33459 FocusNote NO. 29 JULY 2005 AML/CFT REGULATION: IMPLICATIONS FOR FINANCIAL SERVICE PROVIDERS THAT SERVE LOW-INCOME PEOPLE Executive Summary Across the world, new measures are being introduced to combat money laundering and the financing of terrorism. All financial service providers, including those work- ing with low-income communities, are--or will--be affected by these measures. This paper summarizes the implications of the international framework for anti-money laundering (AML) and combating the financing of terrorism (CFT) for financial serv- ice providers working with low-income people. While each country may adapt the international AML/CFT standards developed This Focus Note was a coopera- tive effort by CGAP and the by the Financial Action Task Force (FATF), in general financial service providers are Financial Market Integrity Unit of required to: the World Bank. The authors are enhance their internal controls to cater specifically for AML/CFT risks; Jennifer Isern, lead microfinance specialist, CGAP; David undertake customer due diligence procedures on all new and existing clients; Porteous, consultant; Raul Hernandez-Coss, financial sector introduce heightened surveillance of suspicious transactions and keep transaction specialist, World Bank; and records for future verification; and Chinyere Egwuagu, junior profes- report suspicious transactions to national authorities. sional associate, World Bank. These measures could bring additional costs of compliance to financial service providers; and customer due diligence rules may restrict formal financial services CGAP from reaching lower-income people. Although the framework applies to all financial 1818 H Street, NW institutions, the risk of money laundering or financing of terrorism varies with the MSN Q4-400 country context, the institution's legal form, and the type of financial service. The Washington,DC 20433 USA introduction of new or tightened AML/CFT regulations may have the unintended and undesirable consequence of reducing the access of low-income people to formal Tel: 202-473-9594 financial services. As a means to avoid this outcome, this paper argues in favor of (1) Fax: 202-522-3744 gradual implementation of new measures; (2) the adoption of a risk-based approach to regulation; and (3) the use of exemptions for low-risk categories of transactions. Email: cgap@worldbank.org South Africa provides one example of how a country's AML/CFT regulations can be modified to take into account better the needs of low-income clients. Customer Web: due diligence regulations which require an income tax number and proof of residen- www.cgap.org tial address for clients proved too stringent to allow many low-income people to open bank accounts. Often low-income clients have no tax number and are unable to produce third-party verification of address. The South African authorities have now adopted a more flexible approach to client identification and verification and introduced a compliance exemption that relaxes requirements for a category of clients known as "mass banking clients": those clients with small balances and small size transactions. Building financial services for the poor This area of regulation is a young and rapidly commercial banks, financial cooperatives and developing field, and there is scope for further credit unions, low-capital rural and/or local banks, work to explore the particular challenges facing state development and agricultural banks, and institutions serving low-income clients in complying postal savings banks and other postal financial serv- with the new regulations. ice providers (see annex 1).2 These institutions can be classified as more or less risky based on the Introduction financial services they offer. Since September 11, 2001, the introduction of AML/CFT--Why Is It Important? measures to combat money laundering and the financing of terrorism has taken on new Money laundering and the financing of terrorism urgency for international agencies, governments, can damage national financial systems. Illegitimate and financial service providers. Implementing financial holdings, assets, and enterprises are unre- these new regulations can present particular liable sources of investment capital for sustainable challenges for financial institutions serving economic development. Among other effects, low-income clients. money laundering destabilizes national economies As recent fines and sanctions levied on banks in by increasing the demand for cash, increasing the the United States have shown, the economic and volatility of interest and exchange rates, and even financial impact on institutions that fail to comply contributing to higher inflation.3 with the requirements of the law can be devastat- Developing and transition economies strive to ing. Even the perception of having inadequate become reputable members of the global payments controls to prevent money laundering can damage network to increase their ability to access capital an institution's reputation. Hence, it is important flows, and consequently work to conform to inter- for financial institutions to develop internal con- national codes to combat abuse of this system. trols to protect themselves from exposure to Countries with weak enforcement of AML/CFT money laundering and the financing of terrorism controls could damage their reputations in interna- and to comply with regulations. The Financial tional financial markets, and thus may not attract Action Task Force on money laundering (see box international flows such as foreign direct invest- 1) has developed international standards on ment and/or donor funding. AML/CFT.1 Within this comprehensive, general Countries therefore have a public policy interest framework, individual countries are responsible for in making sure that their AML/CFT regime is introducing local legislative and regulatory regimes. comprehensive and appropriately includes financial AML/CFT regulations can have serious impli- service providers working with low-income clients. cations for financial institutions that serve low- Likewise, these institutions have an interest in income clients, especially in developing countries. protecting themselves from the adverse effects of The additional costs of compliance and tighter being involved, or even the perception of being restrictions may have the unintended consequence involved, in money laundering and the financing of driving low-income clients from the formal of terrorism. financial sector. The challenge is to strike a balance that promotes prudential practices at a reasonable cost for financial service providers that want to offer services to less well-off clients. AML/CFT 1Currently, there are 40 FATF recommendations on anti-money laun- regulations should be implemented in a flexible dering and 9 special recommendations on combating the financing way to ensure that they do not restrict access to of terrorism. 