KNOW YOUR CUSTOMER TO PROTECT YOUR ORGANIZATION’S EXPOSURE TO MONEY LAUNDERING

WHITE PAPERThomson Reuters September 2015

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Money Laundering

IS YOUR ORGANIZATION PROTECTED?

WHY MONEY LAUNDERING?

Like it or not, criminals are people, too. They have bills to pay like everyone else - cell phone, electric, heat, and water - and they like to buy nice things – a new home or a car of which they ’ve dreamt. Instead of obtaining these goods through legitimate means, they either obtain their funds through an illegal activity, or, they deliberately hide their wealth to avoid paying taxes or alimony.

While there are many methods of transforming illegal funds into legitimate currency, from using digital currency such as Bitcoin to trading goods and commodities, the most commonly detected scheme used by unsophisticated money launderers to move large amounts of paper currency is called smurfing, according to Dawn Scalici, Government Global Business Director, Thomson Reuters. This process involves eluding the $10,000 currency reporting Rule of the Bank Secrecy Act by breaking a large sum of illegal cash and depositing small amounts in one or more accounts with various financial institutions. Drug cartels often employ a group of people, often referred to as “mules,” to deposit cash in multiple accounts throughout a city or region to spread their risk of being detected.

regulations and rules, which increasingly place higher economic costs on today ’s financial organizations.

“Money laundering is all about ‘squeezing the balloon,’” said Brett Wolf, senior money laundering correspondent with Thomson Reuters Risk Management Solutions. “When regulations tighten in one part of the industry or in a specific country…the money flows to the path with the least resistance.”

Money laundering has become so rampant and woven into the fabric of our world’s economy that the United Nations Office on Drugs and Crime (UNODC) estimated in 2009 that criminal proceeds amount to approximately 3.6 percent of global gross domestic product (GDP).

And it’s not just about cleaning illegal drug money anymore. Today, hiding money to avoid taxes or to shift money into investments in other countries represents a large chunk of illegal activity as well. In China alone, about $1.08 trillion in currency was exchanged illegally between 2002 and 2011, despite the country ’s currency control laws that require a permit to exchange more than $50,000 a year worth of yuan into any foreign currency (Business Insider).

While money laundering has been around for decades, efforts to curb its impact have grown in response to the 9/11 terrorist attacks, as Western governments have fought to stem the funding of terrorism. After a year-long investigation, the U.S. Senate issued a report in July 2012 about the lax anti-money laundering (AML) efforts of an international banking operation based in London. It was discovered that the company ’s operations in the United States had laundered billions of dollars in Mexican drug cartel funds, as well as funds linked to terrorist operations in Iran, Pakistan and Bangladesh.

At its essence, the act of laundering money is a shell game. Its greatest constraint is the process of moving and eventually transforming paper currency into useful forms of legitimate digital funds. Any number of illegal activities, such as fraud (e.g. insurance, healthcare, mortgage, government, securities and commodities) illegal gambling, prostitution, Ponzi schemes, public corruption, or drug trafficking can serve as the source of illegally obtained funds. While drug lords tend to earn the most headlines, money laundering is also prevalent at the neighborhood level. Someone who might otherwise be seen as an average, “upstanding” neighbor, could be embezzling funds from their business, church, or youth athletic association.

As the impact of money laundering continues to grow, the one constant that all financial institutions, big and small, can count on is new and revised AML

“...the money flows to the path with the least resistance.”

—Brett Wolf, Thomson Reuters

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Money Laundering

Sophisticated money laundering operations employ a wide range of strategies to move large sums of currency through the world’s financial systems undetected. In a 2013 report from the United Nations’ Office on Drugs and Crime, the most commonly employed vehicles included digital currency (e.g. Bitcoin, Paymer, PerfectMoney), online gaming, work-from-home schemes, and online mule schemes (MIT Technology Review, Oct. 18, 2013). Similarly, in a February 2015 article, Business Insider reported wire transfers to bank accounts established in other countries still remain the most popular form of money laundering for Mexican drug cartels. Ultralight aviation (such as drones) has even been employed to fly drugs and cash across the Mexico border to “mules” waiting on the U.S. side. Overall, it is becoming more difficult to detect this level of money launderer, notes Scalici.

“Sophisticated money launderers are not only more technology savvy, they’re patient,” adds Jason Thomas, Manager of Innovation for Thomson Reuters, “And that’s

what gives them their edge. They employ a risk-based mindset to reduce their risk of detection – not too dissimilar from large banks and financial institutions that leverage technology to reduce their risk of financial exposure to money launderers.”

