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2023 REVIEW OF THE FUND’S ANTI-MONEY LAUNDERING AND COMBATING THE FINANCING OF TERRORISM STRATEGY—BACKGROUND PAPERS
BACKGROUND PAPER I: MACROECONOMIC IMPACT OF ILLICIT FINANCIAL FLOWS (IFF)
Executive Summary
IFF have received increased attention globally due to their significant adverse effects on the macroeconomies of countries where they originate, transit, and/or are integrated. This background paper takes stock of the efforts to estimate and address cross-border IFF and discusses potential solutions that the Fund could advance to mitigate IFF, highlighting how technology can be leveraged to analyze big data on cross-border payments and prioritize efforts. The paper discusses the economic impact of IFF and how the Fund—although it does not yet have a dedicated policy on IFF—could help address related macroeconomic risks building on its anti-money laundering and combating the financing of terrorism (AML/CFT) strategy and the Framework for Enhanced Engagement on Governance.
A. Addressing IFF1
1. In recent years, IFF started attracting increased attention of policymakers, civil society, and international organizations. Relevant work by the United Nations (UN), the World Bank, the Organisation for Economic Co-operation and Development (OECD), national AML/CFT authorities’ risk assessments; and typologies of relevant crimes contributed to the growing awareness about IFF adverse effects on tax and broader public financial expenditures and revenues, external and financial sectors’ stability, and governance and rule of law. In addition, IFF are often discussed as a barrier to sustainable and inclusive economic growth, benefiting narrow elites and widening inequality, promoting informality, and undermining social cohesion and trust in governments.
2. International organizations and civil society organizations (CSO) have contributed to a multi-pronged global agenda on IFF. The discourse around IFF gained increased prominence in 2015 with the adoption of the Sustainable Development Goals (SDGs), which include tackling of IFF as a target2 in its recognition as a key disabler of sustainable development. In recent years, IFF have been recognized among significant global economic challenges, as reflected, for instance, by the Group of Twenty (G20) and Group of Seven (G7).3 International organizations including the World Bank and the OECD have also been active in global efforts against IFF, for instance, through development of methodologies and toolkits on measurement of IFF as well as through analytical and capacity development (CD) support on topics including AML/CFT, anti-corruption, beneficial ownership transparency, stolen assets recovery, among others to strengthen countries’ capacity to tackle IFF.
1 Prepared by Maksym Markevych, Alexander Malden, Adrian Wardzynski, and Indulekha Thomas (all LEG).
2 SDG 16 on Peace, Justice and Strong Institutions includes addressing IFF as a target in SDG 16.4.
3 For instance, countries expressed their strong commitment to address IFF in the 2021 and 2019 G20 Declarations. The importance of tackling IFF was also noted in the G7 Leaders’ Communiqué in 2022 and 2023.
National and bilateral efforts have also begun to emerge in the fight against IFF. In 2021, the United Kingdom and the United Arab Emirates signed a partnership which focuses on addressing IFF used for terrorist financing (TF) and those resulting from money laundering (ML) in high-risk sectors such as dealers of precious metals and stones, real estate, and virtual assets (VAs).4 CSOs are also prominently involved in combating IFF through the development of global measures, as well as analytical work and campaigns against proceeds generating crimes (including tax crimes and corruption).5
3. Following the 2009 financial crisis, the issue of tax abuse, a key component of IFF, found its way to the top of the global policy agenda. The public interest in this area was further fueled by tax scandals and numerous data leaks. The Financial Action Task Force (FATF) Recommendations recognized serious tax crimes as one of the predicate offenses for ML in 2012. Another major breakthrough was the international tax transparency standards developed throughout the 2010s and their peer review by the OECD Global Forum.6 It is estimated that progress on transparency and exchange of information helped to identify about €114 billion in additional revenue (tax, interest, penalties). 7 O’Reilly, Ramirez, and Stemmer (2019) further demonstrated that increased international tax transparency led to a decline of about 24 percent (or US$410 billion) between 2008 and 2019 in offshore bank deposits by foreign residents in offshore financial centers (OFCs). 8 Today, international tax abuse, one of the key components of IFF, continues to be the focus of policymakers, supported by the challenging post-pandemic economic outlook with high sovereign debt levels and persistently high inflation.
B. Economic Impact of IFF
Definition
4. There is no internationally accepted definition of IFF, but certain common features or hallmarks can be distinguished among its various definitions. This paper refers to IFF as cross border-financial flows associated with illegal activities in their origin (e.g., results of illegal acts such as corruption), transfer (e.g., conduit tax arrangements), or destination (e.g., funds used for illegal purposes such as TF). This definition excludes legal tax avoidance flows, consistent with approaches adopted by the OECD9 and the World Bank.10 Notably the UN’s statistical definition of IFF has a broader scope, including flows that are not strictly illegal (such as tax avoidance flows) as well as exchange of value beyond financial transfers (e.g., illicit cross-border bartering ).11 For the purpose of staff’s work on IFF, the narrower definition used by the OECD and the World Bank seems to be more fitting.
4 United Kingdom Ministry of Justice, ”New landmark partnership with UAE to tackle illicit finance“ (London, 2021). https://www.gov.uk/government/news/new-landmark-partnership-with-uae-to-tackle-illicit-finance
5 Report of the High-Level Panel on IFF from Africa
6 For a discussion on the relevance of the international tax transparency standards to tackling IFF, see OECD, “Facilitating the Use of Tax-Treaty-Exchanged Information for Non-Tax Purposes: A contribution to a whole-of government approach to tackling illicit financial flows” (Paris, 2023).
