Mine Your Way to Combat Money Laundering, Part 1

Information Management Special Reports, October 2007

G. S. Vidyashankar, Rajesh Natarajan, Subhrangshu Sanyal

Money laundering generally involves a series of multiple transactions used to disguise the source of financial assets. This enables those assets to be used without compromising the criminals who are seeking to use the funds. Through money laundering, the criminal tries to transform the monetary proceeds derived from illicit activities into funds with an apparently legal source. Worldwide value of laundered funds in a year ranges between $500 billion to $1 trillion, according to the United Nations Office on Drugs and Crime. Weak financial regulatory systems, lax enforcement, gaps in the information systems of financial institutions and corruption are key factors that make certain jurisdictions particularly attractive for laundering illicit proceeds.

In this article we present the risks of money laundering and the need for anti-money laundering (AML). Challenges in detecting occurrences of money laundering using traditional methods and the limitations of the same are outlined. We also examine how data mining can deal with the complexities of the modern money laundering operations. Finally, the advantages of data mining and its challenges are elaborated.

Process of Money Laundering

There are three phases to the complete laundering of funds, beginning with the placement of currency into a financial services institution (placement), continuing with the movement of funds from institution to institution to hide the source and ownership of the funds (layering), and concluding with the reinvestment of those funds in an ostensibly legitimate business (integration). This is done by using the services of formal financial systems such as banks, money changers, wire transfers, etc. Advances in information technologies for banking and financial services have not only increased efficiencies of routine financial transactions but have also allowed criminals to use the same services to launder money.

Money Laundering Risks - Need for AML

Money laundering poses serious threats not only to financial institutions but also to the nation. The risks faced by financial institutions are:

• Reputation risk: The integrity of the banking and financial services marketplace depends heavily on the perception that it functions within a framework of high legal, professional and ethical standards.
• Operational risk: It can be defined as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events. A public perception that a bank is not able to manage its operational risk effectively can disrupt or adversely affect the business of the bank.
• Concentration risk: This risk relates to the exposure of banking and financial services market place to a single customer or groups of related customers.
• Legal risk: Banks may become subject to lawsuits resulting from the failure to observe mandatory KYC standards or from the failure to practice due diligence.

Society is also at risk because money laundering provides the fuel for drug dealers, terrorists, arms dealers and other criminals to operate and expand their criminal enterprises. Hence, the government regulatory bodies partnering with the financial institutions and law enforcement agencies have initiated elaborate AML programs to track and prevent financial crimes.

A Typical AML Solution

While countermeasures to all three phases of money laundering are important, laundered money is most vulnerable to detection at the placement stage.¹ Hence, international regulatory and law enforcement efforts have concentrated especially on developing methods to make it difficult to place illicit funds without detection by developing measures.

AML Legal Framework

The first step in the AML initiative was setting up the legal framework which would become a major tool for fighting the money laundering activities. The different laws and acts, such as the Bank Secrecy Act and the Patriot Act, evolved focusing on this area. These laws spell out the mandatory requirements to be followed by the financial institutions (FIs). The major requirements are:

• Retention and traceability of financial transactions and
• Reporting of certain suspicious financial transactions.

In addition to these laws, there are several guidelines and recommendations (e.g., FATF recommendations, Wolfsberg principles) developed by international bodies that help the FIs to set up appropriate checks and balances so that it satisfies the regulations and help them fight financial crimes. The focus areas are:

• Customer identification and customer due diligence: Measures to establish the identity of the clients and beneficial owners; collect and record the proofs establishing the identity - commonly referred to as know your customer (KYC).
• Continuous monitoring of the customer transactions and identifying suspicious activities.
• Reporting on suspicious activities (SAR) and policy violations.
• Establishment of a compliance office and internal audit function; and
• Continuous employee education and training.

Building Blocks for an AML System

In today's world, it has become mandatory for the bank to implement a robust internal AML system. There are heavy penalties for noncompliance such as heavy fines, asset forfeiture and even suspension of the charter. Trends show that money laundering is becoming more and more of a cross-border phenomenon and new crime strategies are coming up almost daily. Hence an effective AML system should have:

1. Interfaces that integrate with the international network of financial and regulatory bodies and enhances the capability for information processing;
2. An enterprise-wide architecture that integrates internal core financial applications and facilitates information flow and traceability across the applications within the financial institution;
3. Transaction monitoring system having the intelligence to detect and alert suspicious activities;
4. Case management workflow to efficiently investigate and action the alerts;
5. Customer risk assessment model to restrict entry of unwanted entities into the financial system; and
6. Efficient reporting system for both regulatory and internal control reporting.

Figure 1 illustrates the major components within an AML System

Figure 1: Components of an AML System

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