The Risks of De-Risking

Compliance officers at financial institutions have the monumental task of acting as guardians at the gate: protecting their organization and the global financial system from abuse while also ensuring that licit funds flow undisturbed. This is a delicate balance, as global regulations continue to grow in complexity and regulators threaten to impose harsh penalties for knowingly, or unwittingly, facilitating the transfer of illicit funds originating from high-risk customers. Despite the ever-expanding web of regulation, each financial institution sets its own risk appetite, meaning there is no single globally consistent consensus on what constitutes a high-risk client.

The strain of regulations has prompted some financial institutions to de-risk from certain markets or jurisdictions, which could deprive individuals and businesses in high-risk jurisdictions of critical banking services. Additionally, by moving financial flows towards methods which are less subject to regulatory measures – such as informal money transfers – de-risking can inadvertently undermine efforts to promote integrity and transparency in the global financial system.

What are high-risk clients? Must a bank cease its relationships with these clients to protect its reputation and mitigate the risks of regulatory penalties?

What is a High-Risk Client?

A high-risk client is a customer who presents a greater risk of financial crime and who warrants enhanced due diligence and monitoring throughout the client lifecycle. While financial institutions will differ in how they approach their business with high-risk clients depending on their own risk appetite, some markers of high-risk clients are well-established.

Generally, four factors determine if a customer is high-risk: geography/jurisdiction, profession or industry, products/services, and channel. Client-specific characteristics may also influence their risk rating including political exposure, adverse news, sanctions nexus, ownership structure, or entity type.

Geography/Jurisdiction

A client could be considered high-risk if they live in a jurisdiction particularly vulnerable to illicit finance risks, such as geographies with lax AML/CFT controls. For business customers, this would apply where the business is registered, operates in, or has clients in these higher risk jurisdictions. Geographic risk factors also can include countries subject to sanctions, and countries with significant levels of corruption, and criminal and terrorist activity, according to the Financial Action Task Force Interpretive Note to Recommendation 10. Geographic/jurisdictional risk factors also include proximity to, and cross-border transactions with, high-risk countries.

Profession or Industry

This category of high-risk clients is the most wide-ranging given the number of industries and sources of wealth that may be considered vulnerable to illicit finance risks. The Wolfsberg Group Guidance on a Risk-Based Approach outlines several professions and sectors as high risk, including armaments, the financial sector (including money services businesses), casinos and other cash-intensive businesses, and charities and nonprofit organizations. Dealers in precious metals and stones, as well as art, antiquities, and real estate are also vulnerable to illicit finance.

The shipping sector is particularly vulnerable to trade-based money laundering and sanctions and strategic trade control evasion. Industries in that sector include commodity traders, port operators and others.

Clients operating in defense or dual-use goods – meaning those which can be used for both military and civilian purposes – may be subject to strategic trade controls. If strategic trade control requirements are breached, the institution financing the trade may be subject to regulatory action too.

Products or Services

High-risk financial products and services include those that facilitate high-speed transactions, present anonymity, and intermediate relationships. Trade finance instruments, dollar clearing services, correspondent banking accounts, and pooled vehicles that manage assets on behalf of clients, and others, may be vulnerable to abuse.

Intermediated relationships should warrant extra caution. The greater the number of financial intermediaries, the more complicated KYC and CDD efforts become.

Client-Specific Characteristics

A client with opaque ownership or control structure or unclear client base can be considered high-risk. The involvement of shell companies, shelf companies, nominee arrangements, and other complex ownership structures also increase the risks of financial crimes.

Key Considerations for Financial Institutions

The majority of clients are engaged in perfectly legitimate business, even those with high-risk characteristics. The decision to onboard or maintain a relationship with a high-risk client may differ depending on a financial institution’s risk appetite.

The costs of enhanced due diligence for high-risk clients are burdensome. Financial institutions must accommodate both meet regulatory requirements and ensure profitability from a relationship. De-risking from high-risk markets and jurisdictions can be a legitimate risk management tool, or commercial decision as profit margins diminish with compliance costs, but it can also lead to financial exclusion.

Risks of De-Risking

Certain financial institutions have chosen not to service high-risk markets, jurisdictions, or client types altogether rather than exert resources on due diligence required to maintain effective control for these high-risk clients. The repercussions of de-risking may be severe for the affected markets or clients.

FATF believes de-risking could increase the use of informal financial services, undermine financial inclusion efforts, and increase money laundering and terrorist financing risks. The U.S. Department of Treasury, in its 2023 De-Risking Strategy, outlined how de-risking could disrupt the “unencumbered flow of development funding, as well as humanitarian and disaster relief.”

Money services businesses, non-profit organizations, and foreign respondent banks, especially in high-risk jurisdictions, are also highly vulnerable to de-risking. While most financial institutions cited profitability as the cause of termination of business with these types of customers, interviews conducted with representatives of financial institutions reflected an ingrained belief that the “potential for added scrutiny” is a “reason they may choose not to bank or service certain accounts.”