By Jacob Shiman

Each year, development agencies spend billions of dollars to expand and improve access to financial services. International funders committed $47 billion dollars in 2018 alone.[1] Providing people access to finance is proven to help them plan, weather shocks, and most importantly, grow their small businesses.[2] Getting a loan is often rated the biggest obstacle for the developing world’s small and medium-sized enterprises (SMEs), which employ more than 70 percent of workers in low-income countries and are critical for job creation.[3][4]

Unfortunately, strict U.S. government regulations intended to counter money laundering and terrorism financing likely raise costs for the innocent far more than for criminals. The financial burden necessitated by these regulations drives many banks to disconnect from entire regions of the world, rather than incur the compliance costs and regulatory risk now necessary to work in some of the world’s poorest countries.[5]

The federal government requires studies that compare the expected societal benefits and costs of most regulation, but rules aimed at stopping money laundering have somehow avoided these assessments. The U.S. Treasury Department should conduct cost-benefit analysis of anti money laundering and counter terrorism financing (AML/CTF) regulations, which could prove they hurt the poor more than they impact criminals and provide ideas for reform. These analyses should evaluate not only domestic effects, but also international effects. 

Complying with these regulations require institutions to gain deep knowledge of their customers, and often their customer's customer, which disproportionately increases the cost of serving the poor. Banks and other financial institutions have been forced by this regulatory regime to develop large compliance departments that require loan officers to collect more information and conduct more due diligence. These additional costs and increased application requirements lead many financial institutions to find small clients in the developing world unprofitable.[6]

LexisNexis estimates American financial service firms spent $26.4 billion on compliance with anti-money laundering regulations in 2018. Costs are growing rapidly, with estimates showing a  16 percent increase from 2016 to 2018, and a projected additional 14 percent increase in 2019.[7] Financial service providers have responded to increased anti-money laundering regulatory requirements by passing many of these costs on to consumers and  abandoning perceived high-risk countries and sectors. If financial institutions do offer services in these environments, they charge risk premiums and require more identification, which is often difficult for small business owners in informal economies to provide.[8]

Reducing requirements for financing and lowering the cost of credit dramatically helps the poor. Additionally, requirements decrease the odds that entrepreneurs will apply for financial products to help them grow, as business owners cite high prices and complex procedures as top reasons for not applying for financing[9][10][11]. (Figure 1 is an illustration of the effects of cost on demand). The World Bank estimates that SMEs in the developing world need an additional $5.2 trillion dollars in financing per year.[12] These regulatory policies make closing that gap more difficult.

Criminal enterprises seeking to legitimize their funds, on the other hand, often have substantial resources to launder their money. In many developing countries, it is common to earn income informally and not pay taxes, decreasing the need for small-scale criminal enterprises to legitimize funds through money laundering.[13][14] Large-scale criminal enterprises, such as drug and human traffickers,  are willing to pay substantial fees to have their ill-gotten gains legitimized.[15][16]

There is no evidence of the systematic effectiveness of AML/CTF policy. Proponents of the dramatic increase in regulation have not been able to demonstrate that these regulations have significantly increased the costs of legitimizing illegal income, or have reduced crime.[17] In fact, most practitioners surveyed believe these rules have little positive impact.[18]

Conducting cost-benefit analyses would bring the U.S. Department of Treasury in line with longstanding policy. The Reagan, Clinton, Bush, and Obama administrations introduced and expanded these assessments so these analyses are necessary for regulatory actions that likely have “an annual effect on the economy of $100 million.”[19] It is unclear how the Treasury Department’s AML/CTF regulations – which well exceed this threshold – have avoided cost-benefit analyses.

Cost-benefit analyses of AML/CTF rules should include these regulatory actions’ international effects. Though this is unusual, it is necessary because of the power U.S. regulators wield in the global financial system. It is rare for governments to punish foreign entities for behavior outside their borders, but the U.S. government justifies it by claiming that its anti-money laundering and counter-terror financing initiatives benefit the global financial system. It is only fair that those purported international benefits are compared to the international costs.[20]

The torrent of financial industry regulations issued since 9/11 to limit terrorist and criminal access to finance disproportionately harm the poor and small businesses central for job creation in developing countries. U.S. regulatory agencies should seriously weigh their actions’ domestic and international costs, not only benefits, to ensure these effects are justified and to determine which components are most and least cost-effective. This could enable the Treasury Department to adapt these programs to reduce unintended side effects, relaxing the disproportionately costly elements of the regulatory regime while strengthening rules which cause less harm.

About the Author

Jacob Shiman is an international economic development professional with substantial financial sector development experience. He worked for the Finance, Competitiveness, and Innovation Global Practice at the World Bank for two years and has studied development as a masters student at the Yale Jackson Institute for Global Affairs. He has experience in developing economies on three continents, and is currently working with Colombian microfinance firm Finamiga to help it quantify its social impact.

Endnotes

1. Olga Tomilova and Edlira Dashi, “CGAP Funder Survey 2018: Trends in International Funding for Financial Inclusion,” (Consultative Group to Assist the Poor, December 2019), https://www.cgap.org/research/publication/2018-trends-international-funding-financial-inclusion.

