The blind spots in anti-IFF strategies

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Insights from U4 Anti-Corruption Resource Centre

14 min readOct 23, 2017

IFF touch on many areas of regulation, such as trade, border control, and financial markets . If policymakers simply assume these other policy areas will take part in implementation efforts, they are likely to become frustrated when confusion arises. Photo: DFAT

Putting the IFF agenda into action at the country level. Part 4 of 9

Illicit financial flows (IFF) became an international concern in the late 2000s and are now an established policy concern in the development context. Still, policy makers have yet to address important questions about putting anti-IFF programmes into practice. This fourth blog post discusses the relationship of anti-IFF strategies to various policy areas, while asking about the lack of coherence.

Implicit policy targets?

IFF may result in a loss for development. To prevent IFF and facilitate development, policy makers need to think about the national dynamics that give rise to IFF, including local political forces and economics.

However, since both national and international factors facilitate IFF, policymakers also need to consider international coordination of anti-IFF efforts (UNDP). For example, international organisations such as the Organisation for Economic Co-operation and Development (OECD) have endorsed specific anti-IFF policy areas (OECDa).

On financial sector, see FATF. Quote, see OECDa, p73.

In addition, non-governmental organisations also advocate for anti-IFF policies. For example, the advocacy organisation Global Financial Integrity (GFI) promotes government policies to prevent and enforce laws against international tax evasion (GFIa):

Country-by-country reporting, specifically, requirements that multinational companies publicly disclose their revenues, profits, losses, sales, taxes paid, subsidiaries, and staff levels on a country-by-country basis;

Tax information exchanges, that is, the automatic exchange of tax information between countries concerning foreign tax subjects;

Prevention of trade fraud, including adopting mechanisms for collecting trade transaction and market price data, as well as better equipment and training to detect fraudulent trade misinvoicing; and

The Addis Tax Initiative, which aims to enhance the mobilisation and effective use of domestic revenues and to improve the fairness, transparency, efficiency and effectiveness of their tax systems.

Mismatch

There is a mismatch between the definitions and the recommended anti-IFF policy areas.

In the first post of this series, we discussed components of differing definitions of IFF. As the table below shows, both the GFI and OECD definitions require one or several illegal factors that make a cross-border transfer an IFF (GFIb and OECDa, p16). This can be the source of funds or financial capital, and/or the mechanism of cross-border transfer, and/or the purpose of the cross-border transfer.

From the perspective of coherence, it is therefore somewhat surprising to see that the policy areas the OECD lists target only part of the definition of IFF:

1. The transfer of criminal proceeds through AML measures (that is, not other illegal activities that could give rise to IFFs)

2. Select criminal activities, such as international bribery, international tax evasion, and domestic bribery, when proceeds are transferred across a border (rather than all illegal activities)

3. The return of stolen assets, which presumably primarily concerns public funds stolen through corruption (but not other types of illegal activities)

In other words, recommended policy frameworks for thwarting IFF are not sufficiently comprehensive nor coherent. Illegality — not criminality — is the key factor in both the OECD and GFI definitions of IFF. Illegality can manifest in the underlying conduct, the transfer mechanism, or the purpose or actual use of what is tranferred across the border. However, the anti-IFF policies suggested by the OECD only concern criminal activities. With the addition of the Addis Tax Initiative, GFI goes a step further by also looking at the quality of the tax system and how revenues are used. Still, both represent a mismatch between the definitions and the recommended anti-IFF policy areas.

Recommended policy frameworks for thwarting IFF are not sufficiently comprehensive nor coherent.

Comprehensiveness and coherence matter from a practical and results perspective. Policy makers struggle to improve development outcomes when interventions are poorly targeted and coordinated. Anti-IFF measures are also more likely to garner public support if they seek to address real gaps. For this to occur, policy makers need to coordinate anti-IFF strategies to gain multi-agency support and achieve coherence.

Policy coordination

The illicit flow of funds or financial capital touches on many areas of regulation, such as trade, border control, and financial markets (just to name a few). If policy makers simply assume these other policy areas will take part in implementation efforts, they are likely to become frustrated when confusion arises. The better approach is to identify — in advance — both (a) the goals of an anti-IFF strategy and (b) the policy areas that may be relevant to achieve these goals. Policy makers can then coordinate the overall anti-IFF strategy with specific measures that address areas of concern.

Listing instrumental policy areas can help policymakers assess the feasibility and risks of competing policy recommendations.

