Anti Money Laundering Some Inconvenient "Facts"

Not a Red Arrow in the Quiver

Last month Matthew Collin published a blog entitled “Angola and the money laundering paradox” in which he noted that the dos Santos case highlighted certain paradoxes about money laundering.

His key points were that contrary to what many believe a large volume of money laundering takes place in jurisdictions that score well on Transparency International’s Corruption Perceptions Index, have good ratings (mutual evaluations) on their anti money laundering regulations and system from the FATF or similar bodies, score high on transparency,, etc.

Be sure and read his article it is full of worthwhile insight and information.

None of this is surprising to those involved in international finance nor to those who follow money laundering.  

There are more inconvenient "truths" or at least observations about money laundering. 

As usual, AA is not shy about highlighting them.

First, the "developed and well-regulated" markets are where the bulk of large value money laundering takes place over all three stages of the process: placement, layering, and integration. 

As the chap in the picture above (Robin Hood or Robin Gud) will tell you, the best place for a “hood” to hide out is where there are lots of trees.

It’s much easier to get lost among the trillions of dollars of daily transactions in the major "developed and well-regulated" markets.

These are places that you’d like to hold financial or other assets (properly disguised of course) for a variety of reasons:  greater liquidity, potential for appreciation, systems that protect your rights from arbitrary actions.

Those with assets to sell or banking services to provide in those markets are keenly interested in maximizing sale proceeds or service revenues. And perhaps not of the sort to get overly "fussed" about the source of funds.

A booming property market and vibrant stock market are every government's dream.

This is no secret. There are reliable official estimates of money laundering that cut through imaginary "halos", including those of their own jurisdictions. 

Here are two examples.

Each year the US Department of State publishes the International Narcotics Control Strategy Report pursuant to a statutory requirement. Usually in late March covering the prior year. The INCSR is based on input from various US governmental agencies.

As you'd expect with any national source, it is not free from political considerations. 

Within Volume II of the INSCR is a list of “Major Money Laundering Jurisdictions”. 

You’ll find the list of such countries for 2018 in the INCSR 2019 Volume II pages 14 -15. 

Tucked in among the usual suspects of Afghanistan, Uzbekistan, the UAE, you’ll find the United Kingdom, the United States, etc. 

In past years, the DoS would rank countries as being of “primary concern”, “concern”, and “other countries monitored.”

In the “primary concern” list, the United States, the UK and several European countries were routinely included.  

Here’s an archived version from the 2017 INSCR. 

The UK’s National Crime Agency notes that “Although there are no exact figures there is a realistic possibility that the scale of money laundering impacting the UK annually is in the hundreds of billions of pounds.” 

If you think about a country like Angola, any serious money laundering through the financial system there would be noticeable because of the lower volume of transactions. Not enough trees. In some cases countries only have “bushes". 

Here's an example of how "lack of trees" can aid in identifying unusual, perhaps even suspicious transactions.

Back in 2016 SWIFTs August RMB Tracker noted further imaginary progress in the development of the RMB as an "international currency" citing a spike in RMB transactions in "South Africa".

A fairly cursory examination of publicly available material disclosed that the spike wasn't only in transactions for South African customers.

More importantly that analysis disclosed the spike was primarily due to a single RMB 2.7 billion transaction in Mauritius.

Second, fines give a fairly good idea of where money laundering is taking place and how serious it is.

By amount the bulk of money laundering fines are levied by regulators in the USA and Europe on banks operating within their jurisdictions. The size of these fines indicates the volume and seriousness of the infractions.

According to AccountancyDaily, there were 58 AML penalties worldwide in 2019 totaling USD 8.14 billion nearly double the amount of the 29 penalties in 2018.

US regulators were the most active with 25 penalties totaling USD 2.3 billion, the UK with 12 penalties totaling USD 388 million.

(Fines like the UK's aren’t going to do much to combat money laundering. They’re unlikely to silence the laughter in board rooms.) 

