ECONOMICS OF ANTI-MONEY LAUNDERING REGULATIONS

Posted on : April 27, 2020
Author : AGA Admin

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Introduction

“Money laundering is the illegal process of concealing the origins of money obtained illegally.”^[i]

Thus, money laundering automatically comes into existence whenever there exists a given potential to turn any dormant source of purchasing power to an effective one.  The purchasing power from crime proceeds remains dormant because an increased spending means an increased probability of being caught by authorities.

In fact, money laundering is not new at all. The attempts to control proceeds from criminal proceeds trace its roots to colonial times and anti-money laundering efforts have seen sustained institutional responses from the prohibition era. (In famous Al Capone was caught by Tax Evasion only). Thus, the specific form that Money Laundering has taken might have varied through ages but the underlying idea remains the same: “cash from crime needs to be turned into usable assets.”^[ii]

Money laundering is undesirable because “it corrupts markets, shifts an unfair economic burden to the common man in the legal economy, and undermines the stability of international finance, apart from raising various civil liberty issues.”^[iii]

With Globalization, crime also has taken an international form and money laundering too has evolved to become an international operation. Thus, the decade of the 80s saw persistent efforts at a trans-national front to curb money laundering. This was undertaken to confiscate the proceeds of drug related cash streams.

As has been said before, Money Laundering is undesirable. So what are the prevalent schools of thoughts for Anti-Money Laundering (AML) activities?

The majority view is “going after the dirty money is the best way to tackle organized criminal activities.”

There exist three rationales for this.

• Hit the criminals where it hurts; that is target their incentive to commit crime; that is go after the money directly.
• Powerful criminals are difficult to nab because they maintain contact with their crimes however they are in constant contact with proceeds of their crime.
• Confiscation of the proceeds of crime is a ready made revenue stream for law enforcement.^[iv]

Thus there exists a direct correlation between the economics of money laundering and law & regulation of money laundering and this paper is an attempt to highlight this nexus between Money Laundering and its Regulation and the economic rationale behind such regulatory steps.

Theoretical framework of Anti-Money Laundering Regulations

We now know that a money laundering service is essential for criminals for criminals for carrying out their illegal acts. It is at this point a crucial agent is introduced in this crime cycle: The person who needs the clean money a.k.a (the money launderer).

It is the Money launderer’s goal to turn “dirty liquidity, coming from any criminal or illegal activity, into clean money that can be used without risk for consumption, saving, investment in legal sectors, as well as for new investment in illegal markets.”^[v]

Thus, whenever AML regulations are conceived, they all aim to target these agents of money laundering.

However, it is not as easy as it sounds as the development of AML regulations can be quite a costly affair due to repeated policy failures, and policy failures particularly among the following two axes:

• The risk of law enforcement weakness; and,
• The risk of capture.

The law enforcement weakness arises from the inherent lack of policy and investigative prowess of financial intelligence agencies. Thus, by passing AML regulations it becomes more incentivized and easier.

So does this mean the administrative financial agencies fare better?

It appears that the administrative delegation and administrative oversight for AML is quite prone to three main shortcomings.

• Regulatory Capture – This means that the more the financial authority will don administrative functions; the risks of capture by the regulated firms will also increase in proportion. This in turn will adversely affect regulation quality.
• Political Capture – This concerns politicization of AML authority by the agents of the incumbent government.
• Bureaucratic Capture – This means overshadowing the separation of power doctrine and risk of an over powerful AML regulator.

Thus any theoretical framework for evaluation of AML Regulations will involve the following four properties:

• Financial or information skills;
• Enforcement and investigative skills;
• Independence from politicians (top-down) & independence from the regulated firms (bottom-up); and
• ^[vi]

So we have identified that Money Laundering is undesirable and we have also zeroed in on the theoretical framework for AML regulations then what is missing?

