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Is de-risking an over-reaction to over-regulation?

By Signature Litigation
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Signature Litigation
Signature Litigation

Associate Jessica Thomas’s article has been featured in the following publications:
Professional Adviser – 24th August 2016
Insurance Day – 24th August 2016
Money Laundering Bulletin – 14th September 2016

In the wake of the global financial crisis, “risk avoidance” appears to have replaced “risk management“[1], with banks embarking upon wholesale cullings of customers deemed to be “outside of risk appetite“. This practice is called “de-risking“, and whilst many regulatory authorities insist that it is not in line with international guidelines, the unfortunate reality is that it has become a recognised problem within the global financial services sector and termed a large-scale market failure[2].

The increased regulatory activity means increasing costs to banks either in the face of sanctions imposed by the regulators, or in the face of mandatory standards of risk and compliance. This has not gone unnoticed and the World Bank’s 2015 report on de-risking points to low profitability of a customer base as one of the key, if not the most important, driving factors behind de-risking practices. Banks are now frequently left in a situation where they lack both “market and regulatory incentive” to maintain a wide range of customer accounts, with the preferred approach being to off-board high-risk, low-profit customers.

The risk of falling short of existing Anti-Money Laundering (“AML”) legislation is another factor. In the UK, the application of the Money Laundering Regulations 2007 and, specifically, the concept of a Politically Exposed Person (“PEP”), has an extensive application across a wide range of customers (covering not only the PEP itself, but also any of its “close associates” and “immediate family members“). Moreover, once a PEP has been identified banks are then under an obligation to carry out enhanced customer due diligence and monitoring – rather than adhering to these ongoing obligations, the more financially viable and risk-adverse option for a bank is often to simply close the customer’s account.

The Financial Action Task Force has observed that de-risking has the potential to force entities and persons into less regulated or unregulated channels. Something which Gloria Grandolini (Senior Director of Finance and Markets Global Practice at the World Bank Group) agreed with when she stated that “[t]here is a real risk that turning away customers could actually reduce transparency in the system by forcing transactions through unregulated channels“. So what can be done to counter the adverse effects?

The FCA’s recently commissioned report (“De-risking & Impacts of Derisking”) recognised the need for banks to “retain flexibility in setting up appropriate systems and controls to ensure they comply with legislation as well as in making commercial decisions on whether to provide banking facilities that are consistent with their tolerance of risk“.

Many hope that the Financial Services Act 2016, which came into force on 6 July 2016, will go some way to achieving this. The act makes provision for the FCA to issue guidance on the meaning of a PEP for the purposes of the Money Laundering Regulations, going so far as to suggest that compensation might be owed to the customer concerned if the banks effectively “over-comply” with the regulations. This latter proposal appears to address the “one size fits all” approach by introducing an element of accountability for any de-risking decisions and encouraging a more active management of risk portfolios. To ensure this initiative has any real impact, however, it would need to truly penetrate; training should highlight more than just a need to focus on treating each client on a case-by-case basis, and work to avoid the systematic allocation of clients into convenient risk buckets to be emptied out of the firm if out of sync with its risk appetite.

Many hope that the arrival of the Basic Payment Accounts Regulations 2015 (“BPARs“) on 18 September 2016 will also provide a buffer to across-the-board de-risking practices. The BPARs will, subject to certain conditions, make it mandatory for banks to offer a basic payment account to any consumer who applies for one on or after 18 September 2016.  Banks will also see a limitation of their discretionary termination rights: under the BPARs, basic payment accounts may only be closed in clearly defined situations (for example, if the account is being used for illegal purposes, or if the customer subsequently opens a second account elsewhere). The FCA sees the introduction of the BPARs as positive progress in the fight against de-risking; not only do they provide clear cut rights to customers, but they also lay down unambiguous rules of governance for banks in respect of certain customer accounts. That said, the restricted application of these Regulations cannot, unfortunately, be ignored: basic payment accounts are not overly appealing due to their limited functions, they are also notably under-advertised by most high street banks and as a result make up only a small number of accounts on most banks’ books. Despite the BPARs being a step in the right direction, therefore, their impact might not actually be felt on any extensive scale.

Outlook

It is unlikely that these new initiatives will totally eradicate the problem of de-risking. What is promising, however, is that UK regulators appear at least to have realised that the current regulatory environment is close to being unworkable. Banks need more clarity on what risks they actually face, and an improved dialogue between the financial services sector, the regulators and the consumers will prove essential in achieving this.

[1] World Bank Report: “Understanding Bank De-risking and its Effects on Financial Inclusion“, November 2015.

2 As above at 1.

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