6 – Selected studies · in “dirty” money may potentially bring strong instability to nations. Due to the globalization and the integration process of financial domestic markets,

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Financial Stability Report May 2003

The purpose of this chapter is to publish studies dealing with themescorrelated to the matters discussed in the framework of the Report.This issue includes the following papers:

a) The Role of the Bank Supervisor in Preventing MoneyLaunderingThe objective of this study is to contribute to a betterunderstanding of the role of the bank supervisor in preventingmoney laundering, with emphasis on the performance of his/herclassic responsibilities. The proposal in this study is that thesupervisory entity has an important role to play in light of theobjective of ensuring national financial system stability. Threeactivities to be performed by banking supervision entities arepresented and discussed: elaboration and dissemination of rulesand guidelines; evaluation of quality controls aimed at preventingmoney laundering and application of coercive measures.

b) Mathematical Analysis of the Hyperbolic Multiplier andPerformance of a Polynomial MultiplierThis study analyzes the mathematical properties of the multiplierdefined in the Technical Note on Circular 2,692 and examineswhether or not there is improvement in its performance when apolynomial function is used to define it instead of a hyperbolicfunction. The results indicate that a polynomial multipliereliminates the spikes that can occur when there is a significantchange in the value of the volatility percentile, but does not satisfythe concept of smoothing the curve.

6 – Selected studies

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c) Modeling the Credit Risk of Legal Entities in BrazilThis paper estimates parameters for implementing a credit riskmodel in the framework of the Brazilian financial market. Themodel produces credit transition probabilities quite similar tothose reported by the Credit Risk Center. This credit risk modelhas the potential of being utilized in many different ways,including analysis of the risk of bank failures and capitalrequirements for banks.

d) Factors Affecting the Technical Efficiency of Production ofthe Brazilian Banking System: a Comparison of FourStatistical Models in the Context of Data EnvelopmentAnalysis.This paper uses an output oriented Data Envelopment Analysis(DEA) measure of technical efficiency to assess the technicalefficiencies of the Brazilian banking system. Four approaches toestimation are compared in order to assess the significance offactors affecting inefficiency. These are nonparametric Analysisof Covariance, maximum likelihood using a family of exponentialdistributions, maximum likelihood using a family of truncatednormal distributions, and the normal Tobit model.

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The Role of the BankSupervisor in MoneyLaundering Prevention

Romantini, Gerson Luís1

Hijjar, João Tiago2

Anjos, Wolney José dos3

Preface to the August 2002 version

The first version of this paper was written in June 2002 and sent tothe Financial Stability Institute of the Bank for InternationalSettlements (BIS). Sponsored by the Brazilian Central Bank, itspurpose was to participate in the FSI Supervisory Essay Award 2002.In this second version several changes have been made in order tomake the text clearer.

It is important to emphasize that the authors’ intention has been thatof contributing towards the debate on the role of banking supervisionin the prevention of money laundering. In this sense any commentsor suggestion are welcome. We also hope this essay may contributeto the development of other studies related to this subject.

The authors

1/ Enforcement Against Illegal Foreign Exchange and Financial Activities Department (Decif),Banco Central do Brasil, [email protected].

2/ Enforcement Against Illegal Foreign Exchange and Financial Activities Department (Decif), BancoCentral do Brasil, [email protected].

3/ Enforcement Against Illegal Foreign Exchange and Financial Activities Department (Decif), BancoCentral do Brasil,[email protected].

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Abstract

This essay aims at contributing to understand the role of banksupervisor in money laundering (ML) prevention. In this sense, twomain roles are presented and discussed. The first role is that ofcollaborating with domestic ML prevention and combat institutions,according to each country’s legal system’s specifics. The second roleis that of pursuing a reduction of banking system ML-related risks.

This essay focuses on the second role, which is more connected tothe classic attributions of banking supervision. It is proposed thatbank supervisors have an important role to play in ML preventionaccording to its typical duties of securing the soundness and stabilityof the domestic banking system.

As a consequence of this second role, three activities to be developedby bank supervisors are submitted and discussed: preparation anddissemination of ML prevention rules and guidelines to the bankingsystem, assessment of banks AMLC quality and application ofcoercive measures in order to improve banks’ controls that havebeen negatively assessed.

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1 – Introduction

According to the Financial Action Task Force on Money Laundering:FATF (n.d.):

The goal of a large number of criminal acts is to generate a profitfor the individual or group that carries out the act. Moneylaundering is the processing of these criminal proceeds to disguisetheir illegal origin.

Money Laundering (ML) is fundamental to the sustainability oforganized crime. It disguises the origin of illicit funds that becomeapparently legitimate and can be afterwards reinvested in performingnew crimes.

According to FATF (n.d.), citing International Monetary Fund’sestimates, the aggregate yearly size of ML over the world rangesfrom two to five percent of the world’s gross domestic product.Considering 1996 statistics, this range means that money beinglaundered is equivalent to something between US$ 590 billion andUS$ 1,5 trillion per year.

ML is considered to be a very harmful activity to society. Besidesbeing one of the main pillars of criminal activities holding high offensivepower, it may result in negative macroeconomic consequences to acountry due to the high amounts involved each year. Large transactionsin “dirty” money may potentially bring strong instability to nations.Due to the globalization and the integration process of financialdomestic markets, it has been admitted that even the internationalfinancial system might be affected (Tanzi, 1996; Quirk, 1996).

Because of the seriousness and the transnational feature of the problem,the international community has developed several efforts in fightingML. These efforts include recommendations to criminalize ML, emphasison the participation of several governmental and private institutions inML prevention, and promotion of international cooperation.

Due to the great variety and sophistication of financial products, theease in transferring funds, the banking secrecy laws and the large

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number of financial transactions processed every day, banks havebeen one of the principal vehicles used by money launderers.

As a way to avoid that ML operations take place in the bankingsystems, several countries have adopted measures that promoteeffective participation of banks in this prevention activity, inspiredby the recommendations of several international institutions, suchas the Bank for International Settlements (BIS), the FATF, the IMF,the World Bank and the United Nations (UN).

This essay intends to contribute towards better understanding therole of bank supervisors in preventing ML. It is also intended tointroduce some essential actions in playing such roles.

