Compliance Risk

What is Compliance Risk?

Compliance risk is defined as a bank’s exposure to financial loss and/or financial penalties when it or its employees fail to act in accordance with laws and regulations that govern its operations. It also refers to when employees do not follow internal policies or prescribed best practices.

Legal and compliance risk management involves implementing robust governance frameworks, ensuring adherence to relevant laws and regulations, establishing effective compliance programs, conducting regular audits, and promoting a strong culture of ethical conduct throughout the organization.

Common Types of Compliance Risk

There are many ways in which compliance risk can be subdivided:

Regulatory Risk

Regulatory risk is the risk that the regulations governing a bank are changed by the relevant regulators of that bank, resulting in the bank having to update its operational procedures or business activities. This will usually result in an increase in the costs within the bank to ensure the new rules are complied with.

Conduct Risk

Conduct risk (or people risk) relates to the risk that employees might make poor decisions or breach the bank’s internal processes. This can put the bank or its customers at a risk of financial loss.

Data Privacy

Data privacy is the risk that customers’ data ends up in the public domain by malicious or accidental means. Breaches can result in heavy fines and negative press for the bank.

Financial Crime

Financial crime covers a wide range of crimes but money laundering, the financing of terrorism, and insider dealing, are some of the more significant examples.

Cybersecurity

Cybersecurity deals with the risk that the bank’s computers, servers, mobile devices, electronic systems, networks or data might be targeted in a malicious attack. These can potentially lead to data breaches of private information, or the banks systems being put out of action. If the banks systems are frozen or clients are unable to access their accounts and money it can lead to an exodus of customers who will switch to a more reliable system.

Third-Party Risk

Third-party risk is the risk faced by the bank from working with outside vendors. These vendors may be independent companies acting in the name of or providing solutions to the bank, which are then sold to the clients. Errors made by these third parties might carry financial loss for the bank itself. The bank will also rely on these third parties to uphold its reputation and deliver best in class services to the client base.

Cloud Risk

Cloud risk is the risk of a data breach from servers that are hosting client data through the cloud.

Why is Compliance Risk important?

Compliance risk management is vital to ensure the successful ongoing operations of the bank. Here are the key reasons why compliance is important:

• Legal obligations: organizations must comply with laws and regulations to avoid legal consequences, including fines and sanctions.
• Reputation management: compliance helps maintain a positive reputation and public trust, which is essential for business success.
• Operational efficiency: compliance programs can streamline operations and reduce the risk of costly disruptions.
• Risk Mitigation: by identifying and managing compliance risks, organizations can prevent financial loss and protect their assets.
• Ethical Responsibility: compliance ensures that organizations operate ethically, contributing to a fair and just society

What Is the Importance of Building a Culture of Compliance Within an Organization?

A strong culture of compliance helps to ensure that all employees understand the importance of adhering to laws, regulations, and internal policies, thereby promoting ethical conduct throughout the organization. It also reduces the risk of financial loss or penalties due to non-compliance, which can arise from poor decisions or breaches of internal processes by employees. Organizations can more effectively adapt to changes in regulations, which may require altering operations or business activities, potentially increasing costs. A culture of compliance emphasizes the need for continuous training and education, ensuring that employees are always aware of compliance requirements and qualifications for their position.

Common Compliance Acronyms

AML – Anti Money Laundering

CFT – Countering the Financing of Terrorism

ML – Money Laundering

PEP – Politically Exposed Persons

KYC – Know Your Client

Money Laundering

One of the financial crimes that banks are most concerned with from a compliance perspective is money laundering. Money laundering is when cash gained from illegal sources is reintroduced to the financial system with a view to make the money look like it’s been legitimately earned. Banks are often targeted for money laundering activities because they are part of the financial system where cash can be reintroduced to appear as if it has been legitimately earned.

The three stages of Money Laundering are:

1. Placement – the illicitly obtained funds are introduced into the legitimate financial system. This is typically done by depositing cash or converting it into other forms of assets, such as bank deposits, money orders, or investments. The accounts used to do this may be based on fictious information or using individuals or companies who are unaware or are complicit in the deception.
2. Layering – the illicit funds are subjected to a series of complex transactions and movements to obscure their origin and make it difficult to trace them back to their illegal source. Creating layers of transactions, such as wire transfers, currency exchanges, investments, or multiple purchases and sales of assets.
3. Integration – the laundered funds are reintroduced into the legitimate economy, appearing as legitimate assets or income. Like purchasing legitimate assets like real estate, luxury goods, or businesses, or using the funds for investments or other financial transactions.

Anti Money Laundering (AML)

Anti-money laundering regulations (AML) are guidelines that banks must follow to actively prevent being used for money laundering. The International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 is intended to facilitate a comprehensive and coordinated approach to combat money laundering, terrorist financing, and related financial crimes. It establishes legal and regulatory frameworks that promote greater transparency, accountability, and cooperation among financial institutions, law enforcement agencies, and international partners.

