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The History of Financial Crime: Know your Customer (KYC)

Financial fraud concept, using KYC in instigating financial crime activities.

A lesson in financial crime and the compliance laws designed for modern financial institutions sounds like a slow day in history class. However, you may be surprised to know that the origins of customer identification legislation began with a variety of dangerous crimes like mob activity, drug trafficking, and even terrorism. International KYC policies are an important part of eliminating these activities and avoiding the impact they have on financial institutions and the individuals who use them.

KYC, or know your customer, is a term used to describe the process used by banks, insurers, and other financial institutions to ensure a customer’s identity is accurate and avoid misuse of banks and government institutions. The goal of KYC is to assess the level of risk a person poses to the financial institution serving them. Typically, KYC processes occur when a customer opens an account (onboarding) and periodically during the working relationship for risk management. While specific legislature varies from one country to another, KYC policies typically include these elements:

  • Customer acceptance policy
  • Customer identification procedures
  • Monitoring of transactions (especially those over $10,000)
  • Risk Management

A History Rich in Crime Leads to KYC

Whether it’s fed by the desire for wealth and riches or a need to keep rightfully earned income for survival, criminal actions involving dishonest or criminal financial activities have been documented throughout history. In fact, financial crimes were reportedly occurring in Asia over 4,000 years ago. Still, international legislation to prevent these crimes wasn’t enacted until 2001.

Early Tax Evasion in China

It comes as little surprise that the earliest documentation of financial crimes involves tax evasion. As early as 2000 B.C.E., Chinese merchants hid their wealth from the state to avoid taxation. Often, wealth was hidden from rulers by moving funds to remote places, and even out of China. While you might not exactly call these actions offshore banking, it sounds pretty similar.

Legal Cartels in Germany

Industrial growth in Germany in the late 1800s led to an explosion of cartels. Since these organizations seemingly boosted economic growth after the depression in the 1800s, they were considered useful features of the political economy. Disagreements between cartels ended up in court, shaping the legislature of business. In the famous Saxon Wood Pulp decision of 1897, cartels were deemed not only to be legal but to be beneficial. The legal rule was established that cartel agreements were valid and enforceable, although a cartel to establish an actual monopoly or exploit consumers might be struck down.

The Use of Casinos as Business Fronts Rise in the US

In the 1940s, U.S. gangsters discovered the necessity of business fronts to avoid suspicion and tax issues related to extravagant amounts of income from criminal activities. Infamous gangsters Bugsy Siegel and Meyer Lansky turned to casinos as a front for organized crime activity. Lansky developed a worldwide gambling empire and was known as one of the most successful gangsters in history with a suspected net worth of $20 million. However, he was never convicted of any crimes and upon his death in 1983, his estate was only reported to be worth $57,000. It was suspected that Lansky bribed and blackmailed politicians in the U.S. and Cuba to maintain his criminal lifestyle.

Protected by financial secrecy provided by the 1934 Swiss Banking Act, the profits from these businesses were funneled into Swiss bank accounts to avoid tax evasion penalties. With this offshore banking activity, U.S. financial crimes and money laundering became an international affair. It was suspected that Lansky left behind an estimated $300 million in secret bank accounts, though the money was never found.

1950 Federal Deposit Insurance Act

In response to the far-reaching effects of the Great Depression and to reassure the American public of the safety of banks, the Federal Deposit Insurance Act was passed by U.S. congress. While this piece of legislature wasn’t related to the increase in financial and organized crime, it included regulations for banks that formed a foundation for future KYC laws.  

The Bank Secrecy Act is Enacted in 1970 

As organized crime and drug trafficking continued to grow out of control, the U.S. government sought new means to eliminate the profit of these crimes. Designed to prevent money laundering and the use of a criminal activity to fund terrorist acts, the 1970 Bank Secrecy Act (The Currency and Foreign Transactions Reporting Act) was enacted. The legislation imposed restrictions on all financial institutions in the U.S., including foreign banks with U.S. branches.

KYC Financial law concept, showing a gavel, calculator, and several American banknotes.

A Teenage Con Artist

Born in New York to a French mother and Italian-American father, Frank Abagnale Jr. may be one of the most well-known criminals to highlight the necessity of KYC laws. Beginning in 1963, at age 15, Abagnale used a variety of fake identities to open bank accounts, forge checks, and pose as an airline pilot and a physician. 

Abagnale was first arrested in France in 1969, where he served 6 months. He also spent time in a Swedish prison. After escaping police custody twice, he eventually served less than five years for his crimes. Though his criminal career lasted less than a decade, it was the inspiration for the 2002 movie “Catch Me If You Can.” A reformed Abagnale eventually served as an FBI consultant and opened a financial fraud company.