Chapter 2 analyses some banking risks, emphasizing those most closelyassociated to ML: the reputational, legal and operational risks.

Chapter 3 focus on the multiple roles played by bank supervision inML prevention. Two main roles are discussed, based on a review ofrecent facts. The first one is to cooperate with domestic MLprevention and fight institutions, according to the specifics of eachcountry’s legal system. The second one is to pursue a reduction ofML-related risks to the banking system.

Chapter 4 scrutinizes the second bank supervisor role in MLprevention. In this sense, it is proposed that the supervisor shouldbe responsible for: (a) preparation and dissemination of rules andguidelines on ML prevention to the banking system, (b) assessmentof the banks’ AMLC quality and (c) application of coercive measuresin order to secure the necessary improvements.

Chapter 5 deals specifically with the activity of assessing banks’AMLC quality. The chapter emphasizes the importance of definingthe concept of AMLC’s quality while implementing a model tomeasure such quality.

In Chapter 6, the concept of AMLC’s quality is defined.

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Chapter 7 dedicates to the development of two fundamental elementsin the definition of the AMLC measuring model: (i) the variablesand (ii) the way to integrate them in order to reach an overall gradefor the banking institution. In this sense, the advantages anddisadvantages of two models are shown: the Minimum Grades Modeland the Weighted Grades Model.

In Chapter 8 the need to create a rank taking into account banks’ AMLCgrades is discussed in the context of assessing banks’ AMLC quality.

In Chapter 9, the bank supervising activity of applying coercivemeasures to ensure that banks do implement effective AMLC isdiscussed. We also point out that ML prevention should not be facedjust as a matter of capital adequacy to the banking risks.

Last, we explain a few terms used in this paper in order to makeclearer the ideas we discussed here. The expression “Anti-MoneyLaundering Controls (AMLC)” has been chosen to designate the setof policies, organizational structures and procedures implementedby banks aimed at preventing ML.

ML prevention policies should be understood as a set of principlesand internal rules that apply to a bank aimed at preventing theinstitution from being used for ML purposes.

The organizational structures for ML prevention should beunderstood as the way by which human and material resources areorganized in the bank in order to prevent ML.

ML prevention procedures are the working routines implemented bya bank to avoid its use in ML operations. The tools and software usedin these working routines are part of the ML prevention procedures.

The term AMLC is used in a sense equivalent to other expressions,including “Internal Controls”, “AML Program”, and “ControlSystem”. We chose this expression due to the lack of consensus onthe terminology to be used in bank practices and related literature.

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2 – Risks associated to ML

The banking activity, as well as any other business activity, is alwayssubject to risks. If a bank turns out to be insolvent as a result fromthe risks taken, generally, the damages to the economy areconsiderably worse than those caused by insolvency of a non-banking corporation.

Some of the reasons that lead to a larger economic impact when theinsolvent firm is a bank are: (a) the fact that commercial banks arean important part of the countries’ payment systems; (b) the negativeeffects in economic policy, mainly due to fiscal and monetary impactscaused by banks’ bankruptcy; (c) the great number of people directlyharmed, specially when insolvency reaches large retail banks; (d)loss of confidence in the capacity of regulation and supervision ofgovernment institutions; (e) the systemic risk, that is, the risk of thewhole system being affected, due to the loss of trust in the soundnessand solvency of other banks. This explains why banking institutionsare under strict regulation and supervision by government authorities.

The BIS encourages banks to develop and use techniques to bettermanage risks they are submitted to (BIS, 2001d). Some risks areidentified and measured more easily than others. Measurementtechniques are available to assess some types of risk, like interestrate risk, market risk and credit risk. On the other hand, however,the operational, legal and reputational risks are difficult to bemeasured. Nevertheless, these are the most strongly ML-related risks.

Banks offer a great variety of financial products and services,generally protected by the banking secrecy. At some point in time,money launderers might use these products and services.

ML is a criminal activity different from the typical frauds againstbanking institutions. Frauds against banks aim at the embezzling theinstitution’s or its customers’ funds. Banks are permanently awareof frauds and usually have advanced controls to avoid them.

People who look for banking services for money laundering purposes,usually have their own funds. That means there is no credit risk. Yet,

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people are ready to “lose” part of their funds in order to disguisetheir origin. In this sense, the cost of banking services is a minorfactor to money launderers. According to these ideas, MLtransactions may represent a good business opportunity with highrevenues in the short term.

However, the profit from these operations may not compensate thefinancial and non financial losses resulting from: (a) damage to reputationand (b) legal consequences, if the ML activities are found out.

The possibility of harm to the reputation includes the so-calledreputational risk. According to BIS:

BIS (2001a, p.4) – Reputational Risk is defined as the potentialloss of confidence in the integrity of the institution caused byadverse publicity, whether accurate or not, regarding a bank’sbusiness practices and associations.

The reputation of a banking institution before the financial market,customers and society is one of its most valuable assets. Damage toreputation may endanger the public confidence in a bank, a threat toits survival. Publicity on a bank’s involvement with ML operationsmay result in serious harm to the banking institution’s reputationeven if there is no law in the country criminalizing ML. Damage toreputation may cause banks to loose customers and businesstransactions, as well as a decrease in the price of their stocks.

This harm occurs notwithstanding the institution is a criminals’ victimor intentionally cooperates with them, though in the case ofcooperation the legal and reputational damages can be more severe.

The possibility of legal consequences includes the so-called legalrisk. According to BIS:

BIS (2001a, p.4) – Legal Risk is the possibility that lawsuits, adversejudgments or contracts that turn out to be unenforceable can disruptor adversely affect the operations or condition of a bank.

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Therefore, the establishment of clear duties and penalties is afundamental condition for reaching higher quality standards in banks’AMLC. However, the establishment of new duties and penaltiesincreases banking legal risks. These new risks are related to: (i) thepossibility of penalties being applied by the bank supervisor; (ii) thepossibility of penalties being imposed by legal authorities.

Besides, the existence of legal responsibilities indirectly increasesthe reputational risk. The higher the possibility of a bank beingexposed to public opinion, due to lawsuits resultant from MLoperations, the higher the risk. Reputational risk can also be higherif people are aware of the institution’s unlawful behavior.

