Statement by Edward W. Kelley, Jr., Member, Board of Governors of the Federal Reserve System.

Statement by Edward W. Kelley, Jr., Member, Board of Governors of the Federal Reserve System, before the Committee on Banking and Financial Services, U.S. House of Representatives, February 28, 1996

I am pleased to appear before the banking committee on behalf of the Federal Reserve to discuss the impact of crime on the stability of the banking system and the Federal Reserve's efforts to assist banks and law enforcement officials in countering criminal activity. As a bank supervisory agency, the Federal Reserve Board places a high priority on providing assistance in deterring, detecting, and reporting criminal activities directed at banking organizations, and we appreciate the committee's interest in this important area.

Your letter of invitation asked me to address the threat that criminal activity poses to the banking system, and I would like to turn initially to that issue. Although all bank losses that result from criminal activity are unacceptable, it is important to put the risks associated with criminal activities affecting banks in the appropriate context. As of September 30, 1995, the more than 10,000 insured commercial banks in the United States had total aggregate assets of about $4.2 trillion, combined capital of approximately $350 billion, and earnings of $37 billion for the first three quarters of 1995.

In view of the current financial strength of the U.S. banking system and estimates of the extent of banks' losses resulting from criminal misconduct, which include the banking industry's 1994 estimates of approximately $800 million in losses associated with check fraud and $700 million from credit card fraud, we believe that losses from criminal activities do not pose a systemic risk to the banking system. Also, we have no information that suggests that any individual US. banking organization has been overtaken or substantially threatened by criminal organizations or activities.

Although we see no systemic threat to the banking system, we obviously are concerned about the risks to the reputation and integrity of our nation's banks arising from criminal elements using the banking system for illicit purposes. These risks are best illustrated by money laundering, estimates of which range between $300 billion and $500 billion annually. Although no amount of money laundering is acceptable, there is no evidence that the flow of these funds through U.S. banks on its own poses a systemic risk. However, if left unchecked, the use of our banking system by criminal elements could undermine the reputation of banks or weaken the public's confidence in banks as safekeepers of their funds. For this reason, and to support our law enforcement agencies in their efforts to combat crime, the Federal Reserve's efforts to attack the money laundering problem continue to be one of our highest bank supervisory priorities.

Federal Reserve Role

As a banking supervisor, the Federal Reserve has an important role in ensuring that criminal activity does not pose a systemic threat and, as important, in improving the ability of individual banking organizations in the United States and abroad to protect themselves from illicit activities. Because bank systems and bank employees are the first and strongest line of defense against financial crimes, the Federal Reserve places a high priority on ensuring that banking organizations have appropriate controls in place to protect themselves and their customers from criminal activities. The Federal Reserve places an equally high priority on supporting efforts by U.S. law enforcement agencies to apprehend criminal enterprises before they can cause harm to consumers and banking organizations.

A banking organizations best protection against illicit activities is its own policies and procedures designed to identify and then reject potentially illegal or damaging transactions. For this reason, the Federal Reserve and other regulators have implemented various directives for banks to establish internal controls and procedures designed to detect unusual or suspicious transactions that, if unchecked, could lead to fraud, money laundering, or other types of criminal misconduct.

To understand and properly evaluate the effectiveness of a banking organization's controls and procedures, we have developed extensive examination procedures and manuals, and our bank examiners are provided with comprehensive training and with timely information to assist them in identifying suspicious or unusual transactions. I need to emphasize, however, that we do not expect our examiners to act as police. The Federal Reserve is a bank supervisory agency, not a criminal law enforcement authority; we see our role as auxiliary to the legitimate law enforcement duties of criminal justice agencies. Our examiners do not, nor should they, possess the necessary tools required to fully investigate and prosecute criminal conduct. This is a function ably handled by our law enforcement colleagues.

In recent years, however, the Federal Reserve determined that in some instances it is necessary to go beyond the scope of an ordinary bank examination to determine if violations of law or regulation have occurred. For this reason, in 1993 the Special Investigations and Examinations Unit was created in the Board's Division of Banking Supervision and Regulation. This unit's function, in part, continues to be that of taking information developed during the course of an examination and conducting a specialized investigation or examination to determine what, if any, laws have been violated through activity conducted at a bank. The unit notifies the appropriate law enforcement agency when apparent criminal violations are detected and works hand in hand with them whenever necessary.

