After foreign exchange and petroleum, money laundering is the world's largest industry in terms of turnover and yet little academic or empirical research exists on the matter. This essay attempts to counter this in some way. Firstly, a definition of money laundering is offered, before attempting to justify its study and estimate its size. Second, the risks money laundering poses to the financial system will be assessed in the wake of the new anti-money laundering laws being implemented across the EU budget and beyond. The final section discusses the policies adopted for the prevention of money laundering and the problems associated with them.
What Is Money Laundering?
Money laundering is all about deception. Its aim is to deceive the authorities as to the origination, existence and/or application of illegal sources of income and the subsequent processing of that income to make it appear to have been legitimately earned. Money laundering plays a fundamental role in facilitating the ambitions of the drug trafficker, the terrorist, the organised criminal, the inside dealer, the tax evader as well as the many others who need to avoid the kind of attention from the authorities that sudden wealth brings from illegal activities. This 'facility' is the placing of the proceeds of such activities beyond the reach of asset forfeiture laws.
Why Study Money Laundering?
Governments are now realising that the pursuit and confiscation of illegal monies from crime is as effective a way of attacking crime as arresting the felons, perhaps even more so given that many drug barons are able to continue to conduct business from their prison cells e.g. Pablo Escabor. So by seizing the rewards from crime it is hoped that such rent seeking activity is discouraged. The extent to which money laundering enables criminals to engage in activities harmful to the economy validates its study so as to prevent such activity.
A second reason for studying the economics of money laundering is that most financial institutions are unaware of the extent to which the world financial markets and banking system are being used to process illegal monies. Banks and financial institutions are at risk from being used for such activities as failure to observe their new legal responsibilities in combating money laundering leaves many of them open to criminal prosecution and the subsequent adverse publicity.
Therefore the study of money laundering as a means to countering crime, which imposes huge economic resource costs on society and threatens the proper functioning of the economy, as well as threatening the stability of the banking system, is a fully justified area of research.
However, it should be noted that money laundering is not merely confined to criminals. Many governments and their agencies engage in money laundering activities to provide a cover for various covert operations. The Central Intelligence Agency (CIA) is known to have used money laundering to forward money to support the Iran-Contra Rebels, while the British Government use of it in the Matrix Churchill Affair is widely known. However the size of such activities are dwarfed by illegal ones.
The Magnitude of Money Laundering
By its deceptive nature, the full extent of money laundering is unknown; estimates range from $100 billion to $300 billion. The main bulk of monies to be laundered originate from the narcoeconomy and so by estimating the size of the narcoeconomy a good approximation of the size of global money laundering may be achieved.
The Financial Action Task Force, (FATF), established in 1989 by the G7 and European Community to assess the problem of money laundering and prevent the financial system being used for its purposes, estimated in 1990 that in the US and Western Europe drug trafficking generated $85 billion annually from laundering and investment. Thus almost $233 million in drug money is available daily for laundering. The task force concluded in 1990 that, in the US and Western Europe, drug traffickers' profits probably yielded $232,115 per minute. One can get a feel for the size of the narcoeconomy by the fact that in 1990 approximately 20 per cent of Peru's Gross National Product was generated by narcotics, whereas legitimate exports accounted for only 14 per cent.
Combining these monies with the monies from insider dealing, tax evasion, kidnapping, and corporate extortion, yields a figure likely to be in excess of $100 billion. It is surely inconceivable that such flows of money can enter the banking and financial systems without someone questioning their provenance.
The Method
There is no one method of laundering money and those methods that are the most successful are of course unknown to the authorities. Methods of money laundering range from the purchase and resale of yachts and antiques to the transference of money through a purposefully complex system of legitimate international businesses: shell companies and banks, which may be held by a holding company, usually registered in a jurisdiction where no annual accounts need be filed, foreign or domestic nominee directors may be appointed and bearer shares are permitted, (e.g. the islands of St. Kitts and Nevis in the Caribbean). As most money being laundered comes from street level drug deals, a cash intensive business by nature, this source will be the main area of focus.
