Uldis Cērps, Chairman of the Financial and Capital Market Commission

Speech at the seminar Strengthening Financial Sector Cooperation between Latvia and the United States

Washington, March 2, 2006

Ladies and Gentlemen,

First, I would like to congratulate the organizers of this seminar – the Latvian Development Agency and the Latvian Association of Commercial Banks – with a successful seminar, which for the second time has brought together Latvian and American bankers and policymakers to discuss the issues of compliance. As you know, I am heading the Financial and Capital Market Commission (FCMC), an autonomous consolidated regulator of financial markets, which carries out the supervision of Latvian commercial banks, insurance undertakings and the stock market1.

In this short amount of time I would like to focus on a few key issues. First, I would like to tell how Latvia, as a country and its financial sector in particular, have been implementing measures to effectively address the risk of misuse of financial system. Then I will focus on the impact of these measures on the financial system development as well as on the general business environment. Finally, I would like to share some of the lessons learned that might be interesting in a broader context.

Latvian Banking Sector in Brief

The Latvian financial sector is a part of the common financial market of the European Union (EU). It is a rapidly developing sector of economy, contributing almost 5% of Latvia’s GDP – a figure broadly comparable to other countries of the European Union2. Commercial banks make up the largest share of the financial sector, accounting for over 90% of the financial sector total assets3. There are 22 banks and one foreign bank branch4 operating in Latvia. In the area of the financial markets, Latvia has introduced and implemented all the EU directives, which was a precondition for joining the European Union, thus completing the introduction of a modern, comprehensive and internationally recognized legal framework for financial markets. In the implementation of the Basel Core Principles in banking, Latvia was ranked by the European Bank for Reconstruction and Development (EBRD) among the top 4 countries in Central and Eastern Europe5. The financial sector has large growth opportunities taking into account that the saturation of the market has not yet reached EU levels6.

1 As a consolidated regulator, FCMC cooperates with its counterparties in the U.S. – the banking regulators (The Federal Reserve, The OCC), and the securities regulator – the U.S. SEC. 2 For more information, see the homepage of Eurostat at (http://epp.eurostat.cec.eu.int). 3 Total assets of the Latvian banking sector at the end of 2005 were over $20 billion. 4 There are only 6 other EU countries where there are fewer banks per capita than in Latvia. Source: “Supervisory Arrangements: the Next Five Years”, p. 10. European Commission, Internal Market and Services DG, 28 October 2005. 5 “The Quality of Banking Legislation in Transition Countries”, Law in Transition Online, October 2005, http://www.ebrd.com/pubs/legal/OL05b.pdf, p. 5.

1 What Latvia has done to Strengthen its Financial Sector

Before telling what exactly has been done in Latvia in order to strengthen its financial sector and its resilience to the risks of misuse, I would like to briefly summarize the main challenges, which Latvia was facing.

The first challenge was the lacking capacity of the law enforcement. According to the IMF calculations, the global volume of money laundering annually is about 5% of GDP7. One can assume that roughly the same figure applies to each separate country, and that such scale of the problem would warrant serious attention from the law enforcement. However, in Latvia the capacity of law enforcement to fight financial crimes has lagged behind rapidly and healthy expanding financial sector. Up to the beginning of the year 2005 there had only been one conviction for money laundering8. The fact that the situation in other EU member states was not remarkably different is not an argument for the “race to the bottom”, but rather a cause for concern9.

The other challenge was geopolitics. Latvia’s eastern neighbors were both a blessing and a curse. Latvia’s banking system since its inception has been characterized by the fact that its services were actively used by the clients from the Commonwealth of Independent States – CIS (former Soviet Union). The primarily factor attracting customers from this region is a geographical proximity to Latvia (Moscow is only 600 miles from Riga) and the access to ice-free ports with oil transit infrastructure. Over the years, Latvia has developed a sophisticated infrastructure of ports and logistics to transit raw materials from the FSU countries to the West and for transit of goods the other way10. Russia’s role as Latvia’s direct trading partner diminished over the years11, but Latvia still retains an important role in transit of goods from Russia and other countries of the CIS to the West. Combining these objective circumstances with the situation in Russia itself12, it is not surprising that customers from the CIS have been attracted by the stable banking system, where the bankers are able to understand 6 Proportion of banking assets to GDP in Latvia was 74% at the end of 2005, while in EU it was 114% (data at the end of 2004), "EU Banking Structures", European Central Bank, http://www.ecb.int/pub.