France took the record that year for the largest penalty USD 5.1 billion levied against UBS who are appealing the fine. 

In terms of money laundering and sanctions violations penalties (the latter a particular preserve of the USA) there have been some USD 36 billion since the 2008 financial crisis according to a recent report by Ferengo who publish this data annually. 

Again the countries whose banks were “tagged” with the fines come from “developed and well-regulated” markets. You won’t find Angola or Iran among them.

Third, despite apparent precision attempts to quantify money laundering, corruption, and other illicit activity results in crude estimates at best and often in semi-educated guesses. Sometimes they measure less than we think they do.

Here are some examples from previous posts.

1. The generally accepted quantum of annual money laundering. Or the 2 to 5% solution.  
2. Difficulties in modelling illicit financial flows.    

Sometimes they don't model everything we think they do.

For example, Transparency International’s Corruptions Perceptions Index is based on perceptions.  There are no public statistics on corrupt transactions, except those arising from legal cases.

More importantly TI considers only governmental corruption as clearly outlined on TI's website.

A fuller discussion here. 

The latest TI CPI rated Denmark as the least corrupt country in the world tied with New Zealand.  In 2018 Denmark stood atop the CPI alone.

Yet, Den Danske Bank’s branch in Estonia was involved in a Euro 200 billion money laundering scandal over more than a few years.

According to reports, the Central Bank of Russia informed both Danish and Estonian regulators in 2007 and 2013 that Danske's Estonian branch was being used for money laundering.

It would appear that warning was not acted upon, presuming that these reports are correct.  

Denmark and several other TI highly rated countries are victims in a multi billion euro tax fraud based on “dividend stripping” or a “cum/ex” operation. Denmark Euro 2 billion, Germany 5 billion. 

Major European banks colluded with clients to implement the scheme. Not one Angolan bank in the mix.

So, if you’re relying on TI to frame your money laundering risk profiles, think again. It's only a partial source and has its own limitations. 

Most money laundering takes place through private sector not public sector banks. And be aware that other rankings of financial crimes risk use the CPI as input. 

Fourth, assessments (mutual evaluation reviews) of anti-money laundering regulations and systems miss key factors.

Much of these are based on whether there are laws on the books that cover the key elements in a good AML regime (based on FATF recommendations) and how strict they are.

Geography plays in important role in this process because "zip code" is used to risk exposures.

MENA countries are likely to be scrutinized more for terrorist finance than Latin American ones. Deficiencies found in MENA will be treated as more serious than those in Latin America.

Checking the robustness of legal regimes is certainly important. 

But, if laws are robust but ignored, they are of little use.  If they provide less than perfect solutions as all legal systems do, then reliance on them should be tempered by this knowledge.   

The same with individual financial institutions procedures for enforcing the national AML regime.

Fifth, compliance with AML regulations involves a lot of "box ticking".

Financial institutions are required to perform two key AML tasks:  (a) conduct CDD (customer due diligence) prior to accepting a customer and (b) monitor a customer's transactions and conduct of its relationship to detect suspicious activity. The bank should investigate suspicious activity and where warranted file a report with its financial regulator.

CDD consists of "proving" a customer's identity, financial condition, etc. and assessing whether the potential customer is not engaged in illegal or terrorist activity. 

This involves obtaining various documents depending on whether the potential customer is a legal entity or a natural person, e.g. passports, commercial registrations, financial statements, etc. 

As a general rule, one can say that individuals and businesses that need their money laundered have rather high gross margins. Thus, they have ample budgets to pay intermediary fees and make facilitating payments.

They have the money to pay for the creation of documents to comply with AML requirements and to set up complex structures to hide realities. 

Here it's important to note banks are not required to “verify” documents but can accept them on their face as valid unless the documents are clearly forgeries or inconsistent. This is similar to their obligations regarding the authenticity of documents presented under letters of credit. 

