The context of de-risking
In the past decade, the financial services sector across the globe has experienced increased regulatory scrutiny, particularly in the areas of financial crimes, anti-money laundering (AML) and anti-terrorist financing (ATF) regulation.
Financial institutions have generally reacted to the new regulatory environment by bolstering their compliance and risk management divisions with increased budgets and headcounts.[i] However, as the price and regulatory risk of banking increases, some financial institutions are assessing the cost-benefit analysis of certain activities and are opting, simply, to exit entire product lines or customer segments. This phenomenon is one aspect of what is known as “de-risking”.
There are several reasons why banks may engage in such de-risking practices. The main one is to shed counterparty risk. By severing relationships with the highest risk customers, the bank can improve its own risk profile. This is an important part of complying with the risk-based approach to AML/ATF advocated by regulators. Banks with strong risk management practices also reduce the likelihood of regulatory action and decrease reputational risk.
De-risking has the potential to reduce compliance costs and allow banks to become more efficient. The highest risk customers require the greatest amount of bank compliance resources. Severing relationships with them can free up these resources to focus on other challenges. Moreover, by focusing on fewer product lines with reduced compliance costs, a bank can increase its efficiency and potentially boost profitability at the same time.
Where are we seeing de-risking?
The scale of de-risking can vary widely. Case-by-case de-risking involves an individual analysis of every customer in high-risk segments using enhanced due diligence. Wholesale de-risking occurs when banks completely exit a market segment. This can mean a bank might stop offering a particular product or service and close the accounts of all customers in that segment regardless of an individual’s risk profile. According to a 2015 Global Center on Cooperative Security Research Report, de-risking of high-risk clients is occurring primarily in the following segments[ii]:
- Money Services Businesses (MSBs) – Entities which transmit or convert money outside of the traditional banking sector, such as remittance managers or hawalas, can be seen as higher risk, particularly if they operate internationally.
- Politically Exposed Persons (PEPs) – Individuals holding elected office or important public positions are typically at higher risk of bribery or corruption. Embassies can be affected as well if they house PEPs.
- Foreign Correspondent Banks (FCBs) – Financial institutions in other jurisdictions providing services on behalf of another bank. For example, a correspondent bank will serve as an intermediary for an international wire transfer between Bank A in the United States and Bank B in the Caribbean when there is no other commercial working relationship between the two institutions.
- Charities – Most charitable organizations are small and lack the staff or knowledge required to quickly satisfy enhanced due diligence questions. Charities working in foreign jurisdictions are particularly high risk.
- Fintechs – Start-up organizations face the same resource challenges as charities. Entities in the virtual currency industry (such as virtual currency ATM operators or virtual currency exchanges) face additional challenges
Unintended consequences and risks of de-risking
“Just because a particular customer may be considered high risk does not mean that it is ‘unbankable’ and it certainly does not make an entire category of customer unbankable. It is not the intention of the AML regulations to shut legitimate business out of the financial system. I think we can all agree that it is not possible for financial institutions to eliminate all risk. Rather, the goal is to provide banking services to legitimate businesses by understanding the applicable risks and managing them appropriately.”[iii]
- Jennifer Shasky Calvery, Director, US Financial Crimes Enforcement Network
While reducing risk in the financial services sector can be quite desirable, regulators have also expressed concerns that wholesale de-risking may be having unintended consequences and present its own legal risks. In the summer of 2016, announcements by both the UK’s Financial Conduct Authority (FCA) and the US Office of the Comptroller of the Currency (OCC) suggested that financial institutions that attempted to avoid regulatory risk by terminating, restricting or denying services to entire segments of customers would also be monitored by regulators.[iv]
The following are some of the potential consequences of de-risking:
- Shadow banking – Regulators have expressed concern that de-risking may drive transactions underground where they are more difficult to track. Organizations and individuals who have had bank accounts closed often begin doing business in cash instead. This makes it more difficult to investigate money laundering and terrorist financing – the complete opposite of the intention behind AML/ATF regulation. This is of particular concern in newly-legalized industries such as the Canadian legal marijuana industry where entrepreneurs are finding alternative sources of funding in lieu of banking with financial institutions that are hesitant to bank what they see as a high-risk industry. For example, Cannapay Financial recently signed an agreement with Glance Technologies to introduce mobile payments to the legal marijuana market. [v]
- Restricted foreign aid – Small charities cut off from obtaining banking services cannot deliver aid to the high risk areas where it is most needed. Further isolating these areas from the global economic system is a potential driver of terrorist ideologies.[vi] In addition, decreasing the availability of money services businesses as a result of de-risking limits the global remittance market, a key driver of developing country economic growth.
- Copycat de-risking – Wholesale de-risking can be a concern because of the risk that one bank’s decision to exit a market segment will prompt other banks to reconsider their continued involvement in that segment.[vii] This is of particular concern in countries where there are only a few major banks for customers to choose from. While no bank wants to be the last one servicing a particularly risky market segment, there can be reputational and regulatory risk associated with being the last bank to cut off services to charities and not for profit organizations.
- Reduction in bank profits and diversification – In financial services, higher risk means higher reward. When banks compete only for the lowest risk customers who have the most options, their ability to charge more for financial services is diminished. It is often easier to manage existing customers, even those in higher risk categories, than to attract new customers without pre-existing relationships with that bank.[viii] In addition, reducing the number of market segments or products a bank caters to may mean the bank is less diversified in the long run.
While there is no magic panacea for managing risk in the financial system, de-risking is one method in which some banks have sought to address their risk profile. However, de-risking, and in particular wholesale de-risking, can have consequences for the financial system as a whole and carry its own regulatory risk. Prudent financial institutions should focus on risk management of customers and consider the impact of de-risking decisions from all perspectives.
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[i] Artingstall, D., Dove, N., Howell, J., & Levi, M. (2016, February). Drivers & Impacts of Derisking: A study of representative views and data in the UK, by John Howell & Co. Ltd. for the Financial Conduct Authority. UK Financial Conduct Authority. Retrieved from https://www.fca.org.uk/publication/research/drivers-impacts-of-derisking.pdf
[ii] Durner, T., & Shetret, L. (2015, November). Understanding Bank De-Risking and its effects on Financial Inclusion. Global Center on Cooperative Security. Retrieved from http://www.globalcenter.org/wp-content/uploads/2015/11/rr-bank-de-risking-181115-en.pdf
[iii] Shasky Calvery, J. (2014, August 12). Remarks of Jennifer Shasky-Calvery, Director, Financial Crimes Enforcement Network. Speech presented at 2014 Mid-Atlantic AML Conference Washington D.C. Retrieved from https://www.fincen.gov/news/speeches/remarks-jennifer-shasky-calvery-director-financial-crimes-enforcement-network-10
[iv] Kentour, Chris (2016, June) AML De-Risking: Regulators Warn No Big Brooms http://finops.co/investors/aml-de-risking-regulators-warn-no-big-brooms/
[v] Press Release (2017, May) Glance Enters Marijuana Fintech Market With $1,000,000 Licence to Cannapay Financial Inc. http://whatcounts.com/dm?id=F3E9F8B48F1CF39061AE9E5CA235A8F84B93FB24D3F3D6A0
[vi] Artingstall, D., Dove, N., Howell, J., & Levi, M. (2016, February). Drivers & Impacts of Derisking: A study of representative views and data in the UK, by John Howell & Co. Ltd. for the Financial Conduct Authority. UK Financial Conduct Authority. Retrieved from https://www.fca.org.uk/publication/research/drivers-impacts-of-derisking.pdf