7 Testimony of Treasury’s Stuart Eizenstat before the U.S. House Banking and Financial Services Committee on March 9, 2000. www.state.gov. 8 However, the number of convictions in Latvia cannot be the only criteria used to assess the effectiveness of criminal justice system. Latvian authorities were active in international cooperation, since the predicate crimes were often committed in foreign jurisdictions, and therefore the effectiveness of the fight against financial crime crucially depended on cooperation and information sharing with foreign law enforcement agencies. Thus, in 2005, the Public Prosecutor’s Office processed 449 requests for assistance, most of them regarding the predicate crime. 9 For instance, in respect of terrorism financing, in the period between 2002 and 2004, in only 2 countries out of the 13 participating in the EC Internal Market and Services DG survey there were cases of terrorist financing reaching court. “Effectiveness of the anti-money laundering and anti- terrorist financing defences. Summary of the replies to the February 2005 questionnaire.” Money Laundering Contact Committee. Brussels, 2005. 10 Of total rail transit (56 million tons), 49 million tons accounted for international freights. A major share of freights has been delivered through the Latvian ports. Main types of freights via ports were oil and oil products (40%), dry chemicals (11%), timber (12%). Latvian Statistical Yearbook (2005). Latvian Central Statistical Bureau. 11 Russia still is the third largest foreign trade partner for Latvia after Germany and Lithuania, with export volumes to Russia accounting for $234 million (138 million lats), and import from Russia – $563 million (332 million lats) at the end of 2004. Latvian Statistical Yearbook (2005). Latvian Central Statistical Bureau.

2 mentality of customers, to speak the same language and provide modern services. Very often, the customers from Russia and other countries of the CIS associate Latvia not only with sentimental feelings remembering their vacations at the Baltic Sea resorts in the past Soviet times but rather with their present ownership interests and business partners.

However, the servicing of customers from Russia and the other CIS countries, where Latvia has a strategic advantage, also carries with itself not only profit opportunities but also significant risks. It is a well-known fact that these countries are characterized by a much higher level of financial crime13, corruption14, and tax evasion15 than Western Europe or North America. Some sources reckon that a significant percentage of the Russian banking system and private business are still in the hands of organized crime16. In fact, one has to realize that financial crime in the CIS countries is not something that was committed by seasoned criminals only. According to Russian sources, up to 50% of population in Russia receives the so called “envelope salaries” with no taxes being paid or earn their living in the shadow economy17. The volumes are also shocking. In Russia, which has a GDP equivalent that of Holland18, the estimated annual volume of proceeds from corruptions is as high as $40 billion19; the size of the shadow economy is estimated in an interval between 23 percent and 50 percent of GDP, that is up to $350 billion20. The growth in cyber crime over the years has actually outpaced the growth of computerization21 in Russia. The situation is similar in many other CIS countries. This simply means that there is a big risk in providing services to the customers from this region, and even when the highest standards of banking and know-your-customer rules are followed, some of the customers may later turn out to have been criminals22. In this respect, two 12 Russia has fallen to “not free” status, according to Freedom House, a U.S.-based human rights group. “Russia’s step backward into the ’Not Free’ category is the culmination of a growing trend under President Vladimir Putin to concentrate political authority, harass and intimidate the media, and politicize the country’s law-enforcement system,” Freedom House Executive Director Jennifer Windsor said in a statement. Moscow Times, December 21, 2004. 13 In March 2000, US Secretary of the Treasury Department, Lawrence Summers, announced that the total of illegal capital flight from Russia exceeded $100 billion. www. bps.org. (PBS, headquartered in Alexandria, Virginia, is a public non–profit media enterprise owned and operated by the nation's 348 public television stations). 14 Presenting in Moscow the results of a two-year study of corruption, the director of the INDEM think tank, Georgii Satarov, said that Russians pay about $37 billion each year in bribes and unofficial fees, a sum that is roughly equivalent to 12 percent of the country's gross domestic product, Russian news agencies reported on 22 May. June 4, 2002. Radio Free Europe/Radio Liberty. 15 Yakovlev, Andrei (2000) “Black cash tax evasion in Russia: Its forms, incentives and consequences at firm level”, Bank of Finland Institute for Economies in Transition, BOFIT. 16 United Nations Office for Drug Control and Crime Prevention (2000) “Russian Capitalism and Money Laundering”. United Nations, New York. 17 Polishchuk, Igor (2004) "Krizis srednego vozrasta", in Russian (The Middle Age Crisis), Vremya Novostei, May 26. Accessed at www.vremya.ru on July 2, 2004. 18 Russian GDP in 2005 (projected): $741 billion, Dutch GDP in 2005 (projected): $601 billion. The World Factbook. U.S. Central Intelligence Agency, www.cia.gov/cia/publications/factbook. 19 June 4, 2002. Radio Free Europe/Radio Liberty, www.rferl.org. 20 Kommersant, November 11, 2002, interview with Mr. Christof Ruehl, chief economist for the World Bank in Moscow. 21 According to the Information center of the Ministry of Internal Affairs of the Russian Federation, 13723 computer crimes were committed in Russia in 2004. It makes a twofold increase over the previous number of 7052 cyber crimes in 2003. Computer Crime Research Center, July 1, 2005. 22 It has been well summarized by the former head of the US Central Intelligence Agency, R. James Woolsey, “If you should chance to strike up a conversation with an articulate English-speaking Russian in, say, the restaurant of one of the luxury hotels along Lake Geneva, and he is wearing a $3,000 suit

