Illicit Financial Flows and the Secrecy that Facilitates Them
When funds flow illegally from poor countries, this undermines potential economic progress. But neither political anti-corruption measures nor transparency programs have put effective limits on the scourge.
Over the last 40 years the globe has witnessed an achievement never before seen: the lifting of more than one billion people out of extreme poverty. This remarkable feat is most recognized in China, which accounts for three-quarters of the total, but numerous other nations including Tanzania, Vietnam, India and Indonesia also made substantial gains in this area.
The pace and scope of progress was such that in 2015 the United Nations adopted the Sustainable Development Goals, an ambitious and wide-ranging set of objectives meant to lift the world’s poor from merely surviving, to thriving. Tucked among the 17 goals and 169 targets largely focused on nutrition, education, health care and clean water was one little-noticed nugget which aimed to “significantly reduce illicit financial and arms flows, strengthen recovery and return of stolen assets, and combat all forms of organized crime.”
This catch-all target was cobbled together from several individual proposals which were, evidently, deemed not significant enough to warrant their own stand-alone status. Among these was a focus on illicit financial flows (IFFs) which, until relatively recently, was an arcane term used solely by development economists to highlight flight capital.
Now however, the term refers to something significantly more meaningful: money that is illegally earned, used or moved and which crosses an international border. This definition, which is almost universally recognized, was first used by Global Financial Integrity in 2006, a Washington-based think tank focused on addressing the corrosive impact of flows of illicit funds. While the issue of illicit flows was not seen to be sufficiently important to merit an individual SDG target, its inclusion signified a revolution in development thinking. For the first time, illicit money flowing out of poor countries would be considered part of the development equation.
The problems caused by IFFs are severe. For example, the UN Conference on Trade and Development (UNCTAD) estimates that in Africa alone over $88 billion in illicit funds – 3.7 percent of the continent’s GDP - leaves the region each year. Further, this amount almost equals the combined total of official development assistance and foreign direct investment flowing into the region thereby undermining the economic progress that could be made. The opportunity cost of this loss of funding cannot be overestimated.
The bulk of illicit funds come from three main areas: corruption, criminal activity and corporate tax evasion. In each case the figures are massive. According to the United Nations, the amount of grand corruption each year is equivalent to five percent of global GDP. In 2020, this amounted to $103 trillion or, about $5 trillion in corruption payments. Transnational organized crime is estimated at $2 trillion per year and tax evasion is said to be $500 billion. In each case developing countries bear the brunt of these illegal activities which undermines their ability to capture the revenue needed to reach the global goals.
These figures are, of course, imprecise. Since adoption of the SDGs in 2015 efforts have been made by UNCTAD and the UN Office on Drugs and Crime (UNODC) to perfect the statistical frameworks needed to provide development experts and policy planners with more accurate estimates. But while honed figures will be helpful, exactitude will be impossible because the illegal activities that generate illicit proceeds are meant to be hidden. No methodology will generate a precise figure. What we do know is that the magnitude of the problem is sufficient for lawmakers to comprehend the severity of the situation and begin to act to rectify it.
It should be noted that in the estimates for tax evasion above the legal avoidance of taxes by corporations have not been included. Whether to include tax avoidance in the definition of IFFs is an issue of some debate among practitioners in the field. It is for this reason that no official IFF definition has been agreed to thus far and why the United State government does not, as a rule, use the term ‘illicit financial flows.’ In this instance the author fully agrees with the position of the World Bank on this issue which “recommends focusing on flows and activities that have a clear connection with illegality.”
There are numerous reasons illicit financial flows are as severe a problem as currently witnessed, some of which are self-reinforcing. For example, weak governance systems in many countries, including a substandard statutory and regulatory structure, enables corruption, crime and tax evasion to occur almost with impunity. At the same time, high levels of corruption, self-dealing and nepotism make it difficult to enact transparency and accountability reforms which would significantly curtail activities that generate IFFs.
More to the point, despite billions of dollars in official aid spent on anti-corruption programs over the past 25 years, there is little indication that much has worked to reduce this scourge on societies around the globe. In its annual Corruption Perception Index examining corruption levels in 2022, Transparency International notes that “most countries are failing to stop corruption.” And, in its report for the previous year, the anti-corruption group provided the sober assessment that “131 countries have made no significant progress against corruption in the last decade (emphasis added) [and] two-thirds of countries score below 50 (out of 100) … while 27 countries are at their lowest score ever.” Given corruption’s stubborn resistance to change it is no wonder IFFs also appear to be an intractable problem.
That is not to say that corruption is the only, or even the primary, factor driving IFFs. Nowhere is this more evident than in the United Kingdom and the United States which rank 18 and 24 (out of 180), respectively, on Transparency International’s Corruption Perception Index while at the same time rank number 1 (US) and 13 (UK) out of 141 countries on Tax Justice Network’s Financial Secrecy Index. The chief explanation of why flows of illicit money occur with such regularity is because there are an array of opaque vehicles through which dirty money can be moved, hidden and laundered. Recent financial scandals highlighted by the International Consortium of Investigative Journalists (ICIJ) point to just a few ways money can ricochet around the globe, out of the reach of law enforcement and tax authorities.
