A PEP Talk

Today’s globally interconnected economy faces a range of significant risks related to corruption and illicit financial flows. At the center of these risks are Politically Exposed Persons (PEPs), individuals who, due to their positions of power, influence, or proximity to government, present an increased money-laundering risk. Because financial institutions across the globe are often used to move illicit funds, they are tasked with the challenge of identifying and managing these risks. In this article, we explore who PEPs are, why they pose a unique threat to anti-money laundering (AML) efforts, and how regulatory bodies and financial institutions are responding to these challenges.

Understanding the Concept of PEPs

PEPs are individuals who hold prominent public functions, or have close links to those who do, and, as a result, present a higher risk of involvement in corruption or illicit activities. According to international standards such as those established by global AML watchdog, the Financial Action Task Force (FATF), PEPs include government officials, military leaders, members of political parties, executives of state-owned companies, and even close family members or associates of these individuals.

Categories of PEPs include:

• Domestic PEPs: Individuals holding significant positions within their own country.
• Foreign PEPs: Individuals holding positions of influence in foreign governments.
• International Organization PEPs: Executives or high-ranking officials in international bodies such as the UN, World Bank, or IMF.

The key risks associated with PEPs include their:

• Access to public funds
• Ability to influence government decisions
• Susceptibility to corrupt practices

These factors make PEPs primary threats for money laundering activities and other financial crimes because they often use their status to funnel illicit funds through legitimate financial channels.

Evolution of PEP Regulations in AML

The inclusion of PEPs in AML regulations was driven by a growing recognition of the role these individuals play in enabling corruption. Historically, the actions of PEPs in foreign jurisdictions were often overlooked, as various countries are or were non-compliant or only partially compliant with FATF Recommendations that discuss additional due diligence for PEPs. However, high-profile scandals and the fallout from global corruption cases have brought PEP-related risks to the forefront of regulator attention and resulted in additional AML regulations.

• For example, the Pandora Papers, published in 2021, revealed that many service providers helped PEPs hide their wealth through offshore accounts in secrecy havens, highlighting the importance of enhanced due diligence on PEPs and other higher-risk customers.

International standards began to evolve with organizations like the FATF pushing for greater scrutiny of PEPs. For example, the European Union’s 4th and 5th AML Directives require enhanced due diligence (EDD) for PEPs, emphasizing the importance of identifying PEPs at the onboarding stage and throughout their relationship with financial institutions. Regulatory bodies around the world now mandate that financial institutions assess the risks posed by PEPs and adopt strategies to mitigate these risks. Today, PEP identification and management are integral to AML compliance programs, with institutions required to implement robust EDD measures for high-risk clients.

Challenges in Identifying and Monitoring PEPs

While regulations provide clear guidelines on the risks associated with PEPs, the actual process of identifying and monitoring PEPs remains a significant challenge for financial institutions. One primary difficulty lies in tracking and verifying the status of foreign PEPs, particularly in jurisdictions with opaque financial systems.

PEP lists, often maintained by third-party vendors, can be incomplete or outdated. Even where PEPs are identified, determining the extent of their influence or their proximity to public funds can be difficult. Furthermore, family members and close associates of PEPs may engage in money laundering activities without directly involving the PEP and even without the PEP’s knowledge, further complicating the monitoring process.

These complexities often create a significant compliance burden for financial institutions, which must balance rigorous oversight with the cost of EDD, relying on the risk-based approach to determine their approach to possible vulnerabilities. Smaller institutions may struggle to maintain up-to-date data on PEPs and rely heavily on technology solutions to stay compliant.

Impact of PEP Status on Financial Institutions

Financial institutions face significant regulatory obligations when dealing with PEPs. One of the core requirements is the implementation of EDD to better assess the risk posed by a PEP client. This process often involves collecting more detailed information about the individual’s source of wealth, scrutinizing their transactions more closely, and implementing ongoing monitoring throughout the relationship.

Failure to properly identify and manage PEP risks can result in severe penalties. In recent years, several institutions have been fined for failing to meet their AML obligations related to PEPs.

• In 2015, for example, Barclays Bank paid over $100 million in fines for failing to adequately mitigate financial crime risks associated with transactions involving several PEPs.

These penalties highlight the serious risks institutions face if they do not properly assess and mitigate the AML risks associated with PEPs.

At the same time, financial institutions must tread carefully, balancing the need to meet regulatory standards with maintaining positive client relationships. In some cases, banks may decide to terminate relationships with PEPs or refuse to onboard them due to the perceived risk, which can lead to reputational challenges.

Real-World Examples

Several high-profile cases illustrate the impact PEPs can have on money laundering schemes and the global financial system.

• 1MDB scandal in Malaysia involved PEPs, including the country’s then-Prime Minister, and resulted in the embezzlement of billions of dollars from a government-run development fund. Funds from 1MDB were laundered through banks across multiple jurisdictions, highlighting the global nature of PEP-related financial crime.
• Similarly, the Panama Papers leak in 2016 exposed numerous PEPs using offshore accounts and shell companies to hide their wealth and avoid scrutiny. These cases led to increased scrutiny of banks’ AML practices and exposed the ongoing challenges financial institutions face in managing illicit finance risks.

The Future of PEP Regulations and Technology

As the world continues to grapple with corruption and financial crime, the future of PEP regulations may lie in leveraging technology to mitigate these risks. Financial institutions are increasingly relying on artificial intelligence (AI) and machine learning to automate the detection of PEPs, monitor their transactions in real-time, and flag unusual behavior that may indicate money laundering. Additionally, real-time monitoring tools are allowing institutions to continuously assess PEP risks rather than relying on static data. However, the global political landscape is continually shifting, and new challenges are likely to arise.

Overall, PEPs represent a unique and growing challenge within the AML landscape. Their access to power and public funds makes them high-risk for corruption and money laundering activities. As regulatory bodies continue to tighten controls around PEPs, financial institutions must adopt sophisticated tools and technologies to stay compliant and safeguard their operations from the risks associated with PEPs. The ability to manage PEP risk will remain a critical aspect of AML compliance for financial institutions worldwide.

It’s important to note that while PEPs are considered higher-risk due to their influence and potential access to public funds, their status does not inherently imply criminal behavior. The primary challenge for financial and other institutions that have or may consider having PEPs as clients is to balance this reality with regulatory obligations.

While performing enhanced due diligence to assess the risk of money laundering or corruption is important, institutions should not automatically assume guilt based solely on a client’s PEP status. This may lead to challenges in maintaining client relationships, as over-scrutiny could harm business opportunities, and under-scrutiny may result in regulatory penalties. This delicate balancing act requires robust monitoring systems that allow institutions to adjust their risk assessments without unfairly targeting their PEP clients.