2Today, financial service providers that serve poor clients go well be- formal financial services for low-income people. yond the traditional non-profit organization model that dominated the All financial service providers dealing with early days of modern microcredit or microfinance. In some countries, financial transactions, including those working some of the original non-profit institutions have expanded their serv- with low-income clients are required to comply ices to become regulated financial institutions, such as banks. Likewise, with AML/CFT regulations. The universe of finan- some conventional banks provide microfinance services to poor clients. cial service providers that serve low-income clients 3See the web site of the United Nations Office on Drugs and Crime includes specialized microfinance institutions, (UNODC), www.odccp.org. 2 Box 1 Financial Action Task Force and FATF-Style Regional Bodies Financial Action Task Force (FATF) is an international grouping of nations that fights money laundering and terrorist financ- ing. FATF currently has 33 country members, more than 15 international organization members, and some 20 observers, among them the International Monetary Fund and the World Bank. FATF has a secretariat headquartered in Paris, and numerous documents are available on their web site (www.fatf-gafi.org), including the Forty Recommendations on Money Laundering and the Special Recommendations on Financing of Terrorism. (See annex 3 for a detailed list of FATF and FSRB-member countries.) FATF-Style Regional Bodies (FSRBs) have also been established. These FATF-Style Regional Bodies are crucial to the promotion and implementation of AML/CFT standards within their respective regions. As part of this process, the countries undertake peer reviews of their AML/CFT regimes, known as "mutual evaluations," and develop technical assistance pro- grams to facilitate implementation in coordination with international donors. The following organizations have been formed to date: · GAFISUD: Financial Action Task Force on Money Laundering in South America · APG: Asia/Pacific Group on Money Laundering · ESAAMLG: Eastern and Southern Africa Anti-Money Laundering Group · CFATF: Caribbean Financial Action Task Force · MENAFATF: Middle East and North Africa Financial Action Task Force · EAG: Eurasian Group · GIABA*: Intergovernmental Group of Action against Money Laundering in West Africa · MONEYVAL: Council of Europe Select Committee of Experts on the Evaluation of Anti-Money Laundering Measures * GIABA is in the process of becoming an FSRB. Source: FATF, www.fatf-gafi.org What Is the Difference between Money What Institutions Are Covered by AML/CFT Laundering and Financing of Terrorism? Regulations? Money laundering is the process of disguising the FATF covers any institution involved in financial illegal origin of criminal proceeds without disclos- transactions, including financial service providers ing their source.4 Illicit proceeds are derived from working with low-income clients. In many countries, diverse criminal activities, including illegal arms financial institutions that serve low-income clients sales, smuggling, organized crime, corruption, embezzlement, drug trafficking, and human traf- ficking. Financing of terrorism is fundraising for, 4 Financial Action Task Force (FATF), www.fatf-gafi.org/document/ or financial support of, organizations or persons 29/0,2340,en_32250379_32235720_33659613_1_1_1_1,00.html, involved in terrorism.5 also known as GAFI, Groupe d'action financière sur le blanchement As figure 1 shows, money laundering legit- de capitaux. 5 imizes illicit proceeds through various methods, The UN International Convention for the Suppression of the Financ- ing of Terrorism (December 1999), Article 2 in its provisions, describes while financing of terrorism uses legitimate or acts of terrorism as "any act intended to cause death or serious injury illegitimate funds to facilitate an act of terror. to a civilian, or to any other person not taking an active part in the hos- Both activities employ similar techniques: tilities in a situation of armed conflict, when the purpose of such act, Placement: the initial posting of funds or by its nature or context, is to intimidate a population, or to compel a assets into the financial system government or an international organization to do or to abstain from Layering: the relocation or alteration doing an act." Signatories to the UN convention continue to disagree on what actions constitute terrorism, since acts of terrorism in one na- of funds or assets in order to disguise the illicit tion can be perceived as acts of civil liberation in another. source or intent 6 It is important to note that placement, layering, and integration are Integration: the conversion of illicit funds, not always sequential steps to launder money. Funds from criminal ac- or legitimate funds intended for illicit activity, tivity can be used immediately for other criminal activity or invested, to seemingly legitimate assets6 depending on financial system, without placement or layering. 3 countries have flexibility in how they achieve this Figure 1 Money Laundering and the Financing of Terrorism objective and can adopt a risk-based approach. For example, if the authorities decide that an institu- tion's operations represent a low risk for money Funds from Criminal Act Legitimate Assets or Funds, laundering and the financing of terrorism, they or Assets or Funds can exempt some financial service providers from from Criminal Act compliance with AML/CFT regulations. If, on the basis of risk analysis, national authorities Placement decide that there is a need to implement Assets deposited into financial AML/CFT regulations, they still have consider- system, e.g., state bank, commercial bank, postal bank, able latitude in how to implement the measures. securities firm Establishing a risk-based approach to regulation requires a good understanding of the extent of risk for money laundering and the financing of terror- Layering ism within the country/jurisdiction. Funds moved to other institutions to obscure origin, e.g., insurance company, AML/CFT Measures Required at the non-bank financial institution Institutional Level At the institutional level, AML/CFT compliance Integration Integration involves four main activities: internal controls, Funds used to finance Funds distributed to finance customer due diligence, surveillance and record criminal acts and to acquire terrorist activities and to keeping, and reporting of suspicious activities. legitimate assets, e.g., real acquire legitimate property, estate, property, stock, and stock, and equipment Establishing new internal controls may require equipment financial institutions to change client in-take Source: World Bank, 2004 forms, operating procedures, and information sys- tems. Training staff in new procedures is vital to are established as non-profit organizations.7 FATF the successful implementation of internal controls Special Recommendation VIII on Terrorist Financing and overall AML/CFT compliance. Background explicitly addresses the exposure of non-profit checks on board members, shareholders, and organizations to terrorist financing, and requires employees help protect the institution. Donations countries to develop regulation to prevent these and contributions should also be verified to ensure