AML-KYC And Compliance In Banks PDF

Indian Institute of Banking & Finance AML-KYC AND COMPLIANCE IN BANKS AML-KYC AND COMPLIANCE IN BANKS 1 © INDIAN INSTITUTE OF BANKING & FINANCE, MUMBAI, 2022 This book has been published by Indian Institute of Banking & Finance. Permission of the Institute is essential for reproduction of any portion of this book. The views expressed herein are not necessarily the views of the Institute. All rights reserved under the copyright act. No part of this publication may be reproduced, transcribed, transmitted, stored in a retrieval system or translated into any language or computer language, in any form or by any means, electronic, mechanical, magnetic, optical, chemical, manual, photocopy or otherwise without the prior permission of the copyright owner. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. First published, 2022 2 Foreword The business of banking is highly regulated and rightly so, given the fact that the banks are at the core of the financial system as the custodians of public trust. Any deviation from the norms as prescribed by the central banks and other regulatory authorities, may lead to catastrophic consequences not only for the bank, but for the entire economy as well. Regulations are the contours within which banks have to operate, in order to ensure financial stability and protection of stakeholders‘ interest. With the banking and financial services sector experiencing a paradigm shift all across the globe, fuelled by changing customer preferences towards an increasingly technology-based interface in a highly competitive market, it is of paramount importance for the banks to adhere to sound compliance and governance norms to ensure continued customer confidence and to safeguard its financial health & reputation. The regulatory environment, too, is fast-evolving with digitalization being the new-normal. In this backdrop, the importance of knowledge of the extant regulatory guidelines, especially in the area of compliance and governance, is irrefutable for the bankers. During its 94 years of service, IIBF has emerged as a premier institute in Banking and Finance education for those employed as well as seeking employment in the sector, aiming for professional excellence. It has been a conscious endeavour on the part of the Institute to genuinely contribute to the professional skill-sets of the banking fraternity by designing contemporary and practically relatable courses. This particular book, designed specifically for UCO Bank, has been developed with the primary objective of equipping the practising bankers with the indispensable knowledge of the AML-KYC and Compliance guidelines. The book, besides walking the readers through the myriad aspects of regulatory frameworks, also concentrates on the day-to-day applicability of the regulations and their impact through lucid and relatable case studies and scenario analyses. While designing the courseware, emphasis has been provided to augment the cognitive understanding of the subject. We believe that, for the banking and finance professionals, this book would provide a deeper insight into the letter and spirit of the regulations in a fast- evolving financial ecosystem. The Institute acknowledges the contributions made by the resource persons in developing this book and invites suggestion for its further improvement. Mumbai Biswa Ketan Das June, 2022 Chief Executive Officer 1 AML-KYC AND COMPLIANCE IN BANKS Syllabus AML-KYC Module I: ANTI-MONEY LAUNDERING (AML) i. Money Laundering: What is money laundering? An overview of impact on global economy, Combating financial terrorism. ii. Money Laundering: Different Methods iii. Money Laundering: Legislation in different countries- International Cooperation among Countries and international bodies Global efforts and co-ordination for AML and CFT iv. Financial Intelligence Unit (FIU) – Principal Officer – Role & Responsibility v. Basel Committee on AML and KYC vi. Financial Action Task Force (FATF) vii. Money Laundering and Correspondent Banking – AML structure in India – PMLA Objectives – RBI Guidelines viii. FIU IND, ED, NIA, SFIO, IBA Working Group – Software for AML Screening ix. Money Laundering & Correspondent Banking – Exchange Companies – Foreign Branches x. Country Risk Categorization xi. Monitoring of Transactions - Enhanced Due Diligence (EDD)  Red flag Indicators advised vide FIU /IBA – Online / Offline Scenario  Monitoring Accounts Transactions – Reporting Obligation Under PML Act, CTR, NPOTR, CBWTR & STR (Scrutiny & Filing) xii. Preservation of records xiii. Providing training to the staff & developing a KYC compliance culture xiv. New Technologies on AML -Data Analytics and Artificial Intelligence based approach Module II: KNOW YOUR CUSTOMER (KYC) i. KYC– Historical Overview and Regulatory Framework ii. KYC: Operating Guidelines- Regulatory guidelines on KYC – Important KYC framework in RBI prescriptions – Customer Profile – KYC Policies – Countries Deficient in KYC Policies, Initiatives / Directions from the RBI iii. Customer Acceptance Policy – Customer: Definition under the KYC Principles iv. Customer Risk Management- Categorization - Updation of KYC requirement as per Risk Category – On Boarding and Periodically v. Customer Identification Procedure a) Types of Customers  Individuals – Including Joint, Minor, Pardanashin Women, Illiterates etc.  Legal entities- Companies, Trusts, Firms, Intermediaries, etc. b) Customer Due Diligence 2 c) KYC (OVDs) for different types of customers / accounts, d) FATCA / CRS e) Small accounts (Jan Dhan A/cs) – operating guidelines f) Accounts of Politically Exposed Persons (PEPs) Residing Outside India g) Accounts of ‗non-face-to-face‘ Customers – Qualitative data – Joint accounts – Minor accounts h) eKYC - Online opening of accounts- Aadhaar offline / online verification, Video KYC, CKYCR i) Beneficial Owner COMPLIANCE Module III: REGULATION AND COMPLIANCE i. Regulation in Banks a) Importance of Banks in the Economy b) Role of Banks c) General Principles of Bank Regulation & Important Acts applicable in India e.g. BR Act, RBI Act, Income Tax Act, Information Technology Act, UIDAI Act, Companies Act, FEMA, NI Act, etc. d) Regulatory Authorities & Role of Regulators e) Universal Functions for Financial Regulators ii. Compliance Function in Banks a) Compliance risk and significance of Compliance Function b) Compliance policy c) Compliance principles, process and procedures d) Compliance programme & Scope of Compliance Function e) Role and responsibilities of Chief Compliance Officer (CCO)- including disclosure requirements iii. Compliance Governance Structure a) Organizational structure- GRC framework b) Responsibility of the Board and Senior Management c) Compliance structure at the corporate office & Functional departments d) Compliance structure at field levels e) Internal controls and its importance f) Whistle Blower Policy Mechanism iv. Framework for Identification of Compliance Issues & Compliance Risks a) Compliance culture b) Compliances issues c) Compliance risk, Inherent risk and Control risk d) Compliance testing 3 Module IV: REGULATORY COMPLIANCES i. Exposure norms ii. Cash Reserve Ratio (CRR) & Statutory Liquidity Ratio (SLR) iii. Capital Adequacy a) Objectives/Aims of the Basel III measures b) Transition from Basel I to Basel III c) Guidelines on minimum capital requirement d) Capital charge for Credit, Market, Operational risk e) Supervisory Review and Evaluation Process (SREP) f) Market discipline iv. Priority Sectors and Micro, Small & Medium Enterprises v. Interest Rates on Advances a) General guidelines b) MCLR and external benchmark c) Foreign currency advances- ARR (in lieu of LIBOR) vi. Prudential Norms for Income Recognition & Asset Classification and Wilful Defaulters a) Salient features of IRAC norms b) Sale of financial assets - Securitisation Company (SC)/Reconstruction Company (RC), NARCL, IDRCL c) IBC code, NCLT and NCLAT d) Wilful defaulters vii. FX Operations under FEMA a) Foreign direct investment (FDI) b) External Commercial Borrowing c) Export & Import of goods & services including Trade Credits d) FX facilities for individuals- LRS, NRE/NRO/FCNR(B) viii. Customer Service – Operational Aspects of banking a) Customer confidentiality obligations b) Operations in Savings & Time Deposit accounts c) Nomination in Accounts d) Cash Operations – As per Income Tax Act e) Garnishee Order, Seizure etc. – as per court order f) Demand Drafts g) Collection of instruments h) Clean note policy i) Safe deposit lockers j) Guidance to customers and disclosure of information k) Disclosure of Information by banks in the public domain l) Dealing with complaints and improving customer relations m) Reconciliation of transactions at ATMs failure - time limit n) Government business 4 ix. Alternative Delivery Channels a) Smart/debit/credit/Prepaid card business b) NEFT, RTGS, IMPS, UPI c) Automated Teller Machine (ATM) d) Online banking and Neo-banking x. Fraud & Vigilance Frameworks in Banks a) RBI Master Circular on Frauds – Classification & Reporting b) RBI Guidelines on Internal Vigilance 5 Contents Sr. No. Chapter Page No. MODULE I: ANTI-MONEY LAUNDERING (AML) 1. Money Laundering Phenomenon, its Impact and Terrorism 9 Financing. 2. Money Laundering: Different Methods 19 3. Global efforts for AML and CFT by International bodies and 34 International Cooperation among Countries Appendix 1: List of FATF Recommendations 52 4. AML/CFT Legislation in Major Countries 61 5. AML Legal and Institutional Framework in India 67 6. Money Laundering & Correspondent Banking Relations 96 7. Country Risk Categorization 101 Appendix 2: Indicative List of High / Medium Risk 108 Countries / Jurisdictions 8. Reporting Obligations and Transaction Monitoring 109 Appendix 3: Transaction Monitoring 134 Appendix 4: Parameters for Risk Based Transaction 140 Monitoring MODULE II: KYC- KNOW YOUR CUSTOMER 9. KYC Policy and Customer Acceptance 145 10. ML/TF Risk Assessment and Customer Risk Categorisation 152 Appendix 5: Indicative List of High / Medium Risk 163 Customers Appendix 6: Indicative List of High / Medium Products 165 & Services 11. Customer Identification Procedure (CIP) 166 Appendix 7: Name Screening Process 196 Appendix 8: KYC documents for eligible FPIs under PIS 204 Appendix 9: Wire Transfers – FATF SR VII Compliance 206 12. Other Modes of Customer Identification, CKYCR & 208 Maintaining Records 13. Organisational Roles and Responsibilities 217 14. Training & Awareness 227 Annexure I- Case Studies 235 Annexure II- Situation Analysis 245 Abbreviations Used 249 MODULE III: REGULATION AND COMPLIANCE 15. Regulation in Banks 251 16. Compliance Function in Banks 264 6 Sr. No. Chapter Page No. 17. Compliance Governance Structure 275 18. Framework for Identification of Compliance Issues & 287 Compliance Risks Appendix 10: Indicative list of Compliance Rules (CRs) 298 for Advances MODULE IV: REGULATORY COMPLIANCES 19. Exposure Norms 306 20. Loans and Advances- Statutory and Other Restrictions 322 21. Cash Reserve Ratio (CRR) & Statutory Liquidity Ratio (SLR) 344 22. Capital Adequacy 359 23. Priority Sectors and Micro, Small & Medium Enterprises 399 24. Interest Rates on Advances 413 25. Prudential Norms for Income Recognition & Asset 422 Classification and Wilful Defaulters 26. Foreign Exchange Operations under FEMA 457 27. Customer Service- Operational Aspects of Banking 523 28. Interest Rates on Deposits 560 29. Alternative Delivery Channels 571 30. Financial Services 614 31. Fraud & Vigilance Frameworks in Banks 621 7 MODULE I ANTI-MONEY LAUNDERING (AML) CHAPTERS 1. Money Laundering Phenomenon, its Impact and Terrorism Financing. 