Funding the Bad Guys – Winning the AML Battle

Traders may not think about the risk of terrorist networks and drug traffickers utilizing the regulated financial system to launder money, but from a societal perspective, this is likely the most important one faced by banks.

Experts estimate that billions of dollars flow through the banking system from such sources every year and thousands suffer as a result of the guns and drugs that the money buys. The largest ever penalty imposed on a financial institution by US regulators was $1.92 billion on HSBC in December 2012 for various anti-money laundering failures.

This followed a penalty imposed on Standard Chartered earlier in the year, Wells Fargo in 2010 and other ongoing investigations at other major US banks. Here we trace the origins of anti-money laundering regulations, why they have not always worked as intended and what can still be done to address these failures.

The Financial Action Task Force (FATF) was founded in 1989 by the G7 countries to counter the growing global threat of money laundering, efforts which gained momentum after 9/11. Under a framework established by the FATF, financial institutions globally, and many non-financial institutions, became obliged to identify and report transactions of a suspicious nature. A profession dedicated to building expertise and responsibility for oversight of AML controls grew as a result of the new regulations. Banks appointed Managing Directors to oversee AML compliance with teams under them responsible for day to day execution. Compliance officers were charged with account monitoring, identifying sources of funds for transactions. All activities of the banks from investment management, to derivative trading, to advisory, were all subject to the requirement to know the customer and know the source of funds. Additionally, anti-money laundering software was developed to filters customer data, classify it according to level of suspicion, and inspect it for anomalies. Any suspicious transactions were to be brought to management and a file reported with the government if management deemed it necessary.

[More News on Regulation: The CFTC Looks at HFT and Wash Trades, But Can They Prove It?.]

It is hard to say what impact these regulations have had in stymying terrorists and drug traffickers, but the implications of the recent settlements between banks and regulators are that it has not been not as much as one would have hoped.

First, it is clear from the investigations conducted by the United State Senate that banks have been severely resource constrained and have not always placed the most qualified staff in important roles in this area.

Second, banks have on occasion differed from the regulators in their judgment of what constitutes a country of high risk. HSBC, for example, apparently identified Mexico as a country of low risk for money laundering between 2000 and 2009, in contrast to the State Department’s own assessment at the time. That assessment meant that transactions emanating from Mexico were not subject to special surveillance.

Third, investment banks and asset managers have at times got into sloppy habits and cut corners, for example, by allowing customers to defer production of documentation per AML requirements from the time they open the account to the time they close it. Leaving it to the time they close the account, if indeed, they ever do, is too late. Fourth, reliance is often placed by traders, hedge funds and asset managers on third parties, such as brokers and outsourced compliance officers to meet the requirements banks and asset managers have to meet under AML regulations.

So how to better mitigate this risk? First, training and education is key. Too often banks and asset managers simply view AML requirements as overhead. They need to educate staff to better understand the reason for the controls and the consequences of failing to implement them effectively, i.e. the damage wrought by terrorists and by drugs on real people.

Second, banks should use better judgment and professional tools to determine the risk and then use efficient ways to monitor for it. This likely means employing staff with expertise in country risk, international relations and international law enforcement. Greater familiarity and passion for understanding the way that international networks move their funds around the globe will help better tailor an effective response to stop them.

Third, armed with this expertise, invest in analytical tools and software to leverage Big Data to detect more quickly potential networks and suspicious patterns of money movements and link together apparently un-linked accounts.

Fourth, indicators of suspicion, rather than risk indicators, will be important in re-tooling the effort to combat these international networks. This means owning an integrated platform that can read across silos and regions.

Fifth, being successful in this battle will also require greater cooperation between banks and law enforcement. Having in Mary Jo White at the SEC, an enforcement official who understands the nexus between drugs, terrorists and financial institutions as well as anybody in the United States should help facilitate that.