organizations from becoming conduits for money they are from legitimate sources. laundering or the financing of terrorism.8 FATF requires financial institutions to be able to verify the identity of their clients. Implementing FATF Recommendations on AML/CFT customer due diligence measures can help institu- for Financial Service Providers tions to comply with the regulations. Although Serving Low-Income Clients FATF's AML/CFT recommendations do not specifically mention the address of customers FATF recommendations provide guidance on what actions institutions should implement internally to 7Even though the FATF recommendations do not explicitly mention reduce the risk of money laundering and financing financial institutions serving poor clients, any institution undertaking of terrorism, such as customer due diligence, record such activities falls under the broad AML/CFT framework. keeping, and reporting. In order to maintain a 8FATF Special Recommendation VIII on Terrorist Financing, "Non- reasonable standard of AML/CFT compliance, profit Organizations," specifies that "countries should review the ad- countries are advised to adopt measures in propor- equacy of laws and regulations that relate to entities that can be abused tion to the potential risk of money laundering and for the financing of terrorism. Non-profit organizations are particu- the financing of terrorism. larly vulnerable, and countries should ensure that they cannot be mis- used (i) by terrorist organizations to pose as legitimate entities; (ii) to exploit legitimate entities as conduits for terrorist financing, including AML/CFT Measures Required at the for the purpose of escaping asset freezing measures; and (iii) to con- National Level ceal or obscure the clandestine diversion of funds intended for legiti- Countries have an obligation to protect the finan- mate purposes to terrorist organizations." See FATF, www.fatf- cial integrity of their financial system. However, gafi.org/dataoecd/39/19/34033761.pdf. 4 Box 2 FATF Definition of Financial Institutions and Their Activities "Financial institutions" refers to any person or entity conducting as a business one or more of the following activities or operations for or on behalf of a customer: 1. Acceptance of deposits and other repayable funds from the public, including private banking 2. Lending--includes, inter alia, consumer credit; mortgage credit; factoring, with or without recourse; and finance of commercial transactions (including forfeiting) 3. Financial leasing--does not extend to financial leasing arrangements in relation to consumer products 4. The transfer of money or value--applies to financial activity in both the formal or informal sector, e.g., alternative remit- tance activity. See the Interpretative Note to Special Recommendation VI. It does not apply to any natural or legal per- son that provides financial institutions solely with message or other support systems for transmitting funds. See the Interpretative Note to Special Recommendation VII. 5. Issuing and managing means of payment (e.g., credit and debit cards, checks, traveler's checks, money orders and bankers' drafts, electronic money) 6. Financial guarantees and commitments 7. Trading in: a. money market instruments (checks, bills, certificates of deposit, derivatives, etc.) b. foreign exchange c. exchange, interest rate, and index instruments d. transferable securities e. commodity futures trading 8. Participation in securities issues and the provision of financial services related to such issues 9. Individual and collective portfolio management 10. Safekeeping and administration of cash or liquid securities on behalf of other persons 11. Otherwise investing, administering, or managing funds or money on behalf of other persons 12. Underwriting and placement of life insurance and other investment related insurance--applies both to insurance undertakings and to insurance intermediaries, i.e., agents and brokers 13. Money and currency changing When a financial activity is carried out by a person or entity on an occasional or very limited basis (having regard to quanti- tative and absolute criteria), such that there is little risk of money laundering activity occurring, a country may decide that the application of anti-money laundering measures is not necessary, either fully or partially. Source: FATF, The Forty Recommendations, "Glossary," which includes both information and interpretative notes on the rec- ommendations; www.fatfgafi.org/glossary/0,2586,en_32250379_32236930_34276935_1_1_1_1,00.html#34276864 in reference to customer due diligence, some official identity card. More work is needed to countries have included verification of client ensure a high level of security in customer due dili- addresses in their national AML/CFT frame- gence that does not threaten poor people's access works. FATF says that "there are circumstances in to services. Financial service providers, working which it would be reasonable" for a country to closely with their industry associations and allow its financial institutions to apply customer national authorities, are well placed to develop due diligence measures "on a risk-sensitive basis." effective methods of verifying the identity of A few countries have shown flexibility in imple- their clients. menting customer due diligence requirements In addition, institutions are encouraged to that accommodate the situation of low-income monitor transactions and keep detailed transaction people. Uganda, Tanzania, and Kenya all accept records. For financial services providers working letters from the local authority in rural villages as with low-income clients, surveillance and record identification for their clients who do not have an keeping could involve new information systems. 5 Box 3 Financial Intelligence Units FATF recommendations require the creation of a specialized government unit, usually called a financial intelligence unit (FIU), as a central point for monitoring transactions and collecting information. In addition, local regulators--and in some cases, industry associations as well--issue guidance notes or circulars on how to interpret sections of the laws or regula- tions. FIUs at a minimum receive, analyze, and disclose information on suspicious or unusual financial transactions provided by financial institutions to competent authorities. Although every FIU operates under different guidelines, under certain provi- sions they can exchange information with foreign counterpart FIUs. In addition, many FIUs can provide other government administration data and public record information to their counterparts, which can also be helpful to those investigating money laundering and financing of terrorism. There are currently 94 countries with recognized operational FIUs, with oth- ers in various stages of development. The ongoing development of FIUs exemplify how countries around the world con- tinue to intensify their efforts to focus on research, analysis, and information exchange in order to combat money launder- ing and financing of terrorism, and other financial crimes. Source: Adapted from the "The Egmont Group Financial Intelligence