2. Money Laundering: Different Methods 3. Global efforts for AML and CFT by International bodies and International Cooperation among Countries 4. AML/CFT Legislation in Major Countries/Region 5. AML Legal and Institutional Framework in India 6. Money Laundering & Correspondent Banking/ Relations 7. Country Risk Categorization 8. Reporting Obligations and Transaction Monitoring 8 CHAPTER 1 MONEY LAUNDERING PHENOMENON, ITS IMPACT AND TERRORISM FINANCING STRUCTURE 1.1 What is Money Laundering? Its Origin 1.2 Impact on Global Economy 1.3 Impact on Financial System and Banks 1.4 Definitions: From International Agencies 1.5 Money Laundering and Its Impact on Banks: Some Examples 1.6 Terrorism Financing 1.7 Let us Sum up 1.8 Check Your Progress 1.9 Answers to 'Check Your Progress' 9 OBJECTIVES Knowing about the phenomenon of money laundering, and understanding its effect on global economy, financial system, banks, and bankers. Knowing terrorism financing, and understanding distinction and commonalities between money laundering and terrorism financing. 1.1 WHAT IS MONEY LAUNDERING? ITS ORIGIN 1.1.1 Money Laundering Phenomenon One of the reasons of engaging in any type of criminal activity is making money. Handling such money poses problems for the persons engaged in criminal activity, especially when the volumes are large. Besides, it increases the risk of their being caught by the law enforcement authorities. ‗Money Laundering‘ is the process by which money derived from criminal activities, e.g., drug trafficking, illegal arms sales, smuggling, extortion, gambling, bootlegging, etc., (‗Dirty Money‘ or ‗Illegal Money‘) is so brought into the financial system as to conceal its illicit origin and to make it appear to be from licit origin (‗Clean Money‘ or ‗Legal Money‘). 1.1.2 Origin of Money Laundering Money laundering has attracted attention of various governments globally in recent times, but it has been in existence since ancient times. The earliest form of money laundering was essentially trade related, when false trading modes were adopted to deal in illegal merchandise. In more recent times, it was said to be used by American gangsters dealing in banned alcoholic drinks. A Chicago gangster, set up the cash intensive business of launderettes to conceal his income derived from alcoholic drinks. Subsequently, money laundering attracted attention in the context of trading in banned drugs, and the modalities used by the high-level drug dealers to handle their earnings from the trade. 1.2 IMPACT ON GLOBAL ECONOMY 1.2.1 Cause for Concern The concern about money laundering arises from its linkage with criminal activities. The phenomenon of illegal money entering financial system in itself is not the cause for concern. The anxiety is more about the negative effects this is likely to have on the society. Money laundering provides avenue to criminals to camouflage their illegal assets into legal form, and also deployment of their surplus funds in legal avenues that would otherwise remain idle or squandered in more super luxurious styles. In a permissive environment it could have several detrimental effects – economic, political and social. 1.2.2 Economic Effects Unhindered conversion of illegal money to legal money could impact economy adversely. It would lead to unfair competition between honest and dishonest businesses. It could also result in distortion of prices, and crowding out of honest business. Thus, the investment climate in the economy gets dampened. Thus, there is an impeding impact on economic growth. Infusion of illegal money makes the money supply unpredictable, making it more difficult to manage monetary situation in the economy. Cross-border 10 movement of illegal funds increases the volatility of international capital, and impacts the exchange rates, as it is not determinable from the official trade. 1.2.3 Social Effects Corruption and organized crimes are two of the major concerns of several jurisdictions across the globe. Money laundering facilitates camouflaging ill-gotten wealth of corrupt officials. It facilitates structuring and perpetration of organized crimes. Thus in a jurisdiction with no control on money laundering corruption and financial frauds are likely to increase. Besides, such countries would be attractive harbors for criminals leading to deleterious effect on their social environment. 1.2.4 Political Effects Proliferation of criminals in jurisdictions where money laundering is prevalent would lead to their gaining influence over the social and political systems. This would gradually lead to their gaining a control over the socio-political system of the country, and it would ultimately undermine its democratic system. 1.2.5 Extent of Money Laundering Due to its very nature money laundering is not amenable to any data collection. Hence, no reliable figures are available about extent of money laundering. However, various global organizations and economic research institutes have attempted to estimate the extent of funds that would have been laundered. The first estimate of money laundering made by John Walker (University of Wollongong) in 1995 was of USD 2.8 trillion. Later, Michael Camdessus (IMF) in 1998 placed the figure at USD 1.5 trillion (about 5% of GDP). Subsequently, Buehn and Schneider estimated that in 20 OECD countries money laundering funds increased from USD 273 bn (1.33 % of GDP) in 1995 to USD 603 bn (1.74% of GDP) in 2006. A study conducted by The United Nations Office on Drugs and Crime (UNODC) estimated that funds generated by drug trafficking and organised crimes amounted to 3.6% of global GDP, with 2.7% (or USD 1.6 trillion) being laundered. The UN estimates that the amount of moneylaundering annually is equivalent to 2%-5% of global GDP. If money laundering were an economy, it would be the fifth largest in the world. 4th 1st $3.9 3rd $17.5 Trillion $4.9 Trillion Trillion 2nd $10.0 Trillion 5th $3.8 Trillion (Source: www.cebglobal.com) Fig. 1.1 UN Estimates of Money Laundering 11 1.3 IMPACT ON FINANCIAL SYSTEM AND BANKS 1.3.1 Vulnerability of Financial System Banks and financial institutions, since they deal in public money and provide a variety of services and instruments, are most vulnerable to receiving criminal money disguised in the form of genuine business. Globalisation of banking and finance coupled with technological advancement in payment systems has widened the scope for concealing criminal money and increased its mobility across borders. Absence of any preventive mechanism would expose these institutions to reputation risk, which is one of their most valuable assets. Prevalence of money laundering also enhances the risk of frauds and economic crimes, thereby impacting the soundness and stability of financial systems and the financial system of a country. 1.3.2 Impact on Reputation Banks and other financial institutions are caught unwillingly as intermediaries in the menace of holding and transferring money derived from criminal activities, from one account to another. Criminal money moves to institutions located in areas with less controls for its tracking. Inadvertent association of these institutions with criminals and criminal money would push them into adverse publicity leading to the loss of public confidence. 1.3.3 Regulatory Action Safety of banks depends on their functioning within a framework of high legal, professional, and ethical standards. The banks would face stringent regulatory actions for failure to check and control the criminal money entering into their system and for violation of relevant laws and regulatory guidelines. Banks and financial institutions therefore must have trained and committed staff and robust technology platforms/ software for scanning transactions. 1.4 DEFINITIONS: FROM INTERNATIONAL AGENCIES Various international organisations that are seized with the issue of money laundering have sought to define it. A few of them have been listed below that would give an idea about various perspectives of this phenomenon. 1.4.1 United Nations Convention against Illicit Traffic in Narcotic Drugs and Psychotropic Substances (1988) (Vienna Convention) ‗The conversion or transfer of property, knowing that such property is derived from any [drug trafficking] offense or offenses or from an act of participation in such offense or offenses, for the purpose of concealing or disguising the illicit origin of the property or of assisting any person who is involved in the commission of such an offense or offenses to evade the legal consequences of his actions; The concealment or disguise of the true nature, source, location, disposition, movement, rights with respect to, or ownership of property, knowing that such property is derived from an offense or offenses or from an act of participation in such an offense or offenses.‘ ‗The acquisition, possession or use of property, knowing at the time of receipt that such 12 property was derived from an offense or offenses … or from an act of participation in such offense or offenses.‘ 1.4.2 Other International Definitions ‗Money-laundering is the method by which criminals disguise the illegal origins of their wealth and protect their asset bases, so as to avoid the suspicion of law enforcement agencies and prevent leaving a trail of incriminating evidence.‘ (United Nations Office on Drugs and Crime) ‗―Money laundering‖ is the process by which proceeds from a criminal activity are disguised to conceal their illicit origin.‘ (IMF) ‗The goal of a large number of criminal acts is to generate a profit for the individual or group that carries out the act. Money laundering is the processing of these criminal proceeds to disguise their illegal origin.‘ (FATF) ‗Any act or attempted act to conceal or disguise the identity of illegally obtained proceeds so that they appear to have originated from legitimate sources‘ (Interpol) 1.4.3 Some More Definitions ‗Money is laundered to conceal criminal activity associated with it, including the crimes it generates, such as drug trafficking, or illegal tax avoidance. Money laundering is driven by criminal activities. It conceals the true source of funds, so that they can be used freely.‘ (Office of the Comptroller of Currency (OCC), Washington DC, USA) ‗Money laundering is the conversion of profits of illegal activities into financial assets which appear to have legitimate origins.‘ (US Senate‘s Sub-committee on Narcotics and Terrorism) ‗The concealment or disguise of the true nature, source, location, disposition, movement, rights with respect to, or ownership of property, knowing that such property is derived from serious crime.