Has the pendulum swung too far?

Posted: 24th August 2015

Derisking, arguably a potential outcome of intensified regulatory scrutiny, has been a hot topic of conversation over the past year.

By enforcing deeper compliance with anti-money laundering obligations, unintentionally, the pendulum may have swung too far the other way. As some firms are seen to err on the side of caution, we’re seeing entire groups of customers in the financial services industry having limited / no access to banking facilities.

It could be suggested that firms are simply trying to cast themselves free of the financial risk and costs that come with financial crime. Ironically, derisking has been seen to hit growth in many areas of the industry; something that could be viewed as making the economic playing field weaker and not necessarily safer.

Have firms derisked to the point that they’ve created an unfair market?

MOTIVES

In today’s less forgiving regulatory environment, the journey to derisking is not hard to fathom. The unearthing of financial crime can cause many complications for a bank:

Regulatory risk

Penalties, remediation plans, restrictions from undertaking certain activities, the absolute loss of banking licences /permissions.

Regulatory costs

The most commonly cited reason for derisking - significant costs involved in completing enhanced due diligence and monitoring on relationships that are arguably not as profitable.

Risks outside of regulation

Law enforcement, political reaction, and potential reputational damage.

MARKET IMPACT

What have been the more widespread drawbacks to this risk reducing strategy? Derisking has manifested itself in:

• Firms’ changing risk appetites i.e. increased risk aversion
• Broad retreats such as pulling out entirely from certain correspondent banking relationships
• Transfer services, charities, money services businesses (MSBs), and fintech firms are amongst the sectors that have found difficulties in accessing financial services after being seen as being higher risk. Thus, competition and innovation could be seen to be floundering

In the long run, these hindrances and lack of advancements could potentially have detrimental long-term economic impacts. Firms often only focus on maintaining market integrity, which is but one FCA objective, yet could be seen to conflict with its competition objective.

If derisking continues, some of the impacts that may continue / evolve include:

• Less diverse bank portfolios
• Challenging institutions in the market such as MSBs could be indirectly forced out of the market through being unable to access banking facilities. This could be viewed as anti-competitive through indirectly forcing out other competitive institutions
• Monopoly of the banking market by the same ‘players’ meaning potentially less choice for consumers
• Banking institutions could be viewed as setting the market agenda / appetite; arguably a questionable role for them to have

THE REGULATOR’S APPROACH

Conflicting confusion

There appears to be a conflicting regulatory approach. On one side of the pendulum’s passage, the FCA is asking firms to have robust systems and controls in place for higher risk situations to maintain market integrity. On the other side, there is a lack of contingency in place when the consequences of those controls – such as derisking – crystallize. This doesn’t appear to reconcile with maintaining a fair and competitive marketplace. It could be said there should be some level of responsibility attributed to the regulator’s approach. Whilst it has actively stated that it is not telling firms to derisk, the reality is that its initial actions may have indirectly encouraged that.

Consequential action

The FCA has since released a public statement clarifying that effective money-laundering risk management should not give rise to wholesale derisking. The statement on derisking highlights that the FCA discourages derisking, and asserts that whilst there may be risks present with individual businesses, all other business in their spheres should not be tarred with the same brush. The regulator urged that firms foster proportionate and effective anti-money laundering systems. It then reaffirmed its commitment in a statement earlier this July as it confirmed its support for the Financial Action Taskforce’s (FATF) investigation into the causes, scale and impact of derisking.

An industry in need of direction

Whilst these comments are helpful, what the industry may require is assurance that if they do decide to take on higher risk relationships, they will not be penalised for that alone, as it naturally could put them under the spotlight. Maybe what is required is a clear and consistent understanding of what a ‘proportionate risk based approach’ is and what is and isn’t considered acceptable in the circumstances. It would ultimately be the responsibility of firms to implement this into their own business, but some guidance from the regulator could assist many in understanding where to draw the line rather than derisking sectors from banking / investment portfolios entirely.

Given the above:

• Are you comfortable your approach to derisking is balanced and proportionate?
• What does an effective risk-based approach look like for your firm?

THE HUNTSWOOD VIEW

Huntswood’s dedicated Financial Crime Risk team have completed a number of independent Enhanced Due Diligence Reviews on behalf of banks for higher risk customers / relationships and we continue to do work in this space. Our recommendations to counter widespread derisking are to:

• Seek independent assurance to assess the adequacy and effectiveness of the firm’s culture and compliance procedures
• Implement heightened procedures and controls wherever you’ve recognised higher risk situations / relationships
• Be sure that you’re able to evidence that your business has gone through the appropriate risk assessment process, and taken the suitable risk mitigating action
• Have relevant MI to ensure you are able to track and monitor the higher risk situations / relationships with ease and speed
• Ensure ongoing monitoring is in place and is proportionate to the risk

Whilst we do appreciate the costs and risks involved, derisking whole sectors is not a true implementation of a risk based approach. It is only a short term solution to a wider risk management issue. Total risk avoidance is not the answer, and could demonstrate a culture in which a firm may not be thinking strategically and sustainably about its business.