3 fundamental questions remain. The first is what can the banks do to enhance the management of risks that I have just described. But the broader question is about Russia and other countries of the CIS, as to how do they plan to strengthen their governance, tax collection and convince their own citizens that the rules of the game are fair and they can trust the state. The second question, however, is not a focus of my presentation. In this regard, I would just like to stress that Latvia is ready to be an active partner of the West in stimulating these democratic reforms, as our President, Dr. Vaira Vīķe-Freiberga23, noted. We, as the banking supervisory authority, are ready to share our experience in how our banks apply risk-based policies and procedures with respect to high-risk customers from the CIS countries.

Latvia is a Good Example for how Best International Standards are Introduced in a Very Short Time

Being aware that servicing of the customers from the CIS countries is bearing significant risks, the Latvian Parliament passed a comprehensive legislative package in June 2005, which was fully endorsed by the financial industry.

One has to remind that also before June of 2005 Latvia’s laws were in all substantial respects corresponding to the European Union requirements. But with the amendments to the Latvian legislation made in June, Latvia was possibly the first EU member state that had transposed the best international practice in its laws, based on the FATF 40 Recommendations that were adopted in Paris in June 200424. In the course of transposition of these requirements, the Latvian authorities actively consulted with their partners in the United States, and are very thankful for their feedback and constructive dialogue.

The main initiatives included the following 8 measures:

and Gucci loafers and he tells you he is an executive of a Russian trading company and he wants to talk to you about a joint venture, he may be what he says he is. He may be a Russian intelligence officer under commercial cover. He may be part of a Russian organized crime group. But the really interesting possibility is that he may be all three, and that none of those three institutions have any problem with that arrangement.” Testimonies to the US Congress, http://commdocs.house.gov/committees/bank/hba59889.000/hba59889_0f.htm. 23 In her address to the forum The Dynamics of Globalized Financial Markets: Opportunities, risks and challenges for financial centers, of the Liechtenstein Dialog, October 17, 2005, H.E. Dr. Vaira Vīķe- Freiberga, President of Latvia, pointed out that: “Latvia has been encountering situations when countries with lax state administration, nontransparent tax systems and poor tax administration, under the pretence of attempts to carry out a fight against money laundering, are willing to obtain an unlimited access to the Latvian and also other foreign banking systems, in order to better perform control activities of their citizens. In order to achieve these goals, more and more new taxes have been introduced in these countries, such as currency controls, in the hope that the use of administrative measures would help retain capital in their countries. Global experience shows that such administrative measures may have the exactly opposite effect – instead of preventing the outflow of private capital to foreign countries, they hamper investments and hinder economic growth. Frankly speaking, quite different measures and instruments would be necessary for enhancing tax collection. Latvia’s opinion is that the best way to keep capital in a country and boost its inflow into a national economy, is openness of the state, low taxes, fair state administration and open labor market. Latvia has shared its experience with its closer and more remote neighbors and is ready to do this also in the future”. 24 Identical requirements have to be transposed by the other EU member states by the 15th of December 2007, along with the package of the 3rd Money Laundering Directive.

