Vulnerabilities to illicit financial flows: complementing national risk assessments

It came as a surprise to many when in 2006, the money laundering watchdog Financial Action Task Force (FATF) found the US’ legal framework’s fitness to counter money laundering wanting. Was the US not leading the fight against dirty money globally? Not long after, the US topped the first edition of the Financial Secrecy Index in 2009 as the world’s biggest enabler of global financial secrecy. And returned to this spot on the 2022 edition of the index. Over the course of the past two decades, the US hypocrisy in international efforts against illicit financial flows has become widely understood.

Today, the risks the US is posing to the integrity of the global financial system are even more glaringly obvious under the Trump 2.0 administration. As if further proof was needed, US president Trump has announced backtracking on already weak efforts at reforming the US beneficial ownership registration requirements, as we have discussed in a previous blogpost (see here).

Yet, the prevailing approaches to assess country risk as part of the efforts against money laundering usually omits the US as a source of substantial risk to money laundering. So why is the US omitted if it has been long understood to be one of the world’s biggest secrecy enablers?

Several years ago, the FATF mandated so-called national risk assessments for countries to evaluate their nation-wide money laundering risks and prioritise the most important ones. Nonetheless, national risk assessments have proven often to be insufficient due to lack of data transparency, outdated methodologies, and time gaps between rounds of evaluation. For instance, so-called “blacklists” of non-cooperative jurisdictions are often based on dubious, opaque and politically biased criteria which tend to perpetuate stereotypes about which countries pose the biggest risk of illicit financial flows.

In our recent publication in the European Journal on Criminal Policy and Research, we present a novel data-driven approach to complement national risk assessments in order to improve their objectivity and reliability in the fight against dirty money.

Unsurprisingly, the US comes in among the top 5 biggest sources of risk for all three case studies featured in our paper. These case studies are Brazil, Nigeria and Indonesia.

The paper, titled Which Money to Follow? Evaluating Country-Specific Vulnerabilities to Illicit Financial Flows, is published in the European Journal on Criminal Policy and Research and freely available here.

Looking for illicit financial flows in the right places

National risk assessments have been central to FATF’s risk-based approach to fight illicit financial flows since its 4th round of mutual evaluations which began in 2014. Their elaboration involves multiple public and private agencies and they are designed to provide a structured understanding of money laundering and terrorism financing risks to enable an efficient allocation of resources based on each country’s profile.

However, national risk assessments present certain deficiencies that undermine their effectiveness. Among the most salient ones is the overdependence on expert surveys, as many national risk assessments rely heavily on expert opinions rather than on objective and verifiable data with solid background, causing subjectivity and the chance to reinforce stereotypes. Another relevant one is the lack of clear and comprehensive methodology, considering that traditional national risk assessments fail to have a methodological approach that integrates qualitative insights with quantitative data comprehensively, resulting in incomplete risk profiles. And a third main one relates to timeliness issues, since national risk assessments are often static exercises conducted every few years, which leaves countries with little chance to keep pace with the dynamic nature of illicit financial flows risks.

The methodology we propose to assess vulnerabilities to illicit financial flows addresses the abovementioned shortcomings. First, it draws on the FATF’s risk analysis matrix, a combination of likelihood of a risk occurring and the significance of impact or damage if it materialises. In addition, our methodology considers that said likelihood increases with increases in the level of financial secrecy. In fact, the easier it is to conceal details in a transaction, the higher the probability of concealment occurring.

Moreover, the methodology focuses on the main economic channels exploited for illicit financial flows. These are: (1) foreign direct investment, made by a firm or individual in one country into controlling business interests located in another; (2) foreign portfolio investments, comprising the purchase of securities and financial assets without necessarily having control over the underlying company; and (3) trade, that is, commerce of goods where manipulation of price, quantity, and quality can take the form of mis-invoicing, among other practices.

The proposed methodology combines two key elements: publicly available quantitative economic data about the economic channels and qualitative analysis of legal frameworks on financial secrecy.

The quantitative side utilises the International Monetary Fund’s Coordinated Direct Investment Survey for bilateral foreign direct investment data and the Coordinated Portfolio Investment Survey for portfolio investments. Industry-specific bilateral trade data is sourced from the UN Comtrade Database. To address gaps where countries are not covered or data is incomplete, mirrored statistics based on partner countries’ data are used.

The qualitative analysis focuses on the financial secrecy of partner jurisdictions, employing the Secrecy Score comprised in the Financial Secrecy Index 2022 of the Tax Justice Network. It offers a detailed and publicly accessible database outlining the legal and regulatory framework of each jurisdiction concerning financial secrecy and the opportunities available for individuals and companies to conceal their identity and activities.