7 Organisation for Economic Cooperation and Development, “OECD Global Forum Annual Report 2022” (Paris, 2022). https://www.oecd.org/tax/transparency/documents/global-forum-annual-report-2022.pdf
8 Additional analytical work from the Fund—Sebastian Beer et al., ”Hidden Treasure: The Impact of Automatic Exchange of Information on Cross-Border Tax Evasion,” International Monetary Fund (IMF) Working Paper No. 2019/286 (Washington, 2019). https://www.imf.org/en/Publications/WP/Issues/2019/12/20/Hidden-Treasure-The-Impact-ofAutomatic-Exchange-of-Information-on-Cross-Border-Tax-Evasion-48781.
5. IFF may have a negative macro-critical effect through a variety of economic channels. The fundamental impact of IFF is undermining the productivity and growth of the economy, as IFF and underlying criminality distort market prices and balance of payments, inhibit genuine investment and effective allocation of resources, eroding the incentive structure of voluntary exchange, embezzle public resources, create volatility not linked to economic fundamentals, as well as weaken cooperation and fair market competition. As an example, tax crimes—one of the main IFF components by value— undermine efficient revenue collection and lead to revenue leakage, while fraud, corruption, and embezzlement lead to misallocation of public expenditure and lower productivity. Furthermore, organized crime, drug trafficking, environmental crimes, and their proceeds could deepen the informality of the economy, distort markets, weaken trust in the government and institutions and rule of law, and affect climate change.
6. Economic and other indirect benefits from IFF can be enjoyed—at least in the short and medium term—by international financial centers (IFCs) focusing on global provision of banking and professional services, which however entail risk of facilitating IFF. Financial centers attract inflows for many legal reasons, including a well-developed financial sector, infrastructure, an educated population, strict adherence to the rule of law, and lack of corruption. At the same time, mixed in with legal flows, IFF can distort normal economic activity. For example, IFF can create “hot money” in the banking sector and/or asset bubbles and push out regular real estate buyers and make the government overly dependent on fees connected to IFF (e.g., fees charged under the citizenship or residency by investment programs), and certain taxes (e.g., higher employment tax and value-added tax yields).
7. IFCs are drawn to gaining a short-term competitive edge through attractive tax, and secrecy and data protection regimes. The more immediate economic benefits, as noted above, often outweigh the less apparent longer-term-risks relating to the balance of payments instability or broader financial integrity of the financial system and the inclusive and sustainable growth in the economy. Such IFCs design tax regimes geared toward non-residents, including citizenship by investment schemes, and offer favorable, or zero tax rates coupled with increased financial secrecy and excessive data protection, and limited international cooperation. All this provides an attractive environment to hide illicit funds and wealth. The international tax transparency standards helped to provide for increased cross-border transparency to tackle tax evasion. The ongoing reforms of the international tax architecture, such as the Global Minimum Tax envisaged under the OECD Project, could help rein in a “race to the bottom” on tax rates.12
9 OECD, “Assessing Tax Compliance and IFF in South Africa 2022” (Paris, 2022).
10 World Bank, “Board Update on Domestic Resource Mobilization and IFF” (Washington, 2017).
11 United Nations Conference on Trade and Development (UNCTAD)—United Nations Office on Drugs and Crime (UNODC) Statistical Task Force, “Conceptual Framework for the Statistical Measurement of IFF” (2022).
Originator Countries
8. IFF outflows negatively impact the macroeconomy of the originator country through impeding domestic revenue mobilization and public and private investment. The majority of global IFF originate from low-income countries (LIC) and fragile and conflict-affected states (FCS), 13 hindering domestic revenue mobilization, which in turn affects these jurisdictions’ ability to address their development challenges and to reduce their dependency on aid. Putting in place measures to mitigate risks of domestic laundering of proceeds of crimes and reduce IFF outflows can increase a country’s domestic revenue mobilization from taxes, especially those generated from goods and services. Significant illicit outflows can also distort originator countries fiscal position, asset prices, and reduce foreign reserves, resulting in significant development challenges. The impacts of IFF outflows are particularly acute in resource-rich and low-income FCS, which often face severe governance vulnerabilities and corruption, and IFF challenges that can stifle economic growth and development. Furthermore, illicit outflows have been found to have a strong negative effect on public and private investment rates14 in a country, depriving it of domestic resources required to foster robust long-term sustainable and inclusive economic growth needed to help reduce poverty.15 The African Development Bank (AfDB) noted that in Nigeria and Angola, for example, preventing IFF could have resulted in additional investment of US$10.7 billion and US$3.6 billion per year, respectively, in the period 2000 to 2008.16 According to this study, had illicit outflows from Africa been invested efficiently, their economic impact could have reduced the poverty ratio for the continent by an additional 4 to 6 percentage points.17
13 Kasper Brandt, “Illicit financial flows and developing countries: A review of methods and evidence,” Journal of economic surveys (2022). https://doi.org/10.1111/joes.12518
14 J.D. Nkurunziza, “Illicit Financial Flows: A Constraint on Poverty Reduction in Africa,” Association Of Concerned Africa Scholars Bulletin, 87 (2012).
