(MONEY Magazine) – Nobody knows how much money gets laundered around the world every year, except that it's probably a lot.

By one commonly used International Monetary Fund estimate, the practice of making dirty money look clean sucks somewhere between 2% and 5% out of the world's GDP every year. That means as much as $1.5 trillion--that's trillion with a T--disappears from the legitimate global economy, ending up in bank accounts in odd places like Nauru and Niue, where it can be neither touched by the world's tax collectors nor tracked by the world's cops.

Until Sept. 11, few people in Washington, D.C.--and nobody in the Bush administration--seemed to be up nights worrying about that. Various anti-money-laundering proposals left over from the Clinton years languished in Congress, and this spring Treasury Secretary Paul O'Neill announced that the U.S. would not participate in an effort to put pressure on countries named as money-laundering havens by the Paris-based 35-nation Organization for Economic Cooperation and Development (OECD)--of which the U.S., by the way, is a member.

A few murderous attacks by suicidal Islamic fascists later, things look rather different. A blizzard of new legislation and executive orders aimed at money laundering and other kinds of illicit banking activity has come out of Washington. Perhaps the most important of these is the International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001, which President Bush signed into law on Oct. 26. The sprawling law's purpose is to make financial life miserable for drug dealers and terrorists, but it will have consequences for the rest of us too. The law, among other things, puts new restrictions on banks and extends to a host of nonbank institutions--insurance companies, brokers, even car dealers and pawnbrokers--a long list of reporting requirements that banks have had to meet for years. That means more costs for those businesses, which almost certainly means higher fees for their customers. It also means that your financial activities are more open than ever to federal law enforcement and intelligence agencies in Washington--who don't have to tell you when they're picking through your accounts. In fact, they're not allowed to tell you.

ON A TINY ISLAND

What is it the government is trying to stop with all this legislation, anyway?

Money laundering can be fantastically complicated--multitiered transactions, numbered shell corporations and so on--but its goal is always simple: bad guys putting money where the authorities can't see it and therefore can't get it. There are a lot of ways to do this, including funneling dirty money through legitimate businesses to conceal its origins. The method, though, that has received the most attention lately from both regulators and the press involves offshore banks in places with low or no taxes and tough financial secrecy laws.

Every year the OECD issues a report naming the jurisdictions that it says are the most hospitable to money laundering. This year's winners: the Cook Islands, Dominica, Egypt, Guatemala, Hungary, Indonesia, Israel, Lebanon, the Marshall Islands, Myanmar, Nauru, Nigeria, Niue, the Philippines, Russia, St. Kitts and Nevis, and St. Vincent and the Grenadines. (Places that have been on the list in the past but have since straightened up enough to be let off include the Bahamas, the Cayman Islands, Liechtenstein and Panama.)

The basic mechanism is the same everywhere. Let's pick on Nauru. (For the record, Nauru's leaders have long rejected the charge that they encourage money laundering and, under international pressure, have recently taken some steps to clean up their financial system). Nauru is a tiny island in the South Pacific. A sovereign nation since 1968, and a member of the U.N. since 1999, it comprises about nine square kilometers and has a population of about 10,000. Before being completely mined out, huge deposits of fossilized bird droppings that could be used as fertilizer and in products like gunpowder were Nauru's primary--indeed only--source of revenue. Now that almost all the phosphate is gone, Nauru is a large hole in the ground surrounded by a strip of beach. (It has also, incidentally, become a dumping ground for Afghan refugees turned away from Australia.)

Since the collapse of its phosphate business, Nauru has turned to the financial services business as a way to generate fees and licensing income. Microscopic Nauru is home to about 400 banks. The country's aggressive financial secrecy laws attract interesting depositors. The Russian central bank, for instance, estimated that in one year alone, 1998, as much as $70 billion of that country's wealth migrated abroad via banks in Nauru, which helped cripple the ex-superpower's economy.

Most of Nauru's banks aren't really banks--they are bookkeeping fictions, shells that exist only on a computer server. Most of them aren't even permitted to do business in Nauru; they can only handle deposits from people who live elsewhere. But foreign money on deposit in one of these quasi-imaginary institutions gets the very real benefit of being shielded from taxes and cops from the depositor's home country. Nauru has given no help at all to any U.S. or other foreign authorities who have tried to get a look at the records of its banks.

