Combatting financial crime and global illicit financial flows (IFFs) are priorities for all States, and not just those of Global North. However, there is growing recognition that misapplied global rules aiming to stop these practices are having unintended consequences, particularly for the financial inclusion and development prospects of the world’s most disadvantaged jurisdictions and peoples.
In February 2021, the Financial Action Task Force (FATF) commenced a two-phased workstream to study and mitigate the unintended consequences resulting from the incorrect implementation of its standards. The four focus areas are: de-risking; financial exclusion; suppression of non-profit organisations or the NPO sector as a whole; and threats to fundamental human rights.[i] While FATF notes that it is not an investigative exercise, the aim is to study the trends and propose solutions.
This article argues that this new FATF workstream on unintended consequences is a welcome development for IFCs which have been on the frontlines of de-risking and financial exclusion of their populations.
FATF And Its Standards
FATF is a 39-member international policy-making body created by the Group of 7 (G7) in 1989 to examine and develop measures to combat money-laundering with an initial focus on proceeds of drug crime. Its mandate expanded in October 2001[ii] to include terrorist financing and in April 2012 to counter the financing of weapons of mass destruction (AML/CFT/PF).
First published in 1990 and subsequently revised, FATF’s now 40-plus 9 Recommendations (the FATF standards) are regarded as the globally recognised standards for AML/CFT/PF. They are often described as ‘soft law’ since they are non-binding and voluntary and countries are ‘encouraged’ to adopt them nationally to suit their own local circumstances. However, “despite the facial veneer of soft law, at its core the FATF imparts hard law onto jurisdictions” (Ghoshray 2014).[iii] FATF and its FATF-styled regional bodies, such as the Caribbean Financial Action Task Force (CFATF), rate countries through peer reviewed mutual evaluation reports (MERs) on their level of compliance with the FATF standards. As of the fourth round of MERs, jurisdictions are not just rated on their ‘technical compliance’ with the FATF Standards, but also their ‘effectiveness’. Therefore, it is not enough to just translate the FATF standards into domestic law, but the jurisdiction must now “demonstrate in the context of the risks it is exposed to, it has an effective framework to protect the financial system from abuse”. [iv]
The problem with plurilateral standard-setting bodies, such as FATF, is that developed countries which comprise the majority of their members drive their agenda, despite some attempts to address the democratic deficits. The net result is that the policy imperatives of these plurilateral standard-setting bodies and the so-called ‘soft law’ they create do not always align well with the development realities, circumstances or context of developing countries, especially small States, which are compelled to adopt these externally-made standards or face blacklisting and possible sanctions. As such, there is a small but growing canon of empirical studies on the unintended negative impact of the global financial governance structure and its rule-making on developing countries.[v]
In popular culture and even in some academic writings, Caribbean IFCs are fetishised and exoticised as opaque hideaways for tax cheats and other nefarious actors, leading the region to be unfairly painted as a high risk place for conducting business. Besides the fact that the majority of global IFFs does not flow through the Caribbean, much of the analysis completely ignores the important role of the international business sector to Caribbean IFCs’ economies as a source of foreign exchange inflows and employment, with spillovers for the wider economy. Caribbean countries have little incentive to be seen as welcoming to financial crime. Moreover, these tropes are more than mere inconveniences but impact the lifeblood of their economies and livelihoods of their populations.
Although FATF standards require a risk-based approach[vi], Caribbean banks and money transfer operators have been disproportionately subjected to wholesale de-risking from global banks through withdrawn or restricted correspondent banking services.[vii] Correspondent banking relationships (CBRs) connect economies to the global financial system, allowing their citizens and firms to engage in cross-border business. Additionally, several major international banks have either scaled-down their presence in the Caribbean region or left entirely. This not only reduces competition in the regional banking sector but also impacts consumer choice for banking services. There has also been derisking of money transfer operators, important for the flow of remittances to the region.
Reputational Risks And Investment Attraction
Blacklisting, or the threat thereof, by large States is one way in which heavy-handedness of the FATF Standards has been felt by IFCs. The FATF maintains two lists. The blacklist, which lists jurisdictions for which a FATF call for action is issued, has, for some time, only included North Korea and Iran. The grey list is comprised of jurisdictions subject to enhanced monitoring. These lists are used by governments and financial institutions as the basis for risk-rating countries. While finding limited impact on cross-border trade or flows, Collin et al (2016) show, using SWIFT payment data, that countries that have been added to a FATF grey list “face up to a 10 per cent decline in the number of cross border payments received from other jurisdictions, but no change in the number sent”.[viii]
In 2017, the EU commenced working on its own methodology for identifying third jurisdictions with strategic deficiencies in their AML/CFT regimes. This new EU methodology, which only uses the FATF lists as a starting point, was adopted in 2018. It begs the question why would the Commission, which is a full FATF member, see the need to create a separate list from FATF – the globally recognised standard-setting and monitoring body for AML/CFT matters? Moreover, unlike the FATF which provides detailed country-specific information through the mutual evaluation reports , the EU did not publish any detailed reasons for the inclusion of each jurisdiction.
The EU’s list lumps jurisdictions which are on FATF’s grey list, i.e., the list of monitored jurisdictions with an action plan with those which are on the actual FATF blacklist, that is, those countries for which there is a FATF call for action, namely North Korea and Iran. That poses additional reputational risks for named countries. Listed countries have complained that they were not given any advance notice of the updated list or any opportunity to query or contest their inclusion. These countries were also listed during the height of the first wave of the COVID-19 pandemic when their economies were already reeling from the pandemic’s economic fall-out.