15 Marc Herkenrath,“Illicit Financial Flows and their Developmental Impacts” (2014).
9. Resource-rich FCS are often most heavily impacted by illicit outflows. These countries face significant governance, corruption, and IFF challenges that can stifle economic growth and development. In sub-Saharan Africa and the Middle East, countries with a high share of oil and petroleum products in their total exports have been found to have higher levels of IFF. 18 The high-value, complex value chains and transnational ownership structures, high-level of discretionary political control, and difficultly of monitoring outputs within the extractives industries make the sector high-risk for significant IFF, through corruption, trade mis-invoicing (i.e., trade based money laundering (TBML)), and tax evasion. The heightened IFF from resource-rich countries impede the ability to use the resource revenues resulting from the extractive industries to support the development priorities of the country. In order to address IFF more effectively in the extractives sector, efforts have been made to produce official data on the size of IFF, including a pilot project aiming to identify the IFF through gold exports in Burkina Faso.19
Transit Countries
10. IFF can result in short-term economic benefits for transit countries but present also longer-term negative consequences risks. As outlined above, IFCs or smaller offshore centers may benefit from attracting IFF inflows through offering favorable tax regimes and quality professional services (neither of which are illicit), and financial secrecy and overly restrictive data protection rules (which are not in line with international standards). (See Box I.1 which discusses the role of OFCs and IFCs in facilitating IFFs). However, these transit countries can face longer-term economic impacts as they face pressures from countries and multilateral institutions to minimize global negative externalities of facilitating transit of IFF, notably if it is established that their system is not in compliance with international norms. Countries that pose risks to the international financial system, including those that are placed on the FATF grey list or the European Commission’s list of high-risk third countries, can face correspondent banking pressures, and increasing cost of payments critically on remittances. Being listed as a ML/TF high-risk country can impact a country’s cross-border trade and have a significant reduction in capital inflows. Grey-listed countries can also face reductions in access to development assistance.
16 AfDB, OECD, United Nations Development Programme, and United Nations Economic Commission for Africa, “African Economic Outlook 2012” (Paris: OECD, 2012).
17 Landry Signé, Mariama Sow, and Payce Madden, “Illicit Financial Flows in Africa: Drivers, destinations, and policy options,” AFRICA GROWTH INITIATIVE 2020 (2020). https://www.brookings.edu/articles/illicit-financial-flows-in-africadrivers-destinations-and-policy-options/
18 Natural Resources Governance Institute, ”Resource Governance Index 2021” (New York, 2021). https://resourcegovernanceindex.org/publications-data
19 UNCTAD, “First-ever official data on illicit financial flows now available” (Geneva, 2023). https://unctad.org/news/firstever-official-data-illicit-financial-flows-now-available
Destination Countries
11. The country where the IFF are integrated into the legitimate economy can also be negatively impacted, although the impact on these countries is less well understood and more difficult to measure. IFF destination countries can face distortion of the sectors targeted for integration of the criminal proceeds, notably banking and real estate, but often face bubbles and busts and reputational risks when scandals erupt. For example, Canada’s 2018 Article IV (AIV) consultation covered ML through the real estate sector and the country’s latest ML risk assessment acknowledges that illicit foreign funds have been used to purchase Canadian real estate.20 The United States Strategy on Countering Corruption recognized that illicit actors take advantage of the vulnerabilities in the United States and in the international financial system more broadly to conceal their illicit proceeds, noting, for instance, that the U.S. real estate market had become a significant destination for the integration of proceeds of illicit activity.21 The strategy highlighted the need to address gaps in the domestic AML frameworks to curb illicit finance. Similarly, in the United Kingdom, a report by Transparency International indicated that £4.2 billion worth of property owned in London has been bought by individuals and companies representing a high ML risk.22 The U.K.’s Foreign Affairs Committee assessed the impacts of illicit finance on the United Kingdom following the additional attention brought to the issue by the initiation of the war in Ukraine. The Committee noted that the United Kingdom’s role as a global financial center is damaged by its reputation as a destination for illicit finance and that the inflow of illicit flows can have consequences for the country’s national security and integrity of its institutions.23 Strong institutions and proper regulations coupled with effective AML/CFT frameworks can help minimize the macroeconomic impact on the integrity of the financial sector and the broader economy, and assist those countries to detect and disrupt those activities and recover the ill-gotten proceeds to the country of origin. Efforts to prosecute the perpetrators of financial crimes, confiscate and recover the ill-gotten proceeds are becoming more effective in countries of destination but they are still not commensurate with the size of laundered proceeds.24 This is partly due to the fact that the proceeds are already layered and far from the country of origin where the underlying crimes were committed which make the detection more difficult and the negative impact on the macroeconomy more diffuse, but also because destination countries are often focused on proceeds of crimes produced domestically and less so on cross-border financial flows from other countries. Finally, professional enablers (e.g., lawyers, accountants, real estate agents) continue to play an important role in facilitating IFF, notably when effective AML/CFT regulations and implementation are significantly lacking (Box I.1)
20 A survey of real estate advisors in Canada showed that plurality of real estate advisors reported purchase by foreigners of 25 percent or more of luxury properties (Royal LePage, “One in Four Real Estate Advisors Believe that 25 Per Cent or More of Luxury Properties Are Purchased by Foreign Buyers” (2016). https://www.royallepage.ca/en/realestate/news/one-in-four-real-estate-advisors-believe-that-25-per-cent-or-more-ofluxury-properties-are-purchased-by-foreign-buyers/). Risk assessment available at: Department of Finance Canada, ”Updated Assessment of Inherent Risks of Money Laundering and Terrorist Financing in Canada” (2023). Updated Assessment of Inherent Risks of Money Laundering and Terrorist Financing in Canada
21 White house, “United States Strategy on Countering Corruption” (2020), https://www.whitehouse.gov/wpcontent/uploads/2021/12/United-States-Strategy-on-Countering-Corruption.pdf.