‘ (Article 1 of the EC Directive of March 1992) ‗Money Laundering is the process by which criminal proceeds are sanitised to disguise their illicit origins. Acquisitive criminals will attempt to distance themselves from their crimes by finding safe havens for their profits where they can avoid confiscation orders, and where those proceeds can be made to appear legitimate.‘ (The Crown Prosecution Service, UK) 1.5 MONEY LAUNDERING AND ITS IMPACT ON BANKS: SOME EXAMPLES 1.5.1 Bank of Credit and Commerce International Established in the 1970s, the Bank of Credit and Commerce International (BCCI) emerged as one of the world‘s largest privately owned financial institutions, with operations in over 70 countries. BCCI was found to have engaged in a number of illicit activities, including money laundering. It had been wholly indiscriminate about its 13 clients, which included traffickers, terrorists, dictators, fraud merchants, arms dealers, and other organised crime groups. The bank‘s operation was made up of multiple layers holding companies, affiliates, subsidiaries, etc. related to one another that was too complex to be noticed readily. It was thus able to evade usual restrictions on the movement of capital and goods. Exploiting the facilities of offshore financial centres, shell companies, and political influence, BCCI was not accountable to any jurisdiction or regulations. In July 1991, assets of BCCI worth more than US $ 12 billion were seized after regulators discovered evidence of widespread fraud. BCCI case points out a number of important issues for bankers: bankers should be careful about knowing correspondent banks, carefully screen potential major shareholders, pay attention to the quality and extent of supervision foreign banks receive in their home countries, and be aware that asset forfeiture laws put bankers at the risk of having accounts frozen or seized. 1.5.2 European Union Bank of Antigua The European Union Bank (EUB) initially registered as an offshore bank in Antigua in June 1994, launched its website in September 1995, and claimed to be the first Internet- based bank with facilities for customers to create and manage accounts online via the Internet. In 1996, it claimed to have a deposit base of US $ 2.8 million and 144 accounts with account holders spread across 43 countries. The bank‘s advertisement was explicitly aimed at people seeking to evade taxes or find a haven for dirty money where it would be beyond the reach of law-enforcement authorities. Customers could open numbered accounts, in which the customer‘s identity is known only by a EUB private banker or coded accounts (numbered accounts those are operated by password rather than signature). In July 1997, the EUB collapsed and the bank officials disappeared along with the deposits. 1.5.3 Riggs Bank (USA) (Pinochet) Augusto Pinochet, the former dictator of Chile, has been widely accused of corruption and illegal arms sales since 1973. A recent report has revealed that Riggs Bank (Washington DC-based with branches in the surrounding metropolitan area, and offices around the world) helped Pinochet disguise millions of dollars that had been stolen from the Chilean people. By hiding accounts from US Federal Regulators, Riggs Bank illegally allowed Pinochet to retain access to much of his fortune. The bank and Allbritton family, the people who controlled the Riggs Bank, agreed to pay US $ 9 million to Pinochet victims for concealing and illegally facilitating movement of Pinochet money. 1.5.4 Riggs Bank (USA) (Mbasogo) Investigations into the accounts of Riggs Bank in July 2004 revealed that the accounts of the embassy to the United States of Equatorial Guinea were allowed to make large withdrawals without properly notifying federal authorities. At least US $ 35 million were siphoned off by long-time dictator of Equatorial Guinea, Teodoro Obiang Nguema Mbasogo, his family and senior officials of his regime. Subsequently, Riggs Bank 14 pleaded guilty and had to pay a US $ 16 million fine for violations of the US Bank Secrecy Act in February 2005. 1.5.5 Fraudulent Encashment of Cheques – KYC Issues In August 2013, RBI received a complaint from a reputed statutory organisation through which the details of a fraud perpetrated in five large banks, with the connivance of certain officials of the statutory organization, came to its notice. The fraudsters had managed to open fictitious accounts in the name of the statutory organisation in the above five banks and operated the accounts mainly for encashing cheques/demand drafts/postal orders of which they were not the rightful owners, for periods ranging from one month to two years, without being detected by the banks. A scrutiny done by RBI in these banks revealed non-adherence to certain aspects of Know Your Customer (KYC) norms like customer identification and acceptance procedure, and non-adherence to instructions on monitoring of transactions in customer accounts. Consequently, RBI levied penalties of Rs. 50 lakhs and Rs. 25 lakhs on two banks; and cautioned three other banks. 1.5.6 Fraudulent Overdraft against FDs – KYC Issues In July 2014, consequent upon a complaint received from a private organisation, a scrutiny of fixed deposit accounts opened in its name in Mumbai based branches of certain public sector banks was undertaken. In view of further such complaints, a wider thematic review was conducted by RBI covering 12 branches of 11 Public Sector Banks. This scrutiny revealed non-adherence to certain aspects of KYC norms of the Reserve Bank like customer identification and acceptance procedure, non-adherence to the Reserve Bank‘s instructions on monitoring of transactions in customer accounts, and opening of fixed deposit accounts and granting overdrafts there against without due diligence or process, etc. Consequently, RBI levied penalties of Rs.1.5 crore each on three banks, and cautioned eight other banks. 1.5.7 Trade Based Money Laundering Investigations (October 2015) 1.5.7.1 Remittances for Fake Imports through a Public Sector Bank During 2015, ED and CBI both took action on their investigations in suspected money laundering transactions and between them arrested ten persons – of which three were bank officials whom these agencies suspected of having aided the money laundering transactions. Between July 2014 and July 2015, through a branch of a Public Sector Bank nearly 8000 illegal remittances worth about Rs.6000 crores were made by many companies in India to a foreign destination, as payment for imports that did not take place. All these transactions were below the threshold value. Several of the companies were ‗shell companies‘, as also the entities. Of this amount around 6.5% was deposited in the said accounts in cash, while the remaining amount was received through other banking channels. These transactions may have covered several banks. Serious Frauds Investigation Office is also investigating into the case. This bank has been penalized by both the RBI and FIU-India for violations of various regulatory and statutory norms related to AML/KYC measures. 15 1.5.7.2 Remittances for Fake Imports through Eight Banks In the second week of October 2015, the ED took action in another forex transaction matter in which an individual was suspected of having transferred around Rs.500 crores (between 2006 and 2010) through 70 fake bank accounts opened in 7 banks. He was also remitting money to two entities abroad as payment for imports. The amount was further remitted to another international destination. The amounts remitted were deposited in cash. The individual held 66 fake bank accounts in just one bank, besides having fake accounts in several other banks. 1.5.8 Lessons for Banks and Bankers Banking Regulators and law enforcement agencies have become stringent in enforcing AML/CFT related regulations. Not only they are more probing but are also adopting stricter approach in determining the punitive actions against erring bankers. In certain countries, especially the US and the UK, the regulators, besides taking actions against institutions, are also taking actions against the individual employees responsible for letting the violations take place. Consequences of laxity in implementation of measures for compliance with the legal and regulatory provisions could therefore be serious. These would not only result in heavy penalties, but also grave strictures by the law enforcement agencies. This could lead to significant reputation loss for the institutions. Such eventualities would have detrimental impact on the businesses of the institutions, and also on their ability to attract global investment. Besides, lapses in customer identification and/or in monitoring transactions can possibly lead to not only money laundering problems, but also to other frauds of various kinds thereby increasing operational loss of the institutions. Not only the institutions, even their employees are exposed to several risks arising from failures in compliance. Besides, facing personal strictures and fines, they also run the risk of facing imprisonment under legal provisions. Reputations of individuals‘ subject to any of such actions would also be impacted adversely and harm their future careers. 1.6 TERRORISM FINANCING 1.6.1 Terrorist Financing Phenomenon Terrorist financing refers to mobilising or providing funds with the intention that they may be used to support terrorist acts or organizations. Funds for terrorism activities may stem from both legal and illicit sources. Those involved in the financing of terrorism do not necessarily seek to conceal the sources of the money, but to conceal both the financing and the nature of the financed activity. Terrorism activities per se do not require large quantum of funds. However, creating, running and maintaining the organisations for carrying out terrorist activities require substantial funds. 1.6.2 Definition As per the UN‘s International Convention for the Suppression of the Financing of Terrorism (1999): 16 Any person commits an offense within the meaning of this Convention if that person by any means, directly or indirectly, unlawfully and willingly, provides or collects funds with the intention that they should be used or in the knowledge that they are to be used, in full or in part, in order to carry out: (a) An act which constitutes an offence within the scope of and as defined in one of the treaties; or (b) Any other act intended to cause death or serious bodily injury to a civilian, or to any other person not taking any active part in the hostilities in a situation of armed conflict, when the purpose of such act, by its nature or context, is to intimidate a population, or to compel a government or an international organization to do or to abstain from doing an act. For an act to constitute an offense set forth above, it shall not be necessary that the funds were actually used to carry out an offense referred to in (a) or (b). 1.6.3 Differences in Perspectives Not all countries that have adopted the convention agree on what actions constitute terrorism. The meaning of terrorism is not universally accepted due to significant political, religious and national implications that differ from country to country. 