You don't even have to physically go to Nauru to take advantage of all this. Few of Nauru's depositors have ever been there. They get access to their money via so-called correspondent accounts that Nauru banks have with banks in other countries, including the U.S. Most correspondent relationships are completely legitimate and enable banks to do business in other countries. But some of those arrangements make it possible for dirty money to be laundered overseas and then funneled into the United States through legitimate American banks.

It works like this. A bank in, say, Nauru opens what is called a pay-through account with a bank in New York. The account is in the name of the Nauru bank, but the bank's customers in the U.S. may also use it to write checks or make deposits. When they do, the Nauru bank makes the appropriate charge or credit to the individual customer's account. The New York bank, though, doesn't know--or care--who those individuals are, because they are not its customers, the Nauru bank is. As long as the bank is legally licensed in Nauru and pays the fees charged to maintain the pay-through account, the New York bank is happy. Although all the day-to-day banking is done in the U.S., the money is technically in Nauru, so anybody trying to follow the money's path will get only as far as the Nauru bank's correspondent account in the U.S. before running into Nauru's bank secrecy laws.

If the Nauru bank really wants to avoid scrutiny, it can bring banks in a third country into the picture. The Nauru bank could, for example, open a correspondent account with a bank in the Cayman Islands, which in turn has a correspondent account with a U.S. bank in New York. In banking industry jargon, the Nauru account is "nested" within the Cayman bank's correspondent account--and thus doubly hard to trace.

Last February, in a much publicized report on the ills of correspondent banking, the U.S. Senate Permanent Subcommittee on Investigations declared: "The U.S. correspondent banking system has provided a significant gateway into the U.S. financial system for criminals and money-launderers...because, in many cases, U.S. banks fail to adequately screen and monitor foreign banks as clients." The report took note of recent scandals involving big U.S. banks, including the Bank of New York (a former executive admitted to helping Russian bankers move $7 billion abroad via a shell account in Nauru) and Citigroup (which maintained a correspondent account for a Cayman Islands shell bank operating in Argentina that U.S. drug enforcement authorities say, was used to launder drug proceeds.)

Crooks, though, are not the only people who want to move their money across borders, and that is why the correspondent system has been so tough to police. There are rich people all over the world who want to put their assets in places where taxes are low or want to hide their money from spouses, heirs, business partners and others. Some of those efforts are completely legal and defensible--Russians, for instance, who sent their money abroad to avoid being caught up in domestic Mafia shakedown rackets. Others are no more than naked tax-evasion schemes. (The Internal Revenue Service has estimated that it loses $70 billion every year from Americans who have squirreled their money away offshore.)

Telling the difference isn't always easy, and the private-banking departments of the U.S. banks that handle much of this international migration of money do not have much incentive to try--the private-banking business is a lucrative one. According to Sen. Carl Levin, chair of the Senate investigations subcommittee, however, "Servicing a [private banking] client almost always means using [banking techniques] that are also the tools of money laundering--secret trusts, offshore accounts, secret name accounts and shell companies." If private-banking customers can use them, the Senator's argument runs, so can drug dealers and terrorists.

THE NEW LAW

The legislation that President Bush signed late in October reflects Sen. Levin's premise that private banking and money laundering are joined at the hip; it's designed to close the correspondent-banking system to criminals.

Technically, the new legislation is a series of amendments to the Bank Secrecy Act of 1970--a law whose title is a miracle of legislative nomenclature since, as has been often pointed out, it has little to do with secrecy and plenty to do with disclosure. The first section of the BSA declares that its purpose is "to require certain reports or records where they have a high degree of usefulness in criminal, tax, or regulatory investigations or proceedings." In essence, the law requires banks to keep records that the government can use to investigate or prosecute crooks.

The amendments, cobbled together in a hurry by a panicked Congress, range all over the map and will have to wait for detailed regulations from the Treasury Department to go into full effect. Nonetheless, some of the broad implications are clear now.

Under the new rules, the Treasury Department can require banks to watch their correspondent accounts more closely and to ask more questions about who actually controls them--that is, they must know who the real "beneficial owner" is. More important, U.S. banks are now banned outright from having correspondent relationships with foreign shell banks in suspect jurisdictions unless they have a physical presence somewhere and at least one employee--which means most of those Nauru accounts don't comply.