In a first moment, the new responsibilities and penalties brought byML prevention increase the legal and reputational risks of a bank.However, in a second moment, the banks tend to adopt AMLC tomanage these new risks. When doing so, banks contribute to MLprevention and at the same time to lowering the risks brought by moneylaundering to themselves and to the whole banking system.

On the other hand, the decision of adopting AMLC in a bank is not asimple task. Such decision implies efforts and investments that shallbe carried on and that may represent high costs to the bankinginstitution.

Besides, AMLC may cause serious embarrassment to the largest partof the customers, who are not involved in ML activities. They mayfeel their privacy invaded when they are questioned about theirbanking operations. On the other hand, the non-adoption of AMLCmeans that ML-related risks are not under control and, thus, seriousdamage can be caused to the bank.

So, the banks should make their investment decisions on their ownAMLC based on an evaluation of (1) the legal and reputational risksthey are subjected to, and (2) the costs of adopting AMLC.

Moreover, when banks set AMLC, the institution shall manage them.In addition to the cost of managing AMLC, the possibility of failures

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in these controls shall be considered. Such possibility means anotherrisk to be managed: the operational risk. According to BIS:

BIS (2001a, p.4) – Operational Risk can be defined as the risk ofdirect or indirect loss resulting from inadequate or failed internalprocesses, people and systems or from external events.

According to the New Agreement of Capital of Basel (BIS, 2001d),the legal risk is part of the operational risk. The latter, as well as thereputational risk, has been inserted in the so called “other risks”group. This group gathers difficult measurement risks. From thisgroup, only the operational risks integrate the new capital adequacycriterion and some techniques to measure it have been introduced.

In summary, the possibility of banking services and products beingused for ML transactions brings several risks to banks. These arepredominantly reputational, legal and operational risks that threatenthe health of the banking institutions and the stability of the system.Therefore, banks are expected to use efficient AMLC in order tomanage these risks.

3 – The role of the bank supervisor inML prevention

The role of the bank supervisor in ML prevention may vary fromcountry to country, according to the nature of the legal responsibilitiesattributed to it. The laws that define the duties of a bank supervisormay change in the course of time. Law changes have been takingplace in a context of increasing international awareness on the harmcaused by ML activity. The establishment of internationalconventions, the creation of inter-governmental entities and thepublication of several papers reflect the international awareness.

The last fifteen years offer a brief background to understand whatthe role of the bank supervisor in ML prevention should be.

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The Vienna Convention was signed in December 19, 1988, duringthe United Nations Conference Against Illicit Traffic in NarcoticDrugs and Psychotropic Substances. This was one of the initiallandmarks of international efforts against ML. During the conference,the member States agreed in a commitment of criminalizingconversion, substitution or concealing of any goods originated fromthe traffic in narcotics.

The growing concerns about the harmful effects of ML has motivateda reaction from the nations. Until then, ML has been seen as basicallyrelated to drugs dealing. Since the Vienna Convention countries haveintensified, either in large or short steps, the fight against ML.

In the same year, 1988, one of the first publications referring to therole of the bank supervisor in ML prevention was published. Thispaper (BIS, 1988) is called “The Prevention of Criminal Use of theBanking System for the Purpose of Money-Laundering”.

In that paper, the Basle Committee noticed that its several bankingsupervision members did not have the same roles and responsibilitiesin ML prevention. According to the paper, some supervisors haddirect responsibility, whereas others did not.

In that article, the Basle Committee stated that the primary functionof banking supervision:

BIS (1988, p.1): is to maintain the overall financial stability andsoundness of banks rather than to ensure that individualtransactions conducted by bank customers are legitimate.

Even though, at that moment, the members of the Committee saidto believe that the supervisors could not be indifferent to the use ofthe banking systems by criminals. They understood that the banks’reputation and the banking system stability could be affected.

For these reasons the Committee represented that:

BIS (1988, p.2): […] the members of the Basle Committeeconsider that bank supervisors have a general role to encourage

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ethical standards of professional conduct among banks and otherfinancial institutions.

In the same document, as a means to reach this goal, the Committeeissued the “Statement of Principles”. It suggested that the severalsupervisors should compel banks to implement principles related to:(a) customer identification; (b) discouragement of likely illegitimateoperations; and (c) cooperation with law enforcement agencies.

In the next year, during the 1989 G-7 Summit, held in Paris, theFinancial Action Task Force on Money Laundering (FATF) wasestablished. The Task Force is an inter-governmental body,responsible for developing and promoting policies to fight ML atdomestic and international levels.

In April 1990, FATF published a report with 40 Recommendations:a basic framework for anti-ML efforts (FATF, 1990). The FATFcountry members firmed up a political commitment in order toimplement the recommendations. Their progress in suchimplementation is periodically monitored by FATF.

Besides monitoring the performance of its members, FATF reviewsperiodically the 40 Recommendations to check whether they remainsuitable to the new ML techniques. The FATF also encourages theadoption of the 40 Recommendations by non-member countries.

The FATF 40 recommendations, revised in 1996, are given in thefollowing main chapters: (a) the general framework of therecommendations; (b) the role of domestic legal systems in fightingML; (c) the role of the financial system in fighting ML; (d) thestrengthening of international co-operation.

Among those recommendations, the ones referred to in item (c) showthe importance ascribed to financial systems in the fight against ML.These are 22 recommendations, from the eighth to the twenty-ninth,representing more than a half of the total.

Concerning the role of the financial system in combating ML, FATF(1990) suggests: (i) customer identification and record-keeping rules;

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(ii) increased diligence of financial institutions; (iii) measures to copewith the problem of countries with no or insufficient anti-MLmeasures; (iv) other measures to avoid ML; (v) activities and role ofregulatory and other administrative authorities.

Specifically in reference to item (v), FATF makes the followingrecommendations:

FATF (1990) – Recommendation 26: The competent authoritiessupervising banks or other financial institutions or intermediaries,or other competent authorities, should ensure that the supervisedinstitutions have adequate programs to guard against ML. Theseauthorities should co-operate and lend expertise spontaneouslyor on request with other domestic judicial or law enforcementauthorities in ML investigations and prosecutions.

FATF (1990) – Recommendation 28: The competent authoritiesshould establish guidelines which will assist financial institutionsin detecting suspicious patterns of behaviour by their customers.It is understood that such guidelines shall develop over time, andwill never be exhaustive. It is further understood that suchguidelines will primarily serve as an educational tool for financialinstitutions’ personnel.

