Although underground banking has long been used by overseas workers transferring money internationally, there is concern that the system could be used to launder money or finance terrorist activities.

Legislation such as the Financial Transactions Reporting Act (FTR) 1988 and the United States’ Patriot Act protects underground operations, keeping them beyond the reach of authorities.

But a recent paper by Rob McCusker, a research analyst at the Australian Institute of Criminology (AIC), suggests that proposed reform of the sector could drive it further underground, increasing the potential for money laundering and terrorist financing and further limiting official oversight.

Recent media reports also suggest that Osama bin Laden may have used underground banking systems to fund terrorist activities. In 2003, the US Treasury blocked the assets of the al-Barakaat network, a global money remitting company used by al-Qaeda.

However, Chris Cass, a partner at Deloitte who has worked on some of the largest money laundering cases in recent years, believes the criminal mentality and culture are unlikely to drive illicit funds underground. Cass said that criminals laundering money often demand many of the same legal safeguards as people legitimately transferring money and are brazen enough to use the mainstream finance system. He added that there may be weaker areas of the financial services sector that may be more prone to money laundering activities than others, once the Federal Government’s reforms are fleshed out.

But underground banking is attractive to launderers for several reasons. Under the hawala system India’s underground banking system for example, transactions require no identification from either the sender or the receiver of any funds. While this anonymity is designed to protect illegal immigrants overseas fearing detection through mainstream banking, it could be a boon for launderers fearing the new ‘know your customer’ elements of the upcoming reforms. But the lack of formal identification could leave criminals open to blackmail threats from those transferring money.

Cultural issues may also play a part in deterring the flight of money underground. “Ironically, heightened security and increased oversight of the formal sector may increase the propensity for transnational criminals to try laundering their profits via the less regulated underground banking sector,” wrote McCusker. “However, it has been argued that if a member of an underground banking network engaged in money laundering, this might impact so negatively on the network as a whole that it would provoke social and commercial ostracism of the member, which might deter such activity.” However, he added that there has been a long-standing underground banking practice in respect of Colombian drug traffickers using the black market peso exchange.

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But solutions remain thin on the ground. “Underground bankers are still difficult to identify or locate,” wrote McCusker. “Even if it were possible to identify them, their transactions are so varied that it would be difficult to regulate them. Even if it were possible to regulate them, it would be difficult in many countries to establish the necessary infrastructure to implement such regulation. In addition, formalising an informal system removes its advantages. The net result might be that the whole system is driven yet further underground so as to avoid infiltration.”

The best chance of minimising the use of underground banking for illegitimate transactions is to alter the economic conditions that make it attractive. “Perhaps increased focus needs to be applied to issues such as financial policies, taxation, currency and trade restrictions,” said McCusker. “The mistrust of banking systems within developing countries and the arguably anti-competitive global presence of formal money service providers (such as Western Union) should be perhaps also be addressed.” Gaps between official and black market foreign exchange should also be closed to reduce the benefits of underground networks, McCusker added.

Doing nothing is not an option. “Reducing the level of underground banking globally and increasing its transparency has become increasingly important,” said Dr Toni Makkai, director at the AIC.

Meanwhile, as the Federal Government’s AML reforms continue to take shape ahead of the release of draft legislation, speculation is mounting over what the impact of a negative assessment on Australia’s AML efforts from the Financial Action Task Force (FATF) might be. FATF is due to table a report on Australia following an assessment in March of this year. The lack of progress on combating money laundering has left nations like Nauru in an international trade no-mans land.

Stuart Fagg is the Editor of Risk Management magazine, Lawyers Weekly’s sister publication.