However, because greed often trumps patience, the majority of money launderers are often tripped up by mistakes they make in their urgency to clean funds. The advantage goes to financial institutions that make investments in technology, such as investigative software, and hire experienced individuals and teams that can help them better detect and investigate money laundering activity.

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THE THREAT OF MONEY LAUNDERING

Financial institutions are constantly walking a tightrope in their efforts to confront money laundering. Every day, they deal with questions such as:

• Should we place more emphasis on fighting organized crime versus the local businessperson engaged in embezzling?

• As a small bank, how much can we invest in AML compliance technology and human resources to monitor money laundering activity?

• When we’re audited, will our efforts to prevent money laundering pass the audit?

And then there is the topic of de-risking, which speaks to a greater challenge faced by financial institutions: how does an entire organization institutionally reduce its risk to money laundering? Banks and other financial institutions are required by law to establish policies and systems to proactively identify money laundering risks, as well as procedures to manage and report those risks to bank regulators. After a financial institution invests in the technology, staff and training to prevent and investigate money laundering, what more can it do?

The answer, based on the action of some organizations, is to deny service to high-risk customers, whether they are individuals or commercial enterprises. For example, if a

financial institution determines that serving as the bank for payday loan companies, money exchange services, marijuana businesses, virtual currency businesses or businesses in neighborhoods known for drug trafficking, why not simply avoid offering their services to these types of businesses?

Facing these various levels of uncertainty, some financial institutions have shifted to a strategy of de-risking – denying service to specific customers, or to an entire category of customers, such as money transmitters and charities, which pose a high risk of money laundering.

Wholesale de-risking takes that a step further – it’s like putting a sign on the front door of your bank that says: “Payday loan companies need not apply.” The practice of de-risking has come under the scrutiny of financial regulators.

In February 2015, the Federal Deposit Insurance Corporation (FDIC) issued new guidance to FDIC-supervised commercial and savings banks with total assets of $1 billion or less to take a “risk-based approach in assessing individual customer relationships rather than declining to provide banking services to entire categories of customers without regard to the risks presented by an individual customer or the bank’s ability to manage the risk.”

The intent of the “warning,” according to AML experts, is two-fold: to prevent riskier businesses, such as

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KNOW YOUR CUSTOMER (KYC) IS THE KEY

Gathering more extensive data and looking for red flags such as an offshore bank account are just the first steps to reduce a financial institution’s risk to money laundering, said Lauren M. Sparks, CRCM, CAMS, AAP, President of Third Party Resources, Inc. Even the SEC noted that FINRA Rule 3110(e) represents a minimum bar, and that additional, in-depth research may be required based on the applicant’s role (CEO, CFO, controller, etc.), responsibilities and position at a financial institution.

Sparks says that financial institutions must go beyond the data that allows them to know their customer (KYC) and actually get to know them even better.

While KYC requirements may differ between jurisdictions and regulatory regimes, f inancial institutions are generally required to collect information about each customer. Regulators expect client information to be maintained in order to remain current and valid, which implies that financial organizations need to actively monitor the activity of its customers. Financial institutions understand that failure to collect and maintain this data can lead to fines and penalties during a regulatory audit.

However, as Sparks points out, there is no certainty when it comes to criminals. Whether an organization has invested in state-of-the-art due diligence software or not, criminal elements are a moving target. Constant due diligence of customers in the name of KYC could become cost prohibitive for some financial institutions, especially small community banks and money services businesses.

“The key is to apply an investigative mindset to your traditional KYC approach,” said Sparks. Take a proactive approach to identify the gaps in your system, which includes asking the question: “How can we know our customers better?”

“The rules are written to protect the integrity of financial institutions and the entire financial system,” Wolf adds.

“To catch money launderers, financial companies need to think outside the norms.”

For example, to reduce their risk, small banks could concentrate on small-time drug dealers who are notorious for using family members and friends to put illegal gains into a dealer’s accounts. In some parts of the country where healthcare fraud is rampant, small banks and credit unions should embrace extra due diligence on small health care providers with whom they have a current banking relationship. Due diligence efforts also should extend to public record searches on all company executives and directors.

“Many financial companies already feel like they ’re spending way too much money to follow customers who look suspicious,” Wolf added. “New technology that allows financial institutions to see the network of people behind an account can help an organization vet high risk clients and reduce their risk.”

However, new rules proposed by the U.S. Treasury Department’s Financial Crimes Enforcement Network (FinCEN), may provide the tipping point for financial institutions to invest in new software technology to ensure compliance with U.S. regulators.

