Money laundering is practically as old as organized crime. The term “laundering” alludes to the Mafia’s 1920s practice of moving money through laundromats, which served as fronts for their criminal businesses. It also references the process of making “dirty” money “clean.”
Today, money laundering refers to any process that obscures the source of funds. Money laundering is typically composed of three steps:
- Placement: illegally-obtained funds are directly deposited in banks, which introduces them into the financial system
- Layering: the funds are converted to other forms or moved to other institutions to separate them from their criminal source—mixing the money, so to speak
- Integration: the funds are used to purchase assets to move them into the legitimate economy
Somewhat unsurprisingly, economists have a hard time pinning down exactly how much money is laundered every year. The United Nations Office on Drugs and Crime published a study that estimated that in 2009, criminal proceeds amounted to 3.6 percent of global GDP, with 2.7 percent—or $1.6 trillion—being laundered.
What is anti-money laundering?
Anti-money laundering—more commonly referred to by its shorthand, AML—is a system of controls to prevent, detect, and report the above money-laundering activities. AML comprises the three F's: finding, freezing, and forfeiture of criminal assets.
The seminal anti-money-laundering rule is probably the Bank Secrecy Act, which was established in 1970 and lays out requirements to identify the source, volume, and movement of currency transported into or out of the United States or deposited in financial institutions. It also requires banks to:
- report cash transactions over $10,000
- identify people conducting these transactions
- maintain paper trails
The BSA is overseen by the Financial Crimes Enforcement Network, or FinCEN. Since the mid-80s, updates and complements to the BSA have been passed every couple of years—the most famous of which may be the Patriot Act of 2001.
In 1989, the G7 formed the Financial Action Task Force, creating an international framework of anti-money-laundering standards. FATF has developed 40 recommendations on money laundering and 9 special recommendations regarding terrorist financing. In 2000 and 2001, FATF started publicly calling out countries that were deficient in their anti-money-laundering laws.
What does AML do in practice?
In theory, anti-money-laundering laws apply only to a limited number of transactions and criminal behaviors. But in practice they touch nearly every aspect of a bank’s relationships with its customers. The onus is on the institutions themselves to detect and prevent illicit transactions, which can in turn lead to a litany of requirements on the consumer’s part.
For example, financial institutions are supposed to verify each customer’s identity, monitor his or her transactions, and report suspicious activity, like sudden, substantial increases in funds or withdrawals. It’s all part of a suite of rules termed “Know Your Customer.” Here, knowing one’s customer means not only knowing the identity of the customer, but also understanding his or her typical transactions and behavior.
The link between money laundering and terrorist financing
More recently, more than anything, modern anti-money-laundering laws have focused on combating the finance of terrorism, or CFT.
In part, that’s because the techniques used to launder money are essentially the same as those used to mask the sources of terrorist financing. Both often exploit the same vulnerabilities in financial systems. Terrorist financing, in fact, may originate from legitimate sources, but these are disguised in order to remain available for future financing activities.
CFT efforts also require countries to consider expanding the scope of their AML framework to include non-profit organizations, particularly charities, to make sure such organizations are not used in any way to finance or support terrorism.
AML is expensive—but is it effective?
For financial institutions, anti-money laundering is an expensive business. Larger institutions reportedly spend hundreds of millions annually to prevent money laundering, and according to a study by the Financial Times, total compliance costs can reach several billions for some banks. These costs affect smaller financial institutions, too: A recent American Bankers Association survey found that these banks had to reduce their product offerings in order to comply with stiff regulations.
The cost—and the privacy implications—of AML have led to a certain amount of controversy from groups like the American Civil Liberties Union. The very nature of laundering makes it difficult to analyze the effectiveness of various anti-money-laundering requirements; this, in turn, makes it difficult to justify the lengths banks must go to monitor their customers.
Turmoil in the financial sector often creates opportunities for illicit behavior—including periods when financial institutions let down their guards. In 2009, the former chief of UNODC, told The Observer that “in many instances, the money from drugs was the only liquid investment capital” available to some banks at the height of financial crises.
The consequences, though, have been steep. In 2012, HSBC was fined a record $2 billion for allegedly abetting criminal activity by failing to prevent laundering. More recently, the bank has been fighting to prevent publication of a report on how it complies with money-laundering rules.
In the face of such red tape and fines, it’s can be easier for banks to withdraw entirely from certain markets or practices, like remittances. AML rules, then, often disproportionately impact the poor. Cutbacks on remittances leave families unable to send money back to loved ones in other countries, and the documentation requirements like those imposed by AML rules often deter people from participating in the financial system, according to a recent World Bank study.
But AML isn’t going anywhere—if anything, it will become further codified as part of the system. Wider adoption of analytics models and new technologies should help reduce the costs and improve the accuracy of these defense mechanisms.