In formulating policy, one important goal of the United States is preventing any sort of financial crime. Money laundering, terrorism financing, and sanctions violations by individuals, banks, and other financial entities are serious offenses with significant negative consequences for rich and poor countries alike. Therefore, efforts by international organizations, governments, and others to combat money laundering and curb illicit financial flows are a necessary step to increase the safety of the financial system and improve security, both domestically and around the world. (This essay is based on a report issued by the Center for Global Development in November 2015
Under the current approach, banks are asked to prevent sanctions violations and assess and mitigate money laundering (ML) and terrorist financing (TF) risks, or face often severe penalties. However, regulators sometimes send mixed signals about how banks should manage their ML and TF risk. This sometimes results in these entities applying simplistic risk assessment methodologies. There may also be a chilling effect resulting from the imposition of fines on some large banks for egregious contraventions of anti-money laundering efforts, combating the financing of terror (commonly referred to collectively as AML/CFT), and, particularly, sanctions laws. These factors, along with others, have led banks to adopt a conservative position with respect to their customers. This includes no longer providing services to firms, market segments, and countries that are seen as being higher risk and that could be the cause of costly future fines, monitoring, or even prosecutions. In short, banks are engaging in “de-risking” – rather than judging the risks of clients on a case-by-case basis, they cease to engage in certain activities completely.)
Another important U.S. policy goal is allowing finance to flow in the most efficient and competitive manner possible. This helps with global economic growth and leads to more people entering into the financial system in a formal and transparent manner. However, these two legitimate policy objectives have come into conflict, as the policies in place to counter financial crimes may also have unintentional consequences, in particular for people in poor countries. Furthermore, from a national security perspective, today’s policies may reduce the transparency of financial flows. (Note: We use the term “poor countries” to describe the countries that the World Bank classifies as “low-income economies” and “lower middle-income economies.” These are countries with gross national income per capita of less than $4,125.)(Note: “De-risking” is sometimes used in this way, and sometimes in a more general sense, to refer broadly to the process of reducing exposure to risk. We employ the more restrictive definition of “de-risking” for clarity, in order to avoid confusion between “good” and “bad” de-risking.)
Since 2000, the regulatory pressure on financial institutions relating to AML has increased. This is reflected in the number and value of AML-related fines imposed by regulators in the U.S., as Figures 1 and 2 demonstrate. For the purposes of this section “AML” is used as an umbrella term, in its broadest possible sense. In the five-year period from 2010 to 2015, the number of AML/CFT fines increased more than 65% while the amount of those fines went from $161 million to over $2.6 billion, with a jump to over $15 billion in 2014 alone.
For a variety of factors, individual banks may be acting rationally in not serving certain clients. However, the implementation of AML/CFT policy to have created categories of clients whose business cannot justify the compliance costs. The financial exclusion of such clients creates yet another obstacle for economic growth and the alleviation of poverty, especially in poor countries.
There are other factors at work aside from AML/CFT policy and the fact is that the data are too weak to make systemic judgments. However, we do observe strong correlations, and as the IMF recently put it, “Pressure on correspondent banking relationships could disrupt financial services and cross-border flows, including trade finance and remittances, potentially undermining financial stability, inclusion, growth and development goals.”
At the international level, there has been a significant harmonization of legislation that should be counted as a major success for the Financial Action Task Force (FATF), the international standard setter on AML/CFT. At the national level, however, some countries have fragmented regulations. Most importantly, the U.S. has a bureaucratically complex regulatory environment.
State-level enforcement and regulation add to the total. This creates a challenging environment for financial institutions. Anecdotal evidence suggests that the European regulatory environment is equally, if not more, complex, despite concerted efforts to harmonize approaches through EU directives. This problem is particularly daunting for smaller firms and especially new entrants, creating barriers to entry that undermine competition.
As well as bureaucratic complexity, financial institutions in the U.S. and elsewhere are acting under a degree of uncertainty that arises from the process of interpreting and reconciling regulatory enforcement actions and policy statements. For example, in June 2014, the Office of the Comptroller of the Currency (OCC) published an enforcement action against Merchants Bank of California that contained broad statements indicating that the bank needed to treat all of its money services business (MSB) clients as high risk and take a number of extraordinary measures when dealing with them. When the bank, which was servicing Somali remitters, later left the MSB business entirely, the Somali community in the U.S. was left without a reliable channel controlled by ethnic Somalis for sending remittances home. On the other hand, in November 2014 the OCC issued a statement asserting that it does not characterize all money services businesses as uniformly high risk (see Table 2).
