AML/CFT Regulation

Executive Summary

Across the world, new measures are being introduced to combat money laundering and the financing of terrorism. All financial service providers, including those working with low-income communities, are - or will - be affected by these measures. This paper summarizes the implications of the international framework for anti-money laundering (AML) and combating the financing of terrorism (CFT) for financial service providers working with low-income people.

While each country may adapt the international AML/CFT standards developed by the Financial Action Task Force (FATF), in general financial service providers are required to:

• enhance their internal controls to cater specifically for AML/CFT risks;
• undertake customer due diligence procedures on all new and existing clients;
• introduce heightened surveillance of suspicious transactions and keep transaction records for future verification; and
• report suspicious transactions to national authorities.
  

Source: Jennifer Isern, David Porteous, Raul Hernandez-Coss, and Chinyere Egwuagu, https://openknowledge.worldbank.org/bitstream/handle/10986/12495/689230BRI0P1160ome0People0July02005.pdf?sequence=1&isAllowed=y
This work is licensed under a Creative Commons Attribution 3.0 IGO License.

Introduction

Since September 11, 2001, the introduction of measures to combat money laundering and the financing of terrorism has taken on new urgency for international agencies, governments, and financial service providers. Implementing these new regulations can present particular challenges for financial institutions serving low-income clients.

As recent fines and sanctions levied on banks in the United States have shown, the economic and financial impact on institutions that fail to comply with the requirements of the law can be devastating. Even the perception of having inadequate controls to prevent money laundering can damage an institution's reputation. Hence, it is important for financial institutions to develop internal controls to protect themselves from exposure to money laundering and the financing of terrorism and to comply with regulations. The Financial Action Task Force on money laundering (see box 1) has developed international standards on AML/CFT. Within this comprehensive, general framework, individual countries are responsible for introducing local legislative and regulatory regimes.

AML/CFT regulations can have serious implications for financial institutions that serve low-income clients, especially in developing countries. The additional costs of compliance and tighter restrictions may have the unintended consequence of driving low-income clients from the formal financial sector. The challenge is to strike a balance that promotes prudential practices at a reasonable cost for financial service providers that want to offer services to less well-off clients. AML/CFT regulations should be implemented in a flexible way to ensure that they do not restrict access to formal financial services for low-income people.

All financial service providers dealing with financial transactions, including those working with low-income clients are required to comply with AML/CFT regulations. The universe of financial service providers that serve low-income clients includes specialized microfinance institutions, commercial banks, financial cooperatives and credit unions, low-capital rural and/or local banks, state development and agricultural banks, and postal savings banks and other postal financial sevice providers. These institutions can be classified as more or less risky based on the financial services they offer.

Box 1  Financial Action Task Force and FATF-Style Regional Bodies

AML/CFT - Why Is It Important?

Money laundering and the financing of terrorism can damage national financial systems. Illegitimate financial holdings, assets, and enterprises are unreliable sources of investment capital for sustainable economic development. Among other effects, money laundering destabilizes national economies by increasing the demand for cash, increasing the volatility of interest and exchange rates, and even contributing to higher inflation.

Developing and transition economies strive to become reputable members of the global payments network to increase their ability to access capital flows, and consequently work to conform to international codes to combat abuse of this system. Countries with weak enforcement of AML/CFT controls could damage their reputations in international financial markets, and thus may not attract international flows such as foreign direct investment and/or donor funding.

Countries therefore have a public policy interest in making sure that their AML/CFT regime is comprehensive and appropriately includes financial service providers working with low-income clients. Likewise, these institutions have an interest in protecting themselves from the adverse effects of being involved, or even the perception of being involved, in money laundering and the financing of terrorism.

FATF Recommendations on AML/CFT for Financial Service Providers Serving Low-Income Clients

FATF recommendations provide guidance on what actions institutions should implement internally to reduce the risk of money laundering and financing of terrorism, such as customer due diligence, record keeping, and reporting. In order to maintain a reasonable standard of AML/CFT compliance, countries are advised to adopt measures in proportion to the potential risk of money laundering and the financing of terrorism.

AML/CFT Measures Required at the National Level

Countries have an obligation to protect the financial integrity of their financial system. However, countries have flexibility in how they achieve this objective and can adopt a risk-based approach. For example, if the authorities decide that an institution's operations represent a low risk for money laundering and the financing of terrorism, they can exempt some financial service providers from compliance with AML/CFT regulations. If, on the basis of risk analysis, national authorities decide that there is a need to implement AML/CFT regulations, they still have considerable latitude in how to implement the measures. Establishing a risk-based approach to regulation requires a good understanding of the extent of risk for money laundering and the financing of terrorism within the country/jurisdiction.

AML/CFT Measures Required at the Institutional Level

At the institutional level, AML/CFT compliance involves four main activities: internal controls, customer due diligence, surveillance and record keeping, and reporting of suspicious activities. Establishing new internal controls may require financial institutions to change client intake forms, operating procedures, and information systems. Training staff in new procedures is vital to the successful implementation of internal controls and overall AML/CFT compliance. Background checks on board members, shareholders, and employees help protect the institution. Donations and contributions should also be verified to ensure they are from legitimate sources.