Money laundering has both macro and micro levels. The macro level has three distinct stages, that of placement, layering and integration, and innumerable micro phases depending on the size of the operation and the degree of deception required.
Placement
The first stage in the washing cycle is the placement of the monies into the financial system or retail economy or smuggling them out of the country. The aims of this stage are to remove the cash from the location of acquisition so as to avoid detection from the authorities and the attention of other criminals and then to transform it into other asset forms.
This is perhaps the most difficult stage of the cycle, for the launderer is faced with converting small denominations of cash into more manageable monetary instruments or assets. If one imagines a weekly drug revenue of $1 million in $50 notes as a ten foot high stack launderers must deposit, some appreciation of the launderer's problem can be gained. One could not simply deposit such money into a bank account weekly without raising some suspicions or, as in the US, being required to file Cash Transaction Reports (CTRs) with the Internal Revenue Service (which must be filed for all currency transactions over $10,000). To overcome these problems, launderers engage in smurfing - structuring their deposits to avoid having to file CTRs. Or, more likely, have an accomplice in the bank or securities/commodities brokers to help them dispose of the funds. Alternatively, the money may be laundered through legitimate businesses which under-report invoices and over-report sales. Eighty to eighty-five per cent of drug sales monies will find their way into the legitimate economy through these channels, the remaining fifteen to twenty per cent will be smuggled out to be deposited with offshore banks which have bank secrecy laws, [i.e. making it a criminal offence for the banks to reveal any information about their client] e.g. Switzerland. It is estimated that one and a half tons of foreign currency arrives at Zurich airport daily, destined for Swiss banks.
Layering
Once the cash is transformed into another asset the second stage can begin: the layering or 'the heavy soaping'. The purpose of layering is to disassociate the illegal monies from the source of the crime by purposefully creating a complex web of financial transactions aimed at concealing any audit trail as well as the source and ownership of funds.
Typically layers are created by moving monies in and out of the offshore bank accounts of bearer share shell companies through electronic funds transfer (EFT). Given that there are over 500,000 world-wide transfers a day representing over one trillion US dollars most of which are legitimate, and that not enough information is disclosed on a transfer to reveal the source of the money (and hence whether it is clean or dirty), these provide an excellent way of moving dirty monies. An alternative form is by engaging in a complex set of transactions with stock, commodity and futures brokers. Here, the unnatural degree of anonymity provides ample room for layering as the likelihood of the transactions being traced is negligible given the sheer volume of daily transactions.
Integration
The final stage in the process is integration or the 'spin dry' of the illegal funds. Integration of the 'cleaned' money into the economy is achieved by making it appear to be legally earned and so safe from probing officials as to its source. One method of integration is by companies falsely overvaluing exports and undervaluing imports so as to move money from one company and country to another. Another simpler method is to transfer the money (via EFT) to a legitimate bank from a bank owned by launderers, as 'off the shelf banks' can be purchased in many tax havens.
More worrying is the increasing use of the financial markets by money launderers to integrate and layer their funds. For example, a new company may issue a large number of shares, which the launderer director will own through various offshore agencies, and these shares will then be aggressively marketed and sold to an unsuspecting public, while the launderer receives clean cash.
Ironically though, perhaps the most efficient way to launder money is to 'pay' the relevant tax due on it, for it becomes very difficult for agencies of the state to claim that a sum of money represents the proceeds of crime when the beneficial owner has declared tax on it. The main pillar of money laundering is the role that the financial system plays in the laundering. The money laundering industry poses certain risks to financial institutions, risks that are reinforced by the increasingly hard stance of governments around the world about bank complicity in money laundering.
Risks To The Financial Sector
The Financial System
Given that the size of the global money laundering industry is unknown, the extent of the risks to the financial system can only be estimated. However, the ruination of some financial institutions by money launderers in the past, indicates that the risk is a potent one.