Table 2: 2014 Statements by the Office of the Comptroller of the Currency
“As part of [Merchants Bank’s] compliance with Paragraph (1) of this Article, the Bank shall also cease and desist from allowing any [MSB, payment processer, foreign or domestic correspondent bank…] from: adding any new Bank products or services; processing any transaction for which the Bank’s automated system cannot include the individual transactions in its monitoring or for which the Bank cannot otherwise reasonably ensure the legitimacy of the sources and uses of funds…” – OCC cease and desist order to Merchants Bank
The OCC does not direct banks to open, close, or maintain individual accounts, nor does the agency encourage banks to engage in the termination of entire categories of customers without regard to the risks presented by an individual customer or the bank’s ability to manage the risk.
“MSBs present varying degrees of risk.
“Banks are expected to assess the risks posed by an individual MSB customer on a case-by-case basis…” – OCC Statement on Risk Management
Correspondent Banking Relationships
Correspondent banking relationships are valuable to the global economy, enabling trillions of dollars of cross-border transactions every day in order to facilitate economic activity such as remittances, foreign exchange, and trade finance. Despite this, a number of industry and government surveys of banks have suggested that a substantial number of links between banks have been severed in recent years.
A survey carried out by the World Bank in 2015 found that 75% of large global banks are withdrawing from correspondent banking relationships. The World Bank also found that local banks from around the world reported that the termination of correspondent banking relationships was – by far – led by U.S. banks. In the 2014 ICC Global Trade and Finance Survey, 30% of respondents indicated they had recently dropped correspondent relationships. The Society for Worldwide Interbank Finance Telecommunications (SWIFT) provides further evidence. SWIFT documents a significant decline in correspondent relationships between the top 80 payments banks and the American, Europe, the Middle East, and African regions since 2005 (SWIFT 3.0). In a network analysis of SWIFT single-customer credit transactions, Cook and Soramäki note that the majority of links lost in the payments network since 2007 have been to offshore banking sectors, often considered to be high risk.
A desire by banks to reduce regulatory risk and related compliance costs appears to be driving the reduction in the number of correspondent banking accounts. Many regulators ask that banks give these accounts special scrutiny. In the U.S., the enhanced regulatory focus on correspondent banking began with the introduction of the USA Patriot Act, which requires banks to perform special due diligence for foreign correspondent accounts (Section 312 amends the 1970 Banking Secrecy Act).
While FATF has recently stated that knowing your customers’ customers (KYCC) isn’t always necessary, a large number of banks and other institutions continue to make this costly effort. SWIFT’s new KYC Registry is geared toward facilitating data sharing and making the KYCC concept less expensive and more manageable over time.
As the onus on banks to do enhanced due diligence on correspondent links has increased, so have the costs of getting it wrong. In the U.S., a number of the large fines handed down to banks have been due to failed correspondent banking procedures. In 2014, the OCC fined JPMorgan Chase $350 million for not implementing an “adequate BSA/AML program for correspondent banking.”17
Finally, more and more countries are being labeled as high risk. The FATF regularly adds or removes countries from its High Risk and Non-Cooperative Jurisdictions list. (Note: The HNRC process has replaced the NCCT Initiative. That initiative started in 2000 and listed countries deemed to have significant deficiencies and to be “noncooperative” in the context of FATF recommendations. The last country was de-listed in October 2006. The HNRC process is more discriminatory/specific in its classification of jurisdictions’ strategic deficiencies, distinguishing between jurisdictions to which countermeasures apply, jurisdictions that have not made sufficient progress or committed to an action plan, and jurisdictions that have made a “high-level political commitment” and action plan to address their issues. The International Cooperation Review Group (ICRG) monitors and reviews these countries, issuing two public documents three times a year.) While FATF only recommends active counter-measures in the most extreme cases, being added to the list is a signal of high risk. The Financial Crimes Enforcement Network (FinCEN) notes that movement of funds through a listed country could be a sign of terrorist financing activity.
Evidence supports the theory that these factors are causing a drop in correspondent banking. The ECB report specifically mentions compliance costs as a driver of this behavior: “KPMG estimates that global annual expenditure is likely to exceed US$10 billion in the next two years, as billions more pounds, US dollars and euros are been spent building ever-more extensive risk and compliance departments.” The ICC Global Trade and Finance survey reveals that 68% of correspondents have had to decline transactions because of AML concerns, with 31% reporting having to terminate whole relationships in the past year.
For many banks, correspondent relationships are crucial for their provision of cross-border services. Furthermore, if a bank wants to settle a transaction in U.S. dollars, they are required to either be based in a country hosting one of the few U.S. dollar clearinghouses in the world or need to bank with a correspondent in that country (This includes the U.S., Tokyo, Hong Kong, Singapore, and Manila).
