Money Laundering (ML) continues to have adverse economic, social, and political effects. Money laundering is a significant threat to the financial flows of countries. In addition to these, money laundering poses severe risks to any financial institution's soundness and stability. Money laundering risks can also threaten Islamic financial institutions, like traditional banking institutions.
Relationship Between Islamic Finance and Money Laundering
Islamic finance is a financial system that works in accordance with Sharia rules or Islamic law principles. Modern Islamic finance originated in the 1970s. Today, Islamic finance has spread globally to both Muslim and non-Muslim countries. Islamic finance currently constitutes a small but growing sector of the financial industry. Different from traditional banking is a ban on interest (riba) in Islamic finance, a prohibition on uncertainty (gharar), ethical investment promotion, commitment to risk sharing and profit sharing, and asset support. Many people wonder whether these differences in Islamic finance are more or less vulnerable to abuse by money launderers or terrorist financiers.
As with many financial institutions, the Islamic financial sector also has some money laundering risks. While Islamic finance is much more risk-focused than traditional practices, it also needs an improved governance environment for Islamic finance players because negative findings affect the institution and the general sector. Therefore, Anti-Money Laundering issues must be carefully planned and implemented in Islamic financial institutions. Nevertheless, there is little research on the risks of money laundering in Islamic finance from Islamic finance's gradual growth.
AML / CTF Compliance in Islamic Finance Sector
As mentioned before, little study has been done on Islamic finance and money laundering risks. In addition, AML / CTF regulations do not have specific provisions for Islamic finance. The recommendations of the Financial Action Task Force (FATF) standards are valid for Islamic financial institutions and other financial institutions. In addition to these, no evaluation has been made for the different ML / TF risks created by certain Islamic finance features. FATF standards were created by considering the financial sector. One of the basic elements of an effective AML / CFT framework of FATF is the definition of "customer" and who the customer really is. FATF standards do not define the concept of "Customer." It is unclear whether it applies to common-based relationship types (rather than "institution-customer" relationships), which is also an important feature in Islamic finance. To the extent that the parties are not viewed as "customers," they will be outside the standard provisions that require countries to have robust regimes for customer identification and due diligence.
While it can be argued that, based on the rationale for customer identification requirements, such parties should be considered "customers" in terms of standards. It is helpful to state this clearly. AML / CTF policies and procedures in Islamic finance should generally include; customer identification, continuous monitoring of accounts and transactions, record keeping, and suspicious transaction reporting. For this, an advanced Know Your Customer (KYC) policy should be considered a vital requirement for any Islamic bank. In addition, Islamic banks accepted, for example, gambling, alcohol, pork-based products as haram and the trade of these products, etc. No investment is made in businesses that do so, so this is not allowed. Therefore, to comply with Sharia and avoid reputational damage, Islamic banks should be very careful with their customers and ensure that their funding sources do not result from criminal or non-Sharia activities.
On the other side, a crucial point should be considered. Islamic banks must rely on a Sharia board to review and approve financial practices and activities for compliance with Islamic principles and standard audits. Such reviews increase the likelihood of identifying any criminal accounts. This particular adaptation feature of Islamic finance can be regarded as financing terrorism and reliable prevention of money laundering. Compared to traditional banks, Islamic banks think they are better positioned to detect and prevent illegal transactions, including ML / TF activities, due to their active participation and knowledge of their customers.
What Are The ML / TF Risks Specific to Islamic Finance?
In an Islamic finance bank, as in a traditional bank, the most fundamental role is to bring fund owners together with people in need of funds. Islamic banks have the same ML / TF weaknesses as other traditional banks, and in some cases, they are more vulnerable than traditional banks. Money launderers often use sophisticated processes to hide the source of funds or their intended use, thus minimizing their catch rate. On the other hand, Islamic finance products are designed with an asset-based feature to provide economic intermediation instead of financial intermediation for traditional financial products. This feature offers a layer of complexity that can make it more vulnerable to abuse by criminals. Often uses Special Purpose Vehicles (SPVs) in complex legal structures designed to deliver a final product compliant with Sharia. SPVs are shell companies located in offshore centers or tax havens. In Islamic finance, complex financial structures are sometimes used to simulate returns that often require derivatives trading.
On the other hand, in Islamic financial institutions, Zakah and Sadaqa funds are collected on and from customers, often in large amounts, and managed and paid by Islamic financial institutions. Institutions generally have the power to appoint natural and legal persons, including non-profit organizations, as beneficiaries. Suppose Islamic financial institutions do not have robust ML / TF risk management processes. In that case, such a high operating volume may increase banks' exposure to severe risks, especially reputational, operational, compliance, and concentration risks. Such risks can be summarized as ML / TF risks that Islamic Finance institutions have, but AML / CTF programs can be followed to reduce these risks. As we mentioned earlier, in Islamic financial institutions, customers go through a tighter Know Your Customer (KYC) process. These risks can be understood and avoided during customer engagement moments.
Murabaha and Tawarruq Relationship With ML / TF Risks in Islamic Finance
Murabaha is the most widely used tool in Islamic finance. It is the notification of the goods' cost to the customer and the sale of the goods by adding profit. This transaction is mainly used to finance the purchase of physical assets such as cars and real estate. According to this regulation, the bank will first buy the asset that the customer wants and then sell it back at a significant price but on credit. Due to some factors, Murabaha is not suitable for criminals seeking to launder unfair gains. For example, suppose a criminal has entered into a Murabaha operation with an Islamic bank. In that case, he will not be able to receive cash or any amount that can be transferred to another account. In addition, unless the customer requests funds to purchase tangible assets, Murabaha cannot be used as a form of financing, so it cannot be given as a loan in return for cash collateral. Moreover, to be valid for a Murabaha, the asset must be purchased from a third party. At the end of the Murabaha transaction, the criminal always acquires an item that he can sell, which he can receive payment via a check or bank transfer.
However, it is not a smart way to launder money to Murabaha for two main reasons. The first of these reasons is that the criminal can go directly to the commodity seller, buy the goods for cash, and then sell it for check or bank transfer. In this process, criminals can go through an Islamic bank and get caught up in that bank's review and AML / CTF checks. The second is that when the Islamic bank sells the goods in deferred payments, the time given to the customer to pay the price and increase the customer accordingly is taken into account. Therefore, in a Murabaha transaction, the price is always higher than the market price. If the client can use cash to purchase a similar asset from the market, it causes him to pay less in a Murabaha transaction than he had to pay on a loan basis. In case of an earlier payment in a Murabaha transaction, no discount can be determined in advance in the contract, and the customer cannot claim this as his right. All features ensure that the Murabaha transaction is very costly and unsuitable for money laundering.
Tawarruq, a variant of the Murabaha transaction, emerged to synthesize traditional loans. Under Tawarruq, the bank buys the asset on its behalf, sells it on credit to the customer, and then sells it on behalf of the customer at a cash price. Neither Tawarruq nor Murabaha is also seen as an effective method of laundering money for the reasons stated above for Murabaha. Consequently, these two elements' sharia-compliant financing methods are deterrent and inappropriate for conducting money laundering and terrorist financing operations.
Islamic Financial Institutions under AML need to verify their customers to avoid financial crime risks. With the Sanction Scanner AML Name Screening tool, Islamic financial institutions can perform their CDD and KYC transactions under their obligations.