1) Introduction:
Money laundering is a global problem. Measuring its impact is tough, as it takes place behind everyone's eyes and it apparently is a victimless crime. Yet the damage it does can be devastating to the financial sector and economy's 'real' and 'external' sector, especially in case of a developing country. By contrast, effective anti-money-laundering policies can reinforce a range of good-governance policies. This in result helps the country to sustain economical growth particularly by making the financial sector stronger.
1.1) Background
Because of the worldwide growing concerns over money laundering, G-7 summit established Financial Action Task Force (FATF) in Paris in1989. Its purpose was to generate an international response to this increasing problem. Since then this organisation has been playing a vital role in tackling money laundering. It works closely with other international bodies that develops and regulates Anti-Money Laundering (AML) policies world wide. FATF members have 29 countries and jurisdiction includes major financial centres in Asia, North and South America, Europe- as well as the European Commission and The Gulf Co-Operation Council.
1.1.1) Problem statement
Today a country's economy largely depends upon the advancement of technology. It made the job a lot easier, but it came with its own challenge. Which concerns the international financial community the most is the bad guys are also using the technology to give their 'proceeds of crimes' a legal look. In short the money made by various criminal activities in various parts of the world is injected into a nation's economy to camouflage it or give it a lawful appearance. This system is known as Money Laundering and this problem is growing to a serious proportion over time. IMF estimated that the aggregate size of laundered money worldwide is 2% to 5% of global GDP in 1998.
Regardless who or how the 'dirty' money is being used, the operational system or method is always the same. It is a dynamic three stage process. The stages are:
Placement- A large volume of cash which was obtained through illegal means is placed in to the financial system, can be used to buy high-price item or may be smuggled out of the country. The point here is to transform the cash into some other kind of asset to avoid detection.
Layering- this stage takes place to hide the true origin of the unlawful money. Here in layering stage a complex set of transaction takes place to obscure the trail of that cold hard cash and its real ownership. At this point the advancement of technology helps them. One the methods are Electronic Fund Transfer (EFTs). Others include conversion of monetary instrument, investments in legitimate businesses, purchasing real estates. In most of the EFTs are used frequently. Because of the busy lifestyles and easy access, a lot of EFTs are processed everyday. Among all those when a Phoney EFT takes place between an offshore account and a shell company, It is pretty hard to spot a criminal transaction at first look.
Integration- The final step of the process where the illicit money comes back clean to its owner and then integrated to the economy as investment into a legal business. Once integrated, it hides the identity or origin even further.
1.1.2) Research significance
There has been little research into the effects of money laundering on the economic growth, particularly in a developing country. Most of the researchers and their works were focused on measuring the amount and usage of money-laundering. Hence the majority of this vast subject has remained unstudied. Therefore the developing countries, which are the prime channels for international money-laundering, are suffering from the need for the guidelines to stop the erosion of the long-term economic growth caused by this problem.
1.1.3) Research question
In a developing country's economy the role of the financial institutes such as- banks, non-bank financial institutes (NBFI), equity market-are critical. They help to sustain the economic growth by concentrating the domestic savings, even the overseas funding. For all these gaining customer trust is vital. Money laundering erodes these institute and affects the customer trust as this is interrelated with other criminal activities that is performed by the workers in financial sector or government. Besides that, money laundering facilitates domestic corruption and crime which results depressed economic growth. It also diverts the resources to less productive activity.
In the light of above discussion, proposed work is on following questions:
* What is money laundering?
* What are the negative effects of it on economic growth?
* How does it harm the developing countries?
1.2) Aims and objectives
The purpose of this study is to analyse harmful effects of the money laundering on the economic growth of a developing country. Because of the weaker economy, lack of strong policies and comparatively easy regulations the developing countries become an open market for such activities. Therefore those countries have scope to improve their policies, regulations and laws. The objectives of the proposed study are to know:
* What sectors are mostly being affected?
* What is the extent of the damage?
* What can the developed economic community do?
* What kinds of policies or regulations are being implemented?
* What kinds of policies or regulations can be improved?
