A Latvian Sock In The Laundromat? The Fight Against Money Laundering – Analysis

By Eriks Selga*

(FPRI) — The recently exposed “Russian Laundromat” scandal alerted the world to a $20 billion money laundering scheme that bankrupted three of Moldova’s largest banks, forcing the country to apply for—and eventually receive—an IMF bailout. Half of the laundered money travelled through a Latvian bank. This piece of news is not the first time Latvia’s financial system has been used to launder money. Though Latvia has recently worked towards fixing this problem, money laundering has negatively affected Latvia’s relations with other countries as well as its ability to participate in certain international organizations.

Globally, each year, people and organizations launder funds equivalent to an estimated 2% to 5% of the world’s GDP. Recent efforts to re-capture the resources and prevent further laundering have shifted attention towards implementing better anti-money laundering systems. For Latvia, the issue has become particularly salient given the country’s accession to the Organization for Economic Cooperation and Development (OECD) in June 2016. Weaknesses in anti-money laundering prevention systems were among the primary obstacles delaying OECD accession, especially with regard to monitoring bank deposits of non-residents.

Latvia’s Money Laundering Problem

Latvia faces money laundering risks for several reasons. Once its economy stabilized after the 2008 financial crisis, Latvia gained the reputation as a safe place to store money, attractive to investors from less stable Eurasian countries such as Russia and its neighbors. Together with low taxes and Russian-speaking financial professionals, Latvian banks are convenient for residents of the former USSR member countries. They are particularly appealing to elites and business owners seeking sanctuary from capricious governments. By moving their capital into more reputable Latvian banks, residents of less stable former Soviet nations ensure these funds are beyond the reach of their own states. Their money is guarded from financial and political instability and can access the broader Western market, circumventing stricter regulation in other countries.

Most of Latvia’s 16 banks cater almost solely to foreign clients. At the end of 2016, the share of foreign deposits in the Latvian banking system was 43%. About 70% of these deposits are held for on-demand corporate transaction purposes. In other words, about a third of Latvian bank deposits is unmoored money that can be relocated instantly.

Foreign deposits have a higher risk of money laundering. The majority of the banks implicated by the Financial and Capital Markets Commission, the Latvian financial supervisory authority, for failing to satisfy money laundering prevention requirements cater to non-residents. This situation creates risks for Latvia. Higher rates of money laundering dampen foreign direct investment. It also heightens the risk of volatility of international capital flows, because laundered money typically comes from very short-term investments. A reputation for tolerating money laundering can erode the stable foundation a country needs for healthy economic and financial development. The risks are particularly relevant to Latvia, which houses one percent of all global U.S. dollar transactions. Instability in its financial system caused by money laundering could have region-wide effects.

While the influx of capital may be positive in the short term, the mobility of non-resident funds in Latvia renders it undependable. In theory, Latvia is well equipped to handle the risk of rapid withdrawal of foreign deposits. Liquidity stress tests in 2015 indicated that several of Latvia’s banks would become illiquid only at the removal of 90% of the non-resident deposits—an event that is not very likely. However, if such an outflow occurred, the mass exodus would shave several percentage points off of Latvia’s GDP from the multiplier effect alone.

There is no clear measure for how much money is laundered through Latvian banks. However, several key instances demonstrate that the problem is significant. In 2013, the Financial and Capital Markets Commission levied a fine against a Latvian bank in the Sergei Magnitsky whistle-blower case, concerning the laundering of $230 million that was stolen from the Russian treasury allegedly by Russian tax officials and police officers. At least $63 million of the stolen capital was moved through six Latvian banks to get to offshore companies.

Further claims include a single Latvian bank which was alleged to be responsible for transferring $13 billion derived from fake debt created in several countries. Latvian banks have been alleged to hold several million dollars from a Ponzi scheme run by the U.S.-based Rockford Funding Group, LLC. A leaked document from the Panama Papers asserts that the Iranian government attempted to use Latvian banks to circumvent sanctions. The Organized Crime and Corruption Reporting Project (OCCRP) alleges that various Latvian banks are not just “disinterested parties,” but at the very least, “directly involved” in money laundering activity. Several banks have used offshore shell companies based in tax havens such as Panama or Belize. Most recently, the FBI has alleged that two Latvian banks are holding at least $28 million of illegally obtained money from the company behind Kickass Torrents, the world’s most popular file sharing site.