Currently, FinCEN rules seek to strengthen customer due diligence requirements under the Bank Secrecy Act. Financial institutions are required to identify persons behind commercial customers (legal entities). The rules (Federal Register, Vol. 79, No. 149) would require four levels of due diligence:

1. Identify and verify the identity of customers;

2. Identify and verify the identities of the beneficial owners of a legal entity;

3. Understand the nature and purpose of customer relationships; and

4. Conduct ongoing monitoring to update customer information and identify suspicious transactions.

“Here’s the truth: money launderers go to where they spot pockets of least resistance,” Sparks said. “Because of these regulations, smaller financial institutions will be

international payment services, from being completely shut out of the financial system, and to send a signal to banks that their AML compliance systems and controls must be consistently strong across all lines of services.

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targeted by money launderers more than larger institutions because they are perceived as not having the budget to invest in the investigative software technology needed to meet the intentions of the newly proposed rules.”

AML experts agree that financial institutions need to be more proactive in reducing their exposure to money laundering. Here are some specific suggestions on what financial institutions should consider in the weeks, months and years to come:

Non-Traditional Banking Must Invest More in KYC – The process of banking is rapidly changing. Opening up accounts can be easily handled online as well as over a mobile device, which means financial institutions aren’t necessarily getting to know their customers on a personal level anymore, noted Sparks. Many banking customers are eschewing banks altogether, using money transfer services and nonbanks (e.g. Amazon, Google, PayPal, Square, ThinkFinance, Wonga, Walmart) to conduct financial transactions. Non-traditional financial institutions must be prepared to employ the resources needed in terms of staff, technology and systems. This will help them to know their customers and will also help to build trust among traditional banks and regulators.

Invest in technology – While many banks and financial institutions have invested heavily in new AML technology, according to Sparks, “there are many financial institutions, in particular small banks and local credit unions, that are a step behind. Smaller institutions need to strike a balance between keeping pace with criminal elements and investing in the latest technology to handle the resolution of money laundering alerts.”

Prepare for digital currencies – While talk of digital currencies has faded from front pages, a growing number of small businesses are becoming open to alternative currencies, such as Bitcoin. Smaller banks, which tend to service small businesses, need to take proactive steps in their policies toward businesses that conduct transactions with digital currency, including due diligence to identify risk exposure.

NEXT STEPS: FIGHTING MONEY LAUNDERING MORE EFFECTIVELY

Dig deeper into commercial customers – Where applicable by law, Thomas recommends that financial institutions dig deeper when reviewing commercial accounts. “Look more closely at the people involved in the business,” said Thomas. “It’s so easy to set up a business in the United States. Many money launderers use front corporations to funnel their illegal funds.”

CONCLUSION: KNOWING YOUR CUSTOMER BETTER IS THE ANSWER

If the DNA of the money launderer is to seek the path of least resistance, then today ’s financial institutions must put up more barriers to reduce the ease with which money launderers can access currency systems. Financial institutions will continuously wrestle with questions such as: How much and where? Which resources will gain the greatest ROI? And, which investments will best help us meet the ever-evolving changes in AML regulations and rules?

Investments in staff, technology and systems to increase an institution’s knowledge of their customers is a more prudent choice than wholesale de-risking entire groups of customers or geographic markets.

It’s a mindset in which financial institutions must go beyond collecting the regulated data, to one in which strategy and creativity come together in anticipation of where the money launderers will go next. In other words, ask not what the paths of least resistance are today, but what will be those paths will be tomorrow.

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© 2015 Thomson Reuters

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• “One More Money Laundering Problem for Banks to Worry About,” Skinner, Peter, American Banker, March 3, 2015.

• “FCA: Effective Anti-Money Laundering Strategies Should Not Include Wholesale Derisking,” Out-Law.com, April 28, 2015.

• Interview, Brett Wolf, Senior Money Laundering Correspondent, Thomson Reuters, Risk Management Solutions, May 2015.

• Interview, Jason Thomas, Manager of Innovation, Thomson Reuters, June 2015.

• Interview, Lauren M. Sparks, CRCM, CAMS, AAP, President, Third Party Resources, Inc., June 2015.

• Interview, Dawn Scalici, Government Global Business Director, Thomson Reuters, September 2015.

• Federal Register, Vol. 79, No. 149, Aug 4, 2014, page 45152.

SOURCES

Thomson Reuters offers small, medium and large financial institutions a full suite of investigative solutions to conduct new account due diligence, monitor high-risk accounts, and conduct money laundering investigations. To find out more, visit legalsolutions.thomsonreuters.com/law-products/solutions/clear-investigation-software.

AML SOLUTIONS FROM THOMSON REUTERS

Money Laundering