As the time advanced, money laundering business has also evolved by keeping pace with the time. Technology has made it more undetectable. The businesses are booming and consequences are visible. But regulatory bodies are also taking necessary steps. They are tightening their borders, educating people, creating awareness. Still these are not enough for the countries affected. Most of the time, they don't have enough resources to divert to that sector. As a result they are bleeding internally. Therefore we can assume the following:
1) Most of the economic damage done by money laundering through its developing country channel is at the expense of the developing economy.
2) The weaker regulations and policies are the more liberty a money launderer gets. Therefore they need to strengthen themselves, with the help of others if necessary.
The countries with the developed economy have sufficient resources, therefore options to fight this particular crime. But in case of the developing economies, if not handled in time, it can distort investment, encourage crime and corruption and increase the risk of macro-economic instability. Through this study some solutions may be found, or at least the gravity of the danger ahead.
1.3) Limitations
The expansion of money laundering problem is vast. At the same time a greater portion of this crime is goes unreported, hence unnoticed. Authorities all over the world has been struggling to get a proper grasp of the whole problem. The developments that are being made are on the implementations of AML policies and legal sector. But there is a great lack of research on the effects and consequences of money laundering in the developing economies. Therefore there is not enough data available to come to any exact conclusion. Besides, this research is based on the secondary data. So evaluating the existing data was not possible. To be able to do so, a higher level of intervention, e.g. Government, international banking authority etc. is necessary as this research involves the national financial data.
1.4) Overview
The first chapter of this research introduces the area or the topic to the audience. What is money laundering, how big or vast the problem is, how did it start and how it is done, what are the authorities doing about it and what are the limitations of this particular research has been described in this section. The second chapter includes an extensive and analytic review of the existing literature that is available to refer to about this subject.(incomplete**)
2) Literature review
2.1) introduction
This part of the report contains a thorough and critical study of the books journals, articles and other materials that is available on money laundering. This review gives the audience an idea how much research has been done in this area. It also helps to get an idea of the world's concept of money laundering.
2.2) Review
A channel or medium is required to carry out money laundering activity. The preferred medium that a Money launderer chooses is the financial institution that is efficient and costs less while carrying out the transactions (Masciandaro, 1999).Such activities ruin the integrity of those financial institutions and affects their soundness or stability. As a result of their weak integrity, they loses the investors confidence and eventually direct foreign investments are reduced. This process in turn disturbs the long-term economic growth of the country. Barret (1997),Masciandaro and Portolano (2003), Paradise (1998) and Quirk (1997) argued in their studies that the economic and financial systems of a country are threatened by money laundering.
Despite of money laundering being a global problem, there has been a little research in the area of the harmful effects on economy. Some notable exception will include Uche, C U (1999) and Masciandro, D (2000). Most of the works were done on the legal framework or to develop effective AML policies over the years. Therefore quality data on the pervasiveness or any long term pattern of the affected economy is rather limited.
The origins of money laundering can be traced as far back as 1930s in organized criminal activities (Bosworth-Davies and Saltmarsh, 1994). So it is clear that the concept is not a new one. Over the years it just grew over its proportion. Financial Action Task Force defined the problem as:
' . . . the processing of a large number of criminal acts to generate profit for individual or group that carries out the act with the intention to disguise their illegal origin in order to legitimize the ill gotten gains of crime. Any crime that generates significant profit-extortion, drug trafficking, arms smuggling and some kind of white collar crime may create a "need" for money laundering' (FATF 1998).
According to Mulig and Smith (2004), the term "money laundering" was originated by the organised crime families, who used to own legitimate laundry business to disguise or 'launder' very large amount of cash, which was in fact, earned through extortion, prostitution, gambling and drug business. United Nations office on Drugs and Crime (UNODC) explained that there are two reasons why the criminals, May it be the street crime or the corporate white collar embezzlement or maybe a corrupt public official, need to launder the money because, it leaves a paper trail as evidence of their crime. Secondly, the money itself is vulnerable to seizure so it needs to be protected. In other words it is an 'Unfinished product' to the criminal until it is cleaned.
