Editor's Note: This article originally appeared on the American Banker on April 12, 2017.
Anti-money-laundering rules have always been a challenge in the financial services arena, with regulatory bodies demanding high standards of compliance and levying fines for noncompliance. Financial institutions have long struggled to meet those demands.
But the high regulatory burden of satisfying these rules is not an excuse for the current de-risking phenomenon, in which financial institutions are pulling out of regions and client relationships seen as carry money laundering risk, rather than face the costs and regulatory risk of maintaining those relationships. The conundrum associated with satisfying AML regulations has as much to do with a failure of imagination in efforts to follow the rules as it does with how onerous the regulatory requirements are.
Banks have a propensity to blame regulators and excessive compliance costs for their pulling out of business lines without necessarily trying to find a way to make it work. Compliance teams and other stakeholders have resisted being honest about the need to innovate. There has been a failure to experiment and an overreliance on “conventional” AML standard operating procedures.
Banks’ frustration with current industry tools, practices and standards have prompted a lobbying effort to call for reforms. A February 2017 report released by The Clearing House provided some excellent suggestions regarding information sharing, prioritization of AML/combating-the-financing-of-terrorism (AML/CFT) standards and beneficial ownership reporting requirements, among others. However, the report failed to acknowledge the possibility that existing regulations may be purposely broad and open to interpretation. The risk-based approach is a recurring theme in regulatory guidelines, but why must regulators have to clearly define priorities and standards for banks?
Banks can test hypotheses and discover new trends where guidelines may not exist, but the industry has discouraged deviations from accepted norms. The Clearing House report suggests that banks are afraid to innovate for fear of regulatory sanction. One can only wonder whether this is a palpable risk or a manufactured fiction spread by the AML industry. The explosion of funding in regtech startups by venture capital firms demonstrates that investors realize there is an opportunity to redefine the AML industry because it is evident that innovation will not come from within.
In fairness, the banks are not completely to blame, as the currently accepted tools to fight financial crime do not allow them to innovate. The conundrum associated with satisfying AML regulations has as much to do with a failure of imagination by a whole host of entities in the AML supply chain as with onerous regulatory requirements and compliance burdens. AML stakeholders — including banks, certification organizations, technology companies, regulators and the compliance community as a whole — have resisted being honest about the need to innovate.
To move the innovation needle forward, all parts of the supply chain will need to do their part. For the banks, part of the answer is to integrate AML/CTF with risk management processes more generally. This should not be a difficult task, particularly as so much of what banks do is transactional in nature. Nearly all banks have developed formal programs to manage transactional risk, and most of these are centralized so as to establish and maintain control over an entire network of operations. Transactional risk management is usually integrated with the credit risk management function, but larger banks tend to integrate transactional risk management into their overall risk management process.
Most banks take a comprehensive view of risk, but tend to differ in terms of how specific risks affect their risk-rating system. Many banks apply a single country rating to all types of exposures, while distinguishing between foreign and local currency funding. Formal exposure limits tend to be set annually and managed through the use of aggregate country exposures. Nearly all banks have developed formal programs to manage transactional risk, and most of these are centralized so as to establish and maintain control over an entire network of operations. Almost all banks assign formal country ratings, most of which cover a broad definition of risk. Ratings are typically assigned to all types of credit and investment risk, including local currency lending.
Transactional risk ratings establish a ceiling that also applies to credit risk ratings. Most banks do not generally have formal regional limits to lending, but some banks monitor exposures for a given region informally, and most have specific country limits. Many banks apply a single country rating to all types of exposure, while distinguishing between foreign and local currency funding. Formal exposure limits tend to be set annually and managed through the use of aggregate country exposures.
Few banks can say they have fully, effectively and efficiently integrated AML into the larger risk management process, or have linked AML with their country risk management programs. But such steps are needed, rather than merely continuing the de-risking blame game. The AML sphere is ripe for transformation on the part of all players in the supply, delivery and user chain. It may just be that the very regulatory oversight used to enforce compliance can be turned into the vehicle driving AML innovation.