prone to high financial integrity risks coupled with liquidity constraints. Liquidity pressures stemming from financial integrity failures may be higher for small and medium size banks. Lower income jurisdictions may also be more likely to experience correspondent banking relationships pressures affecting the banking sector due to assessed or perceived compliance weaknesses. Quantifying such impacts in these countries could help inform prudential and AML/CFT supervision efforts to mitigate systemic impacts from AML/CFT failures.
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Paper prepared by Grace Jackson, Pierre Bardin, Indulekha Thomas (all LEG), and Antoine Bouveret (LEG consultant).
TF usually entails smaller sums and can be largely macro-critical for FCS or states where terrorist groups have control over natural resources. While the focus of the background note is on ML, measures to mitigate ML are often complementary to those that mitigate TF. In these instances, the background note refers to ML/TF or AML/CFT.
Financial stability is defined as the ability of the financial system to facilitate and enhance economic processes, manage risks, and absorb shocks.
In an effort to protect their financial sectors, national supervisors, often in response to the FATF/FATF-style regional bodies’ (FSRBs) calls for action, are increasingly prohibiting their banks from dealing with financial institutions from countries with actual or perceived weaknesses in their AML/CFT frameworks, or at least, to subject transactions with institutions from such countries to stricter conditions.
The review period corresponds to the period covered by the 2018 AML/CFT strategy review, i.e., 2018-2023.
Referred hereafter as financial integrity events.
Tax crimes are a predicate crime under the revised FATF Standards (they appear in the list of designated categories of offenses in the FATF Glossary).
This transmission channel could also be used when non-bank financial institutions part of a banking group face financial integrity issues.
For example, Iceland (2019 and Latvia (2019) AIV consultation staff reports.
Financial integrity issues are covered in AIV consultations when they are macro-critical, i.e., when these issues significantly influence present or prospective balance of payments and domestic stability or when spillovers from these policies may significantly influence the effective operation of the IMS, see the 2012 ISD.