A bigger portion of literature on money laundering concentrates on the legal framework. That includes the legislation and regulations that can be traced back to the US "war on drugs" in 1980's (Gill and Taylor, 2004). Since then it was a concern that was growing over time. In response to that, international agreements were being made to tackle such activities amongst which, the UN was the first international organisation to combat the crime globally. Subsequently, in 1989 G-7 established FATF. In the FATF annual report (FATF, 2006b) it was stated that, most of the illegal activities are linked with corrupt practices and lack of transparency. This subsequently arises to weaker governance which results poor and ineffective use of AML policies. Those are the places that become heaven for money launderers. Their activities erode the financial system from inside while taking advantage of the volatile economy.
In large scale money laundering operation, cross-border factor is always included. Therefore an international approach was a crying need to handle this problem effectively. That was also a reason why the UN and the Bank for international Settlement took the initiative to address the problem in 1980. Following the FATF formation, the regional grouping such as- Council of Europe, European Union, Organisation of American States And many others designed AML policies required and effective for their member countries. Asia, Europe, the Caribbean and southern Africa have created regional AML task force-like organizations, and similar groupings for western Africa and Latin America are being planned too.
As discussed previously, second stage of money laundering widely uses the technology as one of their means of 'layering' the 'dirty money', the use of it is becoming rather popular to them. The advances in technology, especially in Information and Communication Technology (ICT) have benefited the whole world. Money launderers are also included in the group of beneficiaries. They take full advantage of these benefits.
Modernisation in technology, particularly in ICT has brought various different ideas banks or other NBFIs to offer new products and services through new means of delivery. These new products and services and often contain fast transmission of digitized information, facilitating of fund movement and transcending distance within or across the national boundaries (Bradley and Steward,2002) and anonymity (Philippsohn,2001). According to Mishkin and Strahan (1999) and Berger (20003) speed, distance and anonymity are the key factors that are rapidly changing the financial system. However, Masciandro (1998, 99) and Philippson (2001) implied that those new benefits including e-banking and all sorts of e-money technologies have made money laundering activities even more robust. As a matter of fact, FATF (2001) on their typology report identified the online banking facility and internet as the major money laundering vehicle now days. According to Chief Financial Officer Report (2002) "Technology changes have influenced the operating strategies of many banks and Non-banks as they seek to compete in the increasingly fast-paced and globally Inter-dependent business environment."
3) Methodology
3.1) introduction:
In this chapter all the data that has been collected will be shown. That data will be analyzed and interpreted in to results. As this is not a very comprehensive research, All the data has been collected from secondary sources.
3.2) Data collection
3. Empirical methodology
In this section, the theoretical framework for capturing the pervasiveness of money laundering via two channels, namely through banks and non-banks in a sample of 88 developed and developing countries is discussed. This is then followed by a discussion of the econometric method employed to examine the relationship between the key factors and the pervasiveness of money laundering in these countries. In this paper, it is assumed that the pervasiveness of money laundering through banks and non-bank channels are composed of three stages.
The first stage of the money laundering activities refers to countries which are characterized by low investment in the key factors of the money laundering activities. These countries still remain passive and complacent with regards to financial, economic and political dangers posed by laundering. In this stage of development, the factors of the money laundering activities namely technology, quality of human capital, efficiency of the legal framework, ethical behavior of firms and capacity for innovation are usually weak and ineffective. Investments in the factors are low; hence result in high-money laundering activities. The second stage represents the countries where the pervasiveness of money laundering improves rapidly due to efforts taken to improve the quality and quantity of the factors of the money laundering activities namely technology, quality of human capital, efficiency of the legal framework, ethical behavior of firms and capacity for innovation. Improvements in the key drivers which include implementation of laws and regulations tend to decrease the money laundering activities. New technology and new financial instruments together with good integrity system reduce money laundering activities. The third stage represents matured financial sectors where the factors of the money laundering activities namely technology, quality of human capital, efficiency of the legal framework, ethical behavior of firms and capacity for innovation are highly developed hence the prevalence of money laundering is low. The pervasiveness of money laundering activities can be modeled using the logistic function:
Yt ¼
ys
1 þ aef ðx;bÞþm
ð1Þ
where Yt is the pervasiveness of money laundering through banks and non-bank, ys is the upper limit of Yt (refer to Table I). The factors that have an impact on money laundering are denoted by the design matrix where X ¼ [X1,X2,X3,X4,X5] 0 (the factors are defined in Table I) and b is the factor that capture the marginal return of the factors on the pervasiveness of money laundering. Equation (1) can be re-written as:
Y* ¼ f ðx0bÞ þ u ð2Þ
where:
Y* ¼ ln
Yt
Ys 2 Yt
_ _
and u is the residual.