1.6.4 Money Laundering and Terrorist Financing These are two different phenomena. In money laundering the source of funds is illegal and concealed, and the use of funds is legal; whereas in terrorism financing the source of funds may be illicit or legal but the use is criminal and is sought to be concealed. However, in both the cases there is an illegitimate use of the financial sector using similar or identical processes. The techniques used to launder money are essentially the same as those used to conceal the sources of, and uses for terrorist financing. There are also situations when funds raised through criminal activities are diverted for terrorism financing using similar techniques. Therefore, the measures taken for prevention of money laundering would also help detect and prevent terrorism financing related transactions. 1.7 LET US SUM UP This chapter broadly dealt with the phenomenon of money laundering (ML), its initial stages world over; how these practices impact global economy; and its serious and visible effects on social and political environment. Further, ML practices in a jurisdiction significantly impact the Financial and Banking system of the geography. Banks / FIs, while facing the challenges have learnt lot many lessons for upgrading the solutions for the issues. Various international fora and agencies have defined money laundering phenomenon with different perspectives. Banks and financial institutions are also abused for financing terrorism (TF). The phenomenon of ML and TF are different but the modalities adopted for both purposes are similar. 17 1.8 CHECK YOUR PROGRESS 1. What is Money Laundering? (a) Money Laundering is type of investment to earn good returns. (b) People use this process for ensuring long term gains. (c) Phrase Money Laundering is described for conversion of dirty money to clean money. (d) Money Laundering is the process followed by Corporates to make bulk payments. 2. What is meant by TBML? (a) Tangible Basis of Money Lending (b) Trader‘s Bank for Multiple Lending (c) Trade Basis for Money Laundering (d) Trade Based Money Laundering 1.9 ANSWERS TO 'CHECK YOUR PROGRESS' 1. (c); 2. (d) 18 CHAPTER 2 MONEY LAUNDERING: DIFFERENT METHODS STRUCTURE 2.1 Money Laundering Process 2.2 Terrorism Financing 2.3 Common Sources of Illegal Money 2.4 Methods/Modes Used for Money Laundering/Terrorism Financing 2.5 Sensitive Avenues for Money Laundering/Terrorism Financing 2.6 Let us Sum up 2.7 Check Your Progress 2.8 Answers to 'Check your Progress' 19 OBJECTIVES Knowing about Money Laundering Cycle, and Terrorism Financing purposes. Understanding how banking products and services are used by money launderers and terrorists. Knowing features of sensitive avenues used for money laundering and terrorism financing. 2.1 MONEY LAUNDERING PROCESS 2.1.1 Nature of Money Laundering Process Money laundering is a diverse, and often a complex process. Depending on the sources of illegal funds, manner of their receipt, quantum of funds, the geographical spread of the activities and the actors involved the modalities of money laundering are conceived and adopted. The range of sophistication, and complexity in money laundering scheme is virtually infinite, and is limited only by the creative imagination and expertise of criminals. A financial institution may be used at any point in the money laundering process. 2.1.2 Basic Money Laundering Cycle Illegal funds are usually generated in cash form be it ransom money received in case of kidnapping, or the amount received by a contract killer, or say the proceeds of illegal sale of drugs. This cash amount is sought to be transformed into legal funds, which would be substantially in the banking system. Thus the traditional methodology developed for money laundering basically involves three independent steps that often occur simultaneously, as mentioned below:  Placement - Physically placing (i.e., depositing) the cash funds into banking system.  Layering - Distancing the funds placed into banking system from their origins, through creation of various layers of financial transactions so that the initial entry of placement stage gets obscured.  Integration - Accumulating the funds scattered over various accounts, and may be across several banks, at one or two points having an apparently legitimate form/purpose. Thereafter the ‗legal‘ funds could be invested in legal avenues or spent on super luxuries. Figure 2.1 below depicts the typical money laundering cycle. 2.1.2.1 Placement This is generally the first stage in money laundering cycle, when the funds generated through illegal activities are introduced into the legal financial system. Typically, this is done through cash deposits in local financial institutions, or else smuggled out across the borders to a safer jurisdiction for depositing in foreign financial institutions. This poses some difficulties due to provisions of reporting requirements for cash transactions above certain threshold. Hence, at this stage typically multiple accounts are used, and through these multiple transactions carried out. Such accounts could be spread in different branches of a bank or of several banks. Besides, the launderers have been innovating new techniques to avoid getting reported under such provisions. 20 2.1.2.2 Layering After introducing funds into the financial system, the launderer seeks to obscure the initial entry points from the eyes of the investigators. Layering, implying creation of layers of transactions, is the technique used for covering up the initial transactions. This is done by carrying out numerous transactions for moving the funds through different accounts, in several names and in various financial institutions. These transactions could even involve cross border transfers. These transactions usually would be in the form of structured/fake deals in prevalent business activities. These are designed to frustrate tracking of the source and nature of funds and their ownership. As high value transactions are monitored by banks closely, launderers pay particular attention to structuring these transactions deftly. Given the large number of transfer transactions of values of trillions of dollars passing through the global financial system, it is easy for launderers to slip through their illegitimate transactions unnoticed. Moreover, the information technology developments resulting in quick electronic fund transfers that can be initiated by the customer remotely through netbanking, have been a boon to the launderers. (Source: UNODC) Figure 2.1 Typical Money Laundering Cycle 2.1.2.3 Integration This is the final stage in the money laundering cycle. It is the stage where the money moves into legal avenues to emerge as legitimate money and integrate into the financial system. These avenues would depend on the quantum of funds involved, the launderer‘s need for the funds and the objective of deployment. Typically, these avenues could be stocks, commodities, futures, investments in real estate, gold, etc. Where the objective is 21 long term deployment of the funds, these could be invested in business activities like construction and real estate development, film making, etc. At this stage, the launderer has accomplished the objective. 2.1.3 Learning for Bankers This analysis of typical money laundering cycle helps us to formulate an approach for detection of such illegitimate transactions. Banks are used by customers for financial transactions that would serve some bona fide or legal purpose. Having knowledge about the customers and their activities would help the banker to determine the patterns of their transactions. Spotting mismatches in the pattern of actual transactions of a customer with that evident from the customer‘s profile is possible with appropriate strategies and measures. At ‗Placement‘ stage, since it involves cash it is relatively easier to detect unusual/ illegitimate transactions. At ‗Layering‘ stage too being alert to the transaction pattern of the customer and insight into funds movement for various business activities enable detection of unusual transactions. At the ‗Integration‘ stage it is extremely difficult for banks/financial institutions to distinguish between legal and illegal money. 2.2 TERRORISM FINANCING 2.2.1 Features of Terrorism Financing Terrorism Financing has two dimensions. One, funds needed to carry out specific terrorist action, say planting a few bombs in some local trains in Mumbai. Such actions do not require significant funds, given the modalities adopted for these. However, since such actions often involve persons in different locations and often different nations movement of funds is needed across these locations. Second, most terrorism activities across the globe are being carried out by organisations set up for the purpose, and these often ascribe certain ‗higher ideals‘ like religion or political affiliations to such actions. These organisations need large amount of funds for enrolling and training their cadres, procuring weapons and other ammunitions, building up network, reconnaissance activities, publicity network for mobilizing mass support. Besides, often these organisations operate covertly under the guise of certain legitimate activities, typically social welfare, charitable activities, medical facilities, etc. 2.2.2 Financing of Terrorist Acts Financing of individual terrorist act would need nominal amounts. These are usually transferred guised as personal remittances from the funding location to the target destination. The source of fund could be in cash or from an existing bank account. Often, the remitters and the beneficiaries could be innocent persons, who are not aware of the real purpose, and carry out the transactions for some nominal commissions paid to them. Due to their low value, these transactions are extremely difficult to notice. The terrorist attacks per se do not require large quantum of funds. However, various related activities like creating, running and maintaining the organisations for carrying out terrorist activities require substantial funds. Terrorist organisations therefore spend considerable efforts and time for raising material resources and funds for meeting the financial requirements for these activities. Many of these organisations are active in several 22 countries and hence their financial transactions span across several countries. Moreover, the large terrorist organisations are typically funded by their sympathisers, both individuals and organisations, located in different countries. Thus, the financial transactions of terrorist organisations have similar features as of any commercial organisations. The funding cycle of a terrorist organisation can be depicted as shown in Fig. 2.2. Figure. 