The Internet Provides New Technology for Criminals

As the World Wide Web established convenient connections between countries, international crime became more established. Large international banks became hotbeds for money laundering. The U.S. Treasury responded with the formation of The Financial Crimes Enforcement Network (FinCEN) on April 25, 1990, to combat domestic and international money laundering, terrorist financing, and other financial crimes.

The first EU Directive is established in 1991, which would eventually become the framework for anti-money laws in European nations. It recognized the importance of an international response to money laundering and targeted the responsibilities of banks. The act introduced the importance of Customer Due Diligence (CDD) and Know Your Customer (KYC) procedures.

9/11 Attacks Spur the US Patriot Act and Revisions of EU Regulations

Preparations for the terrorist attacks on 9/11/2001 cost between $400,000 and $500,000, much of which was spent in the U.S. Government officials discovered the potential for the use of banking data as a tool to track mobile terrorist suspects. As combatting terrorism became emergent, international and European representatives announced the priority of targeting the financing of terrorism.

The Patriot Act was enacted in the U.S. on October 23, 2001, followed by the 2nd EU Directive (2AMLD) in December 2001. These acts listed specific Customer Identification and Customer Due Diligence procedures for the KYC requirements for all financial institutions. The 3rd EU Directive (3AMLD) was enacted as a direct response to terrorism.

Tax Evasion Scandal Leads to 2009 Amendment to Swiss Banking Law

In 2007 Bradley Birkenfeld, a banker who had been employed at Swiss multinational bank UBS, broke bank secrecy laws by divulging the names and crimes of Americans using the bank to evade taxes. Birkenfeld served time and was eventually awarded $104,000 for his whistleblower status. The resulting tax evasion charges against UBS led to the amendment of the 1934 Swiss Banking Act (financial secrecy).

Mortgage Fraud in the UK

Using a variety of aliases, British fraudster Maria Michaela conned banks out of an estimated £13 million during 2007 and 2008. With the use of fake documents, a dozen identities, and a partnership with a land surveyor. Claiming she was an heiress to the luxury Sun City resort in South Africa worth £250million, Michaela obtained multiple mortgage loans which she later defaulted on. Assistance from her partner meant Michaela was able to obtain loans for far more than the homes were worth and sell them at a profit. She repeated the scam multiple times before her arrest in 2012, making her the UK’s most prolific female fraudster.

Tax Evasion and Data Corruption Lead to Amendments

4AMLD was agreed to by the EU in 2015, with an implementation deadline of June 2017. The directive widened obligations and targeted institutions that had been overlooked in previous directives, including all gambling based firms.

April 3rd, 2016 marked the biggest data breach in history, revealing the tax evasion activities of rich politicians, national leaders, and celebrities. Called the Panama Papers because of the location of the firm, the documents implicated powerful individuals in many countries.

During the same year, a new FinCEN rule is issued requiring banks to get additional information from individuals who own 25% or more interest in a legal equity. 

Terrorism and 5AMLD

In response to a series of terror attacks (Bataclan and Charlie Hebdo attacks in Paris in 2015, through to the London Bridge attack in June 2017) 5AMLD was drafted before 4AMLD had a chance to be implemented. The directive targeted to reduce financial options used to fund the attacks.

Managing KYC Today

Throughout history, various financial criminals have been romanticized and their crimes downplayed. Political figures and banks have even gained profits and power due to these crimes. As more information comes to light about financial crime and the activities these crimes so often fund, laws are being enacted and enforced to eliminate the rewards of harboring such criminals. Often referred to as non-violent crimes, financial crimes lead to victims of drug abuse, violent crime, terrorism, and human trafficking. As these truths come to light, financial institutions are now held responsible for the accurate identification of the customers they serve.

As criminals use technology to commit more advanced crimes, the legislature will be broadened and amended to include these new techniques. Financial institutions will be required to follow the regulations or face steep fines and criminal charges. To learn more about protecting your financial institution from criminal activity and staying up to date with changing KYC regulations without taking up a new career learning legislation, see a demonstration of the ForensicCloud KYC software provided by BusinessForensics BV. To learn more about the history of financial crime, stay tuned for the history of money laundering, our next part of the historical financial crime series.


Team BusinessForensics

The team at BusinessForensics consists of hard-working financial crime fighting professionals. Based in The Hague, The Netherlands, BusinessForensics is on a mission to help banks and insurance companies combat and prevent financial crime.