The Risks of De-Risking

by Julie Copeland and Mirella deRose

Over the past several years, financial institutions in the United States and abroad have increasingly engaged in a “slimming down” of their client base.  They have done so by deciding not to accept certain types of clients ranging from individuals engaged in specific industries –such as trade merchants, precious metal dealers or “politically exposed persons” (a term of art to be discussed below) – to whole categories of businesses or entities such as money service businesses, charities and foreign banks.  This trend, which is now commonly referred to as “de-risking,” has significant collateral consequences for those using the global financial network.This blog will discuss de-risking, its causes and consequences, and some of the solutions that have been proposed to address the unintended results of this practice.

Since the passage of the USA PATRIOT Act in 2001 in response to the September 11th terrorist attacks – some would argue even before that – regulators in the U.S. and elsewhere have singled out certain categories of individuals and entities that either are strictly forbidden to hold accounts with financial institutions or, more routinely, require enhanced reviews by the institutions in which the accounts are maintained.  The first category of accounts – those that are forbidden – includes entities such as “shell banks,” which are foreign banks without a physical presence in any country.  Pursuant to law, U.S. financial institutions may not maintain accounts for such entities.

Within the second category of accounts – those requiring due diligence and in some cases “enhanced due diligence” – fall accounts for “politically exposed persons” (“PEPs”) and foreign correspondent banking accounts.  PEPs include senior foreign political figures, their immediate family members, and individuals who are deemed to be “close associates,” that is, individuals widely and publicly known to maintain an unusually close relationship with the senior foreign political figure and who are in a position to conduct substantial financial transactions on behalf of the senior foreign political figure.  Accounts for such individuals are deemed to present a higher risk of money laundering because of the potential for corrupt funds to pass through the accounts.  Financial institutions are therefore expected to conduct an enhanced review of these accounts.  The Financial Action Task Force (“FATF”) has further recommended that the concept of PEPs be extended to include domestic as well as foreign individuals.  This would mean that an account for a member of Congress, a high-ranking employee of a federal agency or the governor of a state would also fall in the category requiring enhanced due diligence.

A second major type of account singled out for enhanced due diligence are so-called foreign correspondent banking accounts.  These accounts, considered a “gateway” into the U.S. financial system, are maintained by foreign banks at U.S. banks so that their clients may conduct U.S. dollar transactions as well as access other products and services.  By way of example, Bank A – incorporated and operating in country Y – maintains a dollar account at one of the major U.S. financial institutions.  Through Bank A’s U.S. dollar account, its clients can conduct U.S. dollar transactions.  The initial risk associated with these accounts that regulators were concerned about is that the U.S. institution does not have a direct relationship with the clients of Bank A and therefore, cannot vet those clients.  It must depend on Bank A’s compliance program to identify and weed out improper clients or illicit transactions.

Foreign correspondent banking has been the subject of Congressional hearings, as well as enforcement actions such as that against Wachovia in 2010.  Wachovia ultimately entered into a consent order with various federal regulators and paid a fine of $110 million for failings in its AML program – principally with regard to its correspondent banking activities.  Subsequent consent orders against major banks have highlighted compliance failings in correspondent banking activities and required banks to take steps to remediate the cited deficiencies.

In an attempt to manage risk and avoid major compliance problems, U.S. financial institutions have been de-risking their portfolios of foreign correspondent banking clients.  In 2013, numerous news outlets cited JP Morgan Chase as having done just that.  In July of this year, Bloomberg News reported that Deutsche Bank was severing ties with several Latvian bank clients.  On August 24th, a report issued by the international settlement processor SWIFT stated that de-risking has been on the rise with respect to African countries, with South Africa losing more than 10% of its foreign counterparties between the years 2013 and 2015, Angola dropping 37% in two years, and Mauritius seeing a decline of 18%.  See also, May 2016 Caribbean Development Bank Policy Brief.

In Somalia, where citizens rely on money services businesses (“MSBs”) to receive funds from relatives in the U.S. and elsewhere, the situation has become acute with most American banks severing accounts for such businesses.  In January 2015, one of the last remaining U.S. banks to handle such transfers – Merchants Bank of California – announced that it would cease processing remittance business transfers to Somalia from the U.S.  One of the unintended consequences then of efforts by financial institutions to manage risk, is that regions of the world and certain populations either have lost access or have very limited access to the global financial network.

