Weaknesses outlined in the recent Financial Action Task Force (FATF) report on China’s anti-money laundering (AML) and counter-terrorist financing (CTF) systems and processes are seen by observers as a ‘wake-up call’ for the nation that could shape future rule-making in this area.
The FATF report - implemented in February 2019 - analyzed the effectiveness of measures implemented by Chinese financial and non-financial institutions since 2002 to address terrorist financing and money laundering, and assessed their level of compliance with FATF guidelines.
Since the FATF is not a regulatory body, its recommendations can’t be enforced. But practitioners believe they carry sufficient influence to shake the Chinese government into taking action on issues with its AML and counter-terrorism financing processes that were identified in the report.
The Chinese government may go as far as revising the current AML laws. We believe that the local regulator may, in the next couple of years, extend its AML requirements beyond financial institutions and increase cross-regional collaboration obligations.
This is significant: China has a number of Designated Non-Financial Businesses and Professionals (DNFBPs) who operate with little or no regulation. These include: auditors, external accountants, and tax advisors; dealers in precious metals and stones; lawyers, notaries and other independent legal professionals; and real estate agents and trusts.
In regulatory jurisdictions, DNFBPs are regulated in much the same way as credit and financial institutions. Some jurisdictions also have tailored regulations to counter the unique money laundering threats posed by different types of DNFBP.
The very real possibility of regulatory action by the Chinese authorities in the wake of the FATF report suggests that practitioners with interest in this space should ensure they are fully familiar with current AML regulations, and continue to monitor global developments in AML regulation as they may ultimately apply to China in the medium term.
Key report findings
The FATF report found that both financial and non-financial institutions in China had an incomplete understanding of the risks associated with money laundering and terrorist financing, and this undermined the effectiveness of the country’s AML and CTF arrangements.
The report said that while the People’s Bank of China has a solid understanding of how Chinese financial institutions could be abused by criminals and terrorists, it has little to no perception of the risks facing non-financial businesses and professions. The report suggested that China should focus more attention on the laundering of proceeds of crime and increase the range of sources used for its national risk assessment.
Also noted were legal shortcomings and effectiveness issues made it difficult to identity the persons who ultimately own or control a legal entity, creating an obstacle to addressing corruption.
The FATF report found that China is committed to pursuing and confiscating criminal proceeds through both criminal and administrative proceedings. Importantly, the report pointed out that China should review the functioning and operational independence of its financial intelligence unit and improve the use of financial intelligence to drive money-laundering investigations.
It recommended that China should extend preventive measures, including reporting of suspicious transactions, to designated non-financial businesses and professions, as well as lending to institutions, and suggested the introduction of requirements for identifying domestic politically exposed persons.
The report characterized China’s targeted financial sanctions related to both terrorist financing and proliferation financing as poor. It said China should strengthen its legal framework and the implementation of United Nations-mandated sanction regimes, and work with both financial and non-financial institutions to achieve implementation without delay.
The report identified several key weaknesses in China’s existing AML and counter-terrorist financing processes and structure. With respect to AML, it found that law enforcement agencies in China were not using financial intelligence to drive money-laundering investigations, despite the availability of intelligence and the competence of investigative bodies.
With respect to CTF, meanwhile, the report found that the implementation of financial sanctions is being hampered by three “fundamental deficiencies”. These relate to limitations in the scope of requirements, leaving some persons and entities uncovered by CTF provisions; restrictions on the types of assets and funds that can be frozen and transactions that can be prohibited; and the lack of urgent actions on non-domestic instances.
More broadly, the FATF report identified flaws in China’s overall approach that negatively impacted both its AML and CFT measures. It found that although China’s decentralized approach to producing financial intelligence can support the needs of regulatory authorities, not all relevant bodies are able to access this intelligence, leading to fragmented analysis and failure to form a holistic view of the situation.
The report found that while regulated financial institutions have a good understanding of their AML and CFT obligations, they were less aware of the risks. As a result, measures implemented to mitigate risk were often not commensurate with risk situations.
The report noted that the China’s AML/CFT supervisory system is almost exclusively focused on the financial sector, with no effective preventive or supervisory measures in respect of the DNFBP sector. In the financial sector, it found that the central bank’s understanding of institution-specific risk was largely based on the institution’s own risk assessment rather than that of the authorities. Finally, the report said that China’s complicated decision-making process for dealing with extradition requests often made it a protracted process.
Implications for practitioners in China
The report made several recommendations on China could strengthen the regulatory environment for both financial institutions and non-financial institutions.
Implications for Financial Institutions
While China’s current AML/CTF measures are focused almost exclusively on financial institutions, the FATF report found there was room for improvement. As a result, China’s regulatory authorities are expected to act in a number of areas. These include addressing the perceived shortcomings on criteria for reporting suspicious transactions, and improving banks’ centralized database storage and database management processes, which were found to be lagging, hindering identification of politically exposed persons and beneficial ownership of entities.
Implications for non-financial institutions
Based on the findings of the report, however, we’d expect for any reforms to hit the non-bank segment harder. They suggest that practitioners should familiarise themselves with accepted practices within the non-bank segment internationally so that they are prepared if and when China addresses issues outlined in the report.
Future actions in the non-bank sector in China may take a number of forms. For example, the report suggests that the People’s Bank of China introduce an effective system to assess risks faced by individual entities and should extend its supervision to include monitoring of DNFBPs. It also suggests that AML regulations should apply to online lending institutions, as well as to DNFBPs.
Meanwhile, China is expected to tighten - possibly within the next year or two - existing AML laws as they apply to DNFBPs. Specifically, for certain types of transactions, the People’s Bank of China may move to require the same AML measures from DNFBPs as are expected from banks. Of particular interest to regulators are transactions designated as high risk for money laundering or terrorist financing. These include real estate transactions; management of client money, securities or other assets; management of bank, savings or securities accounts; company formation and management; or buying and selling business entities.
In these circumstances, DNFBPs may become subject to the same statutory customer due diligence and record-keeping requirements as financial institutions. These could include identifying and verifying customer identification prior to on-boarding; continuous monitoring of business relationships; and maintaining records such as documents, data, account files, business correspondence and information obtained in connection with the transaction for a period of at least five years after the end of the business relationship.
The FATF report on China’s AML and counter-terrorist financing measures was largely positive on China’s embrace of the issues around these two areas of financial crime. But it identified several shortcomings that could have implications for financial institutions and non-bank players should the authorities decide to address them. But observers believe the Chinese authorities are keen to bring the country into line with internationally recognized standards, making it likely that they will move to address issues raised by FATF in the short or medium term.
A checklist for practitioners in China, based on internationally approved approaches to AML and client due diligence might include:
- Holistic risk-based approach that meets regulators’ expectations
- Integrated approach to financial crime that combines KYC/customer identification with AML measures and regulatory reporting
- Integrated customer identification program (CIP)
- Enhanced due diligence (EDD) processes
- Suspicious activity detection
- Case investigation support
- Integrated solution for regulatory reporting, operational risk and fraud detection, based on same source data and historical database
For practitioners involved in China, it’s therefore important to monitor regulatory developments closely. Moreover, it’s integral to watch global developments in AML / CTF specifically and financial crime regulation in general, as these measures are likely to be applied to the Chinese environment at some point soon.