2. “Financial Inclusion Overview,” World Bank (World Bank Group, October 2, 2018), https://www.worldbank.org/en/topic/financialinclusion/overview.

3. Dr. Jennifer Abel-Koch, “Access to Finance Is Main Obstacle for SMEs in Africa,” (KfW Research, January 17, 2019), https://www.kfw.de/KfW-Group/Newsroom/Latest-News/News-Details_503168.html; Meghana Ayyagari, Asli Demirguc-Kunt, and Vojislav Maksimovic, “Small vs. Young Firms across the World : Contribution to Employment, Job Creation, and Growth” (World Bank, April 1, 2011), https://openknowledge.worldbank.org/handle/10986/3397

4. “Small and Medium Enterprises (SMEs) Finance,” World Bank (World Bank Group), accessed October 15, 2020, https://www.worldbank.org/en/topic/smefinance.

5. Denis Kruger, “De-Risking in Africa,” The Banker, accessed October 15, 2020, https://www.thebanker.com/De-risking-in-Africa; Teresa Pesce, “AML and the De-Risking Dilemma,” ACQ5 (ACQ5, 2015), https://www.acq5.com/post/aml-and-the-de-risking-dilemma/.

6. Denis Kruger, “De-Risking in Africa,” The Banker, accessed October 15, 2020, https://www.thebanker.com/De-risking-in-Africa; Teresa Pesce, “AML and the De-Risking Dilemma,” ACQ5 (ACQ5, 2015), https://www.acq5.com/post/aml-and-the-de-risking-dilemma/.

7. “2019 True Cost of AML Compliance Study,” (LexisNexis Risk Solutions, April 7, 2020), https://risk.lexisnexis.com/insights-resources/research/2019-true-cost-of-aml-compliance-study-for-united-states-and-canada.

8. Durner and Shetret, “De-Risking,” (Global Center on Cooperative Security, 2015).

9. Beck, Thorsten, and Robert Cull. “Small- and Medium-Sized Enterprise Finance in Africa,” Brookings, July 21, 2014. Accessed November 20, 2020. https://www.brookings.edu/research/small-and-medium-sized-enterprise-finance-in-africa/

10. Demirguc-Kunt, Asli, and Leora Klapper. “Measuring Financial Inclusion: Explaining Variation in Use of Financial Services across and within Countries,” Report no. Services across and within Countries Asli Demirguc-Kunt and Leora Klapper. Spring 2013. Accessed November 05, 2020. https://www.brookings.edu/bpea-articles/measuring-financial-inclusion-explaining-variation-in-use-of-financial-services-across-and-within-countries/

11. “Financial Access,” World Bank (World Bank Group), accessed October 15, 2020, https://www.worldbank.org/en/publication/gfdr/gfdr-2016/background/financial-access.

12. “Enterprises (SMEs) Finance,” World Bank.

13. Jacques Morisset and Victoria Cunningham, “Why isn’t anyone paying taxes in low-income countries?,” Future Development (blog),  (Brookings Institute, April 30, 2015), https://www.brookings.edu/blog/future-development/2015/04/30/why-isnt-anyone-paying-taxes-in-low-income-countries/

14. “Women and Men in the Informal Economy: A Statistical Picture. Third Edition,” (International Labour Organization, April 30, 2018), https://www.ilo.org/global/publications/books/WCMS_626831/lang--en/index.htm.

15. Channing May and Christine Clough, “Transnational Crime and the Developing World,” (Global Financial Integrity, May 27, 2017), https://gfintegrity.org/report/transnational-crime-and-the-developing-world/

16. Peter Reuter and Edwin M. Truman, “Money Laundering: Methods and Markets,” in Chasing Dirty Money: the Fight against Money Laundering (Peterson Institute for International Economics, 2004), pp. 25-43, https://www.piie.com/bookstore/chasing-dirty-money-fight-against-money-laundering.

17. Ronald F. Pol, “Uncomfortable Truths? ML=BS and AML=BS²,” Journal of Financial Crime 25, no. 2 (May 8, 2018): pp. 294-308, https://doi.org/https://doi.org/10.1108/JFC-08-2017-0071.

18. Gieger, Hans, and Oliver Wuensch. "The Fight against Money Laundering: An Economic Analysis of a Cost-benefit Paradoxon," Journal of Money Laundering Control 10, no. 1 (January 9, 2007): pp. 91-105. Accessed November 20, 2020. https://www.ingentaconnect.com/content/mcb/jmlc/2007/00000010/00000001/art00005.

19. “Executive Order 12866 of September 30, 1993, Regulatory Planning and Review,”

20. Federal Register Vol. 58, No. 190 (Monday, October 4, 1993), https://www.reginfo.gov/public/jsp/Utilities/EO_Redirect.myjsp.

21. “Treasury Strategic Plan for Fiscal Years 2018-2022 (Updated 2020)” (United States Department of the Treasury), accessed October 16, 2020, https://home.treasury.gov/about/budget-financial-reporting-planning-and-performance/strategic-plan.