The causes and effects of de-risking have been recognized by senior members of the U.S. government.  In his speech at the American Bar Association and American Bankers Association Money Laundering Enforcement Conference in November 2014, U.S. Treasury Under Secretary for Terrorism and Financial Intelligence David Cohen stated that addressing concerns about de-risking was one of the Department of Treasury’s top policy objectives, and cautioned banks against terminating relationships with entities such as MSBs and check cashers.  When financial institutions terminate customer relationships such as these to avoid the possibility of an enforcement action down the line, Cohen warned, it can lead to exclusion of the under-banked from financial markets and can undermine financial transparency, with far-reaching political, social, economic and regulatory consequences.  Almost two years later, however, the Department of Treasury continues to struggle with the rapidly accelerating trend.  On August 30, 2016, along with other federal banking institutions, the Treasury Department issued a Joint Fact Sheet on Foreign Correspondent Banking emphasizing what it described as the very limited circumstances under which banks are subject to regulatory action as a result of compliance failures in connection with these relationships.  The issuance of the fact sheet was a clear acknowledgment by federal regulators that fears of regulatory action harbored by U.S. financial institutions have contributed to the decline in foreign correspondent banking relationships.

At the New York Fed on July 18, 2016, Managing Director of the International Monetary Fund (IMF) Christine Lagarde echoed these concerns, highlighting the decline of correspondent banking relationships as a major consequence of de-risking.  Lagarde stressed correspondent relationships as the main avenue through which financial institutions in developing countries and small and emerging market economies access the international financial system for cross-border payments and settlements.  As banks are withdrawing from these relationships in countries they deem detrimental to their risk profile, populations there are becoming poorer and more marginalized.  Like Under Secretary Cohen, Lagarde acknowledged banks’ concerns about inadequate compliance with international anti-money laundering standards in these regions, and the potential financial and reputational penalties associated with enforcement actions, but urged banks to look beyond short-term risks and profitability concerns and to avoid withdrawing entirely from certain regions and relationships.

The phenomenon of de-risking was similarly the focus of a May 24, 2016 report commissioned the U.K.’s Financial Conduct Authority (FCA) and two surveys published by the World Bank in November 2015 that were conducted between April and October 2015.  The conclusions drawn in the FCA report and the World Bank surveys mimicked those discussed above: heightened enforcement actions combined with stricter financial regulations and considerations of profitability are causing large banks to avoid rather than assess actual financial risk by limiting or eliminating entire classes of customers based on country and product line.  Correspondent banking and MSB relationships in countries where money laundering and terrorism financing concerns are high are hit hardest.

Moreover, as financial institutions become stricter in their efforts to winnow out what are perceived to be riskier accounts, there is an acute danger that illicit funds will go “underground.”  That is, funds will be moved not through financial institutions but through unregulated means such as bulk transfers of cash or “hawalas” – informal value transfer systems.  This underground movement of funds has caused international concern.  Gloria Grandolini, Senior Director of Finance and Markets Global Practice at the World Bank Group, warned that “[t]here is a real risk that turning away customers could actually reduce transparency in the system by forcing transactions through unregulated channels.” The recent decision by Australia’s major banks to quit the country’s $35 billion per year remittance industry has similarly worried Australia’s regulators and federal police force, who warn that the banks’ actions have “pushed transfers into murky channels, making them harder to trace and leading to compliance headaches for Australia’s anti-money laundering regulator.”

Finally, the fact that U.S. dollar accounts are becoming increasingly harder to access may drive international trade into other currencies and make the dollar no longer the “currency of choice.”  This could have significant strategic import for the United States.

There is no question that de-risking presents a number of problems.  However, the solution to balancing the concerns of financial institutions with the need for financial inclusion and transparency continues to evade the international financial community.  Countries with weak regulatory frameworks must work to strengthen controls.  The financial industry must understand that de-risking does not come without a cost: illicit funds will find an underground route into the international financial system and will be harder to trace and identify.  However, high-profile enforcement actions involving hefty fines and reputational damage have made banks skittish.  Although regulators are quick to stress that those actions generally involve egregious, repeated, or systemic violations in financial institutions with fundamental AML failings, perhaps banks would benefit from more concrete assurances from regulators – a safe harbor rule guaranteeing that if banks fulfill their requirements under anti-money laundering rules, they will not be prosecuted or otherwise held liable should the money they handle for customers land in the wrong hands.  Whatever the solution, scaling back on the disadvantageous consequences of de-risking is critical and will require a concerted effort by financial institutions, regulators, governments, and other actors in high-risk geographical regions and business lines.

Julie Copeland is a Partner in the New York Office of Lewis Baach PLLC.  Ms. Copeland has a long and distinguished career as a senior financial institutions lawyer and prosecutor and practices in the areas of Financial Crimes Compliance and Advisory as well as Internal Investigations. Mirella deRose is a trial attorney in the New York Office of Lewis Baach PLLC and a former regulator with expertise in financial and complex crimes.  Prior to joining Lewis Baach PLLC, Ms. deRose served as Principal Counsel in FINRA’s Enforcement Department.

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