FATF requires financial institutions to be able to verify the identity of their clients. Implementing customer due diligence measures can help institutions to comply with the regulations. Although FATF's AML/CFT recommendations do not specifically mention the address of customers in reference to customer due diligence, some countries have included verification of client addresses in their national AML/CFT frame- works. FATF says that "there are circumstances in which it would be reasonable" for a country to allow its financial institutions to apply customer due diligence measures "on a risk-sensitive basis". A few countries have shown flexibility in implementing customer due diligence requirements that accommodate the situation of low-income people. Uganda, Tanzania, and Kenya all accept letters from the local authority in rural villages as identification for their clients who do not have an official identity card. More work is needed to ensure a high level of security in customer due diligence that does not threaten poor people's access to services. Financial service providers, working closely with their industry associations and national authorities, are well placed to develop effective methods of verifying the identity of their clients.

Box 2 FATF Definition of Financial Institutions and Their Activities

"Financial institutions" refers to any person or entity conducting as a business one or more of the following activities or operations for or on behalf of a customer:

1. Acceptance of deposits and other repayable funds from the public, including private banking

2. Lending - includes, inter alia, consumer credit; mortgage credit; factoring, with or without recourse; and finance of commercial transactions (including forfeiting)

3. Financial leasing - does not extend to financial leasing arrangements in relation to consumer products

4. The transfer of money or value - applies to financial activity in both the formal or informal sector, e.g., alternative remittance activity. See the Interpretative Note to Special Recommendation VI. It does not apply to any natural or legal person that provides financial institutions solely with message or other support systems for transmitting funds. See the Interpretative Note to Special Recommendation VII.

5. Issuing and managing means of payment (e.g., credit and debit cards, checks, traveler's checks, money orders and bankers' drafts, electronic money)

6. Financial guarantees and commitments

7. Trading in:

8. Participation in securities issues and the provision of financial services related to such issues

9. Individual and collective portfolio management

10. Safekeeping and administration of cash or liquid securities on behalf of other persons

11. Otherwise investing, administering, or managing funds or money on behalf of other persons

12. Underwriting and placement of life insurance and other investment related insurance - applies both to insurance undertakings and to insurance intermediaries, i.e., agents and brokers

13. Money and currency changing When a financial activity is carried out by a person or entity on an occasional or very limited basis (having regard to quantitative and absolute criteria), such that there is little risk of money laundering activity occurring, a country may decide that the application of anti-money laundering measures is not necessary, either fully or partially.

In addition, institutions are encouraged to monitor transactions and keep detailed transaction records. For financial services providers working with low-income clients, surveillance and record keeping could involve new information systems.

Box 3 Financial Intelligence Units

FATF recommendations require the creation of a specialized government unit, usually called a financial intelligence unit (FIU), as a central point for monitoring transactions and collecting information. In addition, local regulators - and in some cases, industry associations as well - issue guidance notes or circulars on how to interpret sections of the laws or regulations.

FIUs at a minimum receive, analyze, and disclose information on suspicious or unusual financial transactions provided by financial institutions to competent authorities. Although every FIU operates under different guidelines, under certain provisions they can exchange information with foreign counterpart FIUs. In addition, many FIUs can provide other government administration data and public record information to their counterparts, which can also be helpful to those investigating money laundering and financing of terrorism. There are currently 94 countries with recognized operational FIUs, with others in various stages of development. The ongoing development of FIUs exemplify how countries around the world continue to intensify their efforts to focus on research, analysis, and information exchange in order to combat money laundering and financing of terrorism, and other financial crimes.

Specific software can reduce the operational cost and time required to comply with the need to monitor complex, unusual, and large transactions and patterns of transactions. Finally, FATF recommendations make it clear that financial institutions have an obligation to report all suspicious transactions to their national authorities.

Challenges for Financial Service Providers Working with Low-Income Clients

The main challenges for financial service providers in complying with AML/CFT measures arise from the requirement to undertake customer due diligence and to absorb the potential costs involved in implementing new regulation. Additional challenges include internal control and surveillance and record keeping.

Special Features and Risk Profiles of Financial Service Providers that Serve Low-Income Clients

Microfinance clients are typically low-income, do not own assets that are conventionally accepted as collateral, may be self-employed, or may have uneven streams of income. In general, the majority of clients served by these institutions are "natural persons," not legal persons or entities such as companies or trusts. This client profile reduces the risk of such institutions being used for money laundering.

Microfinance transactions are also generally very small - whether they are savings, credit, or transfer. Given the predominant small loan sizes, sudden flows of large amounts would stand out easily. In the financing of terrorism, however, authorities are increasingly concerned about even small transactions.