22 Transparency International United Kingdom and Thompson Reuters, “London property: A top destination for money launderers” (London, 2023). https://www.thomsonreuters.com/en/press-releases/2016/december/foreign-ownershipof-london-property-shrouded-in-secrecy.html
23 The Foreign Affairs Committee, ”The cost of complacency: illicit finance and the war in Ukraine,” Second Report of Session 2022–23 (2023). https://publications.parliament.uk/pa/cm5803/cmselect/cmfaff/688/report.html
Box I.1. OFCs and IFCs and the Role of Professional Enablers
The role of OFCs and IFCs are critical puzzle pieces in any discourse on IFF. In its simplest form, an OFC is a jurisdiction where the bulk of financial sector activity is offshore.1 The broad scope entails significant diversity in the types of jurisdictions that could be categorized as OFCs, including advanced and emerging economies. The Fund has not maintained a classification of OFCs since 2008, when its OFC program was integrated with the Financial Sector Assessment Program. However, financial centers that exhibit the characteristics of OFCs have unique vulnerabilities to the flow of illicit funds and the creation of companies/trusts that are at risk of misuse for criminal purposes, which merit consideration in discussion of mitigation measures. IFCs, on the other hand, are large international full-service centers with advanced settlement and payments systems, supporting large domestic economies, which have diverse sources and uses of funds. The ill-gotten proceeds are often far from the underlying crimes when they transit or are integrated in other economies. They would have followed many routes of layering which would make the detection and re-establishing the connection to the original crimes more difficult for AML agencies.
OFC and IFCs present significant vulnerabilities to the transit and integration of IFF. Large financial sectors serving non-residents make OFCs and IFCs vulnerable to the passthrough of IFF or their final integration. Characteristics of some OFCs including financial secrecy, relaxed regulatory and tax regimes, and weak financial sector supervision can provide ‘efficient routes’ for the transit of IFF. IFCs are attractive destinations for IFF due to the size of the financial sector and the stability and strength of their domestic economies. IFCs with weak AML/CFT frameworks can be ‘magnets’ for IFF, attracting global illicit flows.
In addition to direct IFF routes, OFCs and IFCs may also have well-developed sectors providing ‘enabling’ services to non-residents, indirectly facilitating the transit and integration of IFF. Many OFCs and IFCs have large sectors providing specialist services to non-residents, including company formation, tax planning, accountancy, and legal services. Some of these sectors (especially lawyers, trust and company service providers, accountants) are identified as ‘enablers’ or ‘gatekeepers’ in that they provide services that can allow criminals to legitimize their illicit proceeds and thus gain access to the financial system and legitimate economy. Thus, even where there is no significant direct movement of IFF through these jurisdictions, the presence of large and underregulated gatekeeping sectors can indirectly facilitate IFF through the use of these services to legitimize illicit funds.
1 This includes centers where counterparties of the majority of financial institutions’ liabilities and assets are non-residents, where the transactions are initiated elsewhere, and where the majority of the institutions involved are controlled by non-residents.
24 Greater emphasis on implementation of a risk-based approach in the fifth round of FATF’s AML/CFT assessments could enhance attention on measures to mitigate risks of integration of IFFs in the destination countries.
Box I.1. OFCs and IFCs and the Role of Professional Enablers (Concluded)
Weak AML/CFT frameworks in OFCs and IFC have negative spillovers for global financial stability. Weak AML/CFT preventive controls and deficiencies in risk-based supervision in the financial sector in OFCs and IFCs can provide established pathways and preferred habitats for IFF. Weak AML/CFT frameworks for enablers can allow their abuse by illicit actors to legitimize illicit funds, indirectly helping the movement of illicit flows. These weaknesses thus have negative externalities for the rest of the world: they undermine other countries’ AML/CFT mitigation efforts by facilitating the flow and integration of illicit proceeds.
Global coordination actions would be key in addressing the role of OFCs and IFCs in enabling IFF. The provision of services to non-residents through oversized sectors (financial or specialist services) may be significant contributors to domestic GDP. Strengthening AML/CFT frameworks—for instance, through more intensive supervision of banks and related (incoming) cross-border flows and gatekeepers or increased transparency on beneficial owners of legal entities—may undermine the competitiveness of sectors seeking to attract non-resident activity, affecting the size of the financial sector and its liquidity, fiscal revenue, and growth. The medium-term impacts (including undue emphasis on the financial sector and adjacent services and the sidelining of other productive sectors) as well as their negative externalities for global integrity and stability remain understudied and under-accounted. To address those issues, the next round of FATF assessments could focus further on materiality and spillovers across jurisdictions resulting from those vulnerabilities. Furthermore, the Fund could highlight those vulnerabilities in FSAPs and both bilateral and multilateral surveillance of OFCs and IFCs, as necessary.
Other IFF Trends and Emerging Issues
12. The AML framework is currently underutilized in the fight against tax crimes and to improve tax compliance, and vice versa. While AML measures have already been deployed to improve tax compliance, including during the European debt crisis, the benefits that such measures could bring to the integrity of the tax system are yet to be fully realized, as set out in a recent working paper. 25 Notably, tax enforcement laws are equally useful in the fight against ML, including to support efforts to strengthen asset recovery frameworks.