The most controversial aspects of the new law involve what kind of financial activity now has to be reported to the government. Under the BSA, banks have had to tell the feds a lot about their customers for years. Under the new law, a slew of other businesses now have to reveal the same kind of information.

The most dramatic example of the new requirements is the Suspicious Activity Report, or SAR. Under the old Bank Secrecy Act, a bank had to file an SAR with the Treasury when it was party to a transaction of $5,000 or more "and the bank knows, suspects, or has reason to suspect that the transaction involves funds derived from illegal activities" or "the transaction has no business or apparent lawful purpose or is not the sort in which the particular customer would normally be expected to engage." Banks also had to keep documents in support of an SAR on file, to be inspected by Treasury or IRS agents--without either a subpoena or the customer's knowledge.

Before President Bush signed the new law, only banks had to file SARs. But now investment companies, currency exchanges, insurance companies, dealers in precious metals, stones or jewels, pawnbrokers, loan or finance companies, automobile, airplane and boat dealers, and people involved in real estate closings and settlement, among others, have to do so as well. And the records behind those SARs can now be inspected, on demand, not only by the IRS and Treasury, but also, for the first time, by the FBI, the CIA, and any other intelligence agency. The new law also permits banks and financial institutions to share information among themselves about customers they regard as suspicious.

All of which means, depending on your point of view, that people like car dealers a) have now become front-line troops in a war on money-laundering villains, or b) are now legally required to spy on their customers and to turn over confidential information to the entire alphabet soup of the U.S. law-enforcement establishment.

THE DEBATES

The debate over the amended BSA, like much of the controversy about other kinds of legislation arising from Sept. 11, concerns whether too much freedom and privacy is being given up in the name of catching bad guys.

We won't really know until the new regulations get written and the law actually takes effect--just as we can't confidently estimate what all this is going to cost consumers. (Michael McDonald, a former IRS money-laundering specialist and now a bank consultant, says he's sure only that it will be "a lot.")

Before signing the bill, President Bush hyped the measure, saying, "It will help law enforcement to identify, to dismantle, to disrupt and to punish terrorists before they strike."

Not everybody agrees. Andrew Quinlan is a former congressional staffer who runs a small but loud Alexandria, Va. lobbying outfit called the Center for Freedom and Prosperity with Dan Mitchell, a Heritage Foundation fellow. According to published reports, they've been able to secure meetings with senior Treasury officials and administration economic advisers. They have also taken credit for keeping some language aimed at low-tax countries out of the final version of the new law.

Quinlan and Mitchell argue that the BSA amendments are misguided as an antiterrorist tool because little terrorist money flows through regular banking channels. Michael Zeldin, former head of the Treasury Department's anti-money-laundering section and now a consultant with Deloitte & Touche, says the revised BSA doesn't give law enforcement any dramatic new tools, but he adds that it will create longer and more detailed paper trails, something investigators always like to see.

But it's not terrorism that's the lightning rod for critics of the BSA amendments, it's privacy and, even more, taxes. According to Quinlan and Mitchell, the new limits on correspondent banking will penalize low- or no-tax countries by locking their banks out of the U.S. financial system. They're convinced the new policy serves only the interests of groups like the OECD, which are trying to keep their citizens from taking their capital abroad to places where taxes are lower. The real issue, they say, is the right of any country to set its own tax policy without being bossed around by bureaucrats in Paris.

That's an argument that the U.S. banking industry lobby wants to stay far away from these days. American Bankers Association chief counsel and lobbyist John Byrne downplays the likely impact of the legislation. Most banks, he says, have been getting out of the business of dealing with offshore shell banks anyway, and the "know your customer" measure is no more than what most banks already do.

Byrne clearly resents the efforts of people like Quinlan to turn the money-laundering debate into a fight over international tax policy. Although the ABA has some quibbles with the new law, Byrne says he hopes that most problems will be ironed out when Treasury finally writes the regulations. (The ABA fought hard--and successfully--to get language giving the banking industry input into the legislation.) "From our perspective, we were pleased with the way things worked out," Byrne says.

Other industries have taken similarly muted public positions. A spokesman for the National Association of Securities Dealers would say only, "We're looking forward to working with Treasury on the new regulations."

We'll take Byrne at his word-- although it's worth remembering that last winter bank lobbyists had been vocal in their objection to proposed new anti-money-laundering legislation. Apparently, that's just one more thing that has changed since Sept. 11.