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On September 14, Liat Shetret – our director of global policy and regulation – testified at the US House Financial Services Committee hearing on When the Banks Go: The Impact of De-risking on the Caribbean and Strategies to Ensure Access to Finance.
Here are some of the highlights from Liat’s testimony, covering the unintended consequences of risk reduction — such as reduced access to financial services — and how technological innovations like blockchain can be used to counter it.
Risk reduction is not a new issue
A 2015 co-authored report commissioned by Oxfam US called “Understanding risk mitigation in banks and its effects on financial inclusion”Liat explored the drivers and responses to de-risking, highlighted case studies of financial access and provided recommendations for banks, regulators and clients of de-risked banks.
De-risking – or debanking – refers to the practice of financial institutions exiting customer relationships and closing customer accounts deemed to be “unacceptably risky” or “high risk” based on the bank’s risk tolerance. Instead of managing these risky customers, financial institutions may choose to terminate the relationship entirely, thereby minimizing their own risk exposure, leaving customers without access to the global banking system. According to the World Bank, there are over 1.4 billion people in the world who either do not have banking services or do not have enough funds.
Drivers of risk reduction
Financial institutions have significantly reduced their appetite for risk. These declining risk appetites – along with increasing global scrutiny of anti-money laundering/countering the financing of terrorism (AML/CFT) – are the most commonly cited reasons for reducing risk.
Underlying the practice of de-risking, however, is the assumption that affected clients pose a greater risk of using bank accounts as a medium to collect, move and store funds that are somehow tainted by illegal activities such as money laundering, terrorist financing. or tax evasion.
In particular, correspondent banks – which provide ancillary services such as check clearing, foreign exchange trading and fund transfers on behalf of other financial institutions – have been identified as a key vulnerability in AML/CFT regimes and are being de-risked. Profitability is also a factor in evaluating correspondent banking relationships. In short, the risk is simply not worth the reward.
Risk mitigation implications and regulatory response
De-risking is an issue that affects the entire market. 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, AML/CFT objectives and, worryingly, 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 altogether – something called re-risking.
International standards encourage financial institutions to adopt a risk-based approach (RBA). Regulators proactively advise financial institutions to assess their vulnerability to money laundering and terrorist financing and to formulate policies and allocate resources according to their unique risk profiles and risk exposures