On a macro level, money laundering poses a risk to confidence in the financial system and in its institutions. 'The soundness and confidence in the financial system as a whole could be seriously jeopardised thereby losing the trust of the public,' if the financial system is seen to be laundering criminal proceeds. The Bank of England is at pains to ensure that the City of London maintains its reputation as a 'clean' financial centre. It would not be difficult to imagine the decline of a reputable financial centre were it to become synonymous with laundering criminal proceeds, given the emphasis on name and reputation in attracting and maintaining business in the financial industry. Therefore the importance of confidence and the need for transparency in the financial system cannot be understated, especially as it makes a significant contribution to certain countries' GNP.
Financial Institutions
Not only is the financial system likely to be at risk, but the individual financial institutions that either, intentionally or unintentionally launder money are too. This discussion will focus on banks and note that a similar predicament applies to other financial institutions such as stock brokers, life assurance companies etc..
Banks are susceptible to risks from money launderers on several fronts. There is today a very small step between a financial institution suspecting that it is being used to launder money and the institution becoming criminally involved with the activity. Banks that are discovered to be laundering money are most certain to face costs associated with the subsequent loss of business as well as legal costs.
At the very least, the discovery of a bank laundering money for criminals is likely to generate adverse publicity for the bank. (E.F. Hutton, a US brokerage house, received a great deal of negative publicity for laundering criminal funds.) A lack of confidence in a banking institution is likely to result in declining business as clients move elsewhere.
Banks also face the risk of criminal prosecution for money laundering whether they know the funds are criminally derived or not. The 1990 United States of America Depository Institution Money Laundering Amendment Act puts the legal onus of reporting suspicious transactions on the bank directors. If it finds a bank flouting these laws, the US Government has the right to take-over the running of the financial institution as well as imprison the directors and fine the bank. This applies to all financial institutions in the USA. All can be indicted if they are suspected of money laundering anywhere in the world. A similar law applies in the EU. If a financial institution in Ireland is found to be assisting a money launderer and has not followed the appropriate course as laid out by the EU, the individual employee and their supervisors (right up to the company directors) are personally liable to imprisonment or a fine or both.
More often than not, bank directors are unaware that their institution is being used to launder money. Typically an employee colluding with a criminal will circumvent the bank's depository procedures to launder money. However, the bank is still liable for the actions of its employees. It is therefore essential that banks adopt and enforce the new legal procedures in deposit taking and keep tight controls on staff likely to be useful to money laundering.
Two conflicts of interest arise here that may dampen the enthusiasm of banks in complying to such laws. The first is that bank officials are under increasing pressure to bring in new business and drive up profits. Bosworth and Saltmarsh note that many western banks remain afloat due to money laundering services. In the case of the Bank of Credit and Commerce International (BCCI), the bank needed to earn profits so as to cover up the huge losses from loans and trading and laundering money provided an easy way to do so. The second conflict is that certain banks and countries have a competitive advantage in providing private banking services, i.e. client confidentiality. Bank secrecy laws exist in fifty nations world-wide and for such banks these are important in attracting customers. Any moves to abolish or continually override such laws are likely to be strongly opposed.
The Securities Markets
The final area of risk to the financial system is the risk posed to the securities markets, notably the derivatives markets. As a result of the degree of complexity of some derivative products, their liquidity and the daily volume of transactions, these markets have the ability to disguise cash flows and hence are extremely attractive to the professional money laundered. However, their activities pose huge risks to these markets.
Firstly, the brokers used to execute orders on behalf of money laundering clients may be criminally liable for aiding and abetting money launderers. A worrying situation is the money launderers' skilful manipulation of the futures markets. On local futures exchanges, individuals have colluded to take correspondingly short and long positions so as to clean money debts being paid with dirty money-while profits now being clean money. Such a case was uncovered in the New Orleans futures market. Due to their capital, and collusion in positions they have also in the past purposefully manipulated market prices. Unless markets are seen to be transparent and the price system exogenous of individual agents' actions, participants may retire from the market and so make the market's allocative efficiency diminish.
