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4 October 2017

Can Chinese banks identify North Korean sanctions evaders?

Aaron Arnold

Aaron Arnold

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Last week, President Trump signed a new executive order that paves the way to impose sanctions against any foreign bank that conducts business with North Korea, going well beyond current UN financial sanctions. These so-called secondary sanctions, which are penalties applied to third-party foreign banks (i.e., not directly against North Korean entities), are particularly focused on Chinese banks.

The reasoning is straightforward: Several recent reports show that China provides a lifeline for North Korea’s economy, and the recent midterm report of the UN Panel of Experts, for example, has concluded that North Korea continues to violate financial sanctions by exploiting what are known as correspondent banking services. (Correspondent banking can be thought of as a network of banks that provide financial services, such as transaction settlements, to other banks. In this way, local or regional banks can send and receive transactions around the world without the need for a direct relationship with all other banks. And as it happens, the United States controls some of the largest correspondent banking networks in the world.)

For China, the message is clear: Chinese banks must cut ties from North Korea or face expulsion from the US financial system. But will the threat of secondary sanctions compel Chinese banks to implement UN sanctions on North Korea? To be sure, shortly before President Trump announced the new executive order, reports surfaced that China’s central bank issued requests to its financial institutions to stop providing services to North Korean customers and “strictly implement” UN sanctions. The problem, however, is that the threat of secondary sanctions in the new executive order goes well beyond requirements in the UN targeted financial sanctions. While UN financial sanctions generally focus on denying banking to specific designated entities, Trump’s executive order prohibits all transactions with North Korea.

Largely missing from the narrative about imposing secondary sanctions, especially against large financial institutions, is that the effect is not a one-way street. In other words, secondary sanctions against any one of the big four Chinese banks will have repercussions for US business and economic interests. As of March 2017, US banks hold more than $24.8 billion in claims on Chinese banks. These are American dollars at risk if secondary sanctions are applied. In addition to these US direct claims, Chinese banks hold more than $142 billion in US assets.

Consequently, if the Trump administration proceeds with imposing secondary sanctions against Chinese banks, the results could be disastrous for both American and Chinese economic interests. With so much at stake, it is time to ask: Is it actually feasible for Chinese (and other foreign banks) to fully disconnect North Korean-linked accounts from the global financial system? How can the Trump Administration hit just the bank it wants, and not risk greater damage to the entire financial system?

First, what is the nature of secondary sanctions? At its core, secondary sanctions use the strength of the US financial system as leverage to further its national security objectives. Whereas country-based sanctions and targeted sanctions focus on specific entities, people, or even sectors of North Korea’s economy, secondary sanctions put third-party actors that conduct transactions with North Korea in the crosshairs.

For example, in 2012 the US sanctioned the Chinese-owned Bank of Kunlun under the Comprehensive Iran Sanctions and Divestment Act for its role in facilitating transactions for Iranian banks. As part of the penalties, US banks were prohibited from opening or maintaining correspondent accounts for the Bank of Kunlun—effectively blocking the Bank of Kunlun access to the entire US financial system. This goes far beyond the typical penalties and fines that the United States has subjected foreign banks to for sanctions violations; in the past, the United States has subjected third-party banks to criminal and civil penalties for violating sanctions. BNP Paribas, for example, had to pay fines of $8.9 billion for its role in violating sanctions against Sudan, Cuba, and Iran under the Trading with the Enemy Act—but got to continue doing business with US banks. While a $8.9 billion fine is of historic proportions, being cut from the US financial system risks a lot a more.

More recently, the US Treasury Department proposed special measures under a provision of the PATRIOT Act to prohibit China-based Bank of Dandong from accessing US financial institutions. According to a Treasury press release, the Bank of Dandong acted essentially as a gateway for sanctioned North Korean banks to access global and US banking channels.

Although each of the above cases made use of a different Congressional act, each bank was essentially prohibited from accessing the US financial system for its dealings with Iran, Sudan, Cuba, and North Korea, respectively.

How far does the new executive order go? In addition to expanding the scope of sanctions against North Korea to include specific sections of its economy such as construction, energy, financial services, fishing, information technology, mining, and textile industries, among others, the executive order also took aim at any foreign bank that “knowingly conducted or facilitated any significant transaction in connection with trade with North Korea.” Although the order does not define what a “significant transaction” entails, Treasury regulations have, in the past, used a set of seven criteria, including: the size and frequency of transactions, the nature of the transactions, how much the bank and its operators knew about the transactions, the nexus between the transaction and designated entities, the impact of the transaction on statutory or policy objectives, whether the transactions involved deceptive practices, and “other factors.” Clearly, these measures leave quite a bit of room for interpretation, and uncertainty is never a good thing in financial markets.