Well for starters “a comprehensive economic theory regarding money laundering is still missing.”^[vii] This poses a difficulty as this restricts the economists to apply empirical models that can test behavior of agents under various conditions and this leads to various externalities and introduces several bypasses wherein the proceeds of illegal activities may be transformed into legal ones because of theoretical oversights.

An example of this has been expounded very succinctly as follows:

“The interaction with the perfectly legal financial or commercial instruments: launderers may ‘invest’ in stocks and shares, open savings accounts or purchase valuable art objects. While the launderer may be a criminal none of these activities are of themselves criminal acts, only becoming so by connection to another crime.” ^[viii]

 

In simpler words, in absence of a comprehensive economic theory, it gets introduced within the AML Regulatory framework the ‘Agency Problem’ which can be elucidated with the help of the following schematic.

 

Here exists an agency problem between Administration (Government) and financial Intermediary (Bank). Since the bank monitors all the transactions, it is the keeper of information. The informed bank then chooses to inform the government by filing a suspicious activity report.

But during this whole process the Government needs information from the bank to investigate the transaction which may or may not be money laundering. That is, the Government, it is dependent on its agent (Bank), and if the Bank rationalizes that not disclosing information is more profit maximizing then it can fudge records.

However, the Government incentivizes, by means of fines, for the bank to monitor and report suspicious transactions yet there exist loopholes.^[ix]

Thus, to sum up, a lack of comprehensive economic theory for Money Laundering leads to institutional oversights and negative externalities on one hand and Agency problem on the other.

 

Economic Perspective

As we have established, the economists’ interest in Money Laundering is not out of any happenstance or even a digression. Money laundering directly concerns financial loss and damage and criminal revenue and all of these are very tangible economic variables. And since we do not have a comprehensive economic theory for AML, Economists have applied both macro and micro approaches to money laundering.

At a macro level, attempts to quantify the overall volume of laundered funds have been made by international bodies like IMF, World Bank and the UN. One such estimate was “2.7% of global GDP or $1.6 trillion in 2009”^[x] However the rider is it impossible to produce estimates with any degree of credibility. In the end these all are just estimates (Guesstimates more correctly)

It is worthwhile to note that at a Micro level economic matters tend to focus on regulations considering costs and benefits to the regulated sectors with a particular focus on compliance.

Now before we elucidate more on the economic rationale of AML Regulations, it is incumbent to highlight a little bit upon the aspect of Rationality. “Rationality is a cornerstone of economics underpinning individual decision making. Homo economicus is assumed to have perfect knowledge not only of present but also of future risks and rewards and thus is able to make perfect decisions.”^[xi]

As mentioned in the introduction, it will not be wrong to assume that the criminal and his money launderer are both rational beings and only partake in crime because it pays. However launderer is more the brains behind this operation and thus he is more exposed to the economics of Money Laundering and thus is not at all immune to costs variations. Thus it can be assumed that the launderer will be considered a “rational cost-benefit calculator”.

So when this rational portion, covering prominent crime-lords and their financial backers, are subjected to a more effective regulation that has the effect of producing an increase in costs, these agents will be dissuaded to carry on these activities by undertaking a cost-benefit analysis.^[xii]

However, under this also there are different opinions. In reference to the public choice theory of regulation by Coase (19609) and Stigler (1964) –it is claimed that “regulation efforts can be either irrelevant or counterproductive.” Thus there is a need to constantly monitor and measure the effectiveness of regulations at hand.

Consistent with welfare economics, effectiveness of regulation can be measured using “Cost Benefit analysis”. However, in this endeavor it has to be kept in mind that costs reported will only be only those that are directly identifiable and will be mostly undervalued. This in turn can present a skewed picture where benefits will be dwarfing the perceived costs whereas the real costs might be greater. Thus, any discussion regarding the efficacy of regulatory intervention for curbing the menace of money laundering practically all the time is always complemented by the disclaimer that efficiency-measurement may not give satisfactory results. “And even if it were possible to accurately weigh up the benefits on the one side and the costs on the other, they do not sit on the same account. The benefit derived from anti-money laundering is a public good, much of the cost of regulation is a private cost that has to be internalized by the regulated institutions and passed through to their customers.”^[xiii]

Even Game Theory has been applied to the issue of “the lack of efficiency in AML regulations” For finding optimal conditions for banks’ compliance with money laundering regulation, principles of game theory states that regulated entities will look at the balance between the cost of compliance and the fine they will incur for noncompliance. Thus, the profit maximizing firm will invest in AML systems only up until the costs of their implementation just compensates the costs arising from sanctions for non-compliance. This flows from the principles of competitive advantage.

