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Efficient, resilient, and accountable governance systems are essential to successfully manage natural resources, provide public services, foster trade, attract private investment, and manage aid relationships. Corruption and secrecy are often at odds with such goals. Illicit financial flows, for example, undermine development and governance while secrecy in extractive industries can squander a nation’s wealth and weaken the social contract.
CGD’s work in this area focuses on contact transparency, tax evasion and avoidance, efforts to combat money laundering and terrorism financing, and the negative effects they can have on remittance flows and international security.
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In his appearance before the committee, Morris outlined findings from newly CGD published analysis exploring the debt implications of China’s Belt & Road Initiative—and offered his views on what it should mean for US global engagement.
A recent article in the New York Times on the current situation in Gaza vividly illustrates what can happen when an entire community loses financial access. Because of Israel’s longstanding blockade of the territory and more recent decisions by Egypt and the Palestinian Authority to cut off financial support to Hamas, money no longer flows in Gaza. Without cash or credit to pay for critical supplies, the Gazan economy has seized up: unemployment is near 50 percent (and even higher for young people), electricity use is limited to 6 or 7 hours per day, and 95 percent of water is undrinkable. The dire situation has created a powder keg that many regional experts believe could lead to a new round of violent conflict with Israel.
The situation highlights the simple fact that goods only flow to the areas where they are needed when money is available to facilitate their purchase and transport. Gaza is not the only region suffering from loss of financial access: a growing number of humanitarian aid organizations operating in conflict zones are also having trouble finding banks willing to work with them. Notably, many humanitarian organizations working in Syria and Yemen report having difficult conducting payments.
Nonprofits cut off from bank accounts and wire transfers
In recent years, many large international banks have either ended or restricted their relationships with certain countries and types of customers. This process, commonly referred to as “de-risking,” is driven by a host of changes to banks’ business and regulatory environment since the global financial crisis, including stricter enforcement of laws and regulations designed to counter money laundering, terrorist financing, and sanctions evasion. In some cases, banks have concluded that certain types of customers pose too great an illicit finance risk, or else are not worth the rising cost of compliance.
The nonprofit sector is among those affected by de-risking, with NPOs reporting a range of financial access problems. This is especially true with respect to Islamic charities, humanitarian organizations operating in high-risk countries, and small nonprofits with limited compliance capacity. In some cases, NPOs have been denied bank accounts or have had their existing accounts closed. More frequently, they have had their transaction delayed. These delays can last for weeks or even months, which in a crisis can be the difference between getting life-saving materials or services to a vulnerable population in time or not. Unable to rely on the formal banking system, some NPOs have resorted to transporting cash or turning to money transfer operators.
The roots of the problem
While banks might have any number of reasons for deciding to exit a particular relationship, concerns about the cost of compliance associated with illicit finance risks often loom large.
Banks’ aversion to working with such NPOs may stem from the fear of inadvertently facilitating illicit finance—particularly terrorist financing and sanctions violations—and of the resulting fines, regulatory scrutiny, and reputational damage. The risk of personal liability for compliance officers undoubtedly fosters even greater caution. In recent years, regulators have consistently emphasized that banks should follow a risk-based approach; however, it appears that many banks and NPOs remain concerned that under US law, terrorist financing and sanctions violations remain “strict liability” offenses. Banks also say they fear being second-guessed by their examiners.
Some banks and bank examiners mistakenly perceive NPOs to be uniformly high risk. This is partly a legacy of the September 11 attacks and their aftermath, during which time NPOs were labeled as “particularly vulnerable” to terrorist financing by the Financial Action Task Force (FATF), the global standard-setting body for anti-money laundering and countering the financing of terrorism (AML/CFT) regulations. Although FATF retracted this language in 2016, the perception that NPOs are especially risky endures. While it is true that some NPOs do need to strengthen their AML/CFT controls, the sector has made important strides in recent years—as recently recognized by the UK government.
Banks’ misperception of NPOs’ riskiness is often exacerbated by a mutual lack of communication and understanding between banks and NPOs. Bank officers may lack a firm grasp of how NPOs operate or how they manage their risk exposures. NPOs, in turn, may not always be cognizant of how banks perceive them or why banks might require certain information of them.
Tackling the problem: advice for policymakers, banks, and NPOs
Due to the multifaceted nature of the problem, tackling it will necessarily entail a coordinated effort on the part of policymakers, banks, and NPOs.