Both key elements are then combined to assess the illicit financial flows risk, providing three different metrics within each economic channel: (1) vulnerability, that is, the degree to which a country is susceptible to illicit financial flows due to the weighted secrecy scores of partner jurisdictions; (2) exposure, the weight of the vulnerability of an economic channel against its relevance for a country’s economy; and (3) secrecy risk contribution, the proportion of the total illicit financial flow risk that a partner jurisdiction contributes to another.

The proposed framework offers the following advantages over traditional national risk assessments:

• The methodology evaluates each country’s regulatory frameworks by using the Secrecy Score of the Financial Secrecy Index 2022, identifying loopholes that enable illicit financial flows. The Secrecy Score is based on 20 indicators made up of a total over 100 data points.
• Each economic channel is considered separately, allowing unprecedented data-driven nuances in the identification of concomitant practices to conceal illicit financial flows under the appearance of legitimate financial transactions.
• The methodology is easily adaptable to the needs of every country, including those with constrained resources, by relying on publicly available data and the Secrecy Score.
• The approach guarantees continuous updates as soon as new data becomes available, allowing in turn a close follow-up of constantly changing practices of illicit financial flows internationally.
• The focus of the evaluation on the action of senders and recipients of money flows, rather than their personal features, allows an assessment devoid of any discriminatory component or stereotyping.

The methodology thus built offers a usable tool both at the macro level for complementing national risk assessments alongside other current risk assessment strategies, and at the micro level, for obliged entities and enforcement agencies to identify and investigate illicit financial flows more effectively, for example by adapting the methodology to assess risk in suspicious transaction reports.

Case studies from the Global South

We illustrate the methodology’s efficacy by means of case studies in three Global South countries, as a response to current literature on national risk assessments focused exclusively on Global North countries. Nigeria, Brazil and Indonesia are therefore chosen as sample countries due to the public availability of their national risk assessments, their large populations, and their locations on different continents.

The assessment of each of country focuses on one specific economic channel per country. Nigeria’s assessment focuses on inward foreign direct investment; Brazil’s focuses on Outward Foreign Portfolio Investment; and Indonesia’s on trade imports.

Below we present the gist of the country level findings captured by our methodology but not by the countries’ own national risk assessments. The US features among the top 5 sources of risk for all three countries.

Nigeria: inward foreign direct investment

From all economic channels, Nigeria’s main vulnerabilities to illicit financial flows lie in inward foreign direct investment, both in the form of debt and equity investment. The activity alone signifies a 11% of Nigeria’s GDP. High-secrecy jurisdictions like the Cayman Islands, the Netherlands and Bermuda contribute 17% of Nigeria’s total secrecy risk, enabling the flow of dirty money under the disguise of a legitimate investments. This highlights the need for stricter oversight in this economic channel.

Brazil: outward portfolio investments

Brazil’s case outlines the risk of outward investment, helping illustrate how outflows can also pose illicit financial flows risk. Brazil’s outward portfolio investments reveal significant vulnerabilities to illicit financial flows, mainly in the form of equity investments. The US emerges as the top contributor to secrecy risks due in part to limited information-sharing agreements. With over US$21 billion in investments from Brazilians in the Global North country, it turns out that it is worth prioritising targeted interventions into the channel.

Indonesia: trade imports

Indonesia’s highest vulnerabilities to illicit financial flows are in imports within the trade channel. Imports represent a value of US$138.6 billion – an amount that makes the activity have a considerable exposure to highly secretive trading partners like China, Vietnam and Singapore, from which a large portion of the country’s secrecy risk is derived. Sectors particularly vulnerable to price manipulation include electronics, textiles, and minerals. A more nuanced view on the specific risks per sectors in imports is needed to better understand Indonesia’s vulnerabilities.

Conclusion

As the global financial system is becoming more fragmented amid rising authoritarianism, and as the good will efforts to please the US under Trump 2.0 dwindle globally, countries must take a fresh look at the data behind their risk assessments. Unbiased and reliable data can help navigate these difficult times and changing terrains, and offer an opportunity to strengthen the ongoing fight against money laundering and the crimes it enables.

Our proposed methodology to gauge vulnerabilities to illicit financial flows helps stakeholders address existing gaps in national risk assessments, acting as a backstop against the amounts of money funneled through economic channels under pretense of legality. The case studies of Nigeria, Brazil, and Indonesia demonstrate that a more robust and effective approach to combating illicit flows is possible. At the micro level, this approach opens the door for obliged entities, law enforcement agencies as well as other relevant stakeholders to invest in new robust tools for enhancing their efforts to counter illicit financial flows.

You can read the full paper here.