In 1997, seven years after the establishment of the 40 FATFRecommendations, the Basle Committee, together with bankingsupervision authorities of non-member countries of G 10 andnumerous other countries, published the “Core Principles forEffective Banking Supervision” (BIS, 1997). The document includes25 basic principles, considered indispensable to an effective bankingsupervision system.

The fifteenth principle should be emphasized. It states the need toprevent banks from being used for criminal purposes. The Committeereiterates and complements the point underlined in the 1988document (BIS, 1988):

BIS (1997) – Principle 15: Bank supervisors must determine thatbanks have adequate policies, practices and procedures in place,

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including strict know-your-customer rules, that promote highethical and professional standards in the financial sector andprevent the bank from being used, intentionally or unintentionally,by criminal elements.

Two years later, in 1999, when detailing how the Principle 15 shouldbe followed, the Basle Committee produced another document, the“Core Principles Methodology” (BIS, 1999).

Eleven essential, and five additional criteria were establishedconcerning to Principle 15. Several of these criteria deal directly orindirectly with the role of the bank supervisor in ML prevention.The following criteria are among the most important ones:

BIS (1999) - Principle 15 - Essential criterion 2: “The supervisordetermines that banks have documented and enforced policiesfor identification of customers and those acting on their behalf aspart of their anti-money-laundering program (...)”.

BIS (1999) – Principle 15 – Essential criterion 4: The supervisordetermines that banks appoint a senior officer with explicitresponsibility for ensuring that the banks’ policies and proceduresare, at a minimum, in accordance with local statutory andregulatory anti- money laundering requirements.

BIS (1999) – Principle 15 – Essential criterion 9: The supervisorperiodically checks that banks’ money laundering controls andtheir systems for fraud prevention, identification and reportingare sufficient. The supervisor has adequate enforcement powers(regulatory and/or criminal prosecution) to take action against abank that does not comply with its anti-money launderingobligations.

Finally, in 2001, the Basle Committee published a document named“Customer Due Diligence for Banks” (BIS, 2001a), which dealsspecifically with minimum criteria to be adopted by banks in theirknow-your-customer programs, aiming at wider prudential practices,in a perspective wider than just that of ML prevention.

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An analysis of the trend of international recommendations, mainlythose from FATF and BIS, shows the growing importance attributedto the participation of bank supervisors in ML prevention. In thissense, it is possible to identify at least two fundamental roles ofbank supervisors in ML prevention:

1. Cooperating with domestic money laundering preventionand fighting institutions;2. Pursuing a reduction in banking system ML-related risks.

The first role, which is the cooperation with domestic moneylaundering prevention and fighting institutions, relate to duties thatmay be not closely linked to the classic attributions of a banksupervisor, though they have great importance in anti-ML effortsand in repression of organized crime.

Once it is legal and according to FATF Recommendation 26 (FATF,1990), bank supervisor cooperation may be performed by initiative ofthe supervisor itself or by request of entities involved in ML prevention.

Some examples of cooperation can be quoted: the identification ofsuspicious banking transactions and its reporting to other institutions(judicial, investigation or crime repression ones); the collection andanalysis of the necessary banking information for investigation orjudicial lawsuits; the collection and analysis of banking informationas a way of backing wider government ML repression strategies etc.

The second role, which is the pursuit of a reduced ML-related risksin the banking system, is clearly related to a typical bankingsupervision activity: to maintain the overall financial stability andsoundness of banks. This paper focus mainly on this role.

4 – Reduction of banking ML-relatedrisks

Once the existence of risks brought by ML to the banking system isadmitted, mainly the legal and reputational risks, the supervisor shallfollow adequate procedures in the sense of protecting the overall

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financial stability and the soundness of banks. In this sense, the banksupervisor shall act aiming at the reduction of these risks.

The main way to reduce risks related to ML is to avoid MLoperations. It is vital for a bank to have efficient AMLC in order toprevent it from being used for ML purposes.

The supervisor shall guide banks and monitor the use of their AMLCbecause these controls reduce the banking ML-related risks. Theperspective of the supervisor shall be that of reducing banking risksas a whole, considering short-, middle- and long-term risks.

Even in countries where there are not specific laws that clearly identifythe legal duties of the bank supervisor, it is expected that minimuminternationally recommended procedures are followed, such asreducing the risks brought to the banking system by money launderers.

As a way to reduce such risks, it could be expected that the banksupervisors perform at least the following activities:

a) Preparation and dissemination of rules and guidelines on ML-prevention;

b) Assessment of banks’ AMLC quality;c) Application of coercive measures.

These activities are not only complex, but also dynamic. They aredynamic because they shall be managed along time, what means, theyshall be continually planned, performed, controlled and corrected.

In the first activity (a), the bank supervisor should establish the MLprevention rules and guidelines and keep them updated. Among thebasic information sources for the execution of this procedure one maymention: the country’s own legislation, other countries’ laws, domesticand international publications on ML prevention, contact with otherbank supervisors and assessment of the banks’ AMLC quality.

The second activity (b) is discussed in the next chapter. The thirdactivity (c) is discussed in chapter 9.

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5 – Banks’ AMLC quality assessment

In the previous chapters the role of bank supervisors in ML preventionwas brought up. It was seen that one of the supervisor’s essentialtasks is to mitigate the ML-related banking risks. Among the mainactivities developed for the fulfillment of this role there is theassessment of the of banks’ AMLC quality.

The main objective of the banks’ AMLC quality assessment is toincrease the bank supervisor knowledge on banks’ controls. Thisknowledge allows the supervisor to operate so as to secure thebank’s soundness and the system’s stability. The knowledgeobtained from this activity will lead the supervisor to makearrangements aiming at the reduction of ML-related risks. Examplesof such arrangements are: (a) demand improvements to be made inbanks that have low quality controls; (b) improve rules andguidelines about ML prevention.

Besides providing an increased knowledge on the banking system,the evaluation of the bank’s controls itself may bring indirectpositive results to the AMLC quality. This assessment activity showsthe banks how important the supervisor considers the adoption ofgood quality controls. In this sense, it is possible to expect anincrease in the importance attributed by banks to the implementationof efficient AMLC.

