Underground Banking: Legitimate Remittance Network or Money Laundering System?

Underground banking, where money is transferred through informal rather than formal banking sectors, is a recognised method by which legitimate remittances from overseas workers are routinely transferred. However, underground banking has also long been regarded as a conduit for money laundering by criminal organisations and arguably by terrorist networks. It is important to achieve a balance between regulating the underground banking sector in an attempt to reduce the flow of illicit funds, and permitting its continued use as a legitimate, alternative remittance system. This paper provides policy makers and others with an interest in underground banking matters with a concise overview of how underground banking systems work, along with the potential associated with such systems for criminal activity and the various regulatory responses that governments have employed to date. Toni Makkai Director Definition Underground banking is a generic term used to describe any informal banking arrangements which run parallel to, but generally independent of, the formal banking system. Underground banking systems are also referred to as alternative remittance systems (FATF 1999), informal funds transfer systems (World Bank & IMF 2003) and informal value transfer systems (FinCEN 2003). Particular types of underground banking systems are also used to describe the underground banking process. These include hawala (India), hundi (Pakistan) and fei chien (China) (Passas 1999). Underground banking takes place in many parts of the world ranging from Hong Kong and Paraguay to Canada and Nepal (Passas 1999). The combination of the geographic diversity and varied typology of underground banking systems makes them attractive for illegal activities and difficult for regulators to control. Process Whatever term is used, the basic principle of underground banking remains the same - it involves the transfer of the value of currency without necessarily physically relocating It. Atypical hawala procedure serves to illustrate the basic process (Figure 1). Value may be transferred to and from both jurisdictions. In either case, the hawaladars need to be paid for their services. Hawaladars may utilise a range of settlement methods (Secretary of US Department of Treasury 2002) but those commonly used include under- and over-invoicing (Figures 2 and 3). Context Underground banking predates the formal banking system. Chinese funds transfer systems, for example, were in evidence during the Tang Dynasty (618-907 AD) (Wucker 2004) and that historical longevity alone makes the continued use of underground banking unsurprising. Underground banking is a rational choice for the transfer of money because it has the same structure and operational characteristics as the formal banking sector without any of its attendant bureaucracy or external regulatory scrutiny (Wilson 2002). Globalisation has created demand for a cheap and mobile labour force and there is often a cultural expectation that members of that labour force will dispatch a proportion of their earnings to their families in their home countries (Passas 1999). In 2002, US$80 billion was remitted through the formal banking sector by workers from developing countries (Sander 2003), constituting the second largest capital inflow to developing countries behind foreign direct investment (Ratha 2003). Allowing for unreported and informal remittance flows, the total remittance figure might be in the order of US$200 billion per annum (Sander 2003). Although the total level of funds is significant, it usually comprises a large number of small transactions which the formal financial sector does not generally facilitate (Buencamino & Gorbunov 2002). The economic situation of the workers and their families makes it necessary for earnings to be dispatched rapidly, efficiently and as cheaply as possible. Advantages Underground banking transactions in the hawala system require no identification from either the remitter or receiver of the funds save for the exchange (via telephone, fax or similar) of a simple password between the remitter and recipient of the funds. …