Money laundering is any activity aimed to hide the origin and/or the destination of a flow of money in order to reduce the probability of sanctions. In order to describe the economics of money laundering, the starting point is the definition of its microeconomic foundations, which are based on the existence of a rational actor who derives revenues from a criminal activity and from the assumption that his/her expected utility depends on four key elements: expected revenues, laundering costs, likelihood of being caught, and magnitude of the sanction.
The micro basis of the money laundering can explain its macroeconomic effects. Money laundering can function as a multiplier mechanism of the weight of the illegal sector in a given territory or country. In order to prevent and combat the polluting effects of money laundering, an effective regulation has to be designed, based on a correct incentives alignment between the supervisors and the financial intermediaries.
KeywordsOrganize Crime Illegal Activity Money Laundering White Collar Crime Financial Flow
Money laundering is any activity aimed to hide the origin and/or the destination of a flow of money in order to reduce the probability of sanctions.
Only recently the economic analysis has developed a peculiar focus on the financial issues related to the study of crime, thus far completely absent (Masciandaro 2007; Unger and Van der Linde 2013). In this entry, a simple framework to explain the micro foundations of the money laundering activities in order to analyze its macroeconomic effects on the relationship between the illegal activities and the economic sector as a whole will be offered.
The emphasis on the study of money laundering has progressively increased, recognizing its potential role in the development of any crime that generates revenues and or in financing a crime. In fact, the conduct of any illegal activity may be subject to a special category of transaction costs, linked to the fact that the use of the relative revenues increases the probability of discovery of the crime and therefore incrimination. The analysis zooms on the economics of concealing illegal sources of revenues, but the same reasoning can be applied in discussing the hidden financing of illegal activities (money dirtying).
However, we should stress that in terms of economic analysis, the financing of illegal activities (money dirtying) is a phenomenon not perfectly equivalent from the recycling of capital (money laundering).
The money dirtying resembles money laundering in some respects and differs from it in others. The objective of the activity is to channel funds of any origin to individuals or groups to enable illegal acts – for example, terrorism – or activities. Again in this case, an organization with such an objective must contend with potential transaction costs, since the financial flows may increase the probability that the financed crime will be discovered, thus leading to incrimination. Therefore, an effective money dirtying action, an activity of concealment designed to separate financial flows from their destination, can minimize the transaction costs.
The main difference between money laundering and money dirtying is in the origin of the financial flows. While in the money laundering process the concealment regards capitals derived from illegal activity, the illegal actor or organization can use both legal and illegal fund for financing their action.
Money laundering and money dirtying may coexist. A typical example is the financing of terrorism with the proceeds from the production of narcotics. In those specific situations, the importance of the transaction costs is greater, since the need to lower the probability of incrimination concerns both the crimes that generated the financial flows and the crimes for which they are intended. The value of a concealment operation is even more significant.
The definition of money laundering points up its specialness with respect to other illegal or criminal economic activities involving accumulation and/or reinvestment. Now, given that the conduct of any illegal activity may be subject to a special category of transaction costs, linked to the fact that the use of the relative revenues increases the probability of discovery of the crime and therefore incrimination, those transaction costs can be minimized through an effective laundering action, a means of concealment that separates financial flows from their origin.
In other words, whenever a given flow of purchasing power that is potential – since it cannot be used directly for consumption or investment as it is the result of illegal accumulation activity – is transformed into actual purchasing power, money laundering has occurred.
Focusing our attention on the concept of incrimination costs enables us to grasp not only the distinctive nature of this illegal economic activity but also its general features. The definition here adopted maintains basic unity among three aspects that, according to other points of view, represent three different objects of the anti-laundering action: the financial flows (layering), the wealth and goods intended as terminal moments of those flows (integration), and the principal actors, or those who have that wealth and goods at their disposal (placement).
In this general framework of analysis, there will always be an agent who, having committed a crime that has generated accumulation of illicit proceeds, moves the flows to be laundered, so as to subsequently increase his/her financial assets, by investment in the legal sector or re-accumulation in the illegal sector. The agent can be an individual or a criminal organization.
By criminal organization, we mean a group of individuals and instrumental assets associated for the purpose of exclusively exchanging or producing services and goods of an illicit nature or services and goods of a licit nature with illicit means or of illicit origin.
In general, following the classic intuition à la Becker, it can be claimed that the choices of an economic agent to invest his/her resources in illegal activities – as money laundering is – will depend, ceteris paribus, on two peculiar magnitudes, given the possible returns: the probability of being incriminated and the punishment he/she will undergo if found guilty.
Now, to undertake money-laundering activity, the agent possessing liquidity coming from illegal activity will decide whether to perform a further illicit act, in a given economic system – i.e., money laundering – assessing precisely the probability of detection and relative punishment and comparing that with the expected gains, net of the economic costs of this money-laundering activity.
The choice of the agent requires that the crime in question, and the relative production function, be basically autonomous with respect to other forms of crime, those that generated the revenues in the accumulation phase.
The economic value, in the strict sense, of minimizing the expected incrimination costs, transforming into purchasing power the liquidity deriving from a wide range of criminal activities (transformation); transformation, in turn, produces two more utilities for the criminal agent.
The possibility of increasing his/her rate of penetration in the legal sectors of the economy through the successive phase of investment (pollution).
The possibility of increasing the degree to which the criminal actors and organizations are camouflaged in the system as a whole (camouflaging).
Having defined the micro choices in the most general terms possible, we can now investigate the macro effects of money-laundering choices.
To define a macro model of the accumulation-laundering-investment process, we focus on the behavior of a general criminal sector that derives its income from a set of illegal activities and that, under certain conditions, must launder the income to invest it. We will highlight the role of money laundering as an overall multiplier of the criminal sector endowment.
Let us assume – as in Masciandaro 1999 and then in Barone and Masciandaro 2011 – that in a given economic system, there is a criminal sector that controls an initial volume of liquid funds ACI, fruit of illegal activities of accumulation. Let us further suppose that, at least for part of those funds, determined on the basis of the optimal microeconomic choices already discussed in the previous pages, there is a need for money laundering. Without separating these funds from their illicit origin, given the expected burden of punishment, they have less value. Money-laundering activity is therefore required.
To underscore the general nature of the analysis, we can claim that the demand for money-laundering services could be expressed – distinguishing the different potential components of a criminal sector according to their primary illegal activity – by organized crime in the strict sense, by white collar crime, or by political corruption crime, also considering the relative crossover and commingling.
If the first laundering phase is successful, the criminal sector may spend and invest the remaining liquid funds (1 − c)yACI in both legal economic activities (investment) and illicit activities (re-accumulation).
The trend to use specialist money launderers – with their explicit or implicit fees – is increasing. These operators use their expertise to launder criminal proceeds. In general, the professionals may be witting or unwitting accomplice; but in any case, the buildup of the overall procedure represents a cost.
We assume that in general, the money-laundering procedures represent a cost for organized crime, notwithstanding it is well known that the criminal groups can implement legal businesses also for the concealment of their illegal proceeds and these businesses can produce profits. As it will be evident below, the smaller the money-laundering costs will be, the greater the multiplier effect.
The criminal sector will spend part of the laundered liquidity in consumer goods, equal to d, while a second portion will be invested in the legal sectors of the economy, for an amount of f, and then a third portion, equal to q, will be reinvested in illegal markets (giving, of course, d + f + q = 1).
On the one side share of illegal funds needs to be spent: minimizing incrimination risks comes at a price; the criminal sector has to pay a price. On the other side, we suppose that a share of dirty money will be reinvested in the illegal market without concealment. For example, in all illicit services, cash is by definition the currency of choice, running in a closed circuit separate from the legitimate market.
Reinvestment in criminal markets is a distinctive feature of actual organized crime groups, given their tendency toward specialization. Organized crime tends to acquire specialist functions to augment their illegal businesses.
If the criminal sector makes investment choices according to the classical principles of portfolio theory, indicating with q(r, s) the amount of laundered funds reinvested in illegal activities, with r the actual expected return on the illegal re-accumulation, and with s the relative. Finally, we can assume that the re-accumulation of funds in the illegal sector requires their laundering only in part, thus indicating with the positive parameter y the portion of illegal re-accumulation that requires laundered liquidity.
The crucial assumption is that both the lawful investment and part of the unlawful re-accumulation require financing with “clean” cash. This assumption can be supported by the presence of rational, informed operators in the supply of services to the criminal sector for the illegal re-accumulation or by rationality of the criminal himself/herself, who wishes to minimize the probability of being discovered.
Therefore, the more effective the money-laundering action, the greater the cash flows available to the criminal sector for reinvestment, illegal and legal, will be. Money laundering represents the multiplier of the illegal sector.
Summing up the key features of money laundering, the micro foundations have been based on the existence of a rational criminal actor or organization, which derives revenues from an illicit or criminal activity. The criminal actor or organization wants to maximize the expected utility of his/her or its illicit proceeds. The expected utility increases with the average return, and it decreases with the costs for laundering, with the probability of being caught, and with the severity of the sanction when being caught.
Further, the macroeconomic effects of money laundering have been captured using a multiplier model. Money laundering triggers a multiplier process, which ends up with higher laundering and higher criminal activities. Money laundering harms the economy. Therefore, it can be useful to design and implement a regulation to prevent and combat the money-laundering phenomena.
On this respect, the starting point has to be to recognize that the banking and financial industry usually play a pivotal role for the development of the criminal sector as a preferential vehicle for money laundering.
The main actors are on the one hand the regulatory agents, who want to combat money laundering, and on the other hand the financial intermediaries, who can be either honest and compliant or dishonest and noncompliant. Asymmetric information and principal-agent problems are typical for this market. The design of anti-money-laundering regulations must take four aspects into consideration: the difference in information assets between the individual intermediaries and the agency, the non-verifiability of bankers’ efforts to comply, the costliness of that effort for the intermediaries, and the non-verifiability of the influence of the effort on the performance of the regulation.
To deal with such difficulties, the best way of analyzing the regulatory issues is to implement a principal-agent methodology, managing the incentive problems that arise at least in a three-layer hierarchy, which includes public authorities, financial institutions, and supervisors. It is possible to show – Dalla Pellegrina and Masciandaro (2009) – that the under asymmetric information, the effectiveness of the regulation depends on three crucial conditions.
First, the participation constraint of the financial institutions requires that the incentive scheme is well balanced, meaning that both rewards and penalties must be defined, in order to minimize the difference between the private costs in implementing a regulatory model and the public gains in collecting useful information against money laundering.
Second, excessive fines per se do not necessarily provide incentives to the financial institutions to improve their action. In particular, given the incentive scheme of the financial institutions, the quality of the supervision can be a good substitute for the severity of punishments: the more effective the (potential) supervisory action in monitoring ex post the money-laundering risk, the more likely the effectiveness of the financial institutions in building up ex ante their monitoring models.
Third, other things being equal, if the cost of supervision depends on its quality, also the efficiency of the supervisory agencies matters. Again, the importance of the quality and the efficiency of supervision can be particularly relevant.