2.2 Terrorism Financing Stages 2.2.3 Financing of Terrorists There are three types of principal sources for terrorist financing: (i) State - financing: This happens in case of state sponsorship of terrorism. In such cases separate entities are created with organizational and financial support of the State. These organizations are outwardly distanced from the state and typically engaged in some charitable/social activities on significant scale. Quantum of funds involved is substantial, and these would be received in the form of grants or indirectly as donations. (ii) Legitimate Modes: These organisations could receive funds in the form of contributions or donations from businesses, individuals, or some charity funds for their declared activities. (iii) Private Funding: Another source of funding for terrorists is funds raised through criminal activities. These are such criminal activities that involve large funds like bank robberies, drug trafficking, kidnapping, extortion, etc. 2.2.4 Learning for Bankers Remittance transactions for the purpose of financing specific terrorist acts are of low value. Hence for tracking such transactions different modalities are required. The challenge is greater because very little information is available on the techniques adopted by the terrorists for this purpose. Paying attention to the locations and certain types of customers may be useful. Timely intervention in such transactions may be useful to the government intelligence and security agencies. 23 As regards terrorist organizations, due diligence and appropriate transaction monitoring by banks can enable them to provide very useful information to the concerned agencies that may help in detection of organisations covertly engaged in terrorist activities. It is important for banks to have appropriate controls to avoid getting into a situation when its name gets associated with organisations or persons found guilty of terrorist activities thereby causing severe damage to the reputation of the bank. 2.3 COMMON SOURCES OF ILLEGAL MONEY 2.3.1 Typical Sources Following are some of the most common criminal activities that generate illegal money.  Drug trafficking  Organised crime, e.g., extortion, prostitution, loan sharking, kidnapping, contract killing, gambling, protection money, adulteration, bank frauds, corruption, etc.  Slush funds maintained by big corporations, e.g., bribery, payment to political parties, politicians, etc.  International trafficking in arms  International trafficking in human beings  Smuggling 2.3.2 Tax Evasion In addition, in recent years focus of governments on tax evasion has increased, perhaps arising from detection of such cases based on reports in respect of suspicious transactions. This is so because, the modalities adopted for evasion of tax on legal income are similar to those adopted by criminals to launder their illegal money. There is however still divergence of views among various countries on considering tax evasion as a predicate offence for money laundering. 2.4 METHODS/MODES USED FOR MONEY LAUNDERING/TERRORISM FINANCING The Joint Money Laundering Steering Group, London has listed a few techniques commonly used by money launderers all over the world which are reproduced below, along with certain other methods in vogue. 2.4.1 Using Normal Banking Services 2.4.1.1 Deposit Structuring/Smurfing The most common manner of introducing cash in financial system is by depositing it in amounts below the reporting threshold. Hence, in India since Rs. 10 lakhs is the reporting requirement, the amounts deposited would be such that they do not cross this amount. To enable handling of higher amount of funds a number of accounts are used instead of one or two accounts. In another variant, the deposits may be made by a large number of apparently unconnected depositors. The money is then generally transferred to another account. The money keeps revolving among several accounts. Countries or locations to which these funds 24 are transferred, often find the funds being promptly removed as cash from the recipient accounts. 2.4.1.2 Multiple Tier of Accounts In this technique, the funds are passed through multiple accounts by splitting them into two or more portions at each stage. Depending on the number of splits and the number of tiers the accounts at the base of the triangular structure could be large. Such a complex structure makes it very difficult to trace the origin of funds. 2.4.1.3 Funnel Accounts In this variant, a bank account is opened for the purpose of deposits of dirty money to be made by several persons usually below the reporting threshold, say Rs.10 lakh. These amounts are immediately withdrawn from the account at the distant locations. 2.4.1.4 Contra Transactions Sometimes to show heavy turnover in accounts, some amount is transferred from one account to another account, followed by an equal amount transferred from the recipient account to the originating account. Such transactions may be repeated several times during a day, over several days or even few months. The real purpose of such transactions is difficult to understand, but there would be no commercial or economic purpose for these. 2.4.1.5 Bank Drafts and Similar Instruments Bank drafts, money orders and cashiers‘ cheques, purchased for cash, are useful for laundering purposes because they provide an instrument drawn on a respectable bank or other credit institutions, and thus break the money trail. This reduces the ability of the law enforcement authorities to seek a judicial order to appropriate such funds. 2.4.1.6 Cash Deposits followed by Transfers Often for laundering huge amount of funds, large cash deposits are made in the account say by drug traffickers or others who may have smuggled this out of the country where the crime originated. Such deposits are usually quickly followed by a transfer to another jurisdiction (which may or may not be the original country where the crime was committed), in the guise of some genuine business transaction, thus lowering the risk of seizure. 2.4.1.7 Connected Accounts Another modality followed is accounts held in the names of relatives, associates, or other persons operating on behalf of the criminal i.e. benami accounts. Similarly, services of professionals such as lawyers are used for the purpose of opening and operating accounts, keeping the identity of the real owner of funds hidden. This modality could also use shell companies, almost always incorporated in another jurisdiction, or offshore incorporation agents. These techniques are often combined with several layers of transactions and the use of multiple accounts. 25 2.4.1.8Front Companies Use of companies engaged in selling goods and providing services having large volume of business often cash dealings are used for mingling of dirty money along with their legitimate business dealings. Similarly, entities like banks, casinos, brokerage firms, etc. may be used. Identification requirements at least make it difficult for criminals to open accounts with false names, and hence preference for using existing companies as front. 2.4.1.9 Legitimate Accounts Individuals may run a number of accounts with several banks. It is not unusual for accounts with one bank to be used for domestic purposes, while accounts with another are for ‗business purposes‘. Into the former, salaries or benefits may be paid, while the latter account will be used for money transfers and cheque payments. Terrorist often use existing accounts of individuals not connected with them – ‗money mules‘. This could be sometimes done for payment of a commission. 2.4.1.10 Dormant Accounts On occasions, dormant accounts have been used to create a purported customer relationship, upon which additional frauds may be perpetrated. Facilities can be accessed, including bank loans, the repayment instalments of which will invariably not be met. Dormant accounts have also been used to receive monies from support members abroad. In one example, a terrorist used a number of banks, holding an account in each of them. Two of the accounts contained a minimal sum, believed to be for two purposes: firstly, to keep the account open, and secondly, to ensure that undue attention was not drawn to it. At a strategic time, a transfer was received into the account, to enable the purchase of terrorist material. The sum was eroded by a daily removal of the maximum cash amount from the automatic teller machines. This continued until the entire transfer sum had been removed, that took almost two months. Dormant accounts are also attractive to terrorists. 2.4.1.11 Wire Transfers These can be effected through banks or wire transfer companies. The experience of law enforcement suggests that banks or wire transfer companies based in retail outlets containing video cameras, are used to a much lesser extent than those where the wire transfer service is franchised to a small, more localised unit. However, the extent to which these facilities are used is also determined by the ease of both sending and receiving the money. The cases where companies do not request documentation, and require only the use of a pre-agreed question and answer prior to the release of the transferred sum, particularly attract money launderers. 2.4.2 Using Special Types of Accounts 2.4.2.1 Collection Accounts Collection accounts are widely used by different ethnic groups in a foreign country to remit funds home. Immigrants deposit small amounts in a single account, and the accumulated funds are then sent abroad in a single transaction. Often, a foreign account 26 receives payments from a number of apparently unconnected accounts in the source country. Whilst this is legitimate purpose for the foreign immigrants, and labourers it can be, and is, used by criminal groups to launder their illegitimate funds. 2.4.2.2Payable-through Accounts Payable-through accounts are accounts maintained at financial institutions by foreign banks or corporations. The foreign bank funnels the deposits and cheques of its customers (usually individuals, or businesses located outside the country) into this single account it holds at the local bank. The foreign customers have signing authority for the account as sub-account holders, and can thereby conduct normal international banking activities. Many banks offering these types of accounts have been unable to verify or provide any information on many customers using these accounts. These accounts pose a challenge to ‗know your customer‘ policies and requirements, and suspicious activity reporting guidelines. 2.4.3 Using Cross Border Trade/Loans 2.4.3.1 Back-to-Back Loans Back-to-back loan arrangements can be used for cash smuggling. A money launderer transfers his/her criminal proceeds to another country as security or guarantee for a bank loan, which is then sent back to the original country. This method not only gives laundered money the appearance of a genuine loan, but often provides tax advantages. 2.4.3.2 International Trade/ Trade Finance International trade in goods and services can be used either as a cover for money laundering or as the laundering mechanism itself. This is essentially done by creating difference in the real value of goods exchanged and the financial transaction value by manipulating the quantity or quality or description of goods. This facilitates transfer of additional amounts between the countries. This additional amount is settled among the concerned parties separately. A trader may pay a large sum of money (from the proceeds of illegal activity) for goods which are worthless and are subsequently thrown away or sold on cheaply (often as part of an invoice manipulation scheme to move money). This additional amount remitted is then credited to the launderer‘s account in the other country. Another mode is, illegal proceeds are used to buy high value assets such as luxury cars, aeroplanes or boats, which are then exported to third countries. Trade/invoice manipulation is one way in which agents and others engaged in alternative remittance systems settle the balance between them. It is often easier for them to engage in trade deals, as opposed to money transfers. They will also avail of usual trade finance services to maintain a façade of genuineness. 