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Earlier this week, Elliptic’s director of global policy and regulation, Liat Shetret, testified before the US House Financial Services Committee at a hearing titled When the Banks Go: The Impact of De-risking on the Caribbean and Strategies to Ensure Access to Finance.
Liat’s congressional testimony referenced a 2015 Oxfam US-sponsored report she co-authored that explored the drivers and responses to risk reduction. He also highlighted case studies of financial access and provided recommendations for banks, regulators and de-risked bank customers. In the seven years since this report was published, risk reduction remains a complex and ongoing challenge.
Derizik is the practice of financial institutions withdrawing from the relationship and closing the accounts of clients who are deemed to be outside the acceptable limit of risk tolerance. As Liat’s written testimony points out, “De-risking is a market-wide issue. All invested stakeholders, banks, regulators and customers and clients of the banks seem to be acting rationally and in their own best interest.
However, in doing so, they have created unintended consequences for market integrity, financial inclusion objectives, anti-money laundering/countering the financing of terrorism (AML/CFT) objectives and, worryingly, have threatened national security interests. This is because the risks are not mitigated. Instead, risk is shifted to less visible places within the traditional banking system, so-called shadow banking – or outside of it.”
De-risking does more to shift risk than reduce it, pushing customers who are subsequently de-banked into smaller or less regulated financial institutions, many of which may lack adequate KYC/AML controls. The practice of financial institutions in accordance with the regulations is increasingly being examined.
At the same time, pressure is growing to improve financial inclusion practices. While these two goals—reducing risk and increasing access—may seem contradictory, technology can play an integral role in balancing the two.
How can technology mitigate the damage from de-risking and bring the unbanked back into the formal system?
- The convening of an action-oriented task force in the Caribbean with stakeholders from the private sector, financial institutions and government agencies will provide diverse perspectives to innovate solutions to these ongoing challenges.
- Congress should explore opportunities to promote digital identities, reducing barriers to entry caused by identification standards required under KYC.
- Congress should accelerate research into blockchain-based technology solutions that increase the global dominance of the US dollar – including stablecoins and central bank digital currencies (CBDCs). This will ensure that market efficiency, privacy concerns and interoperability with other economic blocs – such as with Caribbean partners – are well considered.
- Regulators should consider balancing punitive measures such as sanctions, fines and fines with constructive models, including regulatory sandboxes that reward risk reduction through innovation – recognizing attempts to promote financial inclusion while maintaining a strong approach to market integrity.
- AML/CFT supervisors and prudential regulators should further increase the engagement of US delegations in international forums such as the Financial Action Task Force (FATF) and their regional counterparts.
- Financial institutions could improve their focus on corporate social responsibility by adopting strategies that are more inclusive in nature, relying on individual circumstances, nuanced customer analysis and monitoring transactions from broad risk levels or sector or jurisdictional assessments.
- Blockchain analytics provides an example of how an innovative approach can work in practice to increase systemic security and increase inclusivity. Blockchain-based accounts offer unique innovations such as end-to-end visibility of funds, showing where the money is there is been and where he is going. They also enable pre-screening of accounts before funds can be withdrawn and help identify potential exposure to sanctions. These are all innovative blockchain-based opportunities that simply aren’t possible with traditional finance.
Board questions and answers
During the Board’s questioning of the expert panel, many questions were asked about the importance of fintech and blockchain solutions to reduce risk. Representative French Hill – the Republican leader of the House Financial Services Committee – asked Liat about the possibility of fintech solutions for AML/BSA compliance that improve the ability of Caribbean banks to comply with these regulations.
Answering yes, she explained that these technologies reduce compliance costs by “reducing the noise.” By reducing false positives, compliance teams can focus on high-risk areas and improve the utilization of these resources.
Representative Patrick McHenry – a staunch cryptocurrency advocate – asked Liat if it was fair to say that when a customer is unbanked or the risk is removed that they simply don’t disappear or disappear or don’t need banking services, both of which she confirmed were true.