That makes sense.

Unless it’s a rank amateur forgery how will a bank in Country A, verify your Country B passport?  Or your financial statement?  Or a letter from a lawyer confirming you inherited USD 100 million from your Uncle Abdullah?

Money launders are also able to hire “name” professional advisors and intermediaries. 

The sort of “names” that would add a “halo” to the client.

"If XYZ is dealing with Ms. X, she must be “clean” because they are an international firm and must have done proper 'due diligence'.

Most national AML laws and regulations are based upon the recommendation of the FATF an international body that develops AML standards. FATF Recommendation 17 allows a national regulator to permit its banks to rely on a third party to perform some of the key steps in CDD or customer vetting.  

This can also be a convenient excuse for a bank not to look too closely for fear of finding out something it doesn't want to know or aggravating a potentially lucrative customer.. 

What's hopefully clear from all of this is that there is a great deal of "box ticking" in the CDD process. 

As an internationally mobile individual, I have had to open accounts in a variety of foreign jurisdictions.

In most cases I have been called on to sign a letter that states I won’t use the account for illegal purposes or to fund terrorist activities.

I also have been asked to self-report my income and net worth. Provide proof of my address, e.g., a letter addressed to that address, a utility bill, a driver's license, etc.

But not in every case!

And that's not just overseas, in one case when I lived overseas and wanted to open an account with one of the largest banks in the USA, my Social Security number, a deposit, and a smile were all I needed to open an account.  I wasn't asked to "show" my passport or driver's license! 

Luckily for the banks I deal with, I’m an honest person. But not every client is.

This concept of self-certifying oneself as “not a crook” is an interesting one.

Once while opening an account with a foreign bank, I asked its representative if he thought that a person who wanted to use an account for illegal purposes or terrorism would have his or her conscience troubled by lying in such a letter. 

His retort was “If you don’t sign the letter, no account”. 

Letter signed, box ticked, financial integrity protected, we moved on.

To be fair, how would a bank determine if a potential customer were a terrorist or criminal?

Are banks smarter than law enforcement and certain organs of state security?

Do banks have access to information that these official bodies do not?

Bank financial performance seems to suggest that as a group they are less "smart" and have less access to information about their clients than is commonly imagined. 

Once a customer is accepted then the bank must monitor the account relationship for transactions that don't seem to be compatible with the information provided on financial capacity or contain money laundering patterns. The FATF publishes a list of these, if you're interested.

In general this is "easier" than the CDD step.  A lot of this can be automated fairly simply primarily where the account is being used for many transactions.  

However,if the account is being used for a one off or infrequent transactions, this becomes a harder task.  

Six, The phrase "pecunia non olet" explains why money laundering occurs.

In fact the more you have the sweeter the smell, particularly when fees for advising and handling that money are based on amount.

Ms. dos Santos was clearly a “PEP” (politically exposed person). 

Standard practice AML procedures would require that she be subject to enhanced due diligence at the inception of a relationship and thereafter by ongoing enhanced monitoring by banks, professional service providers, and intermediaries.

She must have had quite a convincing story about how she legally accumulated her wealth and then kept on legally accumulating more. 

Plus a trove of very credible looking documents.

Or maybe it was the “sweet smell” of success?

Or the fear that too intrusive an approach would take her to finding another bank, advisor or professional service provider? 

The rich are different than you or me.  Not only do they have more money than we do.  But their bankers are more deferential.  

Perhaps, a even more compelling story is that of Rabobank NA, the US subsidiary bank of Rabobank in the Netherlands.

According to the US Department of Justice, two of the bank's rural branches in California--Tecate and Calexico cities right on the border with Mexico--had a "lot" of US dollar deposits.

So much that the bank had to send at least one armoured car per week to collect the cash. Depositors then typically wired or otherwise transferred the money out of the accounts shortly after making the deposits.