2.4.4 Using Entities in Lax Jurisdictions 2.4.4.1 Offshore Banks There are centres where regulatory controls are few with tax benefits and secrecy protection. Many banks have flourished in these centres accepting money liberally, which facilitated money laundering. The major centres include Singapore, Hong Kong, 27 Bahamas, Bahrain, Cayman Islands, Switzerland, etc. Deposits in these banks could be in cash smuggled into these countries from other countries, or through remittances under guise of genuine business transactions in the accounts of entities established for laundering purpose. 2.4.4.2Shell Companies A shell company is just that - a shell where no real business is conducted. They appear on paper, but may not physically exist. If at all any of these exists physically, they may not be engaged in manufacturing or trading operations. They are used to create the appearance of legitimate transactions through false invoices and financial statements. They also enter into financial activities such as getting loans against securities acquired from dirty money and paying taxes on profits. There are even shell banks that look like banks but not engaged in real banking activities. A shell bank (or company) can be a convenient vehicle to launder money. It conceals the identity of the beneficial owner of the funds, and the company records are often more difficult for law enforcement to access because they are offshore held by professionals who claim secrecy, or the professionals who run the company may act on remote and anonymous instructions. Such companies are used at the placement stage, to receive deposits of cash which are then often sent to another country, or at the integration stage, for example to purchase real estate. 2.4.5 Using Cards/Remittance Products 2.4.5.1 Credit and Debit Cards Structured cash payment for outstanding credit card balances is the most common use of credit cards for money laundering. These could be with relatively large sums as payments, and in some instances, cash payments from third parties. Another method is to use cash advances from credit card accounts to purchase cashiers‘ cheques, or to wire funds to foreign destinations. On some occasions, cash advances are deposited into savings or current accounts. These could be used by terrorist in a manner that at the point of usage, they are not noticed or caught on a CCTV that could lead to their detection in later investigations. 2.4.5.2 Pre-paid Cards Prepaid cards are a boon to the criminals who desire anonymity. Forex prepaid cards have made it possible to have cash funds available at call anywhere in the world and at any point of time. These usually have lower thresholds than those for credit cards, thus restricting the value of funds available. However, for financing of terrorist acts this is not a constraint. Terrorists find it useful to avail these, as these are not linked to any bank account. They can be used for procuring cash at locations across but near international border of the country where the target destination is located. 2.4.5.3Bureaux De Change (Money Changers) Bureaux De Change (or equivalent) services - such as telegraphic transfer facilities, and exchange services - which can be used to buy or sell foreign currencies, to consolidate small denomination bank notes into larger ones, or to exchange financial instruments 28 such as travelers‘ cheques, Euro cheques, money orders, and personal cheques are attractive to money launderers. The degree of regulation over these businesses is often less stringent than that of traditional financial institutions. Their staff skills are lower, and systems and procedures relatively lax. Criminals therefore tend to uses these, especially in jurisdictions where they are not heavily regulated. 2.4.6 Using Other Remittance Service Providers 2.4.6.1 Remittance Services Remittance systems operate in a variety of ways. Often, the remittance business receives cash, which it transfers through the banking system to another account held by an associated company in the foreign jurisdiction. There, the money can be made available to the ultimate recipient. Another technique commonly used by money remitters and currency exchanges, is for the criminal organisation to receive the funds at the destination country in the local currency, which is then sold to foreign businessmen who need the currency to fund legitimate purchases of goods for export. Remittance services are a feature of many ethnic groups; they often charge a lower commission rate than banks for transferring money to another country, and have a long history of being used to transfer money between countries. These services have also been used for money laundering, since they are often subject to few, if any, regulatory requirements as compared to banks. Terrorists also find it useful for their transactions that are of low value and where covering identities is crucial. 2.4.6.2Alternative Remittance Systems/ Value Transfer Systems These systems commonly involve transfer of value between countries, but outside the legitimate banking system. The ‗broker‘, who may be a financial institution such as a remittance company, or an ordinary shop selling goods, has an arrangement with a corresponding business in another country. The two businesses have customers who want funds in the other country, and after taking their commission, the two brokers will match the amounts required by their respective customers. The details (which are usually minimal) of the recipients of the funds, are faxed or conveyed through a telephone call. Settlement of the net amount owed by one business to the other may not, however, always take place between the two businesses directly. It may be done by one of the businesses settling an amount owed by the other businesses to a third party, or by the amount being placed or deposited elsewhere for the benefit of the second business. Often there is no, or little, physical movement of currency across the border and a lack of formality with regard to verification and record-keeping. Normally, money transfer takes place by coded information being passed through couriers, letters or faxes, followed by telephone confirmation. Almost any document which carries an identifiable number can be used for this purpose. Because there is no recognisable audit trail, the launderer‘s chance of remaining undetected, or avoiding confiscation, is significantly increased. This is another avenue that is useful for terrorists for transfer of funds clandestinely. 29 2.4.6.3 Hawala System It is an alternative remittance system that operates outside the control of the government allowing for undocumented deposits, withdrawals, and transfers. These are trust based systems that leave no paper trail. Money is transferred via a network of hawala brokers. A customer approaches a hawala broker in one city, and gives a sum of money to be transferred to a recipient in another, usually a foreign city. The hawala broker calls another hawala broker in the recipient‘s city, gives disposition instructions of the funds. This is prevalent in certain countries of South Asia. This channel provides total anonymity, and hence is useful for funding of terrorist activity through illegal funds across borders. 2.4.7 Third Party Products/New Technology 2.4.7.1 Insurance Policies General insurance policies provide an attractive laundering avenue; putting an expensive asset on cover, paying a large premium by bank transfer, followed by early cancellation of cover, requesting the refund remittance to be made to another bank in another country. 2.4.7.2 Emerging Technologies The use of Internet for banking services is growing considerably and rapidly, with an increasing range of services becoming available (including savings and deposit accounts, full cheque accounts, electronic fund transfers). These are now being joined combined with Internet-based stockbroking. It is an attraction to the launderer in the absence of a face-to-face contact. Now, credit and financial institutions offer electronic money by way of a card-based electronic purse. Whilst the size/value of such purses is restricted by regulatory requirement, the opportunity to purchase such electronic money for cash, and then to use it to purchase assets, albeit modest, or obtain a refund by cheque, does provide an opportunity for structured placement. 2.4.8 Cybercrime & Cryptocurrency 2.4.8.1 Cybercrime With growing use of technology in commercial and financial transactions, the potential opportunity for cyber criminals has also grown substantially. FinTech has in fact changed the classical first stage of money laundering i.e. in the form of cash. Cybercrimes in fact generate criminal funds within the financial system and route those funds through various stages at super-fast speed to the integration or deployment stage. This could be equally true of the low value phishing or vishing scams that siphon out small amounts of few thousands or a couple of lakhs, as also of very high value cyber-attacks like that on the Central Bank of Bangladesh. 2.4.8.2 Cryptocurrency Crypto currencies are growing at a fast pace. They have not only drawn attention of speculative investors and traders, but more importantly of criminals. The use of crypto currencies in illicit trade and money laundering activities is growing consistently and 30 rapidly. They have also been used by cyber-criminals. FIU efforts uncovered frauds using virtual assets, carrying out SWIFT heists and operating business email compromise schemes, among others. As per statistics, the number of cryptocurrencies as at end-February 2022 were 10,397 as against just a handful of coins in 2013. However, top 20 of these cryptocurrencies make up 90% of the total value of cryptocurrencies. Even amongst the latter, Bitcoins have the predominant share. Crypto coins other than the Bitcoins are called Altcoins. There are several other types of virtual assets like Tokens, Non-Fungible Tokens (NFT), Stablecoins, etc. Reuters has reported that cryptocurrency-linked crime surged to a record high in 2021 in terms of value, with illegal addresses receiving $14 billion in digital currencies, up 79% from $7.8 billion in 2020. 2.5 SENSITIVE AVENUES FOR MONEY LAUNDERING/TERRORISM FINANCING 2.5.1 Gold and Diamond Markets There are significant differences between the gold and diamond markets. Gold is worth much more per unit of weight, and there is a constant market for it. The purity of gold is easy to determine, and assay marks are well understood and available to see. Diamonds, on the other hand, are more complex; individual diamonds can be worth much more than an equivalent weight of gold, but there has to be the ‗right‘ buyer for a particular diamond. Besides, a diamond is not divisible i.e. a diamond worth say $100,000, cannot be cut in two halves worth $50,000 each. Valuation of diamonds is a much more complex process than gold; it involves specialised training, without any guarantee that a sale can be arranged. 