4  the law envisaged easier access for the law enforcement agencies to customer information in banks, in particular in cases where no criminal investigation had been initiated . The legislation prescribes that in such cases the law enforcement agencies are able to obtain bank records with a prior approval by a judge. At the moment, this option is being actively used. The possibility to obtain bank records before initiating a criminal investigation also effectively contributes to cross-boarder information sharing with foreign law enforcement agencies;  another amendment included the ban on maintaining correspondent relationship with shell banks and shell-bank-like entities;  it was also envisaged that in all cases the banks must take proportionate, necessary and adequate steps to identify beneficial owners;  it was also envisaged that the banks had the right to demand from customers and customers had an obligation to provide the banks with information on the source of funds;  Latvia also criminalized submitting of false information to banks about the beneficial owner;  the law also envisaged a possibility for banks to share information with each other about suspicious customers and this possibility is being actively used;  the law provided that the banks may share information with foreign corresponding banks about their customers;  it was also provided that from July 2006 Latvia would introduce cash declaration on external EU borders.

But we all know that making good laws and their implementation are two different things. That is why I would like to stress that simultaneously with the changes in legislation, the government has strengthened the capacity of law enforcement agencies and especially prioritized the fight against financial crime and money laundering. In 2005, the government established the Money Laundering Prevention Council, chaired by the Prime Minister, in order to coordinate anti-money laundering efforts at the highest level of government. These combined efforts have produced concrete results. At the moment, there are over 70 active investigations where money laundering is one of the underlying crimes25.

Many of you will certainly ask: What has been the reaction of the banking sector to these changes, and whether these changes were perceived positively. In this regard I want to remind that last year all the banks signed the declaration on aggressive fight against money laundering, as well as committed to be active partners of the government. The banks have also introduced uniform standards in such areas as the daily limits on cash withdrawal from ATM, which are usually not regulated by the law. Last year banks have also agreed on uniform rules to identify politically exposed persons and other measures designed to implement the know-your-customer rules. The effectiveness of the efforts on behalf of the banks could be seen by examining the number of cases where the banking supervisory agency – FCMC - has detected that a bank has not reported a suspicious transaction26. These numbers have gone down

25 Report of the Prosecutor General’s Office to the Latvian Money Laundering Prevention Council (2006). 26 In 2005, FCMC reported to the Control Service only 23 suspicious undeclared transactions, which were detected during on-site inspections in banks, while in 2004 the number of such transactions was 103.

5 significantly. I would like to express my personal conviction that also in the future the banks will be as active partners of the government as they are now.

Latvia does not regret introducing one of the strictest money laundering regimes in Europe. I would like to stress that this has only strengthened the reputation of the financial sector. One additional aspect, which is not unimportant, is that these measures have also had an effect on Latvian economy and in particular by increasing tax revenues27.

Concerns that Fight against Financial Crime Might Result in Significant Business Volume Reduction have not Materialized

One of the widely circulated myths is that enhanced (or “exaggerated”, as it is sometimes claimed) measures of customer due diligence would frighten off customers and would in leave a negative, irreversible impact on the financial sector itself28. In other words, if banks would like to know too much about their customers, they might lose mainly those customers who have nothing to hide but who have no explicit desire to answer many questions posed by the banks. Latvia is a good example that this is not so. Last year, while introducing one of the strictest money laundering regulations and know-your-customer rules, the impact on the banks’ profitability was negligible. However, we have observed that the reliance of the banking sector on non-resident deposits has decreased, and it has been compensated by the increase of domestic business volume.

Management of Reputational Risk is Key

If one looks back in the history, the key risk of banks has always been a credit risk, followed by such risks as operational risk and market risk. Reputation risk has only recently become one of the key risks in the banking industry. Today banks worldwide should pay particular attention to the reputation risk. I will give just one example. The fact that a banking supervisory institution has concluded that the internal control system of bank is inadequate to manage the risks the bank is assuming can lead to the loss of customers, corresponding banking relationships, and possibly inadvertently affect the business of the bank.