Units (FIUs),"www.egmontgroup.org/about_egmont.pdf; www.egmontgroup.org/list_of_fius_062304.pdf. Specific software can reduce the operational cost Microfinance transactions are also generally and time required to comply with the need to very small--whether they are savings, credit, or monitor complex, unusual, and large transactions transfer. Given the predominant small loan sizes, and patterns of transactions. Finally, FATF recom- sudden flows of large amounts would stand mendations make it clear that financial institu- out easily. In the financing of terrorism, however, tions have an obligation to report all suspicious authorities are increasingly concerned about even transactions to their national authorities. small transactions.9 Annex 2 provides more background on FATF The type of financial service offered also affects recommendations and possible institutional the institution's risk. Some institutions are legally compliance measures. authorized to mobilize savings. Some may have restrictions on providing money transfers, Challenges for Financial Service leasing, and/or insurance. Non-depository institu- Providers Working with Low-Income tions with no access to the national payment sys- Clients tem may present relatively lower risk from an AML/CFT perspective. Among financial services The main challenges for financial service providers for low-income people, money transfers may pose in complying with AML/CFT measures arise higher risks of money laundering and financing of from the requirement to undertake customer due terrorism. For criminals to succeed, they usually diligence and to absorb the potential costs need access to institutions that facilitate domestic involved in implementing new regulation. and international funds transfers, exchange curren- Additional challenges include internal control and cies, and convert these proceeds into different surveillance and record keeping. financial instruments and other resources. Terrorist financiers and money launderers may Special Features and Risk Profiles of Financial pose as legitimate entities to transfer funds that Service Providers that Serve Low-Income later may be diverted to criminal purposes Clients or to disguise funds from illicit activities. Countries Microfinance clients are typically low-income, do therefore need to regulate providers of transfer not own assets that are conventionally accepted as 9 See FATF, 2004, "Guidance for Financial Institutions," collateral, may be self-employed, or may have uneven www1.oecd.org/fatf/pdf/GuidFITF01_en.pdf. Several law enforce- streams of income. In general, the majority of clients ment experts have noted that the funding needed to mount a terror- served by these institutions are "natural persons," not ist attack does not always call for large sums of money and that the as- legal persons or entities such as companies or trusts. sociated transactions are usually not complex, but rather are small This client profile reduces the risk of such institu- sums, below the usual thresholds for cash transaction reporting, and tions being used for money laundering. in most cases consisted solely of wire transfers. 6 facilities appropriately to reduce or prevent abuse software is available. They could work with for money laundering and the financing of terror- national authorities to provide such software and ism. Further analysis is needed to distinguish the take the lead in offering training on AML/CFT risk that each type of financial service provider awareness and compliance. presents depending on their financial services. Although there are always costs associated with Some institutions serving low-income clients, regulations, these costs tend to be greater in such as financial cooperatives and NGOs, have countries where there is generally a culture of poor ownership structures that may require additional compliance. Developing or encouraging wider information and verification by authorities. Financial acceptance of compliance, not only for AML/CFT cooperatives are member-owned institutions with systems, is more cost effective because it reduces a board and other oversight committees, while risk of fraud, helps protect savers and investors, and NGOs typically have no share-based ownership increases the integrity of the institution. and appointed boards and management.10 Box 5 gives examples of two types of financial services providers that serve low-income clients in Compliance Costs Mexico, a FATF member country. Both BANSEFI Like any other financial regulation, the costs of and Compartamos have implemented policies and complying with AML/CFT measures may systems in line with international standards and increase the cost of services. For example, the cost national law. In addition, the Mexican National of monitoring suspicious transactions may be high Association of Non-bank Financial Institutions if suitable automated systems are not in place. (AMSFOL) has been proactive in forming new Financial institutions serving low-income people members institutions about AML/CFT issues, may have to purchase and install new technology offering courses in new AML/CFT regulations, or increase their human resource capacity to com- and developing a procedures manual to help ply with the requirements in their jurisdiction. In members ensure AML/CFT compliance. addition, rules for reporting and record keeping may obligate institutions to save all physical Customer Due Diligence documentation of transactions for defined It is a universal challenge for financial service periods, usually at least five years. Microfinance providers to identify clients according to interna- institutions in particular will need to develop sys- tional standards. In developing and middle-income tems, aided by available software, to reduce the economies, for example, it is difficult for many operational cost and time required to comply with clients to comply with certain "customer due this requirement. Industry associations can play a diligence" identification requirements, such as valuable role by helping members keep costs to a minimum as they comply with regulations. For example, they could consult with the banking 10 See annex 1 for a description of the variety of financial service association in a country to see if AML/CFT providers including financial cooperatives and NGOs. Box 4 Basel Criteria for Customer Due Diligence The Basel Committee document on customer due diligence (BIS 2001) provides some guidelines to financial institutions on how to implement CDD practices: "Banks should develop graduated customer acceptance policies and procedures that require more extensive due diligence for higher risk customers ... It is important that customer acceptance policy is not so restrictive that it results in a denial of access by the general public to banking services, especially for people who are finan- cially or socially disadvantaged."** These general principles were taken further in the Basel Committee's General Guide to Account Opening and Customer Identification, issued in February 2003.