De-risking in AML/CFT: Navigating Compliance Challenges

Monday, 23 September 2024 - Issue 0014

De-risking refers to the practice where financial institutions terminate or limit business relationships with clients perceived to be high-risk, often to avoid the complexities and costs of complying with Anti-Money Laundering/ Countering the Financing of Terrorism and Proliferation (AML/CFTP) regulations.

While this approach may reduce immediate exposure to risk, it can have significant unintended consequences, particularly for financial inclusion and global financial stability. This article explores the drivers behind de-risking, its impact on the financial system, and alternative strategies financial institutions can adopt to balance compliance with maintaining essential services. The article also makes reference to a series of the AML/CFT Insights articles shared in the last 13 episodes.

The Drivers of De-risking

Financial institutions are increasingly required to apply a risk-based approach to AML/CFTP compliance, as recommended by the Financial Action Task Force (FATF). Enhanced Due Diligence (EDD) is one such requirement for high-risk customers. However, managing these risks can sometimes become too costly or complex, leading to de-risking. Key drivers include:

1. High compliance costs: The expenses associated with implementing robust AML/CFTP programs can be prohibitive.
2. Complex sanctions regimes: Jurisdictions or clients subject to comprehensive sanctions programs pose additional challenges (discussed in Sanctions, PEP, and PIP Screening).
3. Reputational risk: Adverse media and negative news about clients can pressure institutions to terminate relationships to protect their reputation (discussed in Adverse Media Screening).
4. Difficulty in verifying Beneficial Ownership: Identifying and verifying the true owners of companies, especially in high-risk sectors or jurisdictions, is often challenging (discussed in Beneficial Ownership).

The Impact of De-risking

While de-risking may initially seem like a prudent risk management strategy, it can result in broader negative consequences:

1. Financial exclusion: Vulnerable sectors, including small businesses, non-governmental organizations (NGOs), and individuals in high-risk regions, may lose access to critical financial services, making them more susceptible to exploitation by illicit actors.
2. Concentration of risk: When several institutions de-risk the same sectors or jurisdictions, remaining institutions face a higher concentration of risk, potentially destabilizing the financial system.
3. Regulatory pushback: Regulatory bodies, such as the Bank of Zambia, the Pensions and Insurance Authority, and the Securities and Exchange Commission, advise against blanket de-risking and advocate for nuanced risk management that aligns with FATF Recommendations. Financial institutions are encouraged to manage risks without disproportionately impacting financial inclusion.

With the impact of de-risking highlighted above, could there be alternatives? Lets explore....

Alternatives to De-risking

It is recommended that rather than resorting to de-risking, financial institutions can adopt stronger risk management frameworks and take advantage of SupTech and RegTech technologies to improve their AML/CFTP program efficiencies (as discussed during recent LinkedIn post on training on supervisory technology). Some viable alternatives include:

1. Enhanced Customer Due Diligence (EDD): Institutions can strengthen Know Your Customer (KYC) and Customer Due Diligence processes (CDD), performing in-depth risk assessments for higher-risk clients (discussed in Know Your Customer). By focusing on managing rather than avoiding risk, institutions can maintain relationships while still ensuring compliance.
2. Transaction Monitoring and Reporting: Implementing robust transaction monitoring systems allows financial institutions to detect and report suspicious activities without severing ties with entire categories of clients. Insights on best practices for monitoring can be found in the article on Transaction Monitoring and Reporting.
3. Collaboration and information sharing: Financial institutions can collaborate with each other and with regulators to share information about emerging risks, enhancing their collective ability to manage complex cases. This reduces the burden on individual institutions and promotes a more holistic risk management approach.

Conclusion: A Balanced Approach to De-risking

While de-risking can help financial institutions manage immediate risks, it often has detrimental effects on financial inclusion and systemic stability. As highlighted in tyr article on AML/CFTP Governance: Board and Senior Management Oversight, it is essential that institutions adopt a balanced approach, applying the risk-based frameworks recommended by FATF. Leveraging technology, improving internal processes, and fostering collaboration with regulators can enable financial institutions to manage high-risk clients without resorting to de-risking. This approach preserves financial inclusion while ensuring compliance with AML/CFTP requirements. It is worth repeating that de-risking should be be a blanket cover but a risk-based approach.

References:

1. Know Your Customer. AML/CFT Insights. Issue No. 003.
2. Governance: Focusing on Board and Senior Management Oversight. AML/CFT Insights. Issue No. 004.
3. Transaction Monitoring and Reporting in AML/CFTP. AML/CFT Insights. Issue No. 006.
4. Sanctions, PEP, and PIP Screening. AML/CFT Insights. Issue No. 010.
5. Adverse Media Screening. AML/CFT Insights. Issue No. 012.
6. Beneficial Ownership. AML/CFT Insights. Issue No. 013.

The author is an Examiner in the AML/CFT Supervision Division at the Bank of Zambia.

Email: [email protected].