Policymakers should continue to work with banks and NPOs to ensure that regulatory guidance is properly understood and followed. To its credit, FATF now regularly consults with the private and nonprofit sectors. However, given banks’ enduring uncertainty regarding the proper treatment of NPOs, it is clear that more needs to be done to ensure that the risk-based approach is implemented correctly. In addition, policymakers should consider expanding the use of humanitarian exemptions, which can smooth the way for humanitarian organizations to operate in high-risk jurisdictions. Currently, only in Somalia are humanitarian organizations exempted from UN sanctions.
While banks must make decisions based on their bottom line, they can also take an expansive view that recognizes the reputational benefit that providing services to NPOs can provide. Indeed, some banks make a point of doing business with charities and humanitarian organizations for precisely this reason. In addition, banks may wish to consider adopting sector specializations, as Barclays has done, so that they have dedicated staff who understand how NPOs operate and can therefore manage these relationships—and their attendant risks—more effectively. Finally, we encourage banks to continue working with policymakers and NPOs to develop a standardized customer due diligence template tailored to NPOs. Such a template, which the World Bank and ACAMs are working to develop, would be useful for establishing mutual expectations about the baseline information NPOs should be ready to provide their banks.
For their part, NPOs should continue to strengthen their own AML/CFT risk controls and to be proactive in managing their relationships with their banks. In addition, large NPOs might consider how they can provide compliance or financial-management support to the smaller NPOs they often work with to provide last-mile services, often in the most volatile circumstances.
If all three sets of actors can’t find a way to solve the problem, more radical solutions may be necessary. These could include setting up alternate payment channels where humanitarian aid can flow outside of the traditional banking sector but with government oversight (similar to the UK’s Safe Corridor Pilot for remittances to Somalia which was designed but never implemented). NPOs are also exploring whether tracking aid transfers on a permissioned blockchain network would give banks greater confidence and lead to easier access to finance.
The international stakeholder dialogue successfully brought together policymakers, banks, and NPOs to develop a common understanding of the problem and a shared purpose for addressing it. The priority now will be to maintain momentum and close cooperation moving forward.
In advance of adopting a new Policy on Public Information, the AIIB is inviting suggestions on how it could best align public disclosure with its guiding principles of “promoting transparency, enhancing accountability and protecting confidentiality.” The adoption of the new policy provides AIIB President Jin Liqun and the AIIB shareholders an opportunity to demonstrate that this newest of multilateral development banks (MDBs) is serious about its commitment to adopting international best practices.
The current practice of co-financing most projects with the traditional MDBs helps President Jin Liqun validate his claim that the AIIB is committed to transparency and accountability. The standards applied by the traditional MDBs are generally considered “best practice,” even if their application has not always been perfect. But as the AIIB increases the number of projects where it is not a co-financier, there are concerns that China’s traditional wariness about disclosing the details of its own bilateral development finance programs will begin to replicate itself within the halls of the AIIB. This makes it all the more imperative that the new disclosure policy display a serious commitment to presumption of disclosure.
In reviewing the AIIB website and the observations of others, such as the US-based Bank Information Center, I identified a number of actions that the AIIB could take to improve its disclosure practices. Here are my top three recommendations:
1. Post all official project-related documents on the AIIB website, including loan agreements and information on the status of projects during implementation.
Despite President Jin Liqun’s laudatory rhetoric and commitment to international best practices, the AIIB has yet to demonstrate a willingness to disclose information equivalent to that which is provided by the traditional MDBs. To illustrate, I compared the information provided by the World Bank and the AIIB on the Indonesia Slum Upgrading Project that is being co-financed by the two institutions. In the case of the World Bank, a number of documents are made available on its website, including project descriptions drafted at the concept and appraisal stages, environmental impact assessments, the project proposal that was provided to the Board of Directors, the actual loan agreement and associated paperwork, and three reports on implementation status and results to date.
In the case of the AIIB, a project summary and a project document are available that are reduced versions of the World Bank’s project information documents. The project summary also includes a link to the environmental and social safeguard information disclosed by the World Bank. But the AIIB does not disclose other documents, most importantly the actual loan agreement and the monthly progress reports that the borrower is required to provide to the AIIB. It should not only provide these documents, but also links to the websites of the government entities involved in implementing the projects it finances.