Donors and governments must always make trade-offs when deciding on policy commitments. Considering a comprehensive palette of instrumental policy areas at the outset improves precision, planning, and allocation of resources among competing areas. In addition, a list of instrumental policy areas can help policymakers assess the feasibility and risks of competing policy recommendations. If one policy area seems to be a real stumbling block in a country, the country’s anti-IFF strategy needs to take that into account. Such circumstances are vital to know when policy makers sequence policy priorities to attain set goals.

Matchmaking

But if there is a mismatch between anti-IFF policy areas and the IFF definitions, what policy areas are then missing? Firstly, that depends on how a country defines IFF. Secondly, it also depends on which instrumental policy areas for IFF that are identified in the country. Although it would be impossible to provide an exhaustive list, here are a few ideas:

1. Regulation and control

The OECD and GFI have defined IFF to include transfers associated with any illegal act, not just criminal activity. Acts such as not paying taxes or conducting business without a permit might be illegal, although perhaps not criminalised in a certain country. Given the current IFF definitions, anti-IFF strategies should target such activities, as well as criminal ones. As a general rule, strengthening regulatory effectiveness will reduce illegal activities that could result in IFF.

Better regulation of business, border controls, and public sector administration and management can help thwart IFF at the outset.

For example, repealing regulations that allow for secrecy through certain types of corporate vehicles will disrupt IFF (van der Does de Willebois et al.). Similarly, by expanding what is illegal, new types of flows could qualify as IFF. Prohibiting thin capitalisation practices in multi-national corporate structures is an example of how to constrain the ability of corporations to reduce their taxable corporate profits in a country (OECDb). Better regulation of corporations, border controls, and public sector administration and management can help thwart IFF at the outset.

2. Corporate governance

Risk management practices that secure corporate compliance are obviously incompatible with tax evasion, bribery, and other illegal activities that give rise to IFF. This includes regular high-quality, reliable external corporate audits (Coffee). To be reliable, external auditors need to have autonomy from the company. A persistent problem for external audits is the risk of conflicts of interest due to prevalent funding models for external corporate control. Auditors may seek to please clients to maintain business rather than to highlight areas of compliance concern (Eriksson et al.; Rovnick).

Corrupt decision-makers can easily pass policies that allow SOEs to drain public resources.

Another corporate governance issue that directly relates to IFF is the integrity and interests of principals and shareholders in state owned enterprises (SOEs). The board is responsible for corporate accountability, but the board’s role may be compromised if it is filled with government officials who wish to extract public resources (Curi and Lozano-Vivas). Corrupt decision-makers can easily pass policies that allow SOEs to drain public resources (Bhorat et al.; Isaksen and Williams). Anti-IFF policies could seek to address such potential weaknesses in corporate governance.

3. Infrastructure and border control

Infrastructure is another area of great importance to those seeking to transfer funds across a border. Would-be wrongdoers must either use wires to transfer funds or use transport systems to physically carry them across the border. Finding and controlling the routes used for IFF is paramount to preventing the practice. Efforts at the border are of particular importance. Customs and border control police need solid surveillance, communication, and coordination capacities to effectively tighten smuggling routes. Of course, infrastructure planning that facilitates effective control of cross-border traffic is certainly a valuable anti-IFF policy.

4. Financial markets

It is extremely difficult for banks to investigate suspicious conduct, as they are required to do under anti-money laundering regimes. Financial institutions do not always have strong incentives for complying with regulatory regimes. For instance, sanctions for noncompliance are rather low compared to the profits they gain by conducting business as usual (OECDa). Even if that was remedied, there is still space for improvements. Government policies that target monitoring of less transparent asset classes (such as over-the-counter, or OTC, markets) can help prevent financial transactions that lead to IFF.

Shadow banking holds a mind-boggling share in the global financial market.

In addition, “shadow banking” — that is, engaging in unregulated parts of the financial market — is highly lucrative in many countries (Kumar; Buehn and Schneider). Shadow banking is not subject to banking regulation (and therefore detection and penalties) as they do not receive any deposits covered by a state-backed guarantee (although governments will likely bail out financial institutions anyway to avoid systemic crash -as evidenced in the last 2008 financial crisis). These financial service providers usually lack capital requirements to compensate for the financial risk they take, and the degree of risk is often not transparent. Shadow banks typically engage as intermediaries between large borrowers and large lenders. The type of entities that make up the shadow banking system are hedge funds, special purpose entities, and structured investment vehicles.

Shadow banking holds a mind-boggling share in the global financial market. For example, the Financial Stability Board has estimated that in the decade or so prior to 2014, assets served globally by the informal lending sector grew from $26 trillion to $80 trillion (Kumar; Buehn and Schneider).