The assessment of banks’ AMLC quality is also a complex anddynamic activity. It shall be continually planned, performed,controlled and corrected by the bank supervisor. There is a greatnumber of banks, each with different features. It demands also fromthe supervisor the ability of managing scarce resources. This isgenerally because the supervisor does not have sufficient resourcesto perform in-depth evaluation of all banks in a short period of time.

While assessing the banks’ AMLC quality assessment the supervisorshould: (i) define a concept of AMLC quality; (ii) define an AMLCquality measurement model; (iii) select the banks to be assessedthrough a priority criterion; (iv) assess each bank’s AMLC; (v)identify any necessary coercive measure that should be taken against

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the assessed banks; (vi) review the assessment process and restart itby incorporating every improvement.

Items (i), (ii), (iii) and (v) are discussed in chapters 6, 7, 8 and 9,respectively.

6 – The definition of the AMLCquality concept

There are several concepts of quality. For the AMLC assessment itseems more appropriate to define quality as the AMLC adherence to:a) The supervisor’s country anti-ML regulations;b) The bank’s ML-risk profile, as it is perceived by the bank supervisor.

Regarding item (a), the bank supervisor should attribute higherquality grades to the banks having AMLC more adherent to thecountry’s ML prevention regulations. The non fulfillment of theseregulation should decrease the banks’ AMLC grades.

As for (b), higher quality grades shall be given the more adherent banks’AMLC are to their risk profiles and to specific features of its operations,customers, employees, and so on.

This means that two banks with identical AMLC may be given differentgrades. This situation arises from the possibility that one of the banks ismore exposed to ML-related risks than the other.

The most risk-exposed bank shall conduct a more advanced AMLC in orderto obtain the same measure of quality attributed to the least exposed one.

It is still expected that a bank holding high quality AMLC is able toidentify suspicious transactions and adopt the appropriate legal andoperational measures. By doing so, the legal and reputational riskswould be minimized. That means that the higher the quality of banksAMLC, the lower the banking ML-related risks.

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7 – The establishment of an AMLCquality measurement model

Based on the concept of quality previously defined, an AMLC qualitymeasurement model may be implemented by the bank supervisor.The model should rank the general AMLC quality of the evaluatedbank. The rank could be used to indicate the progress of a bank’sAMLC quality along time and also across different banks.

One way of obtaining this rank is using a set of partial qualitymeasures. These partial measures are the variables of the model andthey determine, together, the general AMLC quality of the bank.

In this sense, the next steps to establish an AMLC qualitymeasurement model are:a) Defining the variables,b) Defining a methodology to rank each variable,c) Defining a way to integrate the variables in only one general

measure of AMLC’ quality.

The item (a) is discussed in chapter 7.1, which defines variables to measurebanks’ AMLC quality. The item (c) is discussed in chapter 7.2, whichintroduces two different models to integrate the variables in one singlegeneral quality measure. The item (b) will not be detailed due to thelimited scope of this essay. However, it may be foreseen as being a complextask that is strongly reliant on each country’s institutional characteristics.

7.1 The variables

7.1.1 Quality of the ML preventioninstitutional policy

The ML prevention institutional policy is the set of internal rulesand principles established by a bank with the aim of preventing ML-related operations in the institution.

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The institutional policy is the reflection of the organization’scommitment to ML prevention as well as the adoption of effectiveAMLC. The variable to be measured is the “quality of the MLprevention institutional policy”.

In this sense, the institutional policy shall clearly establish thecompliance with valid norms and the non-involvement in suspicioustransactions. Moreover, it still has to establish severe penalties foremployees that fail to comply with these rules.

Every aspect of the institutional policy included in the remainingvariables – e.g. polices and rules of customers’ acceptance -– shallbe explained by this variable, in order to avoid double assessment.

7.1.2 Quality of the ML preventionorganizational structure

The organizational structure is represented by the way human andmaterial resources are organized in the bank aiming at the MLprevention. The variable to be measured is the quality of this structure.

Some of the elements that shall take part on the ML preventionorganizational structure quality analysis are: (a) designation of asenior compliance officer; (b) existence of specialized sectors inML prevention, their localization in the institution’s chart, theirattributions and objectives; (c) degree of segregation of functionsbetween the business and the ML prevention fields, in order toavoid conflicts of interest; (d) quantity, degree of dedication andprofile of the personnel allocated to the activity; (e) responsibilityand duties of each employee.

The quality of banks’ AMLC depends directly on the quantity andquality of the human and material resources that the institutionchannels to ML prevention task.

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7.1.3 Quality of the ML preventiontraining

Training means the transmission of knowledge to a specific personor to a group of people. This activity may be carried out by usingdifferent tools and techniques: expositive classes; lectures; seminars;expositive classes combined with audiovisual resources; e-learning;standard training for all the employees or specific training accordingto the employee’s category, and so on.

In this sense, the ML prevention training may be understood as ameans to make the bank’s employees aware of the importance ofML prevention and to teach them to put into practice the AMLC.The variable to be measured is the quality of this training.

Prevention controls in a banking institution do not function properlyunless all employees are aware of their importance and the functionsthey perform. For that to be true, it is vital that every employee isaware of the institutional policy, the external and internal rules ineffect as well as another AMLC implemented by the institution.

7.1.4 KYC procedures

In 2001 the Basle Committee issued the paper “Customer DueDiligence for Banks” (BIS, 2001a) recommending basic know-your-customer (KYC) procedures for banks.

In that paper the Committee recognizes that the KYC procedures are

BIS (2001a, p.2): […] most closely associated with the fightagainst money-laundering, which is essentially the province ofFinancial Action Task Force (FATF).

However, the Committee states that it is not its intention

BIS (2001a, p.2): to duplicate the efforts of the FATF. […] Sound KYCpolicies and procedures are critical in protecting the safety and soundness

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of banks and the integrity of banking systems. [...] The Basel Committee’sapproach to KYC is from a wider prudential, not just anti-moneylaundering, perspective. Sound KYC procedures shall be seen as a criticalelement in the effective management of banking risks.

Still according to the Committee, sound KYC procedures

BIS (2001a, p.3): […] help to protect banks´ reputation and theintegrity of banking systems by reducing the likelihood of banksbecoming a vehicle for or a victim of financial crime and sufferingconsequential reputational damage.