Now one (at least AA) would think that large cash deposits well beyond economic activity in the area--at least legitimate activity--might be a "red" flag of potential money laundering, warranting at least an investigation.

The immediate transfers would typically also be considered a "suspicious" transaction.

Well Rabo did investigate and apparently decided it was.

So they did what any "responsible" financial institution might do.

They devised a "verified customer scheme" to facilitate continued acceptance of the deposits in an ultimately unsuccessful attempt to hide the transactions from USA authorities. A seemingly high risk strategy.  What were they thinking?. 

5 Fundamental Misperceptions about Transparency International’s Country Corruption “Rankings”

Plenty of Cake to Go Around: Eat Your Fill, Sleep Well

Probably the most well-known source for “rankings” of country corruption is Transparency International.

Well-known as the source, but less so for the contents.

AA believes that most people who use or quote TI’s rankings do not know what they mean and operate with some or all of the following misperceptions.

To be very clear upfront, this post is not arguing that we should not use TI’s CPI.  But rather than we should understand what it is, what are its limitations, and how to use it intelligently.

FIVE COMMON MISPERCEPTIONS ABOUT TI’S CPI

1. TI’s rankings assess the overall level of corruption in a country.
2. While not “facts”, the analytic process behind the rankings results in fairly accurate assessments.
3. TI performs the analysis behind the rankings or at the very least directs it.
4. Every country is rated using the same common set of standards.
5. The rankings are sufficiently precise that we can use them to distinguish the level of corruption in one country from the level in another.

TI provides extensive disclosure about the CPI at its Methodologies page.

Those who read this material carefully will not hold any of the first four misconceptions.  The problem is it appears that TI’s disclosures are infrequently read.

TI’s apparently precise ranking system does give the impression that Misconception #5 is correct.  It is not.

MISPERCEPTION #1 – Overall Level of Corruption in a Country

Here’s a quote from a TI FAQ that on its rankings:

“Is the country/territory with the lowest score the world's most corrupt nation?  No. The CPI is an indicator of perceptions  public sector corruption, i.e. administrative and political corruption. It is not a verdict on the levels of corruption of entire nations or societies, or of their policies, or the activities of their private sector.”

What does TI rank then?  What is its definition of “corruption”?

Why should we care?

It’s very important to understand TI’s focus if one is to use their rankings intelligently.

If you read the FAQs in the Methodologies material (page 2), you will find a list of what is included and what is not.

Money laundering, IFFs, informal markets, the private sector are NOT included.

Broadly speaking, TI’s CPI focuses on the public sector only.

TI is very clear on this but AA wonders how many users of TI’s CPI understand this.

What this means then is that a private sector member’s actions do not affect the ranking of its respective country.

This is very important because if one is using TI rankings to construct assessments of money laundering and terrorism finance, one might be mis-specifying the risk, if one assumes that TI rankings assess the overall level of corruption in a country.

Why?

Private sector enterprises are probably the major channels through which ML and TF take place in most jurisdictions.

MISPERCEPTION #2 – Rankings as “Facts”

TI’s annual ranking for 2018 is here.

The first thing to note is that this is described as the “Corruption Perceptions Index”.

The key word here is “perceptions”.    “Opinions” not “facts”.

That makes sense.

There are no formal reports filed on bribes paid or bribes accepted.

One has to infer the extent of corruption in a country from very limited hard data – corruption cases that have come to light—and other indirect indicators.

The first takeaway then is that a ranking for a specific country is an estimate. 

Likely a very rough estimate.

Similar to the 2% to 5% of global GDP (usually mis-stated as amounts from USD 800 billion to USD 2 trillion) estimate bandied about as the annual flows of money laundering, corruption rankings are often treated as scientific fact.  They are not and should not be treated as such. 

MISPERCEPTION #3 - The rankings are based on TI’s research.

TI uses the published assessments of 13 sources.

Each of these sources prepares reports for its own or its clients’ use using its own criteria and methodology.