What has been Done by the Banks

In the past two years, banks have been performing an extensive retroactive due diligence efforts on their existing customer base, while the requirements for entering into new customer relationships have been based on the best international practice29. I have already mentioned that as a result of this examination, the number of foreign

27 According to the State Revenue Service (SRS) statistics, in 2005, tax and non-tax (duties, payments, fines, etc) revenues administrated by the SRS accounted for $4.51 billion (2.66 billion lats) which is by 25.9% up from 2004; and it was the largest increase over the past seven years (www.vid.gov.lv). 28 Internet users still encounter websites where confidentiality of customer information has been pointed out as one of key competitive advantages. See, for instance, www.swiss-private-banking.com, www.offshore-trust.li, www.account.lu, and others. 29 FATF 40+9 Recommendations (www.fatf-gafi.org); Customer Due Diligence for Banks, Bank for International Settlements (www.bis.org), Wolfsberg Group Recommendations (www.wolfsberg- principles.com) and others.

6 customers dropped by 37% in the course of 2005. Also the proportion of non-resident deposits decreased, having shrunk from 54% to 47% of the overall deposit base.

In relation to knowing the beneficiary owner of customer, the banks in Latvia also require a verification document on the beneficial owner, signed by the customer or the authorized person. Speaking about knowing the business of customers, the banks get first information from a detailed customer inquiry form, and in the course of customer relationship check whether the transactions in the account are in line with the information contained in the inquiry form and correspond to the normal pattern of business activity. In case any suspicious transactions are detected which do not correspond to the normal pattern of clients’ business, banks may request more information from the customers, and, if not satisfied with the answers, are obliged to file a suspicious activity report. In detecting suspicious transactions the banks are guided by the best international practice, the typologies regularly updated by the FIU and the FCMC, as well as by the respective Cabinet of Ministers regulations30. Discussions on further streamlining of the reporting process in Latvia are under way. For instance, during the course of 2005 the banks sent to the Latvian FIU 29 thousand suspicious activity reports (SARs), but only 2.5 thousand were used in 66 initiated investigations31. The proportion between the filed and the used SARs of 12 to 1 is an indication that there is still a room for improvement of the reporting system.

During 2005, those banks that predominantly service customers from Russia and the countries of the CIS countries have obtained an independent testing of their overall AML policies, performed by the “big four” auditing firms32. This was done to verify banks’ compliance with the applicable legislation and best practice, as well as provide their cooperation partners with a comprehensive picture of the banks’ AML/KYC systems. Banks have also ensured that their human resources are adequate for the volume of due diligence work that needs to be done so they can adequately know their customers. The banks have also developed tailor-made IT solutions for the AML, or procured off-the-shelf IT products.

The Steps Taken by the Banking Supervisory Authority FCMC

In the past three years, FCMC has paid a particular attention for the adequacy of internal controls in the area of AML. During 2004, there were 35 on-site audits in banks; there were 21 on-site audits in 2005. As a result of those efforts, we have observed a steady and substantial improvements in internal control systems. The policies and procedures of all banks are now corresponding to the best international practice.

We can see that the banks have become effective partner to the government in detecting and preventing financial crime. This is signified by the number of cases where the banks have frozen funds of their customers on the allegations of suspicious activity, as well as by the efficient collaboration between the banks and different law enforcement agencies.

30 They are similar to cash reporting requirements in the U.S.. 31 About a half of all reports is on the so-called cash transactions, which correspond to quantitative criteria specified in the Council of Ministers regulations. 32 Deloitte, KPMG, PriceWaterhouseCoopers and Ernst&Young.

7 At the same time, FCMC has encountered situations where internal control systems of banks have been inadequate. In those instances the FCMC has applied sanctions such as administrative penalties as well as other sanctions such as mandating a bank to change management or setting restrictions on providing certain banking services33. In the retrospect one can see that our sanctions have been effective, since the follow-up audits have determined that the detected deficiencies had been addressed and rectified.