Banks shall follow the KYC procedures as a means to managebanking risks, including the most ML-related ones: reputational andlegal risks mainly. However, the approach of the Committee regardingKYC goes beyond the management of ML related banking risks.

As one intends to define variables to measure banks’ AMLC therecommendations referred to in the BIS document should be followedto the extent that they are ML prevention-related.

In this sense, there are three control groups, discussed in the BaselCommittee paper, which are fundamental to determine the qualityof the AMLC that should be emphasized: (a) customers’ acceptanceprocedures, (b) customers’ identification procedures, (c) on-goingmonitoring of accounts and transactions procedures.

7.1.4.1 Quality of the KYC customeracceptance procedures

The customers’ acceptance procedures are the set of tools androutines used to carry out the institution’s rules and policies ofcustomer acceptance. These rules and policies shall have a part inthe bank’s ML prevention institutional policy. The variable to bemeasured is the quality of these procedures.

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The routines and tools used to ascertain whether a person willing toopen an account is included in the list of customers barred fromopening accounts are examples of these procedures. Such list shouldinclude names of former customers who had their accounts closedbecause of ML suspicion, names of well-known domestic andinternational launderers, and so on.

7.1.4.2 Quality of the KYC customeridentification procedures

The customer identification procedures comprise routines and toolsthat keep the customers’ record reliable and updated. Otherwise, itwould be hard to establish any judgment about the client’s bondswith criminal activities. The quality of such procedures is the variableto be measured.

The appropriate operation of banks’ AMLC requires much more thanbasic data, such as identity card number and address. An investigationon the customer should be conducted whenever necessary.

It should be assessed whenever possible whether the identificationprocedures are consistent with the customer stored documents andelectronic information (database). It should also be checked whetherthe customers operations are being properly recorded and storedduring the period prescribed by law.

7.1.4.3 Quality of the KYCprocedures of accountsand transactions monitoring

The accounts and transactions monitoring procedures comprise theset of routines and tools used to check whether the customerstransactions are consistent with what would be expected from thecustomer’s profile. The variable to be measured is the quality ofthese procedures.

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This set of routines includes the procedures for selection, analysisand report of suspicious transactions. It is relevant to emphasize theimportance of computerized tools for such control, especially forlarge retail banks.

7.1.5 Quality of the KYE proceduresrelated to ML prevention

The KYE (Know-Your-Employee) procedures are represented bywork routines and tools, which aim at providing a bank with theadequate knowledge on its employees. The variable to be measuredis the quality of these procedures.

Banks generally adopt KYE procedures due to the fear of fraudsagainst the institution. Besides meaning a loss to banks, frauds maycause serious damage to the institution’s reputation.

Moreover, knowing the employee is also important for MLprevention. Since launderers are willing to bear significant costs tolaunder their funds, it is expected that they may try to bribe a bankemployees to cheat the bank’s controls.

Some of the elements that shall be part of the quality analysis ofKYE procedures are: (a) procedures for hiring employees, and (b)procedures for monitoring of employees.

7.1.6 Quality of the AMLCreview procedures

AMLC review procedures are the bank’s tools and routines toperiodically evaluate the AMLC quality. The variable to be measuredis the quality of these procedures.

Some of the elements that could be included in AMLC reviewprocedures are: (a) self assessment by the bank’s ML preventionspecialized areas, (b) internal audit, (c) external audit.

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Regarding the internal and external audits, it should be checkedwhether the banks AMLC are periodically submitted to them. Itshould be also verified whether the bank has adequate proceduresto analyse and correct any deficiencies pointed out in the auditreports. The external audit is the most important one.

Since money launderers are permanently searching for new techniquesand ways to deceive the AMLC implemented by the banks, theperiodic review of such controls is vital to avoid that ML transactionstake place in the banking system.

It is important to emphasize that banks should not expect that bankingsupervision do this work for them. It is expected that banks includeAMLC review procedures in their own controls.

7.2 Models for integrating themeasurement of the variables

As discussed above, the proposed variables represent AMLC qualitypartial measures. Therefore, it is necessary to establish a way tointegrate them in a single general grade to reflect the quality of thebanks’ AMLC.

There are two relatively simple models for integrating those variables:

a) Weighted Grades Model;b) Minimum Grade Model.

In the Weighted Grades Model, as the name suggests, the final gradeis calculated as the weighted average of grades attributed to eachvariable. The model may be represented as ΒΧ=Υ , where:

• B is a matrix , which contains the weights attributed to each

of the m analyzed variables;• X is a matrix , which contains the grades attributed to each

of the m analyzed variables in each of the n banks;

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• Y is a matrix ,n , which contains the final grades of the AMLC

calculated for each of the n evaluated banks.

The Minimum Grade Model calculates the bank’s final grade as thelowest grade attributed to the variables. It may be represented asY=M(X), where:

• M( ) is a function that returns the lowest grade attributed to them analyzed variables in each of the n banks;

• X is a matrix , which contains the grades attributed to each

of the m analyzed variables in each of the n banks;• Y is a matrix , which contains the final grades of the AMLC

calculated for each of the n evaluated banks.

It is necessary to define three elements in the Weighted Grades Model:

a) the variables, represented by the matrix X;b) the methodology for measuring the variables;c) the weights attributed to each variable, represented by the matrix B.

On the other hand, it is necessary to define just two elements in theMinimum Grade Model:

a) the variables, represented by the matrix X;b) the methodology for measuring the variables.

The Minimum Grade Model is based on the concept of “bottleneck”.Making an analogy, the pace of a production line is determined bythe slowest work process. This is the “bottleneck” of the productiveprocess as a whole. Similarly, in the Minimum Grade Model, theconcept is that a bank’s AMLC quality cannot be better than thequality of the worst assessed item. In this sense, all the evaluatedvariables are equally important for the adequate operation of thebank’s AMLC.

The Weighted Grades Model incorporates the grades given to all ofthe analyzed variables when calculating the bank’s overall grade.

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Behind that model there is the idea that the whole shall be representedby all constituent parts, and not only by one of them. However, eachvariable has its specific weight. The most important variables will begranted a weight greater than the least relevant ones.