The impact of the factors on the pervasiveness of money laundering will be examined using the following regression model:
Model 1:
Y* ¼ b0 þ
Xk
i¼1
biXi þ ui ð3Þ
Model 2:
JMLC
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Y* ¼ b0 þ
Xk
i¼1
biXi þdoD1 þ ui ð4Þ
Model 3:
Y* ¼ b0 þ
Xk
i¼1
biXi þdoD1 þ
Xk
i¼1
diðD1 £ XiÞ þ ui ð5Þ
where D1, is the dummy variable for developed countries (D1 ¼ 1 if developed and 0 otherwise); do, is the slope coefficient for the dummy variable; di, is the slope coefficient which captures the marginal effects of the 5Xs on the pervasiveness of money laundering in developed countries and developing countries; ui, is the error term.
Variables Description Proxy
Infrastructure (X1) Facilitate connectivity to the global economy that is access to ICT facilities. Number of internet users (internet users per 10,000 inhabitants, 2003)
Intellectual capital (X2) Knowledge workers' Quality of the educational system (1 ¼ does not meet the needs of a competitive economy, 7 ¼ meets the needs of a competitive economy). Institutions (X3) Legal and regulatory framework that facilitate the knowledge economy Efficiency of legal framework (1 ¼ is inefficient and subject to manipulation, 7 ¼ is efficient and flows a clear, neutral process) Integrity (X4) Governance systems (corporate governance) Ethical behavior of firms (1 ¼ among the world's worst, 7 ¼ among the world's best) Innovation (X5) R&D and new product development Capacity for innovation (1 ¼ exclusively from licensing or imitating foreign companies, 7 ¼ by conducting formal research and pioneering their own new products and processes) Pervasiveness of money laundering through banks and non-banks channels banks ( y) Money laundering through banks and non-banks channels banks Pervasiveness of money laundering through anks and non-bank channels (where the ranking for the pervasiveness of money laundering ranges between 1 and 7 with 1 ¼ pervasive denoting very high occurrence of money laundering and 7 ¼ xtremely rare denoting very low incidence of money laundering) The factors and the dependent variable include Factors affecting money laundering.
The first model which is a general model (equation (3)) considers the factors which include technology, quality of human capital, efficiency of the legal framework, ethical behavior of firms and capacity for innovation on the pervasiveness of money laundering. The second model (equation (4)) includes an intercept dummy variable that controls for developed and developing countries. Lastly the third model (equation (5)) includes the intercept and slope dummy variable. This will enable the model to capture the marginal effects of the factors on the pervasiveness of money laundering in developed and developing countries.
An underlying assumption of OLS is that the residuals of the model are normally distribution with mean 0 and variance s2IT (homoskedastic), that is ui , Nð0;s2ITÞ. As such, equation (2) can be estimated using OLS method. However, if the residuals are heteroskesdastic and the generalized least squares method (The White-Estimator) is employed as the OLS estimator will be inefficient.
Several statistical diagnostic tests were carried out to ensure the estimates were robust. Multicollinearity test was conducted using the variance inflation factor (VIF) method. A maximum VIF value exceeding 10 will indicate that multicollinearity will lead to biased estimators. Parameter stability test was carried out to ensure the model was correctly specified. The residuals of the estimated model were subjected to the heteroskedastic test and Jarque-Bera normality test. This is to ascertain if the residuals satisfied the standard regularity assumptions (homoskedastic and normally distributed).
In this study, secondary data were collected for 88 developing and developed countries (Appendix) for the period 2004-2005 from The Global Competitiveness Report 2004-2005 (Cournelius et al., 2005). It should be noted that data availability for more than one period for some of these variables were not reported. As such this study is limited to only one year to maintain consistency in the variables. Money laundering activities transfer funds via two channels, namely via the banking channel or non-bank financial institutions. Table I provides a description of the factors and the pervasiveness of money laundering.