TI does not do the research itself. It does not set the focus, criteria or methodology for these sources’ studies.

Rather TI repurposes the 13 sources’ reports to create the CPI.  In 2015, one source, IHS Global, stopped providing data to TI.  TI now accesses some IHS data via information published by the World Bank.

MISPERCEPTION #4 – Common Standards and Methodologies

Who are the experts? What are their methodologies?

For a detailed answer click on “Methodologies”. Here you will find a discussion about each expert and its methodology.

Click here to see the sources used in ranking a specific country.

The first thing you will notice is that not every source rates every country.

In a situation where some countries are rated by some experts and other countries are rated by other experts should we automatically assume that all the experts use an identical single common standard and methodology?

Clearly we need to look a bit deeper because if the experts don't have a single common standard, then which experts rate a country will impact that country's rating.

AA has read this material and encourages everyone who uses TI’s CPI to read it as well.

Why?

First, this is quite a heterogeneous group.

It includes multi-lateral institutions (2), NGOs/Foundations (5), companies selling country risk or business information services (4), university affiliated entities (2).

Each of these has a specific purpose for its study motivated by its stated “mission” or, in some cases, perhaps by its ideology.

That is not meant as a pejorative remark. But as a practical one.  We need to be sensitive to conscious and unconscious factors that may influence a rating, particularly in the case where “perceptions” play a key role in determining rankings.

AA argued in another post that the collapse of Abraaj seemed to be treated in some circles as evidencing a more serious failure by regulators and markets than scandals in certain OECD countries that had a much greater impact on the world economydid.

Are there other geographical biases? Is corruption in African Country G more heinous than Baltic Country L?

Without taking a stand on the issue, AA would note that there is some controversy about the independence of Freedom House from US foreign policy. The FH study that TI uses rates former Soviet bloc states.

Second, the experts’ focus is also heterogeneous.

Not all of these sources focus on corruption itself: bribes paid, bribes taken.

Rather a number of them focus on legal/institutional capacity.  Whether the country has an adequate framework to prevent/punish corruption, e.g., legislation, staffing and independence of investigative and legal bodies, administrative practices, e.g., professional independent civil service, open bidding, whether information is available to the public, etc. 

These indicators by themselves are not indicators of corruption but rather perhaps indicators of opportunities for corruption.

Very big difference.

Laws and frameworks are fine but as experience shows repeatedly they do not prevent crime from occurring.

That’s not to say that these elements aren’t important.

They are necessary but not sufficient elements.

The question is how much weight they should be given when assigning corruption perceptions to a particular country.

AA would be in the camp where actual corruption rather than opportunities for corruption would be given more weight in “rankings”.

Third, the experts’ methods are not identical.  Some use in-house experts to make assessments.  Others reach out to local contacts, and other outside experts, e.g., academics, lawyers, accountants, etc.  In some cases like EIU they use in-country free-lancers at least in part.

Some of the experts appear to ask a single or a couple of questions as part of a larger study on more than just corruption.

Others have a more robust set of questions on corruption.  Or survey a wider set of contacts.

For example, in 2018 The World Economic Forum Executive Opinion Survey (WEF-EOS)--one of TI’s sources—received 12,274 responses from executives in 140 countries in 2018 about corruption.

Fourth, some of the experts—primarily the 3 firms that sell political risk and country assessments to businesses -- assess all levels of corruption from the petty to “grand” corruption.  Varieties of Democracy, another of TI's expert sources does as well. 

As a practical matter, their 3 firms' clients (businesses) are likely to be most interested in the need to pay ongoing bribes to ensure their daily operations run unhindered if they invest in Country X.

So smaller recurring cash payments to facilitate clearance through customs of imports and exports, to secure connection to and maintenance of utilities, to deal with tax authorities, to obtain licenses, etc. are of prime concern.

