The term “underground banking system” denotes an informal means of money or value transfer, often characterised by specific monikers such as hawala, hundi, Fei ch’ien, hoe Kuan, among others, due to their regional associations. In Sri Lanka, it is colloquially referred to as Undiyal, while in South Asia, it goes by the names “Fei ch’ien” or “Chit.”
The uniqueness of this method lies in its ability to facilitate cross-border transactions without the physical transfer of money. This clandestine network is susceptible to exploitation by terrorist organisations and money launderers seeking to surreptitiously move illicit funds across international borders.
As evidenced by Daudi (2005), in the wake of the September 11, 2001 terrorist attacks, commonly known as the Twin Towers tragedy in the United States, Time Magazine ran an article titled “A Banking System Built for Terrorism.”
This article shed light on the potential risks associated with the Hawala banking system in relation to terrorist activities. Beyond serving as a conduit for terrorist organisations, this underground banking system also harbours the potential for use by drug traffickers and money launderers, who employ a variety of techniques to evade detection and regulation.
The literature highlights that the Undiyal system is not solely the domain of criminal elements but is also commonly utilised by the populace, particularly migrant workers. Remittances from these workers represent a significant source of foreign income for the nation and have become even more vital in the current financial crisis. The popularity of underground banking can be attributed to its accessibility, operating independently of external support, its straightforward system, and, most notably, its deep-rooted presence within specific cultural and religious spheres.
Underground banking, often referred to as informal money transfer systems, denotes non-formal arrangements for money transfer. This method is frequently employed for legitimate remittances from overseas workers, offering an alternative to formal channels. Its historical origins can be traced back several years to China and the Indian Subcontinent, where traders sought a means to travel without carrying substantial amounts of money, reducing their susceptibility to theft along the Silk Road.
However, it’s worth noting that this informal system has also been exploited by money launderers and terrorist organisations for illicit financial transfers. For instance, Colombian drug traffickers have long used informal money transfer systems to launder their illegal earnings, rendering these systems vulnerable to misuse.
In the context of Sri Lanka, informal remittances are commonplace, and the Liberation Tigers of Tamil Eelam (LTTE) were known for developing a robust informal remittance system known as the Undi system, which is functionally similar to hawala. The Undi system facilitated the transfer of funds from the Tamil diaspora to relatives in Sri Lanka, particularly in areas underserved by the formal banking sector. This system was primarily under the control of a consortium of Tamil jewellers (goldsmiths) based in Switzerland and Canada.
In a study conducted by Cheran and Aiken in 2005, it was observed that following the 2004 Tsunami, Tamil community organisations and Tamil media in Toronto mobilised funds for relief, rehabilitation, and reconstruction efforts. Funds collected by a local radio station were sent to Sri Lanka at regular intervals, approximately every three hours or when the amount reached $50,000, with a particular focus on assisting the country’s North-Eastern region. However, it was noted that banks operating in the post-conflict zone faced challenges in providing even small amounts, such as Rs. 5,000 (equivalent to $50), to disaster victims due to limited resources.
The study underscored the significance of informal channels, emphasizing their efficiency and speed in the context of disaster relief and recovery efforts. Additionally, research by Harris and Terry in 2013 revealed a substantial growth in the informal remittance system in Sri Lanka, especially among poorer labour migrants and the Tamil Diaspora. This preference for informal channels was particularly prominent among those hailing from the conflict-affected Northern and Eastern provinces. According to their findings, during the mid-2000s, an estimated 50 percent of total remittances to Sri Lanka were channelled through the Unidiya system.
According to a study conducted by Patabendige in 2021, Sri Lanka has emerged as a transshipment destination for narcotics. The country has been serving as a conduit for the transit of heroin originating from Southwest Asia and India. Sri Lanka has transitioned from being solely a transit point to becoming an ultimate destination for heroin, indicating an escalation in drug usage. This development carries the potential for exacerbating societal inequalities.