If banks lose access to their primary correspondent account and can’t establish a new one through another bank based in their target country, the bank must rely on a third party that does have access to a correspondent account to process cross-border transactions. These “nested” relationships are inherently less transparent, as they force correspondent banks to know detailed information about their respondents’ clients in order to detect suspicious transactions. These alternate arrangements are also more expensive.Aside from the effects on the transparency and cost of financial flows, the degradation of the correspondent banking network has the potential to hamper global trade, as trade finance often uses correspondent accounts for the processing of letters of credit. Over 40% of respondents to the ICC Global Trade Finance survey noted that AML and KYC requirements were a “very significant” impediment to trade finance, specifically in Africa. (Note: AML/CFT requirements can also restrict trade finance directly by leading banks to deny letters of credit for which they cannot do sufficient due diligence on the listed beneficiary, an issue also covered in the ICC trade survey.) This has the potential to hurt trade in both rich and poor countries: If heavily regulated countries are unable to issue letters of credit due to KYC concerns or lack of correspondent connections, then exports from these countries will suffer. Conversely, if banks in these countries are unable to confirm letters of credit issued by banks in “high-risk” importing countries for the same reasons, exports from poor, high-risk countries will also be affected.
Available evidence suggests that banks are engaged in de-risking linked to AML/CFT. However, rigorously examining the extent and precise causes of this de-risking will require better data and institutional cooperation. Reassuringly, very good data either exists within institutions and just needs to be shared, or could be generated with very little investment. In the meantime, further improvements to the system are warranted. Our five key recommendations combine sensible short-term tweaks with long-term investments in data and analysis.
1. Rigorously assess the unintended consequences of AML/CFT and sanctions enforcement at national and global levels.
The strength of the evidence detailed in this report requires a rigorous causal investigation of the unintended consequences of AML/CFT enforcement.
The Financial Stability Board should assess the global AML/CFT and sanctions environment, including the guidance produced by FATF, with a view to reducing unintended consequences.
FATF should continue to enhance its mutual evaluation methodology to include:
A. Displacement of transactions from more- into less-transparent channels, which are sometimes informal or processed through lower-tier, less-compliant institutions
B. Risks in the whole economy, rather than just in the formal financial sector
C. Risks posed to the important drive toward financial inclusion
D. Overcompliance at the national level and in particular sectors
2. Generate better data and share data.
To assess unintended consequences rigorously, private and public sector efforts should generate more and better data.
The public and private sector, including national financial intelligence units, should collaboratively analyze and evaluate the data available to them around correspondent banking relationships and payment flows in and between countries.
On behalf of central banks and private institutions, SWIFT, CHIPS, The Clearing House Automated Payment System, Bank for International Settlements, and other entities that may collect data on cross-border transactions and relationships, should consider discussing with their members whether data on bilateral payment flows and the number of correspondent banking relationships between countries should be shared, and if so, how the cost should be covered.
Specific data should be anonymized to protect proprietary information and safeguards put in place by data collectors, so that even anonymous data is only released to parties intending to conduct analysis in the public interest.
Governments should make the data that they are using for risk and regulatory assessments available to other jurisdictions and to parties conducting analyses that are demonstrably in the public interest.
3. Strengthen the risk-based approach.
FATF should be congratulated for introducing and strengthening its risk-based approach. However, it needs to be applied more extensively and more consistently.
FATF should provide a definition of money laundering and terrorist financing risk for its purposes that is consistent with a standardized definition (as provided by the International Organization for Standardization) and existing private sector definitions of “risk.”
FATF should clarify its reasoning regarding transparency and the trade-off of risk in the formal and informal sectors.
FATF should further encourage simplified due diligence where it is in the best interests of transparency.
4. Strengthen regulatory and supervisory frameworks.
A new IMF report on correspondent banking stresses the need to strengthen and align regulatory and supervisory frameworks.26 In particular, there needs to be political buy-in to adopt necessary reforms.
National governments need to invest in supervisory capacity in order to ensure compliance with FATF recommendations and the Basel Core Principles for Effective Banking Supervision.
National governments need to invest more resources to increase exchange of beneficial ownership information and ensure greater cooperation among national supervisors.
Sharing information across borders and greater harmonization of regulatory frameworks would likely go a long way toward reducing the level of uncertainty faced by banks.
5. Tech adoption and lower compliance costs.
Governments, banks, and the World Bank should accelerate the adoption of new technology to facilitate lower cost customer identification, know-your-customer compliance, and due diligence.
National governments should provide citizens with the means to identify themselves in order to make the reliable identification of clients possible for financial institutions and other organizations.
National governments should ensure that appropriate privacy frameworks and accountability measures support these identification efforts while ensuring the free flow of information related to identifying money laundering and terrorist financing.
Financial institutions should redouble their efforts, with encouragement from the FSB and national regulators, to develop and adopt better messaging standards and implement KYC documentation repositories.
Financial institutions should accelerate the global adoption of the Legal Entity Identifier scheme.
The World Bank should convene all relevant entities to review the possibility of donor-subsidized third party verification for unprofitable clients.