McHenry went on to wonder if de-risking could be more accurately described as re-risk. Liat replied that this was true due to the fact that risk does not simply disappear into the ether, but is shifted elsewhere. More often than not, that risk shifts to smaller banks or financial institutions that don’t have the framework to handle these risks. It could also shift to jurisdictions that ignore or disregard these regulatory structures, a concept known as regulatory arbitrage. This migration exists for both legal and illegal jobs.
McHenry made the observation that the issue appears to shift what should be the government’s responsibility to the private sector. Liat explained that the private sector needs to police itself to some degree, keeping bad actors away from its platforms and systems. For smaller financial institutions, they are likely unable to maintain relationships with high-risk clients, regardless of legality, due to insufficient resources as well as the high cost of banking these clients.
Using AML to fight crime
Representative Bill Posey asked Liat about research on the effectiveness of our anti-money laundering laws in combating crimes such as drug trafficking and terrorism. In answering this question, she confirmed the strength of our criminal framework. What is important now is implementation and ensuring that implementation takes place across jurisdictions in a standardized manner. Posey then asked how the federal government can help reduce compliance costs for financial institutions. Liat pointed to the need for practical clarity and guidance on what these concepts mean in practice.
Redefining these compliance topics in a modernized or digitized world will help remove some of the ambiguity. Posey then asked what role the government can play in improving the quality of data available to financial institutions in shaping their anti-money laundering responses. Liat highlighted the importance of sharing data held by government agencies with industry partners and banks, providing a holistic view of regional macro trends, typologies and trends. Having more dialogue about actionable insights could help FIs respond.
Representative Roger Williams asked about potential ways to better track income from illegal organizations. Liat responded by highlighting the ability of FIs to follow manual and labor-intensive processes to identify these revenues. If we start implementing innovative transaction tracking – such as those based on blockchain – we may find a concept of traceability that shows where money comes from and goes from. When we think about the US digital dollar, something based on the blockchain will help block, track and contain these illicit proceeds.
The threat of de-risking
Operation Choke-Point issues were raised by several board members. Representative Williams raised a question about issues of indiscriminate de-risking of entire industries. Liat explained that the disappearance of traditional banks is one of the consequences of that action. This results in a greater need for digital Know Your Customer (KYC) measures. The loss of the sector means that there are a large number of businesses moving to where they can find banks, whether it’s in the US or not.
Many committee members also asked witnesses about the implications of Chinese investment in the Caribbean. Representative Gonzalez asked Liat about the impact of China’s Belt and Road Initiative from a sanctions avoidance and financial standpoint in Africa and the Caribbean. Liat highlighted her experience working in the Horn of Africa and the rise of China’s economic power in the region.
The Chinese initiative is not time-bound. Around 2013, when many banks de-risked and essentially left this region of Africa, we saw China step up and pull Africa away from the dollar-based system. This significantly complicates the enforcement of sanctions because the settlement is no longer in relation to the dollar. This parallels the de-risking taking place in the Caribbean.
Representative Bryan Steil noted the breakdown of these correspondent banking relationships and their effect on countries in Latin America and the Caribbean. Steil asked about the impact of the meltdown on American companies. Liat noted a “brain drain” as companies leave the US for jurisdictions where they can innovate freely. In addition, the regulatory framework requires greater adjustments to allow innovation to flourish in the US.
Using cryptocurrencies for illegal activities
Representative Steil also cited digital currencies to bring marginalized regions safely into the financial system. He expressed concern that crypto could not be part of the solution and could be a possible channel for illegal activities. Representative Steil questioned whether crypto poses an external risk in terms of illicit financing. Liat responded that not only did she disagree with that assumption, but simply put, criminals are opportunists.
Bad actors will go where they can look for holes and gaps; this dynamic exists in crypto as well as in traditional financial institutions. A dominant observation is the ability to track illicit crypto financing through blockchain analytics. This provides greater opportunities for companies and exchanges to stop transactions they see as illegal.
Representative Jake Auchincloss asked about using stablecoins for correspondent banking. Liat then responded by strengthening the power of financial inclusion. With risk reduction, an exclusionary barrier has been built that stablecoins can help reduce. The other part is the ability to do AML/KYC/CDD more effectively, efficiently and potentially cheaper.
Compliance with Financial Services Regulations
