Be Careful What You Wish For

According to an article in today’s Wall Street Journal, one of the federal government’s main initiatives against money laundering and terrorist financing may have become self-defeating.  The problem involves so-called Suspicious Activity Reports (SAR), which federal law requires banks to file when a customer completes a suspect transaction:

Banks have been required to file suspicious-activity reports since a 1992 amendment to the Bank Secrecy Act aimed at catching money launderers and drug smugglers. The Patriot Act expanded the requirement to include looking for signs of terrorist financial activity and increased banks' responsibility for monitoring their customers. It also extended suspicious-activity reporting requirements to brokerage firms, casinos and firms that cash checks or transfer money overseas.

Money-laundering laws also require banks to file currency-transaction reports on any deposit or withdrawal of more than $10,000 in cash. They file about 13.6 million of these reports a year, a number that has stayed consistent because these reports don't involve judgment calls.

The Financial Crimes Enforcement Network (FinCEN) (part of the Treasury Department) overseas the SAR submissions.  As one might suspect, recent high profile cases where banks were dinged for less than diligent SAR practices has caused banks to become a wee bit overcautious:

The government's use of the Patriot Act to force financial institutions to report suspicious transactions has resulted in an avalanche of unwanted paper and computer tapes that officials who collect the data say is undermining efforts to detect money flowing to terrorists.

The government's money-laundering crackdown in the past two years has ensnared a handful of banks that were fined for failing to report suspect transactions. This has prompted executives to file more "suspicious-activity reports" -- the majority of which involve activity that isn't suspicious at all, government and banking officials say.

This defensive filing by banks is clogging the database of the Treasury Department's Financial Crimes Enforcement Network, which collects the reports, say current and former officials of the network, also known as FinCEN.

In 2004, 689,414 suspicious-activity reports were filed, up from 507,217 in 2003 and 281,373 in 2002, FinCEN data show. In the first half of this year, roughly 400,000 reports were filed.

The volume indicates that banks' tactic for avoiding regulatory scrutiny is "to file more reports, regardless of whether the conduct or transaction identified is suspicious," said FinCEN Director William J. Fox in an April report. These defensive filings "have little value, degrade the valuable reports in the database and implicate privacy concerns." Law-enforcement and intelligence officials can get detailed information about individuals from the database without having to request and justify subpoenas.

If you think about it, this reaction is predictable.  The cost to the bank of generating a SAR is relatively slight compared to the potential cost (discounted by the probability) of missing a transaction that, though innocent on its face, turns out to be money laundering or terrorist-related.  The cost and probability are likely exaggerated by a few high profile cases have the banks spooked:

Running afoul of regulators carries risks. In January, Riggs Bank in Washington pleaded guilty to a criminal count of not filing proper suspicious-activity reports involving foreign officials and was fined $16 million; it since has been bought by PNC Financial Services Group Inc. AmSouth Bancorp. of Birmingham, Ala., last year agreed to pay $50 million to avoid criminal charges in a deferred-prosecution deal with the Justice Department for failing to file suspicious-activity reports, including on some transactions used in an alleged Ponzi scheme.

So while FinCEN presses banks to be more selective, the banks say they are being pressured by regulators to report anything that technical criteria suggest may be suspicious, rather than analyzing transactions individually. FinCEN data show that some file reports simply because a customer made heavy use of an ATM or received or sent international wire transfers, or because the bank didn't know the source of deposited money.

And hindsight always being 20-20, the bank will be blamed for missing supposed red flags.  The real cost is on the government regulators who have to wade through this morass of paperwork, because the banks will have done relatively little pre-screening.  Then again, what did the government expect?  This may be one of the few areas where over-compliance is actually cheaper for the regulated than the regulator.  This irony would be funny if it didn’t affect such a serious matter:

The increased volume of suspicious-activity reports "is bad for the war on terrorism," said Steve Bartlett, who heads the Financial Services Roundtable, a financial-services trade group. But "until some alterations are made in the system, I believe defensive filings will get worse."