The Socio-Economic Consequences of Money Laundering

Money laundering and terrorism financing can have potentially devastating economic, security and social consequences.

While these crimes can occur in any country, they have particularly significant economic and social consequences for developing countries, emerging markets and countries with fragile financial systems.

The negative impacts of money laundering tend to be magnified in these markets because they tend to have less stable financial systems, a lack of banking regulations and effective law enforcement, and, therefore, are more susceptible to disruption from criminal or terrorism influences.

Some of the effects of money laundering and terrorist financing are:

  • Increased Crime and Corruption

Successful money laundering helps enhance the profitable aspects of criminal activity.

When a country is seen as a haven for money laundering, it will attract people who commit crime. Typically, havens for money laundering and terrorist financing have:

  1. Limited number of predicate crimes for money laundering.
  2. Limited types of institutions and persons covered by money laundering laws and regulations.
  3. Little to no enforcement of the laws, weak penalties, or provisions that make it difficult to confiscate or freeze assets related to money laundering.

If money laundering is prevalent, there is likely to be more corruption. Criminals may try to bribe government officials, lawyers and employees of financial or non-financial institutions so that they can continue to run their criminal businesses.

  • Undermining the Legitimate Private Sector

Money launderers are known to use front companies, or businesses that appear legitimate and engage in legitimate business, but are in fact controlled by criminals who commingle the proceeds of illicit activity with legitimate funds to hide the ill-gotten gains.

These front companies have access to substantial illicit funds, allowing them to subsidise front company products and services at levels well below market rates. Thus, front companies have a competitive advantage over legitimate firms that draw capital funds from financial markets.

This makes it difficult for legitimate business to compete against front companies. Clearly, the management principles of these criminal enterprises are not consistent with traditional free market principles of legitimate business; thus resulting in further negative macroeconomic effects.

Finally, by using front companies and other investments in legitimate companies, money laundering proceeds can be used to control whole industries or sectors of the economy of
certain countries. This increases the potential for monetary and economic instability due to the misallocation of resources from artificial distortions in asset and commodity prices. It also provides a vehicle for evading taxation, thus depriving the country of revenue.

  • Weakening Financial Institution

Money laundering and terrorist financing can harm the soundness of a country’s financial sector. They can negatively affect the stability of individual banks or other financial institutions, such as securities firms and insurance companies.

Criminal activity has been associated with a number of bank failures around the globe, including the failure of the first Internet bank, the European Union Bank, as well as Riggs Bank. Furthermore, some financial crises of the 1990s — such as the fraud and money laundering scandal at the Bank of Credit and Commerce International (BCCI) and the 1995 collapse of Barings Bank as a risky derivatives scheme carried out by a trader at a subsidiary unit unraveled — had significant criminal or fraud components. The failures in Riggs Bank’s anti-money laundering controls contributed to its demise — due in large part to the manner in which Riggs Bank staff administered the accounts of, among others, Augusto Pinochet, the former President of Chile and Teodoro Obiang, the President of Equatorial Guinea. Financial institutions that rely on the proceeds of crime have additional challenges in adequately managing their assets, liabilities and operations.

The adverse consequences of money laundering are generally described as reputational, operational, legal and concentration risks. They are interrelated, and each has financial consequences, such as:

  1. Loss of profitable business.
  2. Liquidity problems through withdrawal of funds.
  3. Termination of correspondent banking facilities.
  4. Investigation costs and fines.
  5. Asset seizures.
  6. Loan losses.
  7. Reduced stock value of financial institutions.
  • Loss of control of, or mistakes in, decisions regarding economic policy

Due to the large amounts of money involved in the money laundering process, in some emerging market countries these illicit proceeds may dwarf government budgets, resulting in a loss of control of economic policy by governments or policy mistakes due to measurement errors in macroeconomic statistics arising from money laundering.

Money laundering can adversely affect currencies and interest rates as launderers reinvest funds where their schemes are less likely to be detected, rather than where rates of return are higher.

Volatility in exchange and interest rates due to unanticipated cross-border transfers of funds can also be seen. To the extent that money demand appears to shift from one country to another because of money laundering — resulting in misleading monetary data — it will have adverse consequences for interest and exchange rate volatility, particularly in economies based on the US dollar, as the tracking of monetary aggregates becomes more uncertain. Last, money laundering can increase the threat of monetary instability due to the misallocation of resources from artificial distortions in asset and commodity prices.

  • Economic Distortion and Instability

Money launderers are not primarily interested in profit generation from their investments, but, rather, in protecting their proceeds and hiding the illegal origin of the funds. Thus, they “invest” their money in activities that are not necessarily economically beneficial to the country where the funds are located.

Furthermore, to the extent that money laundering and financial crime redirect funds from sound investments to low-quality investments that hide their origin, economic growth can suffer. In some countries, entire industries, such as construction and hotels, have been financed not because of actual demand, but because of the short-term interests of money launderers. When these industries no longer suit the needs of the money launderers, they abandon them, causing a collapse of these sectors and immense damage to economies that could ill-afford these losses.

  • Loss of Tax Revenue

Of the underlying forms of illegal activity, tax evasion is, perhaps, the one with the most obvious macroeconomic impact. Money laundering diminishes government tax revenue and, therefore, indirectly harms honest taxpayers.

It also makes government tax collection more difficult. This loss of revenue generally means higher tax rates than would normally be the case. A government revenue deficit is at the center of economic difficulties in many countries, and correcting it is the primary focus of most economic stabilisation programs.

  • Risks to Privatisation Efforts

Money laundering threatens the efforts of many states trying to introduce reforms into their economies through privatisation. Criminal organisations can outbid legitimate purchasers for formerly state-owned enterprises.

Furthermore, while privatisation initiatives are often economically beneficial, they can also serve as a vehicle to launder funds. In the past, criminals have been able to purchase marinas, resorts, casinos and other businesses to hide their illicit proceeds and to further their criminal activities.

  • Reputation Risk for the Country

A reputation as a money laundering or terrorist financing haven could cause negative effects for development and economic growth in a country. It diminishes legitimate global opportunities because foreign financial institutions may decide to limit their transactions with institutions located in money laundering havens because the necessary extra scrutiny will make them more expensive.

Legitimate businesses located in money laundering havens may suffer from reduced access to world markets (or may have to pay more to have access) due to extra scrutiny of ownership and control systems.

Once a country’s financial reputation is damaged, reviving it is very difficult and requires significant resources to rectify a problem that could have been prevented with proper anti-money laundering controls. Other effects include specific counter-measures that can be taken by international organisations and other countries, and reduced eligibility for governmental assistance.

  • Social Costs

Money laundering is integral to maintaining the profitability of crime. It also enables drug traffickers, smugglers and other criminals to expand their operations.

This drives up the cost of government expenses and budgets due to the need for increased law enforcement and other expenditures (for example, increased health care costs for treating drug addicts) to combat the serious consequences that result.

Sources:

  • “The consequences of money laundering and financial crime”, John McDowell & Gary Novis, in “Economic Perspectives”, May 2001.
  • “Reference Guide to Anti-Money Laundering (AML) and Combating the Financing of
    Terrorism (CFT)”, published by the World Bank and the International Monetary Fund, January 2007.
  • ACAMS.

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