Banking On Secrecy

Image: HypnoArt | CC0 1.0

KleptoCast 14: Casey Michel talks to Aaron Klein of the Brookings Institution about challenges to the United States’ outdated anti-money laundering regime.

By Casey Michel

For those following the world of offshore finance, it’s an open secret that the U.S. has challenged jurisdictions like Belize and British Virgin Islands for shell company provisions. Indeed, as neither Washington nor state-level legislatures differentiate between shell and non-shell company formation – one of the many reasons academics consider the U.S. among the worst countries internationally in regulating its shell company industry – it’s effectively impossible to grasp the full scope of both damage and danger American shell companies have inflicted on jurisdictions abroad, from Ukraine to Angola to Equatorial Guinea.

However, shell company formation in the U.S. doesn’t simply allow some of the world’s foremost foreign kleptocrats to store their ill-gotten gains abroad. Nor does it solely allow the kleptocrats to mask such wealth from investigators both domestic and international. Rather, the American shell company industry – and the states like Delaware, Wyoming, and Nevada that gorge on the revenues of anonymous company formation, despite Washington’s prior commitments – has, through its interactions with the American finance industry, made it that much more difficult to pursue the types of anti-money laundering (AML) regulations Washington has set forth.

That is to say, America’s shell company formation industry isn’t simply countermanding Washington’s anti-kleptocracy efforts elsewhere. It’s also gumming the gears of the U.S. finance industry’s efforts to search out customers who would otherwise raise any number of red flags along the way, adding to a litany of other issues already at play.

Take it to the bank

 Despite scattered efforts elsewhere, Washington’s first efforts at formalizing an AML regime came in 1970, passing the Bank Secrecy Act (BSA). As a 2015 analysis from Bipartisan Policy noted, “Despite its name, bank secrecy was not the law’s priority, which instead was the bank secrecy laws of foreign bank havens, especially Switzerland.” Searching for a means to access banking records, the BSA forced banks “to maintain records of financial transactions and report certain cash transactions to the IRS, notably those over $10,000” – a regulation, as Bipartisan Policy adds, that has remained the same nearly a half-century later, regardless of inflation.

The BSA re-focused its efforts in the 1980s to combat drug trafficking, eventually increasing assorted penalties under the 1986 Money Laundering Control Act. Likewise, following the 9/11 attacks, the BSA’s writ expanded that much further via the Patriot Act, forcing banks to identify parties on either end of any transaction in which the bank is involved – that is, knowing who their customers at any time were. Requisite information was relatively straightforward – name, address, passport ID, and the like – and, once obtained, would be run against databases of known and suspected terrorists. As an analyst with PricewaterhouseCoopers wrote, the post-Patriot Act requirements “subject[ed] high-risk customers to enhanced due diligence.”

Clearing the obstacles

However, despite the clear importance of a cohesive AML regime – and despite the improvements, or at least expansions, of AML efforts over the past few decades – a number of substantive issues have begun slowing both compliance and prevention of money-laundering. Paired with the transformation of the U.S. into a global leader in shell company protections, American financial institutions’ current AML regime, aimed in part at countering the financing of terrorism (CFT), is facing any number of issues in helping prevent extremist and cartel financing alike.

A February 2017 report from the Washington-based Clearing House, the U.S.’s original banking association, ably laid out the myriad issues swamping the current AML/CFT regime. For instance, a distinct lack of coordination between banking regulators and law enforcement officials continues to plague effective AML/CFT enforcement. Wrote Clearing House, “[M]any if not most of the resources devoted to AML/CFT by the financial sector have limited law enforcement or national security benefit, and in some cases cause collateral damage to other vital U.S. interests. … The current AML/CFT statutory and regulatory framework is outdated and thus ill-suited for apprehending criminals and countering terrorism in the 21st century.”

This dearth of coordination – stemming in part from financial institutions seeing little input from law enforcement officials regarding AML/CFT resource allocation – has led to further spiraling costs, “amounting to a budget somewhere between the size of the [Bureau of Alcohol, Tobacco, Firearms and Explosives] and the FBI.” Similarly, an inability to broaden the scope of sharing Suspicious Activity Reports (SAR) “inhibits the dynamic flow of information among authorities and institutions and limits the ability of any one institution to see the bigger picture.”

But it’s not only that monitoring resources are misallocated, or that communication remains truncated. As Clearing House continues, one of the primary issues plaguing financial institutions from effectively carrying out know-your-customer (KYC) regulations deals directly with the shell company formation running through both state-level economies and the American real estate industry alike. As the U.S. remains one of the foremost jurisdictions without a registry identifying beneficial owners of U.S.-based companies, financial institutes are forced to expend that many more resources in tracking their customers.

The problem has become so pronounced that Clearing House recently joined assorted academics, international bodies, and watchdog organizations in calling for the U.S. to finally formalize a beneficial ownership registry – one financial institutions can easily access. As the report added, denying these institutions access to such information “would significantly undermine the goals of any [beneficial ownership] bill.”

Nor is Clearing House the lone organization sounding concerns about the effects of shell company formation on America’s finance industry. A 2016 piece from the Harvard Law School Forum on Corporate Governance and Financial Regulation even pointed out that it may be worth lowering a beneficial ownership threshold to 5-percent ownership in the respective company.

Earlier this month, Brookings Institute Fellow Aaron Klein also took to American Banker to outline how anonymous companies continue to undercut financial institutes’ ability to pursue the kind of AML regime Washington would wish. “It is contradictory that the AML/KYC regime should exist alongside the ability for anonymous beneficial corporate ownership,” Klein wrote, likewise pointing to the rising costs in tracking assorted customers – especially those using corporate vehicles in their interactions with financial institutions. As Klein closed, “The current system is a policy lose-lose that makes it more difficult to achieve the goals of tracking down the bad guys, while imposing growing costs ultimately on all users of the financial system. That’s right, you and I may be paying higher fees as bank customers because of anonymous shell corporations.”

All told, shell company formation may not be the primary issue currently facing U.S. financial institutions. Instead, it’s simply an outsized problem – and a growing one, at that – muddying efforts to push a more effective AML regime. However, given that any number of actors, from Islamist terrorists to Central American drug-runners, can currently access U.S.-based shell companies, the issue of anonymous companies’ interactions with financial institutions has all the ingredients of being a far larger issue than either legislators or regulators may appreciate.

Casey Michel has worked as a researcher and journalist in the United States and former Soviet Union. Follow him @cjcmichel.

Aaron Klein is a fellow in Economic Studies and serves as policy director of the Center on Regulation and Markets at the Brookings Institution. Follow him @AaronDKlein.