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2002 - article. "UK: Financial Services: USA PATRIOT Act Regulatory Push Threatens Economies of Small and Developing Countries"

BIScom Subsection: 
Nigel Morris-Cotterill

This article, by Nigel Morris-Cotterill, was first published in September 2002. It is, in part based on a briefing to banks, etc, in London in November 2001 and draws attention to the effect of the money laundering, etc. provisions of the just in-force USA PATRIOT Act.

The term "Regulatory push" has been coined by my company to describe the phenomenon of regulators in one country forcing their style of regulation onto financial services businesses in another country.

Amongst countries of a similar size, wealth and state of regulatory development, this is not a significant problem. However, where the regulation is imposed onto a small or developing country there is a grave risk of serious damage to the economic well-being of the more vulnerable.

The effects of regulatory push has been demonstrated in a slightly oblique way for some time. The USA, in particular, has entered into many Mutual Legal Assistance Treaties (known as MLATs) with all manner of countries. These treaties permit enforcement agencies in each country to co-operate without, in some cases, the more common formalities of, say, court orders. In effect, the MLAT says that the enforcement agency receiving the request will treat the investigation as its own. However, to avail themselves of the benefits of the treaty (which will speed, ease and render less costly an otherwise difficult cross-border investigation) there are formalities that have to be met.

There is frequent criticism by enforcement agencies in the US that certain countries do not assist as readily as they might. All too often, the finger points at so called "tax havens" and there is a pejorative implication – occasionally spilling over into open allegation – that the reason for the supposed lack of co-operation is that it is not in the interest of the "tax haven" to have its customers under detailed investigation.

However, on examination, the point is much more subtle – and demonstrates that this allegation is playing politics more than based in substance.

The number of requests received by so called tax havens is substantial. But they have a small population and a the cost of maintaining a large department to deal with international requests is simply too high. So long as requests are properly formatted, then there is duty to respond within the timescales agreed in the MLAT. However, where there are errors or omissions in the forms, then the recipient is entitled (indeed, under many MLATs must) reject them. What the countries making the requests wants is that the receiving country simply telephones them and tells them what is wrong and how to fix it. What the receiving country says is that they do not have the resources to correct sloppy work by the requesting country. And, of course, they are right.

The effect of regulatory push is precisely the same. Regulators have to get their funding from somewhere. This means either a levy on the industries they regulate or that their cost is met from the taxpayer. A third, worrying option, is that they are met from fines (sometimes called "civil penalties") set against defaulters. The danger here is that fines are set not according to the offence but according to the financial needs of the regulator. A parallel is the substantial increase in fines levied by regulators to demonstrate that they deal with defaulters more severely than do other regulators.

Because regulators have to operate within budgetary constraints, they are anxious to push the burden of costs onto third parties. If the businesses they regulate bear that burden, then there is a lower operating cost for the regulator and the cost of it is hidden within the accounts of the institution as a general administrative overhead.

Regulatory push is also important in relation to businesses which are not regulated by the same sector. This happens where a regulator requires those it regulates to ensure that its own customers have an appropriate regulatory regime as a requirement of doing business with the regulated business.

So, in a fragmented banking market, a regulator can push the burden of quasi-regulatory inspections onto the big banks and reduce its own need to visit each small bank with great regularity. Visiting many small banks is very expensive – but the big banks cannot afford to be found having harboured dirty funds that rest in an account in the name of a small bank. So the big bank inspects the small bank’s systems and, if they are found wanting, the big bank will ensure and enforce, as a condition of continuing to provide banking services, the adoption of a system that satisfied the big bank.

That is, perhaps, acceptable in a domestic market (although the price of meeting the demands of a big bank which is protecting its own position may be higher than meeting the demands of a regulator, and the risk is that this will lead to consolidation in fragmented banking markets) but it is less so in an international environment.

Yet this is precisely the point of much of the law and regulation under the USA PATRIOT Act.

Under that Act, USA banks are required to ensure that foreign banks they deal with maintain a degree of compliance with the requirements of the Act. This is ironic because the USA’s "know-your-customer" (KYC) practices have, by most definitions, been inadequate. Since the latter part of 2001, however, the USA has been able to draft, pass and implement a great deal of legislation that would otherwise not have received such an easy passage.

Within the USA PATRIOT Act there are provisions relating to correspondent banking. Correspondent banking is the oil that lubricates international trade and the US Dollar is the currency of choice for much of that trade. The USA PATRIOT Act contains measures that directly impact on these facts.

When considering these measures, it is important to recognise that every country has the right to protect its own markets and to protect the integrity of its financial system.

However, the fact that the US dollar is so ubiquitous means that those banks which offer trade services to their own customers must have a relationship with a US bank.

The USA PATRIOT Act places a duty on US regulated banks to ensure that the banks to which they offer correspondent banking relationships have in place effective KYC practices. They will therefore have to obtain evidence from those banks of the nature of those procedures and to verify them. It should be noted that this is neither new nor limited to US banks. Certain Swiss banks wrote to those using correspondent services in mid 2001 seeking confirmation as to the counter-money laundering regimes in place.

The cost to the US banks is likely to be significant: they will have to consider visiting banks and making personal checks. For those smaller foreign banks, the cost to the US bank may exceed that which it is willing to pay to retain the business. The danger for banks in small economies is that they are simply too expensive to have as customers.

And of course, those banks which are producing sufficient for the US bank to wish to retain them as customers will only be able to remain so if their systems meet the demands of the US bank. The result here is that those banks will have to find a way of satisfying the US bank – and that may mean the application of technology which the small or foreign bank simply cannot afford. Thus the price of access to the global trading market may be too great for banks, especially those in the developing world, to bear.

Another provision compounds the position: the US Treasury may require a US bank to demand information from its own banking customers – and if they do not give it, within a very tight timescale, the US Treasury can declare the bank persona non grata. This position is reached by linking two provisions: one that requires the information and one which says that, where there is suspicion of terrorism financing, there can be a declaration that a bank (or for that matter any other company) or even an entire country may be subject to orders.

Of course, the USA has already done this in the case of Al Barakaat, the Somali bank using the President’s executive order – and in that case the UN added the bank to the global list of those suspected of involvement in terrorist financing resulting in a near blanket ostracisation of the bank.

The final issue that adds to this burden is the bringing into legislation principles that have been in New York case law since the mid 1970s: that any inter-bank transaction in US dollars clears in New York and therefore as a part of the transaction between the end parties takes place in New York, The District of Manhattan has jurisdiction over it. But the position is strengthened by the provision that assets in the USA may be frozen or confiscated if there is a lack of co-operation into an investigation.

For a small bank with much of its assets held in US Dollars, this presents a significant risk. If the amount frozen affects the bank’s capital adequacy ratio, then its home regulator may have to intervene.

Small banks and banks in developing countries are therefore exposed to significant financial risk.

Overlaid on this is that, if the banks in a country do not have access to the US dollar as a result of the combination of measures set out above, then they will be unable to offer US dollar trade services to their customers operating internationally. The reduction in trade will have a direct impact on the economies in those countries which are the most vulnerable.

Thus the end result of the regulatory push created by the USA PATRIOT Act and the ripples it has sent through regulators around the world may well be that those economies that were beginning to pull themselves out of crisis or poverty may now be pushed backwards with considerable force.

Nigel Morris-Cotterill is a counter-money laundering strategist at www.countermoneylaundering.com and Head, The Anti Money Laundering Network. Portions of this paper are based on a paper given at the World Money Laundering Report / Complinet Briefing on the USA PATRIOT Act in London, November 2001.