In the Panama Papers, ICIJ shined a light on the role anonymous shell companies play in enabling criminals, tax evaders and corrupt officials to move money though opaque corporate structures with ease. The Paradise Papers, demonstrated how major global corporations used subsidiaries in tax havens to evade and avoid taxes in other jurisdictions. And in the Pandora Papers secret trusts in the United States were showed to have hidden at least $1 billion for non-resident clients.
But the methods to hide illicit funds described in these reports are just the tip of the opacity iceberg. Other ways to move illicit proceeds include falsified trade invoicing, free trade zones, trade-based money laundering, fraudulent foundations, non-charitable foundations and, not to be forgotten, high-valued real estate, private investment funds and many more. The most surprising component of this global secrecy system is that many of these methods to move illicit money are legal and can be exploited by criminals and corrupt officials alike.
It is the legal nature of many of these vehicles that poses the challenge for policy makers. How can illicit flows be significantly curtailed without grinding the global economy to a halt? Implementing laws that require transparency is the first step. With transparency comes accountability and with increased accountability there is a greater opportunity to enforce the laws and arrest the criminals.
Second, law enforcement must be improved. Political will to address the problem and implementation of a legislative and regulatory framework creating new transparency measures are key. But, without sufficient law enforcement capability – the ‘third leg of the stool” – efforts to curtail IFFs will likely fall far short of the mark. And how is law enforcement doing in this area? Not well, apparently. In early 2020 the then-head of the Financial Action Task Force – the global standards-setting body for anti-money laundering – was interviewed about the ability of law enforcement to battle financial crime. “Everyone, he said, “is doing it badly.”
That brutal assessment was noticed by more than just transparency campaigners. In December 2021, the US Treasury Secretary Janet Yellen noted “there’s a good argument that, right now, the best place to hide and launder ill-gotten gains is actually the United States.” Keen observers hope that this unprecedented recognition of the US role in the global financial secrecy system will go some way toward addressing the deficiencies in the country’s primary financial crime-fighting agency. FinCEN, as it is known, is plagued by low budgets, poor morale and badly-aging technology.
To be sure, the Biden administration has demonstrated its commitment to bolstering the government’s ability to fight financial crime. In early 2022 it led the charge to boost FinCEN’s budget. And, later in the year, the White House announced its full-throated support for the ENABLERS Act – despite opposition by the American Bar Association – which would require professions such as attorneys and real estate agents to report suspicious financial activity much as banks are required to do. Despite that endorsement and support in the House, the bill failed to win approval in the Senate by a slim margin.
But that was then. This year, with Republicans in control of the lower chamber, it is unclear what is in store for this bill and financial crime fighting in general. After just a week into the new session of Congress, Republicans pledged to repeal $80 billion in funding, which was approved last year, meant to increase the ability of the IRS to catch tax evaders. Moreover, rumors are swirling inside the beltway that the controlling party want to slash FinCEN funding as well. Such a move would be potentially disastrous for US national security and will certainly undermine the government’s ability to identify and seize profits from human traffickers and drug cartels.
New technologies are likely to be the lynchpin to substantially addressing illicit financial flows. Given the magnitude of financial crime introducing artificial intelligence, machine learning edge computing and other technologies into the financial crime-fighting field are needed to keep pace. An assessment of FinCEN’s capabilities by a group of anti-money laundering experts in 2021 highlighted the need for new technologies at the agency. The AML Experts Group, as it is known, recommended that FinCEN establish a “Manhattan Project” “to identify, develop and operationalize state-of-the-art technologies to fulfill the technology needs” of 21st century crime fighters.
Fortunately, substantial progress has been made in establishing more transparency in corporate vehicles (i.e. anonymous shell companies) over the last several years. So-called beneficial ownership (BO) registries, which require the actual person who owns the firm to report basic identifying information to government authorities, have gained wide acceptance. Over 100 governments have committed to introducing BO registries to make it easier for law enforcement and tax authorities to trace movements of illicit cash though related bank accounts. Without this transparency it is quite simple for a bad actor to hide their movements of illicit funds behind the veil of an attorney or company formation agent thereby protecting themselves from prosecution.
Progress in this area, however, is not always a straight line. While more than half of the world’s governments have endorsed the idea of setting up a registry it is as yet unclear how many will actually implement one. Further, questions surrounding the quality of the information submitted to the registries and the motivation of law enforcement to use the data remain to be answered. Additionally, in late 2022 the European Union Court of Justice struck down a law requiring public accessibility of information in beneficial ownership registries established by member-states. Public access – by researchers, journalists and other governments – is a key component to keeping business owners honest and the financial system clear of illicit funds.
What is required now, to counter legal setbacks, proposed budget cuts and “scandal fatigue” due to myriad investigative reports of financial crime, is reinvigorated leadership. Given that the German government declared it is “not afraid to take bold and decisive action” to fight financial crime, Chancellor Scholz could become the European counterpart to President Biden’s vigorous anti-corruption efforts by not only embracing this agenda but by pushing its limits. Indeed, there is much more transparency work to be done to counter illicit financial flows including creating a global beneficial ownership registry for commercial shipping, promoting implementation of best practices for the world’s 5,000 free trade zones and encouraging the use of blockchain technology in every port. These transparency measures will be invaluable pieces of the solution to the financial crime puzzle and they need a champion.