2. Establish a publicly available database on procurement contracts awarded for public sector projects financed by the AIIB.
President Jin Liqun should be commended for requiring open, fair, and nondiscriminatory procurement processes for projects financed by the AIIB. This is consistent with the practices at the traditional MDBs (though it should be noted that the Asian Development Bank continues to discriminate against firms from non-member countries). But despite the commitment to transparency, it appears that the AIIB is woefully lagging when it comes to disclosing information on contracts that have been awarded.
The vast majority of AIIB loans have been to projects co-financed by other MDBs, so information on procurement contracts awarded for these projects is readily available through those MDBs’ websites. But very little information is available on contracts awarded under stand-alone projects (projects not co-financed by other MDBs). In the case of the Bangladesh Distribution System Upgrade project, the AIIB does include a link to a two-page document describing the contracts awarded by the Bangladesh Rural Electrification Board, but there is no information on contracts that have been awarded in either the Oman Duqm Port project or the India Gujarat Rural Roads project. As with my first recommendation, the AIIB should seek to provide procurement information through links to the borrowers’ own websites.
3. Disclose the financial details of all loans to public entities on a monthly or quarterly basis.
Given past debt crises and concern mounting over future defaults, all creditors to sovereign governments, including the AIIB, should disclose the terms and status of their loans to help the public understand the potential risks of new borrowing. The World Bank and the Inter-American Development Bank serve as good models in this regard. In both cases, they make available on their website the current status of all loans and credits approved by their respective boards of directors. The information includes, among other things, the currency of the loan; the amount borrowed, repaid, and outstanding; and the interest rate being charged. The AIIB could go one step further and provide the information in a manner that is easily searchable and where the information could be downloaded in machine-readable format for further analysis.
Given the advancements in information technology, each one of my recommendations would involve little additional cost, but would provide significant benefit. They would allow the public to see what results are being achieved, who is doing the work and how much are they being paid for it, and what are the ongoing financial commitments of the borrowers.
Policies put in place to counter financial crimes have unfortunately had a chilling effect on banks’ willingness to do business in markets perceived to be risky—due in part to the high price of compliance. This has had costly consequences for people in developing countries, and in particular, has hurt migrant workers, small businesses that need to access capital, and recipients of lifesaving aid in conflict, post-conflict, or post-disaster situations the most. But what we’re seeing is that even as changes are being made to address this problem, financial institutions are developing solutions in the form of new cutting-edge technologies to help them comply better and faster with anti-money laundering regulations.
This week, we published a new study—the first comprehensive effort to assess six new key technologies and their potential to solve the de-risking problem. Financial institutions have turned to new technologies to address de-risking and increase the effectiveness and efficiency of their AML/CFT compliance. These new technologies may enhance transparency and information-sharing capabilities, facilitate automation and interoperability between institutions, and improve banks’ ability to accurately identify illicit activity. In doing so, they may offer a partial solution to de-risking by lowering compliance costs and improving risk management capabilities.
These technologies include:
Machine learning – a type of artificial intelligence that allows computers to improve their performance at a task through repeated iterations. Machine learning may be used to augment or transform a number of compliance functions, including those for developing more sophisticated customer typologies and for more accurately monitoring transactions. These uses could simultaneously cut down on false alerts and identify undetected illicit finance techniques.
Biometrics – use distinctive physiological or behavioral characteristics to authenticate a person’s identity and control his or her access to a system, and are more robust than other authentication factors, such as passwords and tokens, as they are generally more secure and easier to use. Biometrics are being used to address the “identification gap” that exists in many developing countries. This use, in turn, could make it easier for banks to conduct customer identification, verification, and due diligence, which may bolster the confidence of their correspondent banks. However, most biometric identification systems are being developed at the national level, meaning that work is required to develop an internationally recognized and interoperable identification system.
Big data – refers to datasets that are high in volume, velocity, and variety, and therefore require systems and analytical techniques that differ from those used for traditional datasets. Compared with relational databases, big data applications offer more scalable storage capacity and processing. They also allow many different types of data to be stored in one place, so compliance staff spend less time gathering information from disparate sources. Most important, they can greatly expand the range and scope of information available for Know Your Customer (KYC) and suspicious transaction investigations.