Taking the industry as a whole, banking has a rather checkered history in successfully implementing anti-money laundering processes internally. Preserving client confidentiality or not providing robust enough investigations into sources and uses of funds have been previous failings. Banks that do not implement robust AML processes will now undoubtedly face fines. The global banking industry has incurred billions in fines due to such failures.

Know Your Customer (KYC)

Money launderers will seek banking institutions to hide their dirty funds. ‘Know your customer’ or KYC regulations are the first line of defence against such activities. KYC regulations aim to promote transparency, integrity, and security in financial transactions. New customers will be required to disclose information about their own background and the sources of funds before banks will agree to accept them.

By implementing robust KYC measures, institutions can mitigate the risk of financial crimes, maintain regulatory compliance, and foster trust and confidence in the financial system.

Counter Financing of Terror

The primary goal of Counter Financing of Terror is to identify and combat the financial resources that sustain terrorist organizations. This includes fundraising, money laundering, and other illicit financial activities. By disrupting the financial infrastructure of terrorist groups, CFT efforts aim to weaken their operational capabilities and hinder their ability to carry out attacks.

Key elements of CFT include these requirements of financial institutions:

• Robust KYC procedures to verify and identify the individuals or entities they are conducting business with
• Enhanced due diligence on higher-risk customers, including politically exposed persons (PEPs) and those with potential connections to terrorism
• Report any transactions or activities that appear suspicious or potentially related to terrorism financing
• Governments and international organizations impose economic sanctions on individuals, organizations, or countries involved in terrorist activities

CFT efforts rely on international cooperation and information sharing between governments, regulatory bodies, and financial institutions. Sharing intelligence and collaborating across borders helps identify and disrupt the global networks involved in terrorism financing.

Politically Exposed Persons

In financial regulation, a Politically Exposed Persons (PEP) is a current or former senior political figure that has been entrusted with a prominent public role or function. PEPs are at higher risk of being exposed to bribery, money laundering, and corruption. This is an increasing global problem as political figures move in and out of government roles.

Banks should monitor transactions from a PEP accounts and should perform enhanced due diligence procedures on PEPs. Their affiliations, employment, and association should be determined, which will help to create a profile of the PEP’s regular transactions. If any transactions fall outside the norm, this will give financial institutions the opportunity to investigate them promptly. A high political official will require closer scrutiny than an average customer to ensure that the financial activity meets regulations.

How can Technology and Automation help with Compliance Risk Management?

Automation technologies offer real-time insights into business processes, helping to pre-emptively address potential risks. AI consistently monitors for compliance, streamlining manual processes into centralized tracking. Predefined workflows in automated tools promote consistency and efficiency in risk assessments and mitigation.

Automated analytics and visual reporting enhance decision-making with precise insights. Integrated automated risk management systems provide an overarching view of enterprise risks. These automated systems outpace manual ones by delivering swift, real-time risk evaluations, enabling quicker responses to emerging threats.

Current Compliance Concerns for Banks

Despite technological and automation helping compliance risk management teams manage risks, there are also some areas of concern for these teams, particularly around technological advances:

• Data security and consequential breaches are often due to human error: demonstrating that cyber security does not necessarily involve a scenario where hostile actors penetrate a bank’s defences. Each access point in a network can be seen as a potential source of attack for a hacker. This becomes more of an issue with an increase in remote working following the COVID pandemic.
• Compliance risk can also originate from outside vendors: often these vendors maybe laxer in their compliance than the financial organizations they serve. Some vendors may not have maintained best-in-class compliance procedures which can leave the bank exposed to this weakness.
• Restricting access: this is a core component of regulatory compliance frameworks. Segmentation of networks ensure intruders cannot traverse the entire network. Strong passwords and multifactor authentication should feature prominently and be updated regularly.
• Malware protection: malware is a general term for malicious software designed to infiltrate, damage and/or control computers and networks. Compliance frameworks require the use of anti-malware protections, and failure to do so can lead to non-compliance.
• Cybersecurity risk: this manifests itself in things such as inadequate or out-of-date policies, along with failure to enforce policies. Banks have dedicated Chief Information Security Officers (CISO) in charge of enforcing such policies. Bank employees should also receive training on standard cybersecurity protocols.

Conclusion

Compliance risk in banking encompasses a wide range of potential pitfalls, from regulatory changes to employee conduct, each carrying the potential for financial loss or penalties. A key concern is money laundering, with banks required to follow anti-money laundering (AML) guidelines to prevent such activities. Financial institutions must also be robust in ensuring they know their clients well and can account for all monies entering their systems.

The banking industry’s track record in implementing robust AML processes has been inconsistent, leading to significant fines and underscoring the importance of effective risk management. With much improvement underway, it will remain a key focus for banks over the next decade, particularly with the rapid advancement of technology and AI.

Download recent Money Laundering issues facing the banking industry.