Regulation is needed to keep unethical parties from using shadow banking for illegal purposes.

Shadow banks can be used to pay and hide cross-border bribes. Imagine that a public official requires a bribe before awarding a procurement contract to a supplier. The supplier could pay the bribe by taking a loan from a shadow bank and paying a hefty interest — consisting in part of the bribe and in part of “true” interest and a fee for facilitating a kickback scheme. Since there is a free market for lending, and interest rates can be set at any rate, that loan would not necessarily be questioned as fraudulent. The shadow bank could then transfer the bribe part of the interest paid via a soft loan (a loan with no interest or below-market rate of interest) to the public official or to some other person or entity that is of benefit to the official.

The only requirement to avoid the scrutiny that comes with regulated lending is that the collateral for the loan is based on tradable collateral, which makes the loan distinctive. A promise to pay back a loan backed by tradable collateral (should the borrower fail to pay back the loan) is acceptable to the lender as long as the lender can trust that the collateral can be converted into money (Gabor and Vestergaard). As there is no regulation of these types of loans, lending to politically exposed persons is easier. Someone else, in this example the supplier who wants to bribe the public official, can supply the tradable collateral for the soft loan to the public official or his or her associate, company or some other entity that is close to the official.

In short, regulation is needed to keep unethical parties from using shadow banking for illegal purposes. Currently, there is none (!).

5. International trade and investment

GFI underscores the importance of trade regulation when it points to trade mispricing as a source of IFF (GFIa). Trade becomes an especially important area of regulation if IFF are defined to include not only financial flows, but also cross-border transfers of other mediums of value that can be converted to money (Van Rensburg). Nonetheless, trade regulation is subject to considerable deficiencies. Many countries have yet to develop the incentives or capacity to adequately produce, collect, and process trade data (Passas), which needs attention.

Recent U4 research has also disclosed the astonishing lack of transparency in very high-value commodity trading -a red alert for IFF and corruption:

An assessment of state owned enterprises active in oil and mineral trading has found that 18 of 45 are under no legal obligation to report on their operations. It is generally impossible to know, even in an aggregate way, to whom commodities are sold and at what price, although some state owned enterprises do, from time to time, publish detailed figures on their trading activities.

International investment and tax agreements have yet to be coordinated.

Another area concerns international investments. International investment and tax policy regimes are closely interrelated. These regimes have the same ultimate objective — to promote and facilitate cross-border investment. And they have a similar architecture consisting of a myriad bilateral and multilateral agreements. Both regimes also face similar challenges when it comes to maintaining legitimacy and incorporating sustainability. Nevertheless, international investment and tax agreements have yet to be coordinated, both with each other and with anti-IFF strategies (UNCTAD).

6. Budget processes

…one of the most political aspects of an anti-IFF strategy concerns budget process policies…

Finally, perhaps one of the most political aspects of an anti-IFF strategy concerns budget process policies to ensure that the necessary shift in priorities can be accommodated. Anti-IFF policies dealing with budget processes have yet to emerge.

Mending the bucket

All of the above examples of additional policy areas are instrumental to IFF in different ways, and therefore highly relevant to counter IFF. Policymakers may need to consider many other areas if IFF are to be effectively reduced. Importantly, this does not mean that a government must address every instrumental policy area at once. Perhaps a reasonable expectation is that a good anti-IFF programme addresses the components necessary to implement it in the areas of known risk. As long as the IFF definitions remain what they are, there is room for improvement.

As long as the IFF definitions remain what they are, there is room for improvement.

Another — equally political — question concerns what vested interests in all these policy areas think of being engulfed in a new and broad policy concept. Merging government policy areas is a vastly unpopular activity among government officials who have fought long and hard for their turfs of power. Should there be an interest in seeking explanations for the mismatch between the IFF definitions and the policy responses defined by governments, one suggestion is to take a closer look at that. Alternatively, if the policy mismatch is better explained by a poor conceptual definition misaligned with the current policy responses, then the range of remaining problems for country level implementation shrinks.

Perhaps a better way of thinking of IFF is to use a revised concept simply as an analytical tool for identifying the instrumental role of various policy areas.

Perhaps a better way of thinking of IFF is to use a revised concept simply as an analytical tool for identifying the instrumental role of various policy areas for ‘illicit value flows’, and to inform their measurement. That would certainly avoid many of the considerable problems here suggested, including those of vested policy interests and the extent of IFF policy responses.