Cleaning the Dirty Laundry

While the above cases may be isolated incidents, the OECD also investigated the systematic strength of Latvia’s money laundering prevention structures. On the outset, the Financial and Capital Markets Commission and other financial institutions are required to file unusual and suspicious transaction reports to the Latvian Financial Intelligence Unit, supervised by the Prosecution Office. In turn, the unit forwards filtered information to law enforcement. However, only 222 of the 28,000 suspicious transaction reports sent to law enforcement went to Latvia’s Corruption Combating and Prevention Bureau for corruption-related investigations. OECD and the Committee of Experts on the Evaluation of Anti-Money Laundering Measures and Financing of Terrorism have posed that this number as “extremely low” in light of Latvia’s corruption risks.

The connection between money laundering and corruption is easy to trace. Pressure for oversight of the banking sector on a national level should come from parliament, though the executive branch is responsible for implementing rules. Either branch can inhibit development of expertise among public officials, or turn a blind eye. In turn, any missing link in the prevention chain can be critical to the success of a money laundering operation. While corruption is the hardest crime to filter out, it is also among the most important factors to countering money laundering. If senior public officials and politically exposed persons are not monitored for the abuse of their office for private gain, then high profile money laundering is more likely.

To that end, the Corruption Combating and Prevention Bureau—the primary authority responsible for investigating corruption—is undergoing systematic organizational issues stemming from mismanagement and institutional politics. It is in a state of organizational flux. With “internal warfare” and “political whirlpools” creating public scandals, and over 15 senior civil servants having left, the institution suffers in its capacity to carry out daily tasks. As noted by the OECD, research into domestic corruption and the number of public officials tried for corruption is “steadily decreasing” with fewer and fewer serious cases being pursued. To make a bad situation worse, only one director of the Bureau has finished a full term in office, and was not considered fit for a second term due to participation in the aforementioned scandals. The position of director has been empty since mid-November 2016. The continued instability of the Corruption Combating Bureau severely detracts from Latvian oversight capacity and directly increases corruption risk within public institutions.

These factors paint a dark picture of Latvian anti-money laundering enforcement capacity. Yet, a broader frame of reference provides a different view. Latvia has bolstered its banking system framework since regaining independence in 1991. For example, major bank reforms were passed in 2005 after two Latvian banks were labeled “rogue actors” and were forbidden access to the U.S. market. From 1991 to the present, Latvia reduced its number of banks from 62 to just 16.

Banking Policy Changes

The year of OECD accession climaxed in tighter anti-money laundering regulations. By implementing OECD recommendations and taking into consideration Financial Action Task Force guidelines, Latvia strengthened its anti-money laundering measures via major legislative changes. This new legislation was reflected in practice as the government levied sanctions against 11 Latvian banks between 2014 and 2016. Almost all of the sanctions concerned failure to implement properly money laundering prevention systems. While most banks received minor penalties, one bank had its license removed, and another was prohibited from offering financial services to clients in Latvia. These enactments indicate a change from a “laissez-faire attitude” towards money laundering in the country.

The main concern now is whether Latvia will continue to increase anti-money laundering enforcement. Though Latvia proved capable of tough measures against negligent banks, most punitive measures have been more symbolic in nature. It is evident that the Financial and Capital Markets Commission does not want to reduce the competitive market advantage Latvia has in comparison to neighbors even though new external deposits fell by almost 30% in 2016 compared to 2015. It remains to be seen whether foreign deposits will continue to decrease at a similar rate in the upcoming years, indicative of an effective warning against money-launderers. The momentum from the Commission is a stark juxtaposition to the Corruption Combating Bureau or the Latvian Financial Intelligence Unit—the trends in combatting the underlying issue of corruption have been negative.

For Latvia, this may mark a challenging period. Balancing heightened anti-money laundering obligations with a highly competitive international banking market will require constant effort. First, enforcement of money laundering legislation must not be allowed to weaken. Second, more resources must be allotted to combatting the corruption which fosters a sense of security for high-profile money launderers. Third, in doing so, the nation should not be too eager to sacrifice its economic advantage solely for international rapport. Latvia has taken great strides against money laundering, and accession to the OECD is evidence of this fact. While further steps are needed to address the underlying issues of financial oversight capacity, Latvia must also ensure it retains its reputation as a stable financial center.

About the author:
*Eriks K. Selga is an Associate Scholar at FPRI’s Eurasia Program and a lawyer at PricewaterhouseCoopers Legal Latvia.

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This article was published by FPRI