Knowing Your Customer and Suspicious-Transaction

Reporting

The Federal Reserve believes that the most prudent method for banking organizations to protect themselves from allowing criminal transactions to be conducted at, or though, their institutions is to adopt what has become known as "Know Your Customer" policies and procedures. Safety and soundness considerations dictate that banking organizations have adequate policies and procedures in this area, including procedures to ensure compliance with the rules and regulations designed to assist in the detection of criminal activity; decrease illegal activity through increased awareness by employees; protect the reputation of a banking organization; and promote good, as opposed to unsavory, customer relationships.

"Know Your Customer" procedures, which are applied to all facets of a banking operation, allow the organization to identify its customers and the transactions that they conduct on a regular basis, be alert to transactions that may be irregular or abnormal for a particular customer, determine whether there is an apparent valid or lawful purpose for the transactions, and report to the appropriate authorities those transactions that appear to be suspicious or criminal in nature. One of the more significant components of "Know Your Customer" procedures is the ability of banking organizations to identify and report suspicious or potentially criminal activities. For the past ten years, the Federal Reserve and the other federal bank supervisory agencies have required banking organizations to report suspected criminal activities to us, as well as to various federal law enforcement agencies. In 1995, more than 70,000 criminal referrals were filed.

To reduce the burden on financial institutions while increasing the usefulness of the information provided on suspected criminal conduct, the Federal Reserve, together with the other federal bank supervisory agencies and the Department of the Treasury, revised the criminal referral process in several significant respects. First, effective on April 1 of this year, the new process combines the current criminal referral rules of the bank supervisory agencies with the Treasury Department's suspicious-activity reporting requirements related to money laundering offenses. Second, a uniform interagency reporting form has been developed for purposes of referrals to all agencies. Third, we have provided for the filing of the uniform form in one location as opposed to the current requirement of filing six or seven copies, and banks will have the ability to use computer software, to be distributed by us, to assist in the preparation and magnetic filing of the reports.

Another important improvement is the statutory protection recently afforded banking organizations that report suspicious or criminal conduct, which provides banking organizations and their employees with immunity from civil liability for reporting known or suspected criminal offenses or suspicious activities. This protection, long sought by the banking community and supported by the Federal Reserve, gives great comfort to banking organizations that they will not be held liable for providing timely and useful information to law enforcement authorities.

Federal Reserve Information Assistance

Over the years the Federal Reserve has also taken the initiative to provide timely and useful information to banking organizations with regard to ongoing criminal conduct or potential schemes that may have an adverse impact on them. In the past few years, the Federal Reserve and the other federal banking supervisory agencies have issued bulletins on such matters as "Prime Bank Fraud" schemes and credit card fraud. Such notices to the banking industry are intended to alert banks of the potential dangers of such schemes and practices.

From time to time, the Federal Reserve has also developed and issued policy statements with regard to activities occurring in banking organizations that we have determined could pose a threat to the integrity of a bank. One such example was the Federal Reserve's development and issuance of a policy statement on "payable through accounts" in 1994. The purpose of the policy statement was to ensure that banks that engage in payable-through activity - which basically involves the use of a checking account at a bank in the United States by an individual who resides outside of this country - have appropriate procedures in place to ensure that no illicit activities are being conducted through these accounts.

Also, in accordance with section 404 of the Money Laundering Suppression Act of 1994, the Federal Reserve has been working with the Treasury to establish a process whereby the federal law enforcement community will provide, on a regular basis, information with regard to new or emerging money laundering schemes, which will then be disseminated to financial institutions.

Anti-Money Laundering Efforts

The Federal Reserve continues to be a leader among the federal banking supervisory agencies in addressing money laundering-related matters. The staff of the Federal Reserve has been in the forefront of the battle to deter money laundering through banking organizations by, among other things, developing anti-money laundering guidelines, conducting money laundering investigations, providing expertise for law enforcement initiatives, and providing training to various government agencies.