Suppose, for instance, a bank that has a low grade for the quality ofML prevention institutional policy. In a scale from 1 to 5, in which 5indicates the best quality, this institution gets 1 for this variable.However, suppose that the grade for all other variables is 4. Underthis circumstance it does not seem advantageous using a modelaccording to which the bank’s final grade is determined only by thedeficiencies found in the variable “institutional policy”.

In the same sense, it does not seem much advantageous having a modelaccording to which another bank, whose analyzed variables have beenhypothetically graded 1, gets the same final grade awarded to the firstbank. It is important that the bank supervisor quickly and objectivelyidentifies, through the attributed final grades, which bank has better AMLC.

Back to the proposed example, if the measuring model adopted isthe Minimum Grade model, the supervisor will have the perceptionthat both banks feature controls with the same quality degree.However, if the model adopted is the Weighted Grades model, itwill become evident that the first bank is in a more advanced stage,though still displaying deficiencies.

Nevertheless, a favorable argument to the Minimum Grade Model isthat, considering as final grade the worst grade ever attributed tothe analyzed variables, a bank would be encouraged to give equalimportance to all variables and develop the corresponding controlsin a homogeneous way. Besides, this model identifies which variableshould be the first to be improved by the institution.

The great advantage of the Minimum Grade Model, however, is itsoperational simplicity. This model requires the definition of only twoelements: the variables and the methodology of grades attribution.

The Weighted Grades Model depends on the definition of an extraelement: the weight of each variable. So, this model has a degree of

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subjectivity higher than the Minimum Grade Model. This is becausethe definition of the variables’ weights relies on the discretion of themodel maker, in addition to being a relatively difficult task.

However, it is important to emphasize that the BIS understands that:

BIS (2001a, p.13): The supervision of banks is not an exactscience, and therefore, discretionary elements within thesupervisory review process are inevitable.

Analyzing the advantages and disadvantages of each model, in spiteof its greater subjectivity and the operational advantages of theMinimum Grade Model, we believe the Weighted Grades Model isthe more adequate to assess the quality of banks’ AMLC.

8 – The establishment of a ranking

A model of AMLC quality measuring, besides being essential for theactivity of banks assessment, can be used to rank these institutions.In this ranking, the banks would be classified according to theirAMLC quality.

This ranking can be obtained through the classification in decreasingorder of the final grades calculated for each of the analyzed banks,the higher grades being considered as reflecting better quality andvice-versa. No matter which of the previously described models isadopted, it will only be necessary to classify the matrix Y in decreasingorder to build the aforementioned ranking.

Such a ranking, that objectively reflects the banks’ AMLC quality,may be used as an important tool for the activity of bank supervision.Through it, the supervisor institution may visualize quickly whichbanks display the worst controls and, indirectly, the highest risksrelated to ML.

A quickly and objective identification of banks that are mostexposed to ML-related risks is vital for the bank supervision. It isan important way to focus the supervision resources, often scarce,

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as well as to act preventively, requesting prompt responses frommore deficient banks.

This ranking may also be used to channel the assessment activityitself, through a feedback flow. It may be used as a good guidelineto identify which banks deserve priority in new rounds of assessment.

However it does not seem convenient to make this ranking publicbecause its dissemination may unleash or amplify speculativemovements against specified banks, specially if they have alreadyfaced difficulties. By publicizing the ranking one may considerablyaggravate the risk of reputation associated to these institutions.Therefore, this tool is considered suitable only to internal use of thebank supervisor.

9 – Coercive measures

In Chapter 4 two other possible ML prevention activities performedby the supervising authority were shown. The application of coercivemeasures is one of them. This activity refers to an enforcement powerenvisaged by law and designed to compel banks that have low-qualityAMLC to make the necessary improvements.

The application of coercive measures is a dynamic activity that aims,in last resort, a general increase in the quality of banks AMLC and areduction of ML-related risks. It shall work as an warning to thebanking system that a low-quality AMLC will cause a reaction ofthe bank supervisor.

The coercive measures shall be based on the legal authority grantedto supervisors by the laws of each country. They shall be usedcautiously and with a perspective of the consequences to thepenalized bank and to the banking system as a whole in the short-,medium- and long-term. Examples of coercive measures that maybe adopted include warnings, fines and prevention from operating.

In Chapter 6, it has been proposed that banks AMLC shall be assessedaccording to their quality. Moreover, quality should be considered

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the AMLC adequacy to: (a) the rules of the country’s ML prevention;and (b) the bank’s risk profile.

Suppose a bank had its AMLC evaluated as low quality just for notbeing in full compliance with the country’s ML prevention rules.Assume that these controls, though little sophisticated, do not bringrelevant risks to the bank due to its customers’ profile. In this case,the bank supervisor’s task is just to require the institution to beadherent to the rules it has infringed.

Even if the bank’s health and the system’s stability are not threatened,the supervisor should use appropriate coercive measures to compelbanks to comply with the legal recommendations. Moreover,depending on the country’s laws, the bank supervisor should beresponsible for reporting any infringement to some other publicauthority, so that further penalties can be applied.

However, if the AMLC are considered low quality because they arenot adequate to the ML-related banking risks, and even if no rule isbroken, the supervisor should have the power to demandimprovements in a bank’s AMLC. It should be so because the banksupervisor is vested with the duty of securing the bank’s health andthe stability of the banking system. The bank supervisor shallcommand appropriate coercive tools to perform this task.

One may argue that in this case, likewise in other kinds of risk, itwould be enough for the supervisor to require the bank to adequateits capital to ML related risks. This way, the bank soundness and thebanking system’s stability would be preserved. However, this pointof view implies a few problems.

First, it is not possible to admit that a bank does not implementefficient AMLC, even if it accepts to keep its capital at a higher leveldue to the greater risks assumed. ML is a very harmful activity tothe country and to the international community and must bevehemently fought. ML shall not be tolerated, even if the banks haveenough capital to face any harm caused by ML.

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Second, it is important not to misunderstand the meaning of capitaladequacy. Capital adequacy is a requirement to face risks caused bylegitimate banking activities, such as credit operations. It should notbe seen as a tool to face risks caused by illicit operations, such as ML.