Evading sanctions is easy; identifying sanctions-evaders is tough. Sanctions compliance and due diligence—the procedures that banks employ to detect illegal transactions—is a costly and time-consuming process. While these steps are necessary to protect the integrity of the global financial system, the costs of complying with financial regulations such as sanctions have reached over $60 million per year for the average bank, estimates The Economist. At least partly driving these costs is the need for experts with deep knowledge of sanctions programs. Also driving up costs is the relative confusion and uncertainty in detecting sanctions violations.

So when it comes to detecting sanctions violations, most financial institutions rely heavily on what essentially amounts to simply cross-checking lists of sanctioned persons and companies, according to one recent report by the Royal United Services Institute.

A second approach, more thorough, and complete method is identifying activity that may be associated with sanctions violations. This latter method, of course, is more difficult, resource-intensive, and far less obvious than conducting name checks.

And evading banking regulations is, unfortunately, easier than one would expect.

Movies and books may give the impression that the world of illicit finance requires special knowledge and know-how, three-piece suits, and exotic cars. But while an understanding of international banking is helpful, anyone with an Internet connection can form a shell company, as a recent CNN podcast explained. For that matter, YouTube explainers now provide guidance on concealing assets and avoiding customer due diligence. In fact, many companies that are devoted to the formation of corporations advertise their services using thinly-veiled language to refer to sanctions evasion, such as “pre-2006 registered shelf companies”—a reference to UN Security Council Resolution 1718, which was the first resolution to impose sanctions against North Korea.

Not surprisingly, North Korea has developed expertise in understanding sanctions-evasion techniques, as well as locating the gaps in banking compliance and due diligence—items which it has continuously used to its advantage. In one recent case, the US Department of Justice alleges that China-based importer/exporter Dandong Hongxiang Industrial Development Company conspired to evade targeted sanctions against a North Korean bank known as KKBC (Korea Kwangsong Banking Corporation). During its ten-year business relationship with KKBC, Dandong Hongxiang established more than 22 front companies, registered in jurisdictions such as Hong Kong, Seychelles, and the British Virgin Islands, where banking secrecy is paramount. Not only did Dandong Hongxiang use code words, like “spices,” to refer to North Korean goods, but it was even warned by Panamanian company registration officials to not use North Korean shareholders on official documents. From a compliance and due diligence perspective, there is little that can be done to detect these evasion techniques.

What needs to be done? Trump’s new executive order provides substantial leeway to impose secondary sanctions, but the executive order does not come with clear guidance as to how global banks should cut ties with North Korea. Will the Trump administration take a zero-tolerance approach? If so, and given what is known about North Korean sanctions-evasion techniques and the efficacy of due diligence programs, is this fair? What are the consequences?

Thus far, the conventional wisdom has assumed that Chinese banks are failing to implement UN financial sanctions out of close political and economic ties with North Korea. To be sure, it is not in China’s interest to destabilize Kim Jong-un’s regime—and China accounts for approximately 90 percent of North Korea’s trade.

On the one hand, there are likely a significant number of North Korean-linked accounts that Chinese banks can identify and shut down immediately. On the other hand, sanctions-evasion techniques make it difficult for even the most robust due diligence and know-your-customer programs to identify illicit accounts and transactions. In other words, depending on how far the Trump administration decides to proceed with the executive order, Chinese banks could be in a precarious position largely out of their control. Engagement, instead of political posturing, would go a long way in demonstrating that US and Chinese banks have common interests (and a lot at stake). Remember, Treasury Undersecretary Stuart Levey spent a considerable amount of energy in 2008 conducting outreach efforts to international banks—assuring them of US intentions and Iran’s threat to the global financial system.

Currently, most national guidance to banks suggests using a risk-based approach to sanctions compliance and due diligence. In other words, assessing the risks of onboarding a new customer based on a number of criteria. But, while a risk-based approach is meant to be flexible, banks generally perceive national authorities to take a zero-tolerance approach to sanctions compliance especially the United States. Political rhetoric and non-specific guidance about the use of secondary sanctions only serve to stoke these fears. Expectations in terms of sanctions compliance and due diligence need to be crystal clear, and the Trump administration should take every effort to reduce global risk and uncertainty in international banking.