13. TBML is another central way IFF are transferred, beyond all other regular channels for moving value. TBML refers to the process of disguising the proceeds of crime and moving value using trade transactions in an attempt to legitimize their illegal origins or finance their activities. 26 TBML occurs through the misrepresentation of the price, quantity, or quality of goods and services resulting on the movement of overvalued cross-border transactions. This can be conducted through over or under invoicing or shipment of goods and services, multiple invoicing of the same goods and services, or through falsely describing the nature or value of goods and services. The financial impact of TBML has been estimated as close to US$9 trillion in losses between 2008 and 2017 in developing countries.27 TBML can also provide unfair access to foreign currency in times of economic crisis. Importers could over-invoice the value of imported essential goods and services, so they get privileged access to scarce foreign currency held by the central bank, banks, and foreign exchange offices. When those trends become the norm for importers, such mis-invoicing could lead to foreign exchange (FX) shortages and manipulation of the FX and large spreads on the black market. The United States Financial Crimes Enforcement Network (FinCEN) also identified TBML as a vehicle for laundering significant illicit proceeds, including those resulting from drug trafficking and transnational organized crime. 28
25 IMF Working Paper advocates leveraging AML measures to enhance tax compliance, tackle tax crimes, and, in turn, help mobilize domestic revenues. See Emmanuel Mathias and Adrian Wardzynski, “Leveraging Anti-money Laundering Measures to Improve Tax Compliance and Help Mobilize Domestic Revenues,” IMF Working Paper No. 2023/083 (Washington, 2023).
26 Financial Action Task Force, “Best Practices on Trade-Based Money Laundering” (Paris, 2008). https://www.fatfgafi.org/en/publications/Fatfrecommendations/Bestpracticesontradebasedmoneylaundering.html
14. Although the key risks of IFF remain through the banking and broader financial sector, an additional emerging risk is the vulnerability of VAs to be exploited for IFF. While efforts have been made to introduce greater supervision and regulation of VAs, their high inherent ML/TF vulnerability, the uneven implementation AML/CFT measures by virtual asset service providers (VASPs), as well as regulatory arbitrage possibilities create opportunities for abuse of VAs.29 Criminals may choose to use VAs to transfer illicit funds due to availability of anonymous transactions with limited traceability and an opportunity to transfer value outside the formal banking system, potentially lowering the risk of being detected by financial institutions through the reporting of suspicious activities or by law enforcement authorities through their investigations.
Measurement
15. Several methodologies have been developed to measure IFF at the global and national levels. Measurement efforts were spurred, in part, by the adoption of the 2030 SDG, which includes a target on the reduction of IFF, 30 and calls for the measurement of global values on IFF. 31 Since then, UN agencies such as the UNCTAD and UNODC have developed a conceptual understanding and guidelines for the measurement of IFF, which have now been piloted in nine countries. This pilot program aims at identifying IFF on a sectorial basis. In certain pilot countries, this sectorial approach is focused on sectors of economic significance, including, for example, a program dedicated to estimating IFF in the precious metals and stones and electrical machinery and equipment sectors in South Africa. The hidden nature of IFF necessitates indirect approaches to measurement. Common methodologies include TBML mis-invoicing typologies (i.e., assessing the discrepancies between reported and true values of traded goods and services), capital account models (i.e., calculating capital accounts anomalies from IFF), offshore wealth models (i.e., deriving IFF from calculation of stock of undeclared wealth in low-tax jurisdictions), tax gap models (i.e., based on the assessment of difference between potential and actual tax collection), and integrated IFF measures32 (i.e., combining several models to increase accuracy). 33 A survey of existing measurement techniques by the UNCTAD/UNODC IFF Task Force broadly categorizes existing efforts into top-down and bottom-up approaches.34 The former comprises models based on inconsistencies in aggregated macroeconomic datasets, while the latter estimates IFF from relevant illicit activities (by IFF source) and aggregates these values to arrive at overall estimates. Top-down approaches have thus far been more prevalent, with common measurement techniques including estimates derived from discrepancies in imports and export statistics (mirror trade statistics) and net errors and omissions in balance of payment statistics (hot money method).35
27 World Economic Forum, “How trade-based money laundering works and its impact on world finances” (Geneva, 2021).https://www.weforum.org/agenda/2021/06/trade-based-money-laundering/
28 FinCEN, “Update on U.S. Currency Restrictions in Mexico: Funnel Accounts and TBML” (Washington, 2014). https://www.fincen.gov/resources/advisories/fincen-advisory-fin-2014-a005
29 Vitalii Rysin and Maria Rysin, ”Vulnerability of Virtual Assets to Illicit Financial Flows”, Economics, Entrepreneurship, Management. 2021, Volume 8, Number 1, pp. 35–42 (Lviv, Ukraine, 2021). Vulnerability of Virtual Assets to Illicit Financial Flows | Academic Journals and Conferences (lpnu.ua)
30 Target 16.4 calls for the significant reduction of illicit financial and arms flows, strengthening of the recovery and return of stolen assets, and combating of all forms of organized crime.
31 Indicator 16.4.1 is set as the total value of inward and outward IFF in U.S. dollars.
16. However, by nature, IFF present serious challenges to measurement, as highlighted by the wide range in existing estimates of IFF. Challenges stem from the temporality of IFF (illegality arising in different stages of the life cycle of the flows) and difficulty establishing linkages between the IFF and the underlying criminal activity. In particular, top-down approaches are hindered by the limited comparability for macroeconomic indicators due to variations in legal and statistical frameworks across jurisdictions and the challenges in distinguishing IFF from measurement inconsistencies. These limitations in measurement manifest in a significantly wide range in estimates of IFF and potentially inflated and misleading estimations of IFF.
