Source: Reason Magazine (US)
Copyright: 1999 The Reason Foundation
Pubdate: Fri, 26 Feb 1999
Author: Walter Olson


"Know your customer" rules send privacy to the cleaners.

Late last year the federal government proposed new rules requiring banks to
adopt "Know Your Customer" programs. Such programs are intended "to deter
and detect financial crimes, such as money laundering, tax evasion, and
fraud," according to the 46ederal Deposit Insurance Corporation, one of the
agencies involved.

If the rules go into effect as planned on April 1, 2000, banks will be
required to monitor and investigate "abnormal" activity in their customers'
accounts. Unless a satisfactory explanation is forthcoming, they will then
have to report such activity to a centralized government database of
"suspicious-activities reports" jointly maintained by the Internal Revenue
Service and other agencies. Federal and state law enforcers have instant
electronic access to these reports and frequently use them as the basis for
launching investigations.

To determine what counts as "abnormal," each bank will need to establish
profiles of "normal and expected" activity for its depositors' accounts. To
assemble such profiles, bankers will probably gather information about
depositors' occupations and lines of business, their typical patterns of
deposits and withdrawals, the nature of any overseas financial ties they
maintain, and what their relationship may be to other persons who use the
same account. Customers who decline to answer questions or provide
documentation may be refused new accounts or required to close old ones.
Irregular cash deposits--ranging from tip income to holiday bonuses and
inheritances--would be especially likely to elicit questions from bank

Much to the apparent surprise of federal officials, the proposed regulations
were met almost at once with a storm of public outrage. "Don't turn banks
into Big Brother," editorialized the St. Petersburg Times. The Sacramento
Bee blasted the proposal as "a potentially grave in-vasion of the privacy of
every bank customer in the country....Know Your Customer means Snoop on Your
Customer." Thousands of Internet-fueled complaints (blamed by an FDIC
official on "anti-government groups") poured in, some from smaller banks
that objected to the rules' anticipated burdens, but most from ordinary
consumers and citizens. (The comment period on the regulations ends March 8;
the relevant addresses are    gov.)

46ederal bank regulators complain that the protests are quite unfair. After
all, it's not as if these regulations appeared out of the blue: They're a
logical next step in an ongoing campaign dating back more than a decade,
since "money laundering" was criminalized in 1986. Informally, the trade
press has reported, examiners have been instructing banks for years to set
up know-your-customer policies, and by now most banks are collecting
information on their customers' transaction patterns and, increasingly,
combining such information into "profiles" of account activity. "No one
seems to understand," griped Federal Reserve spokesman Richard Small, "that
the information that we want as part of this know-your-customer proposal is
not new and has been collected for years." Which falls into the category of
Reassurances That Leave Us More Alarmed Than Ever.

It's easy to forget what a new crime money laundering is, or how rapidly it
has expanded in its short history on the books. Originally referring to
highly complex financial ploys devised to move criminally obtained (usually
drug) money from one form and place to another while disguising its
provenance, it has become a concept under which all sorts of professionals,
from real estate agents and insurance brokers to yacht salesmen and interior
decorators, can be menaced with 20-year prison sentences if they do business
with big spenders who acquired their down payments by illegal means.
Prosecutors need only allege that the recipients knew--or maybe just should
have known (a convenient doctrine of "willful blindness" helps out
here)--that the money was dirty.

At the same time, the crusade against laundering has served as an excuse for
criminalizing a wide range of conduct, such as cash transactions over
$10,000 not reported to the government, in which none of the participants
would in other respects be deemed criminal and no one is trying to "launder"
anything. Somewhere along the way, tax authorities discovered that
anti-laundering rules were a highly useful weapon in the campaign against
their age-old enemy, the economy's unrecorded cash sector.

Nowadays, federal officials boast of a "growing partnership between the
banking industry and law enforcement." Not that the partnership is entirely
voluntary: As White House drug czar Barry McCaffrey warned in a November
1997 keynote address to the American Bankers Association, banks that do not
cooperate risk "being fined" or "having their charters revoked." Perhaps the
key step came three years ago, when federal law began requiring banks to
report "suspicious" transactions, defined as those that have no "business or
apparent lawful purpose" or are "not the sort of transaction in which the
particular customer would normally be expected to engage, [when] the
institution [can learn of] no reasonable explanation for the transaction."

The 1996 law instructs banks to file "suspicious activity reports" in such
cases, while forbidding them to tell their customers that they have filed
such reports. By late 1997 the resulting database was getting 4,600 queries
a month from state and local authorities. (It also shares information with
foreign law enforcement authorities.) The backup material ("supporting
documentation") on a suspicious activity report is held by the bank but is
considered U.S. government property, which means the bank must deliver it on
the demand of an agency, with no need for subpoenas or those pesky warrants.