Training provided by the Federal Reserve staff to law enforcement agencies has included programs at the FBI Academy and the Treasury's Federal Law Enforcement Training Center. Additionally, the Federal Reserve staff has provided training in anti-money laundering procedures to foreign governments, such as Russia, Poland, Hungary, the Czech Republic, Brazil, Ecuador, Argentina, and several other countries in the Middle East and the Far East.

In accordance with section 404 of the Money Laundering Suppression Act of 1994, the Federal Reserve chaired a working group that has developed enhanced examination procedures to identify appropriate anti-money laundering procedures initiated by banking organizations. Along with these enhanced money laundering procedures, the Federal Reserve will very shortly release newly revised Bank Secrecy Act examination procedures that will allow examiners to determine more efficiently and effectively compliance with the Bank Secrecy Act.

Coordination Activities

The Federal Reserve routinely coordinates with federal law enforcement agencies with regard to potential criminal matters, including anti-money laundering activities. The scope of this coordination ranges from our work on the criminal referral process to specific, case-by-case assistance to law enforcement agencies resulting from examinations of banking organizations.

The Federal Reserve is a founding member and active participant in the well-regarded interagency Bank Fraud Working Group, which consists of representatives of thirteen federal law enforcement and bank supervisory agencies. Among other things, this group, which has been meeting on a monthly basis since the mid-1980s, has coordinated the dissemination of relevant and timely information on such matters of mutual interest or concern as Asian gangs' use of check fraud and check counterfeiting; West African advance fee schemes and credit card fraud; and asset forfeiture of criminally derived funds.

The Federal Reserve is also an active participant in the Financial Action Task Force (FATF), which was established by the Group of Seven countries. The Board staff has contributed significantly to the FATF's mission of educating countries around the world in anti-money laundering and fraud prevention efforts.

Offshore Corporations and Banks

As a result of our staffs work with law enforcement authorities, we recognize that crime is an international activity that is increasingly making use of offshore corporations and banks. These are two separate problems that we address in different manners.

With regard to offshore corporations, because the Federal Reserve cannot control a sovereign nation's laws governing the establishment of corporations in its territory, we can only address the activities of these companies when they seek to do business in the United States through banks we supervise. In this regard, our principal tool is the "Know Your Customer" policy. As I said before, every domestic and foreign banking organization supervised by the Federal Reserve should have adequate policies in this area. This means, for example, that if a state member bank or a U.S. branch of a foreign bank maintains a deposit relationship with a corporate entity, wherever it is chartered, it should take steps to identify its business and the nature of its routine transactions to evaluate better whether it is engaging in any suspicious activities. While no federal bank regulator or law enforcement agency can monitor every transaction undertaken by every corporation doing business with a U.S. financial institution, we can, and we routinely do, measure the internal controls and risk management systems implemented by the banks to make certain that the banks are, in fact, adhering to their policies and are aware of the business of their customers, including any that may use offshore corporations.

With regard to foreign banks, the Board, since it was given the power by the Congress in 1991, carefully scrutinizes any foreign bank seeking to do business in the United States. This includes making certain that the bank is subject to comprehensive consolidated supervision in its home country, reviewing the bank's global anti-money laundering procedures, and conducting background checks with U.S. law enforcement and other agencies. In addition, as I mentioned, we thoroughly review the operations of these banks in the United States to make certain their activities here fully comply with U.S. laws and regulations. The Federal Reserve is also working in a number of areas to improve the bank supervisory standards in other banking centers and to make certain that there is adequate cooperation among supervisors so that gaps do not occur in the consolidated supervision of international banking organizations.

Conclusion

In conclusion, we have undertaken extensive efforts and have used significant resources to combat illegal activities involving domestic and international banking organizations. I believe that the Federal Reserve has made significant contributions to the federal government's law enforcement endeavors. Because we have a vital interest in protecting the banking system from criminal elements, we will be continuing our cooperative efforts with other bank supervisors and the criminal justice agencies to develop and implement programs to better detect criminal misconduct involving banks.