Among all the ML-related risks, the New Basle Capital Agreement(BIS 2001d) suggested measurement techniques for just theoperational risk. Even if it were possible to measure all ML-relatedrisks, it is important to emphasize that these risks may vary widelyaccording to the country. The legal risk depends on the existence ofappropriate laws, kinds of penalties and effectiveness of lawenforcement actions. The reputational risk depends on the degree ofawareness and the society aversion to corporations’ involvement withML-related activities.

Under the rationale of attempting to balance higher risks with capitalincreases, there could be, for instance, a country where the legaland the reputational risks were considered very low. As a result, thebank supervisor may possibly not require the banks in that countryto increase their capital due to a fragility in their AMLC. This happensbecause the larger exposure to ML operations would not increasethe legal and reputational risks faced by local banking institutions.Although not likely, this situation would not be suitable in a contextof international anti-ML efforts.

However, it is true that the reputational risk has acquired atransnational dimension due to the globalization process andintegration of domestic financial markets. Therefore, this risk hasthe tendency not to be restricted to the perception of the countrywhere the bank is located.

Hence, one may reach the conclusion that compensating low-qualityAMLC with capital increase is inadequate. In this sense, the document“Pillar 2” by BIS says:

BIS (2001c, p.1): Increased capital should not be viewed as theonly alternative to effectively addressing a corresponding increasein risks confronting banks. Other means for addressing risk, suchas strengthening risk management, applying internal limits, and

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improving internal controls, also need to be considered. Further,capital should not be regarded as a substitute for fundamentallyinadequate control or risk management processes that must beimproved.

The capital adequacy may be used within limited objectives.According to the Basel Committee:

BIS (2001c, p.13): […] increased capital might be used as an interimmeasure while permanent measures to improve the bank’s positionare being put in place. Once these permanent measures have beenput in place and have been seen by supervisors to be effective, theinterim increase in capital requirements can be removed.

Finally, it is important to emphasize that it is not realistic for a banksupervisor to demand banks to inhibit absolutely any occurrence ofML operations through implementation of controls. This is becausethe only way for the bank to reach this goal would be by rejectingevery or almost every customer, making the banking activityunfeasible. Risk is an intrinsic element of the banking activity. Thus,it is necessary to mitigate and manage it, but not to try to extinguishit. In this sense, based on the reasonability principle, the AMLC shallbe implemented in a way to avoid ML operations to be carried out inthe banking system. Moreover, if eventually any illegal operationdoes occur, the bank shall command controls able to identify andreport such operations to the appropriate authorities.

10 – Conclusion

ML is a highly harmful activity to the countries’ economic and socialinterests. It is directly associated to the organized crime, besideshaving the power to negatively affect a country’s economic andfinancial system, due to the high sums involved.

Domestic banking systems have been one of the principal vehiclesused by launderers to make “dirty money” originated from crimeseemingly legitimate. The fight against ML transcends a nations’territorial limits. The illicit money originated in a country is often

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laundered in another one. Due to the high amounts involved and theirtransnational feature, ML has become a problem of global proportionsand its solution now depends on the cooperation of every country.

Several international institutions have supported the fight againstML and encouraged nations to implement FATF recommendations.In this sense, many countries have implemented national MLprevention systems and have endowed their banks with the duty tocollaborate in these efforts.

Bank supervising bodies have also been encouraged to cooperate.Sometimes, an ML prevention activity ascribed to them is not a banksupervisor typical task. However, notwithstanding the existence ofspecific laws, supervisors have a role to perform in ML prevention.In addition, this role is directly related to a typical banking supervisionattribution: to care for the banks’ health and the banking system’s stability.

The typical role that the supervisory institution has to perform inML prevention relates to pursuing a reduction of the banking systemML-related risks. This role involves preparing and disseminating MLprevention rules and guidelines to the banking system, assessing thequality of the banks’ AMLC, and applying coercive measures todemand improvements in bank’s AMLC.

Concerning the assessment of the quality of banks AMLC, it wasproposed that the supervisor should: (i) define a concept of AMLCquality; (ii) establish a AMLC measurement model; (iii) select,according to a priority criterion, the banks to be evaluated; (iv) assessthe AMLC of the selected banks; (v) identify the measures to betaken based on banks AMLC assessment; (vi) review the assessmentprocess to incorporate any eventual improvements.

It was further proposed that the AMLC quality should be understoodas the adequacy of these controls to the country’s ML preventionnorms and to the bank’s risk profile.

It was argued that the measurement of AMLC quality should beaccomplished through the integration of partial quality measures.The qualities considered important to ML prevention have been

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identified as the variables of the model. A grade is awarded to eachvariable. The final grade of the bank’s AMLC is obtained byintegrating these variables’ grades.

Then, the advantages and disadvantages of two models werediscussed: the Minimum Grade Model and the Weighted GradesModel. The conclusion was that the Weighted Grades Model is betterthan the other, despite the advantages offered by the easierimplementation of the Minimum Grade Model. It was also shownthat the adoption of such model would give the supervisor a goodpicture of the institutions’ efforts in ML prevention.

The adoption of a ranking based on grades attributed to the banks,according to the quality of AMLC was also discussed. This rankingshould be used as an important tool of banking supervision. It shouldalso be used to compare banks AMLC and to guide the supervisor’swork in new assessment rounds. The ranking also would identifybanks in which it is necessary to apply prudential measures urgently.

Finally, the need of coercive measures to oblige banks to improvetheir AMLC was under discussion. It was pointed out that MLprevention shall not be faced by the bank supervisor merely as amatter of capital adequacy to the risks incurred by the bank. It wasalso proposed that disposing of coactive measures to make sure banksimplement efficient AMLC is vital for effective bank supervision.

Due to the limited scope of this essay, some of the bank supervisoractivities related to ML prevention were discussed in detail whileothers were just superficially dealt with. The authors’ intention wasto contribute to the debate on the role of the bank supervision in MLprevention and to the establishment of a basic framework to make itoperational.

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BIS (1997). Core Principles for Effective Banking Supervision.Basel: Basel Committee on Banking Supervision - Bank forInternational Settlements. Retrieved from http://www.bis.org/publ/bcbsc102.pdf.

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Documents

6 – Selected studies · in “dirty” money may potentially bring strong instability to nations. Due to the globalization and the integration process of financial domestic markets,