As per insights from Passas in 2005, the proceeds from the illegal heroin trade in Sri Lanka are funnelled out of the country via the Hawala network to India and other less-developed nations. Passas highlights that the Hawala network is predominantly used by criminals in Sri Lanka to launder their illicit earnings. This underscores the role of underground banking systems as a means employed by criminals to transfer their ill-gotten gains. An interesting observation is that when government authorities or law enforcement agencies bolster one side of their efforts, criminals tend to shift their proceeds through alternative avenues.
Makkai, in 2005, emphasized that the utilisation of underground banking systems by terrorist groups is influenced by the increasing scrutiny on formal financial systems. Consequently, criminals might redirect their activities through different channels, such as Trade-Based Money Laundering (TBML), cryptocurrencies, real estate, and others. A study by Kumanayeke in 2015 further indicates that criminals have turned to the trade sector as a new avenue, especially given the enhanced money laundering controls in international financial institutions, which places the trade sector at risk of being exploited for illicit financial activities.
Boyle’s law provides a fitting analogy to elucidate the phenomenon of criminals shifting from one method to another when confronted with the enforcement of Anti-Money Laundering (AML) and Countering the Financing of Terrorism (CFT) measures by law enforcement agencies. This analogy draws a parallel with the behaviour of an inflated balloon.
Boyle’s law, formulated in 1680, describes the behaviour of gases when their volume and pressure are altered. When a balloon is inflated, it swells. However, if you squeeze one end of the balloon, reducing its volume, the pressure inside increases. This increased pressure causes the un-squeezed part of the balloon to expand outward, seeking equilibrium.
In a similar vein, when a Government strengthens AML and CFT measures against a specific entity or sector, it forces illicit actors to seek alternative channels for money laundering and terrorist financing. For example, if a Central Bank imposes stringent AML and CFT measures on financial institutions, criminals may shift their activities to the trade sector. Conversely, if law enforcement authorities intensify their efforts in monitoring AML and CFT measures in the trade industry, criminals may go underground, using less regulated and more discreet channels.
Demand for underground banking system Numerous factors drive the heightened demand for underground banking systems such as Undiyal. As highlighted by Pohoata and Caunic in 2008, the key factors necessitating such systems include:
High costs of banking or official channels
lack of easily accessible formal financial institutions in remote areas of some countries (Afghanistan, Yemen, Somalia) lack of confidence in the conventional banks delays, in official sector, due to holidays, weekends and time differences lack of efficient banking infrastructure so that the local bank has not the means to send the money overseas rigid/strict foreign exchange regulations to avoid currency reporting controls wide divergence between official and black market exchange rates cultural, political, social reasons illiteracy criminal purposes such as money laundering, terrorism financing, tax evasion, accepted by hawala networks
As indicated by Pohoata and Caunic in 2008, hawala dealers typically earn a commission that falls within the range of 0.25 percent to 1.25 percent. According to data from the World Bank, this commission rate could extend from 1 percent to 5 percent.
Efficiency plays a pivotal role in driving the demand for the Undiyal system. Hawala agents can transfer funds to recipients in other countries within a remarkably short period, typically one or two days. In contrast, formal financial institutions often necessitate a more extended time frame, sometimes a week or even longer for international wire transfers. This delay may be attributed to factors like holidays, weekends, and time zone disparities, as noted by Interpol.
Another compelling reason for the preference of migrant workers for the Undiyal system is the absence of bureaucratic hurdles and a paper trail. For instance, if an individual lacks a valid visa, attempting to send money through the formal banking system could prove unsuccessful, whereas an Undiyal agent remains a viable option. Recipients are not burdened with the need to complete a “money-sending form” or furnish other documents to verify the source of funds or the purpose of the transaction, a requirement commonly imposed by most banks.
The report also underscores the significant role of tax evasion as a motivating factor for utilising Undiyal transactions. In South Asia, the black economy constitutes a substantial portion, ranging from 30 percent to 50 percent, of the “white” or documented economy. This prevalence of the black economy underscores the motivation for persons to seek methods to avoid tax obligations, which in turn drives the demand for underground banking systems.