A policy strategy is coherent if it is carefully considered and the different policies that constitute it relate to each other in a clear and reasonable way. The fundamental starting point for coherence is the conceptual definition or a policy goal. But that does not really matter if the concept or goal is incoherent to start with.

Coherent policies with any real-life relevance is not a theoretical construct detached from country level context.

Coherent policies with any real-life relevance is not a theoretical construct detached from country level context. To be clear and reasonable at country level, the key is that both the overall strategy and the implementing policies and procedures account for local circumstances. That includes the political and economic forces in the country. Without that, coherence will eventually have little relevance at country level, at least for implementation.

What do you think?

What do you think about coherence in anti-IFF strategies and the various policy areas included or left out? Does the mismatch matter? Is the problem the definitions or the scope of policy areas included? And how should policymakers and practitioners relate to it? Please share your thoughts in responses below.

In the next blog post in this series, attention shifts to the question of coordination. We discuss why it matters for IFF.

References

Bhorat, H., Buthelezi, M., Chipkin, I., Duma, S., Mondi, L., Peter, C., Gobo, M., Swilling, M. and H. Friedenstein, Betrayal of the Promise: How South Africa is Being Stolen (Johannesburg: Public Affairs Research Institute, 2017).

Buehn, A. and F. Schneider, “Estimating the Size of the Shadow Economy: Methods, Problems and Open Questions,” Discussion Paper no. 9820 (Bonn: IZA, 2016).

Coffee, J. C. Jr., Gatekeepers: The Professions and Corporate Governance (New York: Oxford University Press, 2006).

Curi, C., Gedvilas, J. and A. Lozano-Vivas, “Corporate Governance of SOEs and Performance in Transition Countries. Evidence from Lithuania” (September 16, 2016).

Eriksson, F, Kira, M. and M. Stridsman, “OECD Public Consultation on Liability of Legal Person, submission by U4 Anti-Corruption Resource Centre,” 28 October 2016 (Bergen: U4, forthcoming).

FATF, Corruption: A Reference Guide and Information Note on the Use of the FATF Recommendations to Support the Fight Against Corruption (Paris: FATF, 2010).

Gabor, D. and Vestergaard, J., “Towards a Theory of Shadow Money” (New York: Institute for New Economic Thinking, 2016).

GFIa, Illicit Financial Flows to and from Developing Countries: 2005–2014, xi–xii (Washington: GFI, 2017).

GFIb, “Issues/Illicit Financial Flows,” GTI website (2017).

Isaksen, J. and A. Williams, “Corruption and State-backed Debts in Mozambique: What Can External Actors Do?” U4 Issue 2016: 6 (Bergen: Chr. Michelsen Institute, 2016).

Kumar, A., “How Shadow Banking Works,” Economist (2 Feb. 2016),

Longchamp, O. and N. Perrot, “Trading in corruption: Evidence and mitigation measures for corruption in the trading of oil and minerals” U4 Issue 2017:6 (Bergen: Chr. Michelsen Institute, 2017)

OECDa, Illicit Financial Flows from Developing Countries: Measuring OECD Responses (Paris: OECD, 2014).

OECDb, Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, Action 4 - 2016 Update: Inclusive Framework on BEPS, OECD/G20 Base Erosion and Profit Shifting Project (Paris: OECD Publishing, 2017).

Passas, N., “Concept Paper for a Study into Trade Transparency and Control of Illicit Financial Flows and Corruption” (unpublished, n.d.).

Rovnick, N. “UK regulator fines EY £1.8m for audit misconduct” Financial Times (16 Oct. 2017)

UNCTAD, World Investment Report 2015: Reforming International Investment Governance (Geneva: United Nations, 2015).

UNDP, “Discussion Paper, Illicit Financial Flows from the Least Developed Countries: 1980–2008” (New York: United Nations, 2011).

van der Does de Willebois, E., Halter, E. M., Harrison, R. A.; Park, J. W. and J. C. Sharman, The Puppet Masters -How the Corrupt User Legal Structures to Hide Stolen Assets and What to Do About It (Washington, D.C.: The World Bank, 2011).

Van Rensburg, D., “Are the Illicit Flows Fake?” Fin 24 (27 Aug. 2017).

About U4

The U4 Anti-Corruption Resource Centre at CMI works to identify and communicate informed approaches to partners for reducing the harmful impact of corruption on sustainable and inclusive development.

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All views expressed in this post are those of the author(s), and do not necessarily reflect the opinions of the U4 partner agencies, or CMI/U4.