*** This statement of international best practice defines what a bank needs to know about a client to build a risk profile. The list includes obtaining and verifying name, permanent address, date and place of birth, nationality, occupation and/or name of employer, identity number, type of account and nature of the banking relation- ship, and signature. ** Bank for International Settlements, "Customer Due Diligence for Banks," www.bis.org/publ/bcbs85.pdf. *** www.bis.org/publ/bcbs85annex.htm 7 Box 5 AML/CFT Implementation in Mexico by Two Different Financial Service Providers Mexico has been a member of FATF since 2000, although money laundering and related offences were criminalized in 1996. Banks there have been required to report suspicious transactions over US $10,000 since 1997. In May 2004, Mexican authorities issued more detailed AML/CFT regulations and extended compliance to non-bank financial institu- tions. These two different financial service providers, BANSEFI and Compartamos, which both serve low-income clients in Mexico, implemented policies and systems in line with international standards and national law. BANSEFI is a national savings bank established by the federal government of Mexico in 2001 to support the development of popular savings and credit institutions. It has an active client base of more than 2 million clients, almost all individuals at the lower end of the income spectrum. BANSEFI has developed an AML/CFT policy and appointed a compliance officer as well as an AML/CFT committee. Internal controls, policies, and procedures were upgraded in 2004, and suspicious transactions are actively monitored, especially money transfers. Implementing some of the current laws has been chal- lenging, particularly verifying physical addresses and re-identifying existing customers. BANSEFI puts "know-your-cus- tomer" procedures at the heart of detecting and preventing money laundering and terrorist financing. It added these specific procedures to implement AML/CFT: · BANSEFI developed a new IT system to support the implementation of AML/CFT measures. · A new manual of enhanced internal controls, policies, and procedures was approved in June 2004. · It performs customer due diligence on new and existing customers, which includes client interviews, and verification of photo ID, physical address, and tax numbers. · It monitors all transactions, and reports suspicious transactions to the local financial intelligence unit, including transactions of US $10,000 and over. · BANSEFI employees are trained in AML/CFT compliance and kept up-to-date. Potential employees are screened before being hired. · It maintains all transaction records for at least ten years. · It also receives outside technical assistance to better comply. Financiera Compartamos, a specialized MFI, began operations in Mexico as a non-governmental organization in 1990 and transformed to a regulated financial institution in 2000. (Financiera Compartamos is legally registered as a sociedad financieras de objeto limitado, a non-bank regulated financial institution.) It currently serves over 300,000 clients--mainly individuals who operate microenterprises that usually employ one or two people of the same family, who often are the main income source for the family. Compartamos offers loans with an average outstanding balance of US $310. When it implemented the new AML/CFT regime for non-banks in 2004, Compartamos benefited from already being a reg- ulated institution. This meant that compliance systems, staff, and procedures were already in place. Furthermore, part of the Compartamos loan methodology included weekly visits to clients by loan officers, who already knew their clients well. Use of credit is monitored through the group lending system whereby clients disclose the use of their loans to other group members. Since 2000, Compartamos has been obliged to report any client transaction larger than US $10,000 to the Mexican banking authority, although it has not yet processed any transaction of this size. Compartamos, too, instituted additional procedures for AML/CFT: · Transaction records are maintained for ten years. · Compartamos monitors all transactions using customized software that identifies any unusual, complex, or large transactions by clients. · It appointed a formal AML/CFT compliance officer, the risk manager. In compliance with regulation, a special AML/CFT committee was appointed consisting of the general manager, the risk manager, the internal auditor, and legal officer. · All employees have been trained in AML/CFT issues and compliance requirements, and refresher courses are offered annually. In addition, when hiring new staff, Compartamos screens their legal history before making an employment offer. · The internal audit department and annual external audits verify compliance with AML/CFT regulations. Sources: CGAP-World Bank Survey questionnaire with BANSEFI Chief of Staff David Estefan and Norma Figueroa, AML/CFT compli- ance officer, January, 2005; CGAP World Bank survey questionnaire with Compartamos General Manager Carlos LaBarthe Costas and Risk Manager Lizette Escamilla Miranda in January 2005. 8 national identity numbers or third-party verification to adapt their internal procedures in accor- of physical home address. These requirements are dance with the new regulations. Such an already part of customer due diligence regulations approach will help minimize disruptions in in South Africa, but financial institutions there are their services to clients. experiencing problems with them because at least Take a risk-based approach. The AML/CFT one-third of South African households do not risks of financial service providers vary by have formal addresses.11 The issue at stake is how country, institutional type, and financial serv- to devise customer due diligence requirements ices provided. FATF Recommendation V that are tailored to specific categories of clients, states that "for higher-risk categories, financial such as those the Basel Committee proposes for institutions should perform enhanced due dili- banks in member countries (see box 4). In partic- gence. In certain circumstances, where there ular, a certain level of stringency could be applied are low risks, countries may decide that finan- to the institution's "normal" or low-risk clients, cial institutions can apply reduced or simplified and an enhanced due diligence applied to the measures."12 For example countries could riskier clients. exempt non-depository institutions that offer Since the FATF recommendations do not spec- low-risk financial products and have no link to ify how to establish and verify the identity of the payments system. clients, it is important that financial service Create appropriate exemptions. FATF recom- providers that serve low-income clients work with mendations recognize governments' discretion regulators to develop appropriate rules in each to exempt low-value transactions that fall national jurisdiction to ensure: below a certain threshold from AML/CFT that current or potential low-income clients requirements. For example, FATF Special are not excluded from access to services, and Recommendation IX requires cash couriers to that the regulations do not limit the ability of declare