Until now, while obliged to report any suspicious activities that come to
their notice, banks have not been required to go searching for such
activities. That's where the new rules come in. Which leaves a lot riding on
the question of what counts as a "suspicious" transaction. According to
McCaffrey, "telltale signs" include "multiple bank accounts opened by more
than one individual using the same address" as well as "cash deposits in
amounts that far exceed what could normally be expected from a person with
the type of job description found on the signature card." Another telltale
sign is "the use of a foreign address to open an account, which is
subsequently changed to a U.S. address soon after the account is
opened"--although that sequence might typify the arrival home of a
repatriating corporate transferee, artist, or student. McCaffrey also says
banks should be suspicious of an account "in which a cellular
given as the reference telephone number on the account opening forms,"
advice that might alarm the small but growing cadre of consumers who have
dispensed with landline telephone accounts in favor of portable phones.

Other expert and official sources suggest that a customer's concern for
privacy all by itself--as distinct from, say, a nervous demeanor--should be
taken as a mark of suspiciousness. According to the February 1996 issue of
Money Laundering Alerts, "A customer should be monitored if he or
unwilling to provide personal background data," shows reluctance to proceed
with a transaction after learning that it is considered suspicious, or wires
a lot of money to "tax havens such as...Hong Kong."

As a concept, suspiciousness can be bafflingly inclusive. "Unusual use of
night deposit boxes or safe deposit boxes" is to be flagged, according to
the Alert, but so is the action of the customer who "opens a safety deposit
box, uses it once or twice, and never returns." And what's good news for
bankers--"paying off problem loans unexpectedly"--turns out to be bad news
for borrowers, when the bank's compliance officer ungratefully reports them
to the feds. Other indicia of suspiciousness could as easily signal
eccentricity or inattentiveness: keeping accounts with several banks in the
same city; "mak[ing] cash deposits without first counting the cash";
"abnormal practices, such as bypassing the chance to obtain higher interest
rates on large balances"; and that favorite habit of day traders, "buying
and selling a security with no discernible purpose."

Among the clear losers under the new rules would be small banks; Robert Rowe
of the Independent Bankers Association of America termed the proposal a
"compliance nightmare." (On the other hand, many big banks, which have
generally implemented know-your-customer programs already, seem to be on
board with the plan; so does the American Bankers Association.) Also hard
hit would be residents of many lower-income and immigrant neighborhoods;
even law-abiding persons in those categories often fit a financial profile
that includes numerous wire transfers, under-the-mattress cash hoards, and
overseas payments. Lawrence Lindsay, formerly a Federal Reserve Board
governor and now a scholar at the American Enterprise Institute, has noted
that honest poor persons, after scrimping to amass the cash for a down
payment on a house, are now stymied when wary bankers demand that they prove
their money is untainted.

As readers of Hayek know, it's awfully hard for government to regulate just
one thing. Citizens alter their behavior to dodge the rule, and soon
officials face a choice of either extending the regulation or giving up on
the original idea. The history of the crusade against money laundering
exemplifies the point.

Thus controls on large cash transactions led holders of hot money to divide
it into multiple deposits below the threshold--so-called smurfing--which
meant smaller transactions had to be scrutinized too. Nor can enforcement
efforts be tightly focused on major drug entrepF4ts such as Miami and New
York, since money is so easily moved from city to city.

Already on the horizon are demands for stricter controls on brokerages,
which make handy cash conduits, and perhaps life insurers too. "We want to
see a level playing field," American Bankers Association laundering
specialist John Byrne has announced, "and we won't be satisfied until every
financial service provider in some way is accountable for knowing its
customers in a similar way that banks are being asked to know theirs." Also
looming is an even stranger fight over what might be called "merchandise
laundering": Treasury and Customs are threatening legislation aimed at
retailers who accept cash payment for bulk purchases of various goods--two
of the most-publicized instances have involved sunglasses and home
appliances--without investigating the buyers' bona fides.

46ear of financial freedom is also shaping up as a major impediment to the
emergence of new transaction-settling technologies, such as Internet banking
and smart cards. If genuine anonymity is permitted in such instruments,
officialdom fears, the war against laundering is as good as lost. As a
result, national regulators are tending to attach the kind of conditions to
such technologies that significantly limit their usefulness: restricting the
"stored value" in a smart card to a low denomination, for example, or
providing that only banks can issue such cards and only to their depositors.
The other possibility--requiring full documentation on every transaction--is
a privacy invader's dream. An anti-laundering panel of the Organization for
Economic Cooperation and Development has discussed not only requiring a
trail for transactions done on smart cards but also forcing all card issuers
to enter such transactions into a central database.

>From his side, drug czar McCaffrey has identified the issue clearly enough.
"Money will flow to whatever market is willing and available," he told the
bankers association, which means victory in the drug war "requires us to
close all markets to tainted funds." In plain English, that means imposing
controls, presumably barbed with today's Draconian penalties, on all
markets. Not just the occasional Caribbean money order wired from a Miami
bank but every transaction in the economy is to suffer the resulting
inefficiency, friction, and privacy loss.

Lindsay, the former Fed governor, argues that the laws against money
laundering have proved ineffective. "We are ask-ing for a lot of compliance
to catch a few people," Lindsay told a Cato Institute gathering in 1997. "We
have overstepped the bounds of balance and reason today," he added, "and we
as citizens should start reining our government back before [its] powers
increase even further."

Contributing Editor Walter Olson is a senior fellow at the Manhattan
Institute and author of The Excuse Factory: How Employment Law Is Paralyzing
the American Workplace (The Free Press).

- ---
MAP posted-by: Don Beck