Conclusion

Money Laundering and its economics is a very vast field. Much has been written about it. When we talk of Anti-Money laundering regulations, it is an important topic of law and economics and even borrows from institutional economics.

This paper is extremely limited in its scope and only has tried to touch upon the key features and has tried to act as a starting point for further research. International AML regulations like those which gave rise to the Financial Action Task Force (FATF) have deliberately not been covered as they fall more within the domain of legal studies.

But even though these topics are not covered it surely can be drawn from this paper that in order to control Money Laundering, A convergence of multilateral and domestic initiatives that incorporate rigorous compliance monitoring systems is necessary.

 

Ishan Tiwari

(Ishan has done his graduation from UPES Dehradun and has a degree of integrated B.Tech + LLB. He is currently pursuing Masters in Regulatory Governance from Tata Institute of Social Sciences, Mumbai. Ishan has interests in the proactive disciplines of policy, regulation and strategy.)

Disclaimer: This document was originally Submitted to Dr Ganesh Munnorcode at Tata Institute of Social Sciences

^[i] Money laundering. (2020, March 16). Retrieved March 22, 2020, from                                                                           https://en.wikipedia.org/wiki/Money_laundering

^[ii] Chong, A. and Lopez‐De‐Silanes, F. (2015), Money Laundering and Its Regulation. Econ Polit, 27: 78-123. doi:10.1111/ecpo.12051

^[iii]Kumar, K. (2015). Functioning of anti money laundering legislation in India a critical study (Doctoral dissertation, The Tamil Nadu Dr. Ambedkar Law University).

 

^[iv] Kumar, K. (2015). Functioning of anti money laundering legislation in India a critical study (Doctoral dissertation, The Tamil Nadu Dr Ambedkar Law University).

 

^[v] Masciandaro, D. (1998), “Money Laundering Regulation: The Micro Economics”, Journal of Money Laundering Control, Vol. 2 No. 1, pp. 49-58.

 

^[vi] Bartolozzi, Diego and Gara, Mario and Marchetti, Domenico Junior and Masciandaro, Donato, Designing the Anti-Money Laundering Supervisor: Theory, Institutions and Empirics (December 10, 2019). BAFFI CAREFIN Centre Research Paper No. 2019-126.

^[vii] Unger, B., (2007), The Scale and Impacts of Money Laundering, Pg 32, Cheltenham, UK: Edward Elgar.

^[viii]Van Duyne, P. C., Harvey, J. H., & Gelemerova, L. Y. (2018). The Critical Handbook of Money Laundering: Policy, Analysis and Myths. Springer.

 

^[ix] Takáts, E. (2011). A theory of “Crying Wolf”: The economics of money laundering enforcement. The Journal of Law, Economics, & Organization, 27(1), 32-78.

 

^[x] (UNODC, 2011)

 

^[xi] Van Duyne, P. C., Harvey, J. H., & Gelemerova, L. Y. (2018). The Critical Handbook of Money Laundering: Policy, Analysis and Myths. Springer.

^[xii] Van Duyne, P. C., Harvey, J. H., & Gelemerova, L. Y. (2018). The Critical Handbook of Money Laundering: Policy, Analysis and Myths. Springer.

 

^[xiii] Truman, E. M., & Reuter, P., Chasing Dirty Money: The Fight Against Anti-Money Laundering, Peterson Institute Press: All Books.