17. The challenges in measurement signal the need for a shift towards bottom-up methods for measurement of IFF supported by national strategies. Micro-data for the measurement of IFF are held at the national level, albeit by a range of agencies, including customs, tax, law enforcement, and central banks, among others. National approaches to the measurement of IFF allow the tailoring of measurement to the data specifically available at national/sectoral levels. Recent efforts at developing measurements of IFF have put forth bottom-up measures, particularly to leverage micro-data held by national authorities: For instance, a recent pilot by South Africa with the OECD measured taxpayer data to estimate the stock of non-tax compliant assets held in IFCs and link them to preceding IFF. 36
32 UNCTAD, “Methodological Guidelines to Measure Tax and Commercial Illicit Financial Flows” (published draft for pilot testing) (Geneva, 2021).
33 In a 2019 Evaluation of existing models for estimation of IFF, Nicolaou-Manias categorizes prevalent models as trade mispricing estimates; shadow economy—tax gap models; capital and wealth models; international tax avoidance models; risk-based models; integrated IFF models; and artificial intelligence (AI) and machine learning models. See Kathy Nicolaou-Manias, “Supplementary Report: Review of Existing Indicators for Illicit Financial Flows and Possible Alternative Indicators for African Countries” (2018).
34 UNCTAD-UNODC Statistical Task Force, “Conceptual Framework for the Statistical Measurement of Illicit Financial Flows”.
35 A widely cited top-down measurement of IFF is one used by Global Financial Integrity which aggregates the results from two different methods, i.e., using global trade statistics and balance of payment statistics respectively to derive a total estimate of total IFF.
36 OECD, “Assessing Tax Compliance and Illicit Financial Flows in South Africa.”
C. Addressing IFF and the Role of the Fund
18. The AML/CFT international standards provide important tools to tackle IFF. Effective implementation of the FATF Standards has been fundamental to strengthening countries’ domestic measures against ML/TF, with particular focus on the risk-based approach as required by the standard. As the FATF focuses on the effectiveness of AML/CFT frameworks to tackle ML/TF, it would be important for staff to continue to focus on the impact of ML/TF and IFF on the broader macroeconomic outcomes, such as fiscal performance, financial and external sector stability, economic growth, and its sustainability and inclusivity.
19. Some issues related to countering of IFF are currently covered under the Fund’s policies on AML/CFT and on Governance. IFF can have macro-critical impacts in origin, transit, and destination countries across various dimensions of the Fund’s work as described above. In addition, as IFF cross borders to lower the probability of detection, asset tracing, and confiscation (e.g., regulatory arbitrage to utilize jurisdictions with the least effective AML/CFT regimes), they have a global dimension and are inextricably linked to global financial integrity and stability. Of high relevance to the Fund’s mandate, 37 IFF can lead to unstable exchange rates delinked from the economic fundamentals, imbalanced growth of international trade due to the distorting impact of TBML, as quantity and direction of goods traded is dictated by ML/TF typologies rather than business rationale. In addition, ML/TF concerns undermine trust in the global system of payments, leading to pressures on correspondent banking relationships (CBRs).
20. Staff developed a machine learning algorithm to monitor global cross-border payments to detect unusual and potentially suspicious patterns of financial flows. ML is a covert activity, and ML risks are difficult to identify and assess at the national level, especially when cross-border risks need to be considered. Historically, the Fund’s engagement has been mostly externally driven, based on countries’ mutual AML/CFT evaluations and other relevant assessments (e.g., OECD Global Forum, UNCAC), listing by the FATF and others, law enforcement actions and public information, which is mostly qualitative. The Fund’s access to cross-border payments data provides an important financial integrity tool for staff’s work. It allows for the analysis of financial flows patterns, identification of financial flows that are not explained by economic fundamentals (e.g., foreign trade in goods and services, portfolio, and direct investments) and exploring links with higher ML risk jurisdictions. An outlier detection machine learning algorithm relying on “big data” is being employed for financial integrity screening of cross-border financial flows and identification of lower and higher ML risk jurisdictions. The financial flows analysis toolkit is being used to prioritize AML/CFT-related surveillance engagement for a more data-driven and risk-based identification of jurisdictions where financial integrity concerns could be macro-critical. Staff’s analysis of financial flows from a financial integrity standpoint is intended to provide countries with early warnings regarding elevated risks of systemic ML, possible macro-critical financial sector frauds, corruption events, pressures on CBRs. or evolving tax crimes corridors. The objective of the early warnings is to make the Fund’s financial integrity engagement with its members more proactive, providing a detailed understanding of possible macro-critical risks that countries are facing, potentially allowing them to address emerging financial integrity issues much earlier, to limit economic damages.
37 The purposes of the Fund include: (i) to promote international monetary cooperation through a permanent institution which provides the machinery for consultation and collaboration on international monetary problems; and (ii) to facilitate the expansion and balanced growth of international trade, and to contribute thereby to the promotion and maintenance of high levels of employment and real income and to the development of the productive resources of all members as primary objectives of economic policy. The full list of purposes of the Fund are set out in Article 1 of the Fund’s Articles of Agreement.