Know Your Customer (KYC) utilities – central repositories for customer due diligence (CDD) information. By centralizing information collection and verification, KYC utilities can reduce the amount of information that has to be exchanged bilaterally between correspondent banks and their respondents, thereby reducing the time banks spend conducting CDD investigations.
Distributed Ledger Technology (DLT)/Blockchain– a way of securely organizing data on a peer-to-peer network of computers. In a blockchain, which is a type of DLT, data modifications, such as transactions, are recorded in time-stamped blocks. Each block is connected to previous blocks, forming a chain. Modifications are confirmed and stored by all users on the network, which makes the ledger difficult to tamper with. Although blockchain technology is most commonly associated with virtual currencies, such as Bitcoin, the basic technology has a number of other potential use cases, including uses in regulatory compliance. In particular, DLT may be used for securely storing and sharing KYC information, as well as for cheaper and more secure international payments.
Legal Entity Identifiers (LEI) – unique alphanumeric identifiers, like barcodes, that connect to reference datasets held in a public database. Any legal entity that makes financial transactions or enters into contracts may request an LEI. In many countries, especially developed ones, LEIs are increasingly mandated by regulation. To date, more than one million LEIs have been issued worldwide. By serving as common identifiers, LEIs can enable different platforms, organizational units, and institutions to refer to entities clearly and without any ambiguity. This interoperability can, in turn, facilitate greater automation and information sharing. A further extension of the LEI would be to include it in payment messages to identify originators and beneficiaries, which would further enhance the transparency of international payments.
Scroll through the infographics above
In the face of de-risking, both the public and private sector have tried to find ways to lower the compliance burden without lowering standards. RegTech (regulatory technology) may be the solution to some de-risking woes. But for this to work, policymakers need to invest time in understanding how these technologies work, and what their benefits and limitations may be. This is the first step in coming up with a regulatory framework that maximizes the advantages of RegTech.
You can find the full study here. We welcome your comments!
Even while policy solutions to address de-risking are being implemented, new technologies have emerged to address de-risking by increasing the efficiency and effectiveness of AML/CFT compliance by financial institutions.
Fuel subsidies are bad for the planet, expensive, and often regressive. With new, high-frequency price data researchers explore why they’re also so hard to kill.
Economists rarely reach the kind of consensus that we see on the topic of fuel subsidies. Bottom line: they’re a really bad idea. On the one hand, they encourage us to burn more fossil fuels and kill the planet, and on the other hand, they’re a massive drain of fiscal resources—equivalent to 6.5 percent of global GDP according to the most eye-popping IMF estimates—that are very poorly targeted at the poor.
Yet attempts to roll back subsidies often provoke strong political backlash. Movements from the Arab Spring in Jordan to Occupy Nigeria have marshalled popular resistance to raising fuel prices, and generally won.
So in the wake of the Paris accord, are countries doing anything to unravel these inefficient subsidies? At a CGD event this week organized by my colleague Todd Moss, Michael Ross of UCLA presented his multi-year project with Paasha Mahdavi of Georgetown and others to gather high-frequency gasoline prices from 157 countries around the world since 2003.
Global fuel subsidies are falling—but mostly due to a falling market price in the face of fixed price ceilings, not politically difficult reform
Two things jump out from the visualizations of their data that Ross, coauthor Chad Hazlett, and Mahdavi present in their recent paper in the journal Nature Energy.
First, the price you pay at the pump in most countries is higher than the global benchmark price of fuel, i.e., most countries are net taxers—not subsidizers of fuel. As it turns out, 95 percent of global fuel subsidies are concentrated in just 22 countries, all of which are also oil exporters. (Note the definition of a subsidy here is more restrictive than the expansive definition that IMF researchers use to get to 6.5 percent of GDP.)
Figure 1: Gasoline prices by country and benchmark price trends over time – Ross et al (2017)
Source: reproduced from Ross et al (2017): “Individual country price trends are shown in grey, and the global benchmark price is plotted in red. Countries fall into two groups: those with prices above the benchmark (who tax gasoline) and those below it (who subsidize it). The overall shape of many trend lines is driven by changes in benchmark price. In general, countries that tax gasoline also allow the price to fluctuate in tandem with global prices, while those that subsidize gasoline keep their prices fixed for long periods. All prices are in constant 2015 USD per litre.”
Second, the lower lines are much less squiggly. That means that countries which subsidize fuel, by charging a retail price below the world price, tend not to let the price move with market fluctuations—whereas taxes are more often defined in proportional terms.