Secondly, another major risk created is through the use of offshore banks who may wash money using derivative markets. As these banks are foreign, they are not required to abide by the same regulations as those of domestic investors as regards overexposure to uncovered risk, they are able to take on huge risk relative to their institutional size. Should losses result from such positions the debts may not be fully paid as the contracts purchased may be only one step in the course of a complex laundering chain that is untraceable. Thus potentially huge loses could be incurred by legitimate investors, causing damage to the derivatives markets.
It is therefore essential that policies be enforced to ensure money laundering is prevented from using the financial system as a means to an end and in turn discourage the original crimes from occurring.
Policy Relevance
A fundamental prerequisite to any policy designed to attack money laundering must have strong international co-operation as otherwise professional money launderers will simply move operations to countries with lax money laundering laws. Thus to counter the global problem of money laundering, global policies that are generally consistent must be adopted and enforced. This will require the establishment of a world-wide organisation along the lines of the FATF.
The areas where the authorities are likely to be most effective in combating money launderers are where they have large sums of cash in their possession. This usually occurs at the placement stage. A policy of 'know your customer' where banks know the exact nature of business of their client, maintain records of all transactions and accounts for several years and report all suspicious transactions and those over a certain limit needs to be introduced. Parallel to such policies must be the continued training and education of staff to be aware of money laundering by clients and colleagues so as to prevent bank complicity. Finally, it must also be permissible for banks to report suspicious client account activity without being liable for infracturing bank secrecy laws.
All of the above are currently laws implemented across the EU, following the EU directive on money laundering (1989). A more drastic solution was that supported by the US Treasury Secretary, Donald Regan, in the 1980's: a sudden and unanticipated week's notice that the colour of all dollar notes would be changed, rendering all old colour dollar notes useless, and that individuals could change old dollars for new ones at the bank, but that any transfers over $1000 would be recorded. As the US black economy functions exclusively on cash the vast bulk of a money launderer's cash would become useless. However for such a policy to be effective, it would require continual implementation along with significant transactions costs. The ultimate solution may be of moving to a cashless society, as the registration of all transactions would create significant problems for the professional money launderer. Whatever the policies adopted, they need to be consistent.
Conclusion
Money laundering is a global problem that poses serious risks to the financial sector of every economy. While the above outlined policies are promising solutions, they are rendered almost useless unless their implementation is consistent and on a world-wide basis. Lack of consistency is an unfortunate feature of current EU anti-money laundering policy. While the EU directive was specific about the areas to be tackled by the member countries - 'know your customer' policies, staff training and exemption from secrecy laws - it was not as precise in outlining the appropriate 'punishment' of breaking the new laws. This has given rise to intra-industry problems among the member states whereby in the same countries the financial institutions are simply fined while in others they face imprisonment. The effect of failing to implement such policies world-wide is similar: carrying out interrogations of clients of foreign banks is hardly conducive to good international trade. Furthermore, if the many launderers simply switch the site of their money laundering activities to a more favourable legal climate, the risks posed to the financial sector will not be completely eliminated.
In order to rid the international financial sector of the international problem of money laundering, governments must implement possible policy solutions on an international level. The benefits of these 'solutions' are greater stability in the financial sector and, hopefully, lesser gains for the main laundering criminal.
Bibliography
Bosworth, D.R. and Saltmarsh, G. (1994) Money Laundering: A Practical Guide to the New Legislation, Chapman and Hall, London
The Criminal Justice Act of 1994
The European Directive on Money Laundering (1989) European Community
Intriago, C., (1991) International Money Laundering , Eurostudy
Possibilities of Countering Money Laundering, (Nov.1992) Bank of England/ Bank for International Settlements, Bank of England Quarterly Bulletin
Robinson, J., (1994) The Laundry Men, Simon & Schuster, London