Box I.2. Use of Financial Flows Analysis for AML in the Fund’s Workstreams
The results of staff’s toolkit for financial integrity screening of cross-border payments are being increasingly incorporated in all the Fund’s workstreams, and have informed the analysis and policy recommendations in:
Financial Sector Assessment Programs (FSAPs): FSAPs (AML/CFT Technical Notes) for the United Kingdom (2022) and Ireland (2022).
Surveillance: AIV for Curacao (2021), Singapore (2022), Malta (2023), Cyprus (2023), Lithuania (2022).
Use of Fund resources: Extended Fund Facilities for Moldova, Lebanon, and Armenia.
CD: Nordic-Baltic Constituency AML Project (self-funded); LEG Thematic IFF CD project.
Selected key recommendations and policy advice:
Deepen understanding of ML/TF higher-risk countries and payment patterns based on country specific risk factors and focus on the countries with the most material cross-border financial flows—Nordic-Baltic AML CD Report (2023)
Further improve breadth and depth of risk-based AML/CFT supervision through enhanced data collection, leveraging technology analytical tools (e.g., big data and machine learning)—United Kingdom FSAP (2022)
AML/CFT national policy and institutions should prioritize tackling ML/TF risks related to cross border and non-resident activity—Ireland FSAP (2022)
Develop a national mechanism for monitoring macro-trends in cross-border financial flows—Lithuania Selected Issues Paper (2022)
21. The Fund’s well-developed CD thematic work programs are directly relevant to combatting IFF. A multi-country thematic project on addressing IFF, leveraging staff’s machine learning toolkit was launched with the support of the Fund’s AML/CFT Thematic Fund in 2023, The CD project is intended to help members monitor cross-border wire transfers and strengthen AML effectiveness in mitigating cross-border ML risks. In addition, Fund’s CD engagement has also covered topics directly relevant to the measurement and combatting of IFF, including projects on assessment of cross border ML risks, supervisory strategies to mitigate ML risks, asset recovery, improving tax compliance, enforcement frameworks, and international cooperation and exchange of tax information, 38 among others. On measurement and estimation of IFF, the Fund has elaborated on accounting for illegal activity and IFF in its guidance on fiscal and external sector statistics. For instance, the Fund’s proposed framework for measuring the informal economy inter alia notes that some forms of illicit activity undertaken in the informal sector should be accounted for in the estimation of the informal economy.39 Statistics compiled by the Fund, for instance, are also widely used as the dataset in top-down estimations of IFF. 40 Fund’s work to strengthen members’ governance and enhance anti-corruption measures can be impactful in addressing a variety of economic crimes, preventing IFF at the source.
38 More work, including CD assistance, is needed to reap the benefits from exchange of information especially for developing countries. IMF Fiscal Monitor (April 2022) shows that many developing countries (also members of the Global Forum) are not receiving information.
22. Empowering AML regimes with a greater understanding of risks arising from IFF could also improve tax compliance and help mobilize domestic revenues. Well-designed AML measures could be leveraged for the purposes of tax administration. The AML measures that could be helpful in relation to ensuring tax compliance are the following: (i) greater utilization of customer due diligence (CDD) and transaction monitoring data that can help identify taxpayers, their taxable income, wealth, and assets; (ii) closer inter-agency cooperation and sharing of information between AML and tax authorities, including information available through the various statutory filings made by entities subject to the AML control regime that can support the detection of tax crimes, help assess risks of tax non-compliance, better target tax audits, and contribute to taxpayer risk profiling; (iii) recourse to enforcement tools available under the AML regime that could complement those already available to the authorities responsible for the pursuance of tax crimes, including through parallel ML and tax crime investigations and extending of the accountability framework to accomplices and complicit service providers; and (iv) increase in the overall deterrence effect resulting from the greater transparency, cooperation, and coordination, as well as the threat of potentially higher sanctions arising under the AML laws.
23. Strong beneficial ownership transparency frameworks can also help address the abuse of legal entities for IFF. Notwithstanding the obligation of financial institutions and designated non-financial business professions (DNFBPs) under the FATF standard to identify beneficial owners of their clients, the use of companies and trusts as a vehicle to move illicit funds is likely a significant driver of IFF, with an estimated almost 40 percent of all foreign direct investment passing through empty corporate shells associated with no actual economic activity.41 Several countries, including the United Kingdom and Canada have looked at strengthening beneficial ownership transparency to prevent the use of shell companies to purchase real estate using illicit funds. The FATF Standards for transparency of beneficial ownership of legal persons and arrangements (Recommendations 24 and 25) were recently revised, requiring member countries to ensure accurate, adequate and up-to-date beneficial ownership information is available to all relevant competent authorities. Supporting the development of these frameworks can ensure that member countries are able to better detect and counter the use of legal structures to move IFF or integrating them into the legitimate economy. The Fund has also called for the implementation of beneficial ownership registers as a measure to enhance tax compliance. 42
39 Gabriel Quiros-Romero et al., “Measuring the Informal Economy,” IMF Policy Paper No. 2021/002 (Washington, 2021). Measurement of the informal economy under discussion as part of the update of the System of National Accounts 2008 and the sixth edition of the Balance of Payments and International Investment Position Manual. This includes, in particular, the establishment of the joint informal economy task team to aid the development of statistical standards to conceptually and operationally define concepts to measure work and economic activity, including cross-border transactions, in the informal economy. See Joint Task Team on Informal Economy: Terms of Reference.
40 IMF’s Direction of Trade Statistics, Balance of Payment Statistics, Coordinated Direct Investment Survey, Coordinated Portfolio Investment Survey, International Financial Statistics, and International Investment Position Statistics are among those serving as datasets used in common IFF estimation methodologies.