amounts exceeding a pre-set maximum banks to use microfinance providers as agents threshold of US $15,000.13 Associations of to accept or pay out remittances and other financial service providers that serve low- money transfers. income clients would be well advised to use this approach to negotiate with their respective What Should Financial Service governments to reduce or eliminate the Providers that Serve Low-Income AML/CFT regulation requirements applicable Clients Do? to them for transactions below a specified threshold value. It is important that microfinance institutions do As financial institutions serving low-income people not compromise their core objective of providing face rising pressure to comply with increasingly financial services to a broad range of poor people strict AML/CFT regimes in many countries, they as a result of compliance with AML-CFT regula- should seek to identify, understand, and comply tions. At the same time, to ensure their long-term with the local laws and regulations applicable sustainability and to meet their client needs, these to them.14 Even where there is no national institutions must protect themselves from abuse AML/CFT regime or where national supervision by terrorists and money launderers. In working capacity is weak, institutions should take the towards compliance with AML/CFT measures, initiative to establish measures based on interna- regulators and financial service providers serving tionally-accepted practices to protect themselves low-income clients need to work together to strike a careful balance between regulation and sustain- 11See Genesis Analytics, "Access to Financial Services." 12 ability and client needs: FATF, 2003, The Forty Recommendations, www1.oecd.org/fatf/ 40Recs_en.htm Gradually implement regulations. Financial 13FATF Special Recommendation IX and its interpretative notes, service providers should coordinate with www1.oecd.org/fatf/SRecsTF_en.htm#IX.%20Cash%20courriers country regulators to develop and gradually 14For a list of existing national legislation that has created compliance implement new AML/CFT regulations in regimes with AML/CFT regulations, see the FATF web site, order to give institutions adequate time www1.oecd.org/fatf/Legislation_en.htm. 9 Box 6 South Africa's Customer Due Diligence Framework South Africa was admitted as the fifth developing-country member of FATF in June 2003. The Financial Intelligence Centre Act (FICA) of 2001 established the Financial Intelligence Centre (FIC) as the unit within the South African National Treasury responsible for surveillance of suspicious transactions and coordinating policy efforts to counter money laundering in the country. (Legislation to criminalize terrorist funding is currently being developed by the parliament.) FICA covers a broad range of institutions, from banks and insurance companies to money remitters. Non-depository microfinance institutions are not specifically covered unless they remit money, but regulated institutions which offer prod- ucts at the low end of the market are "accountable" under the legislation. To date, the FIC has promulgated regulations that govern customer due diligence and require "accountable" institutions to report suspicious and unusual transactions. These "know your customer" regulations, which applied to new clients as of June 2003 and were phased in for existing clients beginning in 2004, follow international precedent and require finan- cial institutions to verify identity number, date of birth, income tax number (currently exempt due to system-related issues), and residential address "by comparing these particulars with information which can reasonably be expected to achieve such verification and is obtained by reasonably practical means." In practice, the latter has been interpreted by the banking sector to require utility bills, as is common in other countries. Many low-income clients have no tax number and are unable to produce third-party verification of address--as an esti- mated one third of SA households have no formal address. These requirements therefore prevent low-income and/or some self-employed people from opening bank accounts. A guidance note was issued by the FIC in April 2004 that advocates a risk-based approach for client identification and verification. A compliance exemption (Number 17) in the FICA law relaxes the "know your customer" requirements for a category of clients known as "mass banking clients." The exemption applies to accounts that have a maximum balance at any time of around US $4,000, that limit the size of deposits or withdrawals, and that do not have the ability to transfer funds internationally. Because of difficulties in applying this exemption, the Money Laundering Advisory Council raised the issue with the min- ister of finance in June 2004. He requested proposals from the Council for an exemption to promote the national priority of greater access to financial services. This resulted in the issuance of a revised exemption regulation in November 2004 that gives greater clarity and addresses industry concerns about customer due diligence requirements for low-income clients. However, informed commentators have proposed that changes should go further to eliminate the need for a tax payer number and the verification of address except where there are grounds to suspect it is false. Source: FIC: www.fic.gov.za; Genesis Analytics, "A Brief Case Study of the Effect of the Implementation of the FATF Recommendations"; L. de Koker, "Client Identification and Money Laundering Control: Perspectives on the FIC Act 38 of 2001." from being used for money laundering and the challenges facing institutions serving low-income financing of terrorism. Financial service providers clients in complying with the new regulations. that serve low-income clients should develop an However, measures that drive low-income people AML/CFT policy that identifies areas of risk back to informal means of saving and credit will based on their country, client, and product pro- be counter-productive and make it even harder files, and strengthens institutional capacity. Based to secure the integrity of the financial system. It on the implications of planned or existing laws and is therefore in everyone's interests--regulators regulations, microfinance institutions should and institutions alike--to grapple with these engage policy makers and law enforcement experts issues and develop solutions that accommodate in dialogue about changes where such laws and low-income clients. regulations could potentially affect their operations.15 In the post 9/11 world, AML/CFT regulation 15 See FATF Methodology 31.2. Associations of financial service cannot be ignored. This area of regulation is a providers that serve poor clients would benefit from participation in young and rapidly developing field, and there is reviews of their national systems for combating money laundering scope for further work to explore the particular and financing of terrorism. 