The sustainability of the Undiyal system is bolstered by its cost-effectiveness and low overhead costs. Additionally, its competitive exchange rates make it an attractive option when compared to the formal banking system. Lastly, the high level of trust associated with Undiyal dealers, who are known for their honesty and rarity of trust breaches with customers and fellow dealers, enhances the appeal of this informal system.
The transaction process employed by Undiyal is elucidated in Figure 1. To initiate the transaction, the sender provides fundamental details to the Undiyal agent, including their name, the recipient’s name, the designated sum, and the intended destination country. Subsequently, the Undiyal agent issues a unique code, which is to be conveyed by the sender to the recipient.
The Undiyal agent then establishes contact with their counterpart in the recipient country, typically through a phone call or fax, instructing them to disburse the funds. Once the recipient receives the code, they can approach the Undiyal agent to collect the designated amount. It’s worth noting that Hawaladars, who manage these transactions, often profit by manipulating currency exchange rates.
As highlighted by Passas in 2005, this system harbours the potential for facilitating money laundering activities. However, should the Undiyal agent suspect that the transaction involves illicit or criminal activity, a surcharge of 15 percent to 20 percent may be imposed, as noted by Carroll in 1999. Pakistani authorities estimate that a substantial amount, ranging from USD 5 to 7 billion, enters the country through Hawala channels each year. In India, Interpol has suggested that Hawala transactions may represent 40 percent of the nation’s gross domestic product. On a global scale, it is estimated that between USD 100 billion and USD 300 billion flow through informal remittance systems annually.
Regulating underground banking system
Makkai (2005) put forth the idea that rather than enforcing regulations on the underground banking system, governments should consider providing incentives. Makkai said that certain countries, such as Sri Lanka, Bangladesh, India, and a few others, offer interest rates that surpass the market rates for foreign currency accounts. However, this approach has its limitations, as Makkai noted.
These foreign currency accounts tend to be more attractive to professionals and highly skilled workers, leaving questions about their appeal to the broader labour force, particularly those originating from Middle Eastern countries, which contribute significantly to Sri Lanka’s foreign earnings.
The study also revealed Pakistan’s consistent efforts to address the Undiyal system. Consequently, a notable 64 percent of remittances shifted from the underground banking system to the formal banking sector between 2001 and 2002, as reported by Buencamino and Gorbunov (2002). In their account, the Government of Pakistan introduced stringent currency controls in 1998, limiting withdrawals from foreign currency accounts to the official rate of 46 rupees, while the underground banking rate stood at 58 rupees. The consequence of this measure was a substantial reduction in monthly foreign remittances through the formal banking system, declining from $150 million to $50 million.
Another significant consideration is that intensifying measures to control one entity may inadvertently render other channels more vulnerable. Enhancing Anti-Money Laundering (AML) and Countering the Financing of Terrorism (CFT) processes within financial institutions can certainly reduce the flow of illegal funds through the formal sector. However, this often leads criminals to explore alternative avenues such as Trade-Based Money Laundering (TBML), cryptocurrencies, real estate. In essence, it operates on the principle akin to “squeezing the balloon” – when pressure is applied on one side, the other side expands.
Interestingly, one of the dynamics at play is that the demand for underground banking systems indirectly increases as a response to regulations imposed on financial institutions. This aspect underscores the complexity of the issue and the need for careful consideration.
It is anticipated that this article will assist authorities in making well-informed policy decisions regarding the underground banking system, with the aim of avoiding unnecessary complexities in addressing this multifaceted challenge. Finally, the core issue is not merely how criminals move their money but rather the existence of criminal elements themselves. The focus should be on preventing the entire process to effectively control money laundering and terrorist financing.
The writers are at the Department of Accountancy, Faculty of Commerce and Management Studies, University of Kelaniya.