41 Jannick Damgaard et al., “Piercing the Veil,” IMF Finance & Development. Vol 55, Issue 002 (Washington, 2018).
D. Way Forward
24. The Fund is well positioned to focus on the macroeconomic impact of spillovers arising from disparities and weaknesses in AML/CFT regimes across jurisdictions. Inefficient AML/CFT measures in one jurisdiction can attract illicit flows and create safe havens for the perpetrators of crimes. Considering the importance of cross-border activity for ML/TF, a risk-based approach to AML/CFT focused on IFF and macroeconomic impact calls for stronger focus on jurisdictions that play an important role in facilitating the channeling and integration of IFF in the international financial system.
25. The Fund could work closely with the UN, World Bank and other international bodies engaged in this area while focusing on its comparative advantage related to macroeconomic impact of IFF. While this paper focuses on the AML toolkit in tackling IFF, staff’s broader expertise on fiscal (e.g., tax policy), monetary, financial, and structural reforms could allow an interdepartmental integrated and multidisciplinary approach in developing better measurement and mitigating measures to limit the impact of IFF on both domestic and international levels (e.g., spillovers).
26. The Fund’s near universal membership puts it in a unique position to engage with member countries on issues related to IFF. The Fund undertakes regular economic surveillance of its 190 member countries, with periodic in-depth analysis into the stability of members’ financial sectors through its FSAPs. The Fund’s broad membership allows it to engage with countries (including source, transit, and integration jurisdictions for IFF), many of which are not within the purview of other international organizations undertaking work related to IFF, such as the OECD.
27. In its multilateral surveillance, the Fund focuses on issues that may affect the effective operation of the international monetary system (IMS), Under the Integrated Surveillance Decision (ISD), an AIV consultation is a vehicle for both bilateral and multilateral surveillance. In AIV consultations, staff could, in particular, discuss outward spillovers arising from a member’s policies where the member is not promoting its own domestic or balance of payments stability, or where the spillovers may potentially have an effect on global movement of IFF. Integration of IFF considerations in multilateral surveillance would result in an additional focus on spillovers across jurisdictions, also due to the effects arising from the member’s AML/CFT policies on other countries. The potential for abuse of vulnerabilities and loopholes is particularly high in emerging and advanced economies attractive to the integration of criminal proceeds and financial centers specializing on provision of non-resident professional and financial services, as ineffective AML/CFT policies in these countries provide ML opportunities for criminals from other countries.
42 IMF, “Fiscal Monitor: Fiscal Policy from Pandemic to War” (Washington, 2022).
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. Background
1 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
1 Paper prepared by Grace Jackson, Pierre Bardin, Indulekha Thomas (all LEG), and Antoine Bouveret (LEG consultant).
2 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.
3 Financial stability is defined as the ability of the financial system to facilitate and enhance economic processes, manage risks, and absorb shocks.
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).
4 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.
5 The review period corresponds to the period covered by the 2018 AML/CFT strategy review, i.e., 2018–2023.
6 Referred hereafter as financial integrity events.
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.
7 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).
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.
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.
8 This transmission channel could also be used when non-bank financial institutions part of a banking group face financial integrity issues.
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).
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. Köster 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.
Box II.2. 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).
9 For example, Iceland (2019 and Latvia (2019) AIV consultation staff reports.
Box II.2. Technical Assistance Case Study (Concluded)
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.
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.
Box II.3. 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
Box II.3. 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 (Continued)
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.
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.
1 Bank liquidity could also be impacted on the asset side, if financial integrity issues negatively affect the bank counterbalancing capacity though a fall in value (as in IMF, 2019) or, in an extreme case, if foreign banks counterparties stop interacting with the bank in some currencies, making the bank unable to mobilize its holdings of liquid assets in foreign currency to meet deposit withdrawals. In the case of ABLV, a significant amount of its counterbalancing capacity was in U.S. dollar bonds. However, after the publication by FinCEN of the draft measure to ban the bank from having a correspondent account in the United States, ABLV was unable to find counterparties to sell its U.S. dollar bonds to, making it unable to use its counterbalancing capacity to meet deposit outflows.
2 Other Financial Corporations is defined by the Financial Reporting Standards as “all financial corporations and quasi corporations other than credit institutions such as investment firms, investment funds, insurance companies, pension funds, collective investment undertakings, and clearing houses as well as remaining financial intermediaries and financial auxiliaries” (Annex V, Part 1, Paragraph 6, Article 35).
3 Substitution effects between banks are difficult to measure as other factors might play a role such as the presence of public banks (which are typically considered safer) or that some banks might be hesitant to accept inflows from clients of banks facing financial integrity issues.
Box II.3. 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 (Continued)
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.
Box II.3. 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 (Concluded)
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
4 Based on the pilot, deposit outflows were estimated at 7 percent based on information reported by large cross-border banks. Actual outflows could be higher: ABLV bank experienced deposit outflows of 23 percent in three days in February 2018. The calibration of deposits outflows for banks with similar exposures was obtained by applying outflow rates by types of deposits to the deposit structure of cross-border regional banks in the region in the country.
5 This calibration is illustrative as the results of the contagion analysis could also be used. In that case, shocks to other banks would likely by higher than in the example above.
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).
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.
10 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.
Research
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INDUSTRIAL POLICY COVERAGE IN IMF SURVEILLANCE
BACKGROUND PAPER III: RELEVANCE OF AML/CFT TO OTHER FUND POLICIES