10 Annexes have commercialized and expanded to become regulated financial institutions, such as banks. Annex 1: Microfinance Institutions and Some conventional banks have launched successful Other Financial Service Providers that Serve retail strategies to reach microfinance clients. Low-Income People Today, financial service providers who cater A microfinance institution (MFI) is an entity in to low-income clients take a wide variety of the business of providing financial services to low- legal forms. income people. The original focus of modern Recent CGAP research has established that microfinance was on the provision of micro- there exist many financial institutions which had credit--small loans usually for short periods to traditionally been excluded from definitions of the finance working capital for microenterprises usu- microfinance market, but which provide services ally run by low-income people. However, the field to as many as 750 million account holders who are of microfinance has broadened greatly beyond mainly low-income people across the globe.§ credit only, to include micro-savings, micro- These include credit unions and co-operatives as insurance, remittances, and other payments, all of well as postal savings, and rural and agricultural which can have a great impact on the lives of banks, which remain important in developing the poor. countries. Figure A1 below, excerpted from the As the field has broadened, so has the recogni- paper, gives an indication by region of the number tion that a wide variety of entities provide these § Excerpts from CGAP Occasional Paper 8, Financial Institutions with services, well beyond the non-profit organization a "Double Bottom Line": Implications for the Future of Microfinance, model that dominated the early days of modern www.cgap.org/docs/OccasionalPaper_8.pdf. microcredit. Some of the original institutions Figure A1 Combined Loans and Savings Accounts in AFIs* (in thousands) Region MFIs** Co-ops and Rural State/ Postal Total % of credit banks agricultural/ banks total unions development banks AFR 6,246 5,940 1,117 634 12,854 26,790 4% EAP 81,430 12,145 6,054 78,772 141,005 319,406 48% (incl. China) China only 154 200 ­ 46,570 110,000 156,924 24% ECA 495 5,692 ­ 28 11,503 17,718 3% MENA 1,422 11 ­ 30,712 16,980 48,670 7% SA 25,825 2,434 11,623 61,980 136,383 238,245 36% (incl. India) India only 5,589 392 ­ 57,821 124,010 187,812 28% Total 120,573 34,843 18,955 172,207 318,450 685,028 100% % total 18% 5% 3% 26% 48% 100% Key AFR-- Africa (sub-Saharan) LAC-- Latin America and the Caribbean ECA-- Europe and Central Asia EAP-- East Asia and the Pacific MENA-- Middle East and North Africa SA-- South Asia ECA-- Europe and Central Asia * For institutions reporting numbers of loans and savings accounts, only the larger of the two numbers is included in this table. ** Includes NGOs, banks, and non-bank financial institutions that specialize in microfinance, as well as microfinance programs in full-service commercial banks. Source: CGAP 11 of accounts held by low-income people in these Low-capital rural and/or local banks. Several financial institutions. countries offer a special license for small, locally The CGAP paper distinguishes the following owned, non-cooperative financial intermedi- groupings with the broad AFI sector: aries (e.g., Philippine Rural Banks, Indonesian Specialized MFIs. These MFIs are non- BPRs, Nigerian Community Banks, Ghanaian governmental organizations or officially Rural Banks, and Chinese Rural Credit licensed non-bank financial institutions. Some Cooperatives). Some of these institutions are MFIs have become licensed (and are super- owned by individuals, others by a combination vised by governmental financial authorities) to of local and regional governments. provide voluntary deposit services to their State development and agricultural banks. In target clienteles and to fund themselves either order to reach sectors that commercial banks with deposits captured from the public or do not serve, many governments have estab- from commercial funding. lished state-owned banks to promote agriculture Commercial bank MFIs. As a group, com- or other perceived development priorities. mercial banks do not share the social objec- These banks are often large. tives that characterize most of the AFIs, or Postal savings banks. Many countries take alternative financial institutions. Nevertheless, advantage of their postal infrastructure to pro- a number of specialized MFIs are organized as vide financial services. Postal banks usually do commercial banks. In addition, a number of not make loans: their services are limited to commercial banks have created specialized savings and payments/transfers. Account and microfinance services or departments in addi- transaction sizes tend to be quite small. tion to their more conventional operations. Non-postal savings banks. This category Financial cooperatives (including credit includes both private and public institutions. unions). This category embraces a wide range The latter are often very large. As the name of member-owned savings and loan institu- suggests, they are heavily savings-focused. tions. Membership is usually based on some "com- mon bond" (e.g., employment at a company or residence in a village). 12 Annex 2: Recommended Actions for recommendations outline criminal justice and Financial Service Providers that Serve regulatory measures for country regulators, pre- Low-Income Clients ventive measures to be taken by financial institu- AML/CFT measures seek to promote interna- tions and other financial service providers, and tional standards for transparency in financial international cooperation efforts (including infor- transactions and protect the integrity of the finan- mation sharing). cial sector. FATF takes into consideration the Table A2 suggests some actions that financial diverse legal and financial systems of countries service providers can take to move towards worldwide and recommends minimum standards AML/CFT compliance regardless of the status of that should be implemented depending on the their country's compliance with international specific characteristics of each country. FATF AML/CFT guidelines. SeeFATF web site, www.fatf-gafi.org/dataoecd/38/47/34030579.PDF Table A2 AML/CFT Measures AML/CFT Measures Recommended Actions for Financial Service Providers that Serve Low-Income Clients Internal controls (See FATF Recommendation XV and Financial service providers that serve low-income clients interpretive note.) should consider forming an association on AML/CFT, discussing AML/CFT within an existing industry associa- Institutions should develop internal programs against tion, and/or liaising with the AML/CFT committee formed money laundering and financing terrorism with regard to by the government to design internal policies and estab- their risk for abuse and the size of business. lish common practices. Establishing new internal pro- grams may require changes to client-intake forms and procedures, information systems, transaction monitor- ing, human resource policies, and internal controls. Examples include: · Presenting AML/CFT policies in a manual that is easy to disseminate among employees · Establishing internal thresholds for transfer amounts in order to detect suspicious transactions · Providing annual training for employees on AML/CFT issues and compliance requirements · Conducting in-depth background checks on poten- tial employees, shareholders, and board members · Ensuring that controlling interests, governance, or management positions in the institution are not held by criminals and their associates · Verifying that donations and contributions are from legitimate sources 13 Table A2 AML/CFT Measures (con't.) Customer due diligence (See FATF Recommendations For financial service providers that serve low-income V, VI,VIII, and interpretative notes, where applicable.) clients, implementing "know-your-client" and customer due diligence measures would require: Financial institutions are required to be able to identify and verify the identity of their clients and the nature of · verifying the identities of new and existing cus- the businesses and ownership structures of the entities tomers; and that they serve. Anonymous and/or non-face-to-face · obtaining executive approval within the institution to business transactions and new technologies that establish any relationships with politically exposed encourage anonymity are particularly risky and should persons (PEPs) and then continually monitoring receive special attention. the relationship. According to FATF, "the general rule is that customers The FATF Forty Recommendations Glossary defines should be subject to the full range of customer due dili- politically exposed persons, PEPs, as individuals who are or gence measures. However, there are circumstances in have been entrusted with prominent functions in a foreign which it would be reasonable for a country to allow its country, for example, heads of state of government; senior financial institutions to apply the extent of the customer politicians; senior government, judiciary or military officials; due diligence measures on a risk-sensitive basis." senior executives of state-owned corporations; and important political party officials. Business relationships with family FATF, 2004, "FATF Methodology for Assessing Compliance members or close associates of PEPs involve reputation risks with the 40+9 Recommendations"; FATF Recommendation V similar to those with PEPs themselves. The definition is not and interpretative note. intended to cover middle ranking or more junior individuals in the foregoing categories. Surveillance and record keeping (See FATF For financial service providers that serve low-income Recommendations X, and XI, and interpretative notes, clients, surveillance and record keeping would require: where applicable.) · ensuring that their information systems are ade- Institutions are encouraged to monitor transactions and quate to maintain transaction records. Financial keep detailed, efficient transaction records to facilitate service providers in some jurisdictions may be swift information sharing with competent authorities. required to keep all physical documentation of transactions for defined periods. · paying special attention to all complex, unusual, or large transactions; and all unusual patterns of transactions, which have no apparent economic or visible lawful purpose; and keeping record of the background and purpose of such transactions. Some financial service providers have further devel- oped systems, aided by available software or changes to their existing transactions process- ing and client information systems, to reduce the operational cost and time required to comply with this requirement. Reporting Suspicious Transactions (See in particular Financial service providers that serve low-income Recommendations XIII, XIV, and XV, plus the interpreta- clients can handle suspicious transactions by liaising tive notes.) with their national FIUs and developing systems of mon- itoring and reporting suspicious transactions; and Institutions have an obligation to promptly document reporting suspicious transactions to law enforcement and report all suspicious transactions to their national and competent authorities, in the case that the country financial intelligence unit, or FIU (see box 3 in the text), does not have an FIU. the administrative body charged with ensuring national compliance with AML/CFT measures. Competent authorities have the responsibility to estab- lish guidelines, together with feedback mechanisms, to assist all relevant institutions, including pro-poor institu- tions, to implement AML/CFT measures. (Countries should consult FATF "Best Practice Guidelines," 1998.) All institutions and their employees should have legal protec- tion from civil or criminal liability that results from reporting sus- picious activity and, as required by law, should keep the facts of such cases confidential. 14 Annex 3: List of FATF and FATF-Style the FATF and the various regional bodies. The Regional Body Country Members FATF-style regional bodies (FSRBs) have similar The list in Table A3 shows the countries, territories, form and functions to those of the FATF, and some and organizations that make up the membership of FATF members are also members of these bodies. Table A3 FATF and FATF-Style Regional Body (FSRBs) Country Members FATF APG CFATF EAG ESAAMLG Argentina Russian Australia Anguilla Belarus Botswana Australia Federation Bangladesh Antigua & Barbuda Kazakhstan Kenya Austria Singapore Brunei Darussalam Aruba Kyrgyzstan Malawi Belgium South Africa Chinese Taipei Bahamas China Mauritius Brazil Spain Cook Islands Barbados Russia Mozambique Canada Sweden Fiji Belize Tajikistan Namibia China (observer) Switzerland Hong Kong, China Bermuda Seychelles Denmark Turkey India British Virgin Islands South Africa European United Kingdom Indonesia Cayman Islands Swaziland Commission United States Japan Costa Rica Tanzania Finland Macau, China Dominica Uganda France Malaysia Dominican Republic Germany Marshall Islands Grenada Not signed MOU Greece Nepal Haiti Lesotho Gulf Co-operation New Zealand Jamaica Zambia Council Niue Montserrat Zimbabwe Hong Kong, China Pakistan Netherland Antilles Iceland Republic of Korea Nicaragua Ireland Palau Panama Italy Philippines St. Kitts & Nevis Japan Samoa St. Lucia Luxembourg Singapore St. Vincent & the Mexico Sri Lanka Grenadines Kingdom of the Thailand Suriname Netherlands United States Trinidad & Tobago New Zealand Vanuatu Turks & Caicos Norway Islands Portugal Venezuela GAFISUD GIABA* MENAFATF MONEYVAL Argentina Benin Algeria Albania Malta Bolivia Burkina Faso Bahrain Andorra Monaco Brazil Cape Verde Egypt Armenia Poland Chile Islands Jordan Azerbaijan Romania Colombia Gambia Kuwait Bosnia and Russian Federation Ecuador Ghana Lebanon Herzegovina San Marino Paraguay Guinea Morocco Bulgaria Serbia and Peru Guinea-Bissau Oman Croatia Montenegro Uruguay Ivory Coast Qatar Cyprus Slovakia Liberia Saudi Arabia Czech Republic Slovenia Mauritania Syria Estonia The Former Yugoslav Mali Tunisia Georgia Republic of Niger United Arab Hungary Macedonia Nigeria Emirates Latvia Ukraine Senegal Yemen Liechtenstein Togo Lithuania Moldova *Currently FATF observer, in the process of becoming an FSRB 15 Focus Note Bibliography No. 29 Asian Development Bank. 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