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Hinnerk Gnutzmann Killian McCarthy Brigitte Unger Dancing with the Devil A Micro-Theoretical Study of Transnational Competition in Money Laundering

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Outline Policy Competition and AML Policy Sources of demand for money laundering Incidence of social cost of laundering Focus on a transnational setting: "Seychelles Strategy" Models of Masciandaro and Portolano (2004) Unger and Rawlings (2005) Extension: Competition with heterogenous cost Conclusion

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The Case for AML Policy Crime is harmful and costly, reducing it raises social welfare Means in a Beckerian framework Increasing the duration of the penalty Increasing the risk of capture Reducing the Profitability of Crime AML policy: focus on the latter two

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AML and the Supply of Crime AML aims to prevent proceeds of crime from being used in 'white' economy Consequences 'dirty' and 'clean' money are not perfect substitutes Criminals are willing to pay to 'clean' their funds Adverse supply shock to criminals Definition of ML for our purposes Service that converts 'dirty' money to 'clean' state E.g. by masking source/destination of funds, identity of owner

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AML: The Transnational Dimension Unger and Rawlings (2005): "Seychelles Strategy" Small island nations are incentivised to lower financial transparency, and to attract the proceeds of crime. The incidence of crime can be seperated from laundering profits Small countries tend to get smaller shares of laundering crime Adapt Sinn (2004) model on tax competition Core Analysis: N-country Cournot game Identical countries Captures strategic interaction, but not heterogeneity of social cost

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AML: Transnational Effects II Masciandaro and Portolano (2004): "Laxity Problem" Focus on trade-off of individual policy maker Constant benefit per dollar laundered Costs International reputatation Rise in crime/terrorism Incidence and severity of international sanctions Framework: expected utility maximisation Captures heterogeneity of countries, but not strategic interaction

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AML: This paper Derive demand for money laundering directly Countries can profit from money laundering Strategic interaction through N-country Cournot game In a transnational setting, adverse shocks hit unequally Smaller countries less affected Capture intutions in a simple model

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Criminal Production Technology Without ML, criminal can recover zero profit by assumption Profit-seeking production only takes place if ML is possible ML is an essential input to crime production Express this idea through a Leontief production function: - Money Laundering as an input - "Labour" as a composite input

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Demand and Supply of Criminal Goods Constant Returns to Scale Industry supply function: N countries, with world population share s_i each Consumers' utility is quasilinear and identical Aggregate (world) demand for crime by summation:

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Crime and Money Laundering Policy World crime output: Direct effect of laundering cost on crime Crime consumption in each country proportional to population share (identical consumers) Derived world demand for money laundering:

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Why Compete for Criminal Money? Laundering is potentially very profitable Funds only need to be 'relabeled' If stance in other countries is strict, criminals have high WTP Price of Laundering: Measure of how easily criminal and clean money can be substituted Simplifying assumption: laundering reveneue enters SWF directly Social cost of crime: proportional to quantity of crime Govnt only considers social cost of domestic crime

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Reaction Function Laundering Revenue Domestic crime cost Reputation/ Diversion effects

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Analogy to IO models Cournot competition with heterogenous cost Smaller countries have lower marginal cost, produce more Q(Rest of World) q Smaller country

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Aggregate Crime/Money Laundering Nash Equilibrium: World Money Laundering Output independent of size distribution in this class of models Aggregation problem: Smaller countries launder more, but reduce laundering by larger ones Instance of result from Varian and Bergstrom (1984) Require "beggar-thy-neighbour" for non-neutrality

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Laundering: Transnational Dimension Laundering externality: too much laundering takes place (with N>1 country) If AML policy in one country is successful, others will increase their production Reaction function downwards-sloping (strategic substitutes) Aggregation Problem

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Difficulty of AML policy Socially efficient quantity of crime equals "cartel soluton" Difficulty of sustaining cartel under heterogeneous cost (Scherer 1980) Co-ordination problems Small countries have greater incentive to deviate Difficulty of retalliation against low-cost firm (alleviated through international sanctions)

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Conclusion I Financial Transparency is a global public good Can be undermined by a single country Containing criminal activity "Lax" regulation corresponds to free-riding Need to understand the incentives of policy- makers to be lax or strict

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Conclusion II Incidence of crime can be separated from laundering profits Asymmetric costs of laxness Small countries benefit more Resembles Cournot competition with heterogeneous firms Difficulty of sustaining co-operation Aggregation problem: Do LFRs crowd out laundering elsewhere? Future research Other market structures (especially Bertrand competition) Repeated game effects