Finding out about them is fairly easy.  One can ask businesses in the country. They will be more likely to report such occurrences because they are imposed on them as opposed to grand corruption where they may be a willing participant.

Because it’s harder to find out the true level of grand corruption, there is a risk that corruption ratings based on petty or moderate corruption may skew the rating for a country.

Fifth, unlike the countries in the CPI, the 13 experts are unranked.  Their perceptions are accorded equal weighting.  Each expert’s score is added and a simple arithmetic mean is calculated.

They are all presumed to be all equally smart and informed and use equally valid methods to evaluate corruption.  It doesn’t matter whether an expert asked a single question or sent a questionnaire and got 12,274 responses.

It doesn’t matter if the expert is expert in a limited geographical area or covers the world.  The Economist Intelligence Unit who use in-country free lancers in part to do their assessments and rated 131 countries in 2018 are presumed to know as much about each of those countries as the African Development Bank which uses in-house economists knows about the 54 African countries it rated. Or PERC which contacts a wide range of potential respondents to ask a single question and rated 15 Asian countries.

As you might expect, not every country is rated by all 13 experts.  Some of this is because of geographical specialty. The experts from the African Development Bank don’t rate Switzerland, the USA, or France. PERC’s focus is a slice of Asia.

It’s not unreasonable to say then that the rating standards across all countries are not uniform given the diversity of focus, methodology, level of detail, etc. of the 13 experts and the fact that the same 13 experts do not rate each country.

The full data set shows the score, the standard error (think standard deviation but for a sample), the Upper CI and Lower CI.

There is a wealth of information here.  If you use the TI CPI, then you should be familiar with this information so you can use it intelligently.

For example, should we treat a rating with only 3 experts (the minimum required for a rating) as being as valid as one with 10?

If the standard error is large, should we assess that the rating is less accurate than one which has a smaller standard error?  For example, the SE for Switzerland is 1.57, Bahrain and the Philippines are at 1.81, Saudi is at 6.34, Qatar at 8.08, and Oman at 9.46.

MISPERCEPTION #5 - Ratings are Precise Measures

TI ranks some 180 countries.  100 is the theoretical “best” score.  0 the worst.

Denmark in the first rank with 88.

New Zealand is at 87.

Then four countries follow at 85.

All the way down to Syria (13) and Somalia (10).

This is some very precise parsing of differences in corruption.

Let’s stop and reflect for a moment.

We started with “perceptions” but we seem to have wound up with “precision”.  AA would argue “false” precision.

On a hundred point scale, NZ would appear to be 1% more corrupt than Denmark.

Can we really parse gradations this fine?

More importantly is there really a practical difference in corruption between Denmark (ranking #1 with 88) and Germany (ranking #11 with a score of 80)?

The answer to both questions is no. 

TI agrees with this at least in part.

In their FAQs, they answer a hypothetical question from a reader about changes of 1 or 2 points in a specific country’s rating year-on-year with:

“It is unlikely that a one or two point CPI score change would be statistically significant.”

AA would argue that even larger differences among countries are not significant either.

Let’s look at an endeavor that has more data and more rigorous mathematical analysis of the data, though one which is not devoid of opinion:  credit ratings. 

S&P, Moody’s, and Fitch rank issuers.

But they don’t assign them individual ranked ratings.  Rather they group them into categories of similar risk.

Those issuers least likely to default are rated (placed in category) AAA.  If distinctions are made, a “+” or “–“sign is used.

AA doesn’t think it’s a sensible proposition that corruption analysis is more scientific than credit analysis and hopes you do too.

AA suggests that TI adopt a similar approach in an effort to prevent misunderstanding and misuse of its rankings.  That is, divide countries into broad categories of risk of corruption like credit ratings or S&P's BICRA.

This will have the immediate effect of preventing users from plugging the current “precise” ratings into their models and coming up with equally imprecise results in theirs.

Some even more impressive with results to two digits to the right of the decimal point, though admittedly not on a 100 point scale.