Problem Areas Presenting Challenges to both the Banks and the Supervisors

First, it is a question about knowing the beneficial owner and the source of funds of existing customers. The banks in Latvia have customers - legal persons - where the beneficial owner is from Russia and the other CIS countries. Such companies are usually registered in jurisdictions, which, as opposed to Latvia, do not require disclosure of their shareholders at the moment of registration, and information on shareholders is not publicly accessible from registers in these countries34. Many jurisdictions do not require companies to submit annual reports. That is significantly hampering the capacity of financial institutions to fulfill their AML duties.

What is also important - is that the absence of transparency in those jurisdictions cannot be explained by the lack of administrative capacity or funds because many of these jurisdictions are among of the richest OECD member states. As a result, the banks have to rely solely on the information provided by the customers, or use indirect methods to form an opinion whether their customer can reasonably be assumed as a beneficiary or not. The problem is well recognized in the U.S. Money Laundering Threat Assessment35 and it is also discussed in such forums as OECD36. I think it is very important that the need to enhance corporate transparency and even perhaps to have common global standards in this area shall continue to be on the agenda of the policymakers.

In discussions with banks, the exact extent to which banks should know the business of their customers is often discussed. It is especially important for the companies that are registered in low tax jurisdictions, and which operate outside them, (so-called “shell companies”). Often they are part of a broader holding company structure, having a head office in Russia or in another CIS country. Shell companies have an image that their only aim is to cover up crime. However, the misuse of shell companies in no way means that all of the shell companies are being used for illicit purposes. One can see that shell companies are part of the structure of many public listed companies in the United States37. One theme of discussions with banks is to

33 An overview of sanctions applied by the FCMC is available on its website at www.fktk.lv. 34 These risks were also widely discussed in the United States: “Legal jurisdictions, whether states within the United States or entities elsewhere, that offer strict secrecy laws, lax regulatory and supervisory regimes, and corporate registries that safeguard anonymity are obvious targets for money launderers. A handful of US states offer company registrations with cloaking features – such as minimal information requirements and limited oversight – that rival those offered by offshore financial centers. Delaware, Nevada and Wyoming are often cited as the most accommodating jurisdictions in the United States for the organization of these legal entities”. U.S. Money Laundering Threat Assessment, December 2005. 35 Shell Companies and Trusts. U.S. Money Laundering Threat Assessment, Chapter 8. December 2005. 36 See OECD (2001) “Behind the Corporate Veil. Using Corporate Entities for Illicit Purposes”. OECD Publications Service, Paris. 37 Komisar, Lucy (2005), Offshore Alert, May 31, 2005.

8 understand what particular functions these companies serve in a holding company structure. In this regard it is important that the banks and also the business partners of banks take time to understand the reasons why many Russian companies use these shell company structures, how they use them, and what is the underlying business. In other words, it is important that the approach is nuanced and analytical, instead of ignorant or based on perceptions, e.g. that all Delaware-registered companies with accounts in Latvia are considered suspicious. I am speaking about it, because we have come across cases where some corresponding banks, which were not eager to go in- depth into the issue, have assumed that all the shell companies that function outside the countries of registration of those companies, are suspicious. I think that banks here still have much work to do for a dialogue with their cooperation partners on this issue.

What Remains to be Done

One final note, I would like to focus on one key issue. We have seen that those foreign customers who did not want to fulfill increasing transparency requirements of Latvian banks have found possibilities to use banking services in other countries without any difficulty. We know this because when a customer ceases the relationship with the bank at the bank’s own initiative, the bank cannot return the balance in cash, but it must transfer the money to the customer’s account in another EU member state38. It is a sign that there are still many places around the world that welcome customers which have been rejected in other jurisdictions. More work needs to be done. Therefore I would like to assure in full confidence that Latvia will continue to be an active partner of the United States in fighting all types of misuse of our financial systems. Thank you!

38 In accordance with Section 19.2 of the Law on the Prevention of Laundering of Proceeds Derived from Criminal Activity, “If a financial or credit institution terminates business relationships with its client the accounts of the client concerned at the respective financial or credit institution shall be closed and the monetary resources or financial instruments held there shall be transferred upon the request of the client only to the account of the same client at another financial or credit institution from which the monetary resources or financial instruments have been received or which has been registered and provides financial services, including the receiving of deposits, in the country of registration which appears to be another country of the European Economic Area.”

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