While the EU list does not impose sanctions or any other restrictions on trade, once a country has been listed as high-risk, the level of due diligence imposed by the EU goes beyond what is expected by FATF for grey-listed countries. For such countries, FATF does not call for the application of enhanced customer due diligence (ECDD),but encourages its members to take into account the information presented in its risk analysis. However, the European directives require European banks and other ‘obliged entities’ to apply ECDD on any transactions and relationships involving natural persons or legal entities based in such countries. In other words, transactions originating from or going to those countries will be subject to enhanced scrutiny which could mean longer wait times for completion and more frequent risk assessment reviews of the relationship.
Higher Regulatory Costs For Governments And Businesses
Under the threat of blacklisting, IFCs expend scarce resources to update their legislations and build technical capacity in these areas and in time frames that often do not take into account their limited fiscal space, susceptibility to natural disasters or other development exigencies.
Regulatory costs have also increased for financial institutions in small States through the need to hire compliance officers or, in some cases, establish entire compliance departments. Costs also stem from investments in compliance-related training and software. Standard times for certain functions, such as cheque clearance and opening bank accounts, have increased due to the need to conduct greater due diligence.
Due to Know Your Customer (KYC) standards demanded by correspondent banks, banks in the region are requiring their clients to produce even more information in order to access basic banking services, impacting on the ease of doing business. The constant need for KYC information could also lead to a growing number of unbanked persons. Some financial institutions are refusing to do business with certain clients e.g. politically exposed persons (PEPs) or NPOs which are deemed to be higher risk customers.
FATF’s workstream on unintended consequences is an important acknowledgement by FATF that the misapplication of its standards have had consequences that had not been foreseen. The focus seems particularly to be on NPOs but small offshore IFCs are deserving of special study in this area because of their small open economy status and the large size of their financial services sector relative to their small geographic size. There are wider implications for commercial activity, trade and investment, remittance flows, and development for small open economies dependent on trade, especially in a post-COVID-19 environment.
This FATF work is also important given that small State governments often rely on less effective ‘emotive’ arguments when voicing their frustration over the negative externalities incurred by these standards and the manner in which they are imposed on small States. What is often missing is the empirical data to support the negative impact these policies are having. The Central Bank of the Bahamas must be applauded for its AML Research Conference which has celebrated its second year and aims to foster more scholarly research in this area. To the extent that the FATF work can help, this will benefit IFCs in empirically making their case about the heavy-handed application of these policies. Perhaps, it could also serve as a cautionary tale that failure to include the voices of small IFCs results in such consequences. A similar mistake is being made with regard to the proposed global minimum corporate income tax. It is not unforeseen that a few years or decades from now, we will be discussing the unintended consequences of that initiative.
[i] Phase one will focus on research and engagement to analyse these unintended consequences, while phase two will involve developing options for FATF to consider for preventing and mitigating these unintended consequences. See more generally: https://www.fatf-gafi.org/publications/financialinclusionandnpoissues/documents/unintended-consequences-project.html
[iii] See generally https://digitalcommons.nyls.edu/cgi/viewcontent.cgi?article=1108&context=nyls_law_review.
[vi] At the height of the de-risking crisis, FATF released several guidance notes, including clarifying the Risk-Based Approach. See generally https://www.fatf-gafi.org/documents/riskbasedapproach/?hf=10&b=0&s=desc(fatf_releasedate).
[vii] See, for example, Caribbean Financial Action Task Force (CFATF). 2019. “‘De-risking’ in the Caribbean Region: A CFATF Perspective.” Accessed September 21, 2020. https://www.cfatf-gafic.org/documents/resources/13667-de-risking-in-the-caribbean-region-a-cfatf-perspective.
[viii] Collin, Matthew, Cook, Samantha and Kimmo, Soramäki. 2016. “The Impact of Anti-Money Laundering Regulation on Payment Flows: Evidence from SWIFT Data.” Accessed October 1, 2020. https://www.cgdev.org/impact-anti-money-laundering-SWIFT-data.
Alicia Nicholls, B.Sc.(Hons), M.Sc. (Dist.), LL.B. (Hons) is an international trade and development specialist with over a decade of experience working in, and writing on, trade and development matters of interest to the Caribbean. She holds a Bachelor of Science in Political Science (First Class Honours), a Bachelor of Laws (Upper Second Class Honours), and a Masters in International Trade Policy (with distinction) from the University of the West Indies, and an Associate Degree in French, Spanish and German for Business and Tourism from the Barbados Community College. She also holds the FITT Diploma in International Trade from the prestigious Canadian-based Forum for International Trade Training (FITT) and has been a FITT General Member since 2015. She is also a member of the Michigan-based Academy for International Business (AIB) since 2016. Alicia presents and writes on a wide gamut of trade and development issues for regional and international publications and industry magazines. Her research interests include international business, MSMEs, AML/CFT issues, investment law and policy and investment migration programmes. She is also the author of one of the Caribbean's leading trade and development blogs www.caribbeantradelaw.com. Alicia is currently part of the research team of the Shridath Ramphal Centre for International Trade Law, Policy & Services of The University of the West Indies, Cave Hill, the premier trade policy training, research and outreach institution in the Caribbean.