Fixing the retail price has an interesting side-effect: when the world price of fuel drops, the subsidy—defined as the gap between the world price and the retail price—automatically falls. Cheaper gas masquerades as subsidy reform! Mahdavi et al note that most reductions in fuel subsidies since 2014 have come from this phenomenon—which is fine from a fiscal perspective, but isn't going to save the planet or our lungs from air pollution.
Figure 2: Net taxes and subsidies by country in 2003 versus 2015 – Ross et al (2017)
Source: reproduced from Ross et al (2017): “Eighty-three countries increased their net taxes or reduced their net subsidies between the first six months of 2015 and the first six months of 2003; they are shown in blue and lie above the 45◦ dashed line. By contrast, 46 countries reduced net taxes or increased net subsidies over the same period, and are shown in dark orange below the 45◦ line. While most countries had net taxes in both periods (placing them in the upper-right quadrant), 14 countries had subsidies in both periods (placing them in the lower-left quadrant). Just two countries changed from net taxers to net subsidizers (lower-right quadrant) while two others changed from net subsidizers to net taxers (upper-left quadrant). Text size is proportional to average gasoline consumption.”
Overall, are things getting better or not? The short answer is yes, but slowly. From 2003 to 2015, most countries started and ended as net taxers. And countries gradually raised gas taxes, shown by the cloud of names above the diagonal line in the upper-right quadrant. But most countries who started off with net subsidies kept those subsidies, as see in the population of the bottom left quadrant relative to the upper left.
So why do governments subsidize fuel? And why are climate-killing, anti-poor subsidies considered vaguely left-of-center and populist?
The proximate cause is obvious: attempts to remove subsidies are often met with angry protests. Subsidies are politically popular. But at a deeper level, why?
Trust in government appears to be one factor. In a forthcoming paper in Comparative Political Studies, Jordan Kyle looks at public support for replacing fuel subsidies in Indonesia with a targeted transfer program—in which, crucially, monies would have to pass through local government. Kyle documents large variation in corruption in existing programs and finds that this corruption is highly predictive of support for fuel subsidy reform. In villages where transfers tend to go missing, poor households in particular would prefer to keep inefficient fuel subsidies than move to a transfer system.
In a separate project in Tanzania with colleagues Nancy Birdsall, Jim Fishkin from Stanford, and Mujobu Moyo, we found hints of a similar dynamic: citizens who have more trust in the current government were more supportive of exporting Tanzania’s recently discovered natural gas reserves and using the money for other purposes—whereas those with low trust were somewhat more inclined toward using the gas on shore or subsidizing fuel.
The technocratic hope, embodied in India’s Aadhaar system of biometric identification, is that new technology will make it possible to replace inefficient subsidies with reliable electronic transfers that don’t leak and are beyond the reach of local corruption and rent-seeking. My colleagues Neeraj Mittal, Anit Mukherjee, and Alan Gelb have documented in detail how the Indian government has pursued this goal with the reform of cooking fuel subsidies. The politics of Aadhaar remain contentious to say the least.
Using their price data, Ross and Mahdavi have now turned to exploring the determinants of successful (i.e. lasting) reform, asking who raises the retail price of gas and when? That work is still in process, but preliminary results suggest a few factors. Reform is more likely when prices are low (so a price hike is less painful), countries face sovereign risk (so the expense of subsidies bites), and elections are far off.
At the end of the seminar, Ross noted that so far their model has very little explanatory power. A slew of political and economic factors can't seem to predict when fuel subsidy reform will happen. And that seems to be a good metaphor for experts’ understanding of this topic more broadly. Fuel subsidies are bad economics. They cost gobs of money, increase carbon emissions, and fail to reach the poor. But they remain popular, often with the people we think benefit the least.
This paper looks at estimates of the potential gains from taxing across borders, alongside largely domestic measures such as property tax, personal income tax, VAT, and tobacco taxes. It finds that while action on cross-border taxation could yield additional tax take in the region of one percent of GDP, in many countries measures targeting the domestic tax base might deliver something in the region of nine percent. The main enabler is political commitment.
Domestic measures have greater potential for raising tax yields over time. Rough estimates indicate that there may be $9 of additional tax capacity from domestic policy measures for every $1 from international action. The main enabler is political commitment.