The type of financial service offered also affects the institution's risk. Some institutions are legally authorized to mobilize savings. Some may have restrictions on providing money transfers, leasing, and/or insurance. Non-depository institutions with no access to the national payment system may present relatively lower risk from an AML/CFT perspective. Among financial services for low-income people, money transfers may pose higher risks of money laundering and financing of terrorism. For criminals to succeed, they usually need access to institutions that facilitate domestic and international funds transfers, exchange currencies, and convert these proceeds into different financial instruments and other resources. Terrorist financiers and money launderers may pose as legitimate entities to transfer funds that later may be diverted to criminal purposes or to disguise funds from illicit activities. Countries therefore need to regulate providers of transfer facilities appropriately to reduce or prevent abuse for money laundering and the financing of terrorism. Further analysis is needed to distinguish the risk that each type of financial service provider presents depending on their financial services.

Some institutions serving low-income clients, such as financial cooperatives and NGOs, have ownership structures that may require additional information and verification by authorities. Financial cooperatives are member-owned institutions with a board and other oversight committees, while NGOs typically have no share-based ownership and appointed boards and management.

Compliance Costs

Like any other financial regulation, the costs of complying with AML/CFT measures may increase the cost of services. For example, the cost of monitoring suspicious transactions may be high if suitable automated systems are not in place. Financial institutions serving low-income people may have to purchase and install new technology or increase their human resource capacity to comply with the requirements in their jurisdiction. In addition, rules for reporting and record keeping may obligate institutions to save all physical documentation of transactions for defined periods, usually at least five years. Microfinance institutions in particular will need to develop systems, aided by available software, to reduce the operational cost and time required to comply with this requirement. Industry associations can play a valuable role by helping members keep costs to a minimum as they comply with regulations. For example, they could consult with the banking association in a country to see if AML/CFT software is available. They could work with national authorities to provide such software and take the lead in offering training on AML/CFT awareness and compliance.

Although there are always costs associated with regulations, these costs tend to be greater in countries where there is generally a culture of poor compliance. Developing or encouraging wider acceptance of compliance, not only for AML/CFT systems, is more cost effective because it reduces risk of fraud, helps protect savers and investors, and increases the integrity of the institution.

Box 5 gives examples of two types of financial services providers that serve low-income clients in Mexico, a FATF member country. Both BANSEFI and Compartamos have implemented policies and systems in line with international standards and national law. In addition, the Mexican National Association of Non-bank Financial Institutions (AMSFOL) has been proactive in forming new members institutions about AML/CFT issues, offering courses in new AML/CFT regulations, and developing a procedures manual to help members ensure AML/CFT compliance.

Customer Due Diligence

It is a universal challenge for financial service providers to identify clients according to international standards. In developing and middle-income economies, for example, it is difficult for many clients to comply with certain "customer due diligence" identification requirements, such as national identity numbers or third-party verification of physical home address. These requirements are already part of customer due diligence regulations in South Africa, but financial institutions there are experiencing problems with them because at least one-third of South African households do not have formal addresses. The issue at stake is how to devise customer due diligence requirements that are tailored to specific categories of clients, such as those the Basel Committee proposes for banks in member countries (see box 4). In particular, a certain level of stringency could be applied to the institution's "normal" or low-risk clients, and an enhanced due diligence applied to the riskier clients.

Since the FATF recommendations do not specify how to establish and verify the identity of clients, it is important that financial service providers that serve low-income clients work with regulators to develop appropriate rules in each national jurisdiction to ensure:

• that current or potential low-income clients are not excluded from access to services, and
  
• that the regulations do not limit the ability of banks to use microfinance providers as agents to accept or pay out remittances and other money transfers.

What Should Financial Service Providers that Serve Low-Income Clients Do?

It is important that microfinance institutions do not compromise their core objective of providing financial services to a broad range of poor people as a result of compliance with AML-CFT regulations. At the same time, to ensure their long-term sustainability and to meet their client needs, these institutions must protect themselves from abuse by terrorists and money launderers. In working towards compliance with AML/CFT measures, regulators and financial service providers serving low-income clients need to work together to strike a careful balance between regulation and sustainability and client needs:

• Gradually implement regulations. Financial service providers should coordinate with country regulators to develop and gradually implement new AML/CFT regulations in order to give institutions adequate time to adapt their internal procedures in accordance with the new regulations. Such an approach will help minimize disruptions in their services to clients.
  
• Take a risk-based approach. The AML/CFT risks of financial service providers vary by country, institutional type, and financial services provided. FATF Recommendation V states that "for higher-risk categories, financial institutions should perform enhanced due diligence. In certain circumstances, where there are low risks, countries may decide that financial institutions can apply reduced or simplified measures". For example countries could exempt non-depository institutions that offer low-risk financial products and have no link to the payments system.
• Create appropriate exemptions. FATF recommendations recognize governments' discretion to exempt low-value transactions that fall below a certain threshold from AML/CFT requirements. For example, FATF Special Recommendation IX requires cash couriers to declare amounts exceeding a preset maximum threshold of US $15,000.13 Associations of financial service providers that serve low- income clients would be well advised to use this approach to negotiate with their respective governments to reduce or eliminate the AML/CFT regulation requirements applicable to them for transactions below a specified threshold value.