Invisible Threats: How Financial Institutions Can Mitigate the Threats of Proliferation Financing

Close your eyes for a minute and imagine…the morning news reports an organised Chinese criminal group having defrauded 5.3 million people through online phishing scams across the world. They laundered the proceeds of crime through hundreds of shell companies, registered in Hong Kong, with the money finally being diverted to operate an illegal sweatshop in the deep mountainous regions of South Korea. The products manufactured in the sweatshop are sold by a firm called Natural Styles. Natural Styles prides itself for having its products manufactured in South Korea from locally sourced organic materials. The news observes Natural Style’s skyrocketing profits over the years. The news then zooms in on the world map and drops a pin on the factory’s location; the dangerous vicinity of the long-demilitarized zone a few miles from the border with North Korea, north of the port city of Incheon. Considering the proximity to North Korea, you start wondering—are these profits used to fund a lavish criminal lifestyle or to fund more sinister activities?

Few people may think about this operation supporting North Korea’s ballistic missile programme, which forms part of the UN’s sanctions regime on the country. North Korea’s ballistic missile programme avoided the limelight, however, since Russia’s continued invasion of Ukraine in 2022, the UK became more vulnerable to proliferation financing risk due to its global role as a financial hub and its role as the 7th-largest exporter of major and conventional weapons in the world. This article aims to uncover the challenges faced by financial institutions, the importance of a robust proliferation financing risk assessment and red flags to be aware of.

Despite the Financial Action Task Force definition of proliferation financing, there is no global consensus on a specific definition.¹ Therefore, individual firms must determine their understanding of proliferation financing and how they identify and mitigate the related risks. Many firms have now included proliferation financing in their risk assessments. However, some have failed to comprehend how money laundering and proliferation financing differ in their characteristics. Money laundering relates to the movement of funds obtained through illegal activities, whilst proliferators, akin to terrorists, may source funds from legal activities, including fundraising and donations, which is often the case. This makes it even more challenging for financial institutions to identify cases of proliferation financing. It is less often detected through transaction monitoring and more through unusual trade deals or suspicious parties being involved in the process.

As of September 2022, firms in the UK were obliged to conduct a proliferation financing risk assessment. This assessment can be part of the firm’s broader risk assessment or a standalone evaluation. As a result, firms must then implement appropriate policies, systems, and additional controls to identify and mitigate the underlying proliferation financing risks. So, how can you identify and mitigate the proliferation financing risks your organisation faces?

1. Deepen your Understanding of your Customers, Their Business and the General Risk in the Jurisdictions Your Customers Operate

As part of your firm’s proliferation financing risk assessment, you should be aware of your country’s national risk assessment of proliferation financing to understand the unique risks your firm faces due to the jurisdiction it is located in. The UK’s national risk assessment of proliferation financing published by His Majesty’s Treasury in 2021 can be found here. When conducting your firm’s proliferation risk assessment, you should focus on the following key proliferation financing risk exposure areas:

• Sensitive jurisdictions, including jurisdictions known for having porous borders or corrupt border controls; 
• Connections to entities or individuals located in or in close proximity to conflict zones;
• Customers involved in the production or distribution of dual-use goods;
• Customers involved in logistics and transportation business;
• Products and their economic sense in relation to your customer’s business;
• The nature and purpose of their business activities; and
• Third-party connections and networks. 

Should red flags be identified, network information data can be gathered as a measure of enhanced due diligence, including the identification of phone numbers and addresses of connected parties that are either identified through carrying out Customer Due Diligence or Transaction Monitoring.

2. Look Out for Dual-Use Goods

Dual-use goods are items that are used for legitimate commercial purposes but could also be transformed into Weapons of Mass Destruction (WMD) or used for other military purposes. Proliferators often exploit such goods, as they can be purchased without immediately raising concern. Some examples of legitimate goods that are used by proliferators include machine tools, electronics, software, laser sensors, and even the less obvious silicon chips found in breast pumps. Financial institutions often lack the expertise and struggle to identify dual-use goods, despite the use of publicly available resources and search engines. If a dual-use item has been identified as part of a transaction or as part of a customer’s product offerings, it needs to be dispositioned appropriately to ensure the goods are not used for proliferation purposes. To do so, financial institutions should consider verifying the end-use of the product, take into consideration the risk associated with the destination country, and obtain necessary export licenses if needed. Verifying the transacting parties’ online presence can further help to obtain information on the end use of dual-use items.

3. Stay on Top of New Schemes and Tactics

Customers seeking to finance proliferation activities employ complex tactics to make identification more challenging and, in some cases, almost impossible. They often involve front companies, shell companies, agents, brokers, or intermediaries to pay for proliferation goods. They aim to conceal the nature of these goods, the ultimate beneficiary as well as the true end use of the product itself. Customers with links to sanctioned entities or countries such as Iran, Russia, and North Korea try to hide their connections behind complex ownership structures in sensitive jurisdictions such as Hong Kong, China, the United Arab Emirates and Cyprus. 

4. Test your screening tools and vendors

Do you know if your screening tool provider updates their sanctions lists regularly? Do you know which lists are fed into the tool and what their quality or accuracy is? Too often financial institutions put unwarranted levels of trust in their vendors without understanding the risks the lack of governance and testing might pose.

5. Provide regular learning and awareness 

As proliferators constantly explore new tactics on how to abuse the financial system for their benefit, it is important to ensure your team stays up to date with changes and best practices of risk management. Learning and awareness initiatives should always focus on the specific and unique proliferation financing risks your organisation faces. Those risks should be identified in your firm’s Business Wide Risk Assessment (BWRA). Additionally, any changes related to the risks identified in the BWRA should be incorporated in such training sessions.

Finally, proliferation financing remains a predicate offense that can lead to heavy fines and irreversible reputational damage, including the loss of trust by customers and the public. More importantly, considering the harm caused by WMD, such as loss of life and global instability, firms must take responsibility to ensure that proliferators are cut off from accessing financial systems. Firms can unwittingly become enablers if they do not have appropriate controls in place that go beyond well-written policies and procedures. 

Our team at Guidehouse can help you identify how to:

• Enrich your organisation with trade finance and export controls experts who can help you navigate the complexities of trade transactions.
• Develop your readiness to face emerging proliferation financing risks and assess their potential impact on your organisation.
• Assess the quality and effectiveness of your systems and tools and identify opportunities to increase both efficiencies and effectiveness.
• Design and deliver learning and awareness sessions for boards, senior management, and operational teams to increase confidence in understanding, assessing, and mitigating proliferation financing risk factors.