2.5.1.1 Gold Market The advantages that gold provides are attractive to the money launderer, in particular its high intrinsic value, convertibility, and the potential anonymity in transfers. Most laundering schemes involving gold are linked to drug trafficking, corruption, organised criminal activities, and illegal trade in merchandise and goods. The gold itself may be the proceeds of crime that needs to be laundered if, for example, it has been stolen or smuggled by creating a system of false invoicing. Certain societies have high demand for gold due to cultural or religious significance attached to it, and hence are heavy importers providing avenue for its smuggling. Besides, due to its high value gold is also used for structuring transactions that serve as a cover for laundering operation. 2.5.1.2 Diamond Market The illegal trade in diamonds is important in certain areas of the world, and some terrorist groups are believed to be using diamonds from these regions to finance their activities. The ease with which diamonds can be hidden and transported, and the high value per gram for some stones, make diamonds attractive for the criminal‘s exploitation for profit. As with gold, the simplest typology involving diamonds consists of the direct purchase of 31 diamonds with criminal proceeds. Other common typologies using diamond trading activity include retail foreign exchange transactions, purchasing of gaming chips at casinos, forged or fraudulent invoicing, and co-mingling of legitimate and illicit proceeds in the accounts of diamond trading companies. 2.5.2 PEPs/ Corruption Instances of persons in charge of governing a country and senior government officials involved in corruption and other types of proceeds generating crime are no longer rare occurrences. In the past few years, several high visibility corruption cases involving corrupt politicians and others laundering significant criminal proceeds have been detected and investigated. 2.5.3 Misuse of Non-Profit Organisations (NPOs) and Charities Non-Profit Organisation structure has been found to be very useful by terrorist outfits for carrying out their nefarious activities clandestinely. The misuse of NPOs by terrorist groups can take many forms. One, an NPO set up with a stated charitable purpose, but it actually exists only to channel funds to a terrorist organisation. In another form, an NPO with a humanitarian or charitable purpose is infiltrated by the terrorists and their supporters, often without the knowledge of the donors, or the members of staff, or management. In another mode, the organisation serves as an intermediary or cover for the movement of funds, usually on an international basis. In some cases, the NPO support function extends to the movement and logistical support of the terrorists themselves to raise money. 2.6 LET US SUM UP This chapter broadly dealt with various money laundering methods and processes generally used by the criminals engaged in such practices. The ML cycle usually followed has three stages i.e. Placement, Layering and Integration. Different methods of ML may be used for different sources of illegal money. Uses of various types of bank accounts, schemes and remittance linked banking channels, some avenues being misused for terror funding. 2.7 CHECK YOUR PROGRESS 1. The traditional methods for ML, still in use for illegal funds, are ---------------. (a) Avoiding banking channels (b) Maintaining bank accounts in fictitious names (c) Placement, Layering and Integration of funds (d) Using cash operations without banking facility 32 2. Money laundering is a matter of serious concern; it affects a country‘s economy adversely. Which one of the following statements is incorrect? (a) It affects a country‘s revenue. (b) It affects the social structure, and also leads to corruption and organised crimes. (c) It affects the political system as criminals try to get support from leaders who are in power. (d) It increases money flow in the country to push middle level economic activities. 2.8 ANSWERS TO 'CHECK YOUR PROGRESS' 1. (c); 2. (d) 33 CHAPTER 3 GLOBAL EFFORTS FOR AML/ CFT BY INTERNATIONAL BODIES AND INTERNATIONAL COOPERATION AMONG COUNTRIES STRUCTURE 3.1 Engagement of International Organisations 3.2 United Nations Initiatives 3.3 International Monetary Fund (IMF) 3.4 BASEL Committee on Banking Supervision 3.5 Financial Action Task Force (FATF) 3.6 The Wolfsberg Group 3.7 Financial Intelligence Units 3.8 The Egmont Group of Financial Intelligence Units 3.9 Let us Sum up 3.10 Check Your Progress 3.11 Answers to 'Check Your Progress' Appendix 1. List of FATF Recommendations with brief synopsis 34 OBJECTIVES Knowing about the initiatives taken by various international organisations, viz. UN, IMF, BCBS and Wolfsberg Group for dealing with the ML and FT, including international co- operation and co-ordination. Getting a glimpse of evolution of the Standards for AML/CFT by Basel Committee on Banking Supervision. Knowing about the FATF and FTAF Style Regional Bodies. Understanding FATF Standards for Anti-money laundering, Combating Financing of Terrorism and Prevention of Proliferation of Weapons of Mass Destruction. 3.1 ENGAGEMENT OF INTERNATIONAL ORGANISATIONS Money laundering and Terrorism are major global problems that have engaged the attention of all major primary international organisations. The extent of increase in these activities has made these organisations to continuously evolve standards and procedures for dealing with them. The need for coordination of efforts in dealing with these problems has been appreciated by various organisations. One of the earliest such initiatives was undertaken by the Committee of Ministers of the Council of Europe in June 1980. In its report the Committee of Ministers concluded that ―... the banking system can play a highly effective preventive role while the cooperation of the banks also assists in the repression of such criminal acts by the judicial authorities and the police‖. Initially the menace of drug trafficking attracted the attention of the United Nations and other international bodies. Subsequently, other criminal activities were also included in the efforts to curb money laundering. 3.2 UNITED NATIONS INITIATIVES 3.2.1 The Vienna Convention - 1988 In 1988, at Vienna, the United Nations Convention against, illicit Traffic in Narcotic Drugs and Psychotropic Substances of 1988 mandated The United Nations Office on Drugs and Crime to establish a program for measures to be adopted by various countries for preventing drug trafficking. The measures forming the Convention also included having laws declaring as an offence conversion or transfer of any property known to be from drug trafficking or related offences, and concealing illicit origin, transfer or movement of property derived from such offences. Provision of mutual legal assistance, transfer of proceedings and other forms of co-operation among nations were also included. This essentially was the beginning of establishing legal regime for prevention of money laundering. 3.2.2 Political Declaration - 1998 The mandate to UNDC was strengthened in 1998 by the Political Declaration and the measures for countering money-laundering adopted by the General Assembly at its twentieth special session, which broadened the scope of the mandate to cover all serious crime, not just drug-related offences. 35 3.2.3 The Palermo Convention - 2003 In 2000, at Palermo, the UN adopted the International Convention Against Transnational Organised Crime. This included measures to fight organized crimes and required enactment of domestic laws for this purpose. Certain provisions included were making money laundering a criminal offence, and to make all serious crimes as predicate offence. Besides, it also required establishment of a regulatory regime for detecting money laundering, suspicious transaction reporting, customer identification and record keeping. Further, it called upon co-operation and exchange of information among administrative, regulatory, law enforcement and other agencies at national and international levels. 3.3 INTERNATIONAL MONETARY FUND (IMF) IMF in view of its universal membership, surveillance functions and financial sector expertise made itself a partner in global initiatives for combating money laundering and also terrorism financing. In 2000, IMF took steps in this direction by initiating Offshore Financial Centre assessment. IMF dovetailed assessment of member countries with FATF Standards into its Financial Sector Assessment Program. It also included AML/CFT technical assistance into its regular activities. IMF is also active in studying international practices in implementing AML/CFT regimes that is useful in providing policy advice and technical assistance. 3.4 BASEL COMMITTEE ON BANKING SUPERVISION The BCBS is the primary global standard-setter for the prudential regulation of banks and provides a forum for cooperation on banking supervisory matters. It has published several documents related to prevention of money laundering and customer due diligence. 3.4.1 Prevention of Criminal Use of the Banking System for the Purpose of Money- Laundering (December 1988) (Since superseded) Public confidence in banks, and hence their stability, can be undermined by adverse publicity as a result of inadvertent association by banks with criminals. In addition, banks may lay themselves open to direct losses from fraud, either through negligence in screening undesirable customers or where the integrity of their own officers has been undermined through association with criminals. For these reasons the members of the BASEL Committee consider that banking supervisors have a general role to encourage ethical standards of professional conduct among banks and other financial institutions. In view of the reputation risk and fraud risk faced by the banks due to their inadvertent association with criminals, BCBS published a Statement containing ethical principles recommending the banks to ensure the following: All persons conducting business with their institutions are properly identified; Transactions that do not appear legitimate are discouraged; and Cooperation with law enforcement agencies is achieved. 36 Customer Identification The Basel Statement Adherence to the Compliance with Laws of Principles Statement Cooperation with Law Enforecement Agencies Figure 3.1 BASEL Principles Chart 3.4.2 Core Principles for Effective Banking Supervision (September 1997) BCBS, in pursuance of the call of Lyon G-7 Summit in June 1996 for action for strengthening financial systems in various countries in the world, came out with a document on the Core Principles for Effective Banking Supervision in September 1997. One of the 25 Core Principles laid down in this paper pertains to KYC as indicated below: ―15. Banking supervisors must determine that banks have adequate policies, practices and procedures in place, including strict ―know-your-customer‖ rules, that promote high ethical and professional standards in the financial sector and prevent the bank being used, intentionally or unintentionally, by criminal elements.‖ These Principles have been reviewed several times, the last being in September 2012. The revised set contains 29 Principles. The principle pertaining to KYC has been retained in a revised form as under: ―Principle 29 – Abuse of financial services: The supervisor determines that banks have adequate policies and processes, including strict customer due diligence rules to promote high ethical and professional standards in the financial sector and prevent the bank from being used, intentionally or unintentionally, for criminal activities.‖ 3.4.3 Sharing of Financial Records between Jurisdictions in Connection with the Fight against Terrorist Financing (April 2002) Based on discussions among bank supervisors and legal experts of G10 central banks, BCBS issued guidelines on ―Sharing of financial records between jurisdictions in connection with the fight against terrorist financing‖. The paper recognizes that given the size and geographical scope of the international financial system it was imperative to significantly improve coordination and collaboration between all the parties involved, if measures to identify and prevent terrorist financing are to succeed. The paper covered two mechanisms for information flows: 37 (a) from a governmental body in one country to a governmental body in another country, using an official gateway or some less formal channel, and (b) within a single financial group (i.e. between a financial entity operating in one country and its head office or parent institution in a different country). 3.4.4 General Guide to Account Opening and Customer Identification In October 2001, BCBS had published a Paper on ‗Customer Due Diligence for Banks‘ which has since been superseded by its Paper on ‗Sound Management of Risks related to Money Laundering and Financing of Terrorism (January 2014)‘. It contained general guidelines for the following:  Customer acceptance policy  Customer identification  Ongoing monitoring of accounts and transactions  Risk Management  KYC standards in cross border context In February 2003, BCBS published ‗General Guide to Account Opening and Customer Identification‘ as an attachment to this Paper. It focuses on some of the mechanisms that banks can use in developing an effective customer identification programme. It contains guidance on operational aspects of customer identification, and also information requirements for natural and juridical persons of various types. RBI incorporated the above guidelines in their notifications for KYC AML and issued Master Direction on KYC 2016 advising these as key elements, accordingly, Regulated Entities (REs (REs) have been directed to formulate their own KYC AML Policy keeping these ingredients, re-defined as under:  Customer acceptance policy  Risk Management  Customer identification  Monitoring of transactions 3.4.5 Due Diligence and Transparency Regarding Cover Payment Messages Related to Cross Border Wire Transfers (May 2009) Given the need to exercise greater care in respect of cross border transactions BCBS issued guidelines on ‗Due Diligence and Transparency Regarding Cover Payment Messages Related to Cross Border Wire Transfers‘. These guidelines seek to enhance transparency in payment messages related to cover payments. They contain norms on the information to be included in the payment messages, need for mechanisms to ensure inclusion of such information, and its use for AML/CFT purposes. 3.4.6 Sound Management of Risks Related to Money Laundering and Financing of Terrorism (January 2014, Revised July 2020) Consequent upon FATF reviewing its 40+9 Recommendations and publishing the revised FATF Standards, BCBS published a paper on ‗Sound Management of Risks Related to 38 Money Laundering and Financing of Terrorism‘ in January 2014. This is meant to support implementation of the FATF standards by exploring complementary areas. These guidelines embody both the FATF standards and the Basel Core Principles for banks operating across borders and fit into the overall framework of banking supervision. This document merges and supersedes two previous BCBS publications viz. Customer Due Diligence for Banks (October 2001), and Consolidated KYC Risk Management (October 2004). These guidelines containing distinct parts meant specifically for banks, banking groups and banking supervisors, and are a comprehensive guide for banks for taking appropriate measures for implementation of FATF recommendations. They also cover issues pertaining to AML/ CFT in a group-wide and cross-border context. Besides, in view of an increased focus on the usage by banks of third parties to introduce business, and the provision of correspondent banking services specific guidelines for these situations have been included. Following are the main requirements enunciated in this guidance note. Assessment and To be carried out at the country, sectoral, bank and understanding business relationship level, and to apply appropriate of ML/TF Risks level of mitigation. Proper governance To include that the board of directors to approve and Arrangements oversee the policies for risk, risk management and compliance for ML/TF risks Three lines of defence First line of defence – Business units – in charge of identifying, assessing and controlling the risks of their business Second line of defence – chief officer in charge of AML/CFT, the compliance function but also human resources or technology Third line of defence – the internal audit function. Transaction monitoring Adequate system with respect to its size, its activities System and complexity as well as the risks present in the bank. For most banks, especially those which are internationally active, effective monitoring is likely to necessitate the automation of the monitoring process. Customer acceptance Basic due diligence for all customers and commensurate policy due diligence as the level of risk associated with the customer varies. Customer and beneficial owner identification, verification and risk profiling using reliable, independent source documents, data or information. Ongoing monitoring In relation to all business relationships and transactions based on risk as identified. To have appropriate integrated management information systems, based on materiality and risks to provide both 39 business units and risk and compliance officers timely information. Customer and beneficial A systematic procedure for identifying and verifying its owner identification, customers and, where applicable, any person acting on verification and risk their behalf and any beneficial owner(s). profiling A bank should use information to build an understanding of the customer‘s profile and behaviour. To conduct due diligence on its customers sufficient to develop customer risk profiles. Management of Record-keeping: all information obtained in the context information of CDD is recorded Updating of information: by undertaking regular reviews of existing records and updating the CDD information Supplying information to the supervisors – to demonstrate to its supervisors, on request, the adequacy of its assessment, management and mitigation of ML/FT risks. Reporting suspicious Reporting to prescribed authority. transactions and asset Asset freezing as per decisions made by the competent freezing authority Group-wide and cross- To coordinate and apply policies and procedures on a border context group-wide basis. Thorough understanding of all the risks associated with its customers across the group. Monitoring and evaluating the AML/CFT standards in place in the jurisdiction of the referring bank. Coordination of information-sharing in the Group, taking into account issues and obligations related to local data protection and privacy laws and regulations. 3.5 THE FINANCIAL ACTION TASK FORCE (FATF) In response to the increasing concern over money laundering specifically in respect of the growing drug problem, the FATF was established at the G-7 Economic Summit held in Paris in 1989. It is an inter- governmental body whose purpose is to set standards and promote effective implementation of legal, regulatory and operational measures for combating money laundering, terrorist financing and other related threats to the integrity of the international financial system. The FATF comprises 37 member jurisdictions and 2 regional organisations, total 39 members (as at March 2022), representing most major financial centres in all parts of the globe. Also, it has several regional/global organisations as associate members. Besides, it has several international organisations associated as observers. Today the FATF‘s work primarily focuses on the main areas depicted in Fig. 3.2 below to identify and respond to threats to the integrity of the international financial system. 40 Identifying/ Developing/ refining International Standards analysing threats to for combating Ml/ FT / the integrity of the PF and responding to international new threats to the financial system financial system Promoting global implementation of the FATF Recommendations Assessing/ monitoring how well Identifying/ members have engaging with high- implemented the risk and non- FATF cooperative Recommendations jurisdictions Fig. 3.2 Focus Areas for FATF 3.5.1 FATF Standards FATF Recommendations have over the period become the core of international measures in AML and CFT areas, and have become Standards for this purpose. They form the core of FATF work. In April 1990, ‗Forty Recommendations‘ on measures for prevention of money laundering were adopted. These were aimed at providing measures that would help detect, prevent and punish the abuse of the international financial system for money laundering. Subsequently, in 2001, Special Nine Recommendations to combat terrorist financing were established. In 2003, the standards for money laundering predicate offences and customer due diligence requirements were strengthened. In 2005 it addressed the threat posed by cash couriers by introducing measures to detect physical cross-border transportation of cash and bearer monetary instruments. United Nations Security Council Resolution 1617 (2005) strongly urged to implement FATF's 40 Recommendations on ML and 9 special recommendations on on TF. In 2012, these Recommendations were revised and published as ―International Standards on Combating Money Laundering and The Financing of Terrorism & Proliferation‖. The These FATF Standards updated upto Mar' 2022 are enumerated at Appendix.1. The FATF recommendations cover various aspects that require actions to be taken at various levels viz. the Governments, the Financial Regulators, the banks and the financial institutions. These Recommendations are constantly reviewed and amplified as 41 considered appropriate in the light of emerging and new risks identified. For instance, the aspects related to virtual assets including cryptocurrencies have been incorporated. Similarly, the need for asking legal persons to keep and provide information on beneficial owners, and for such information to be recorded by the registries has been added to the relevant Recommendations. The salient points of those recommendations that pertain to banks

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