A Theory of “Crying Wolf” The Economics of Money Laundering Enforcement The views expressed herein are those of the author and should not be attributed to the IMF, its Executive Board, or its management. Előd Takáts International Monetary Fund

11/01/20072 Roadmap Money laundering Related literature Model and Analysis Information Laffer curve Empirical evidence Policy implications General crying wolf problem

11/01/20073 Money Laundering Definition: illicit transfer Traditional Terrorism financing Predicate crimes Drug dealing, tax evasion, terrorism Importance Funds moved: $ trillion half through US Harm: even larger Revenues: 5-15% Public interest

11/01/20074 Bank Reporting Reports 1)Rule based reports (standard) 2)Discretionary reports (new problem): SAR SAR (Suspicious Activity Report) Bank expertise and judgment “Constructive ambiguity” Bank’s incentive to report: fines Fines for false negatives

11/01/20075 Problem: Outline Government Transaction Bank investigation report fines signal monitor

11/01/20076 Economics Building blocks: 1)Coarse communication 2)Coarse incentives (fines for false negatives) 3)Uncertainty 4)Dual task: monitor and report 5)No ex-post state verification Policy implications Optimal fines (1-3) to avoid crying wolf Reporting fees (4) Increased harm, lower fines (2)

11/01/20077 Information Laffer curve Fines # Prosecution # Reporting F* F** F’

11/01/20078 Information Laffer curve Fines # Reporting # Prosecution

11/01/20079 Some Evidence Empirical predictions: Fines: increase SAR: increase Prosecution: Humped shaped curve Data consistent

11/01/ Prosecution

11/01/ Further Evidence FinCEN (April 2005) on ‘defensive filing’: We estimate that if current filing trends continue, the total number of Suspicious Activity Reports filed this year will far surpass those filed in the previous years. …it fuels our concern that financial institutions are becoming increasingly convinced that the key to avoiding regulatory and criminal scrutiny under the Banking Secrecy Act is to file more reports, regardless of whether the conduct or transaction identified is suspicious. … If this trend continues, consumers of the data - law enforcement, regulatory agencies, and intelligence agencies - will suffer.

11/01/ Policy Implications Decrease fines to stop crying wolf (Prop 2) Lower nominal fines (OCC internal memo, 2005) Centralize prosecution (Attorneys’ Manual, 2005) ‘Safe harbor’ for sound processes Introduce reporting fees (Lemma 4) Price externality of information dilution Or longer reports: higher cost, less coarseness New angle on Patriot Act (Lemma 8, 9) Fine increase: intuitive, but wrong reaction

11/01/ Discussion: Reporting

11/01/ Conclusion Contribution First step: money laundering enforcement Implementable policy recommendations General crying wolf problem Application: auditing Crying wolf and material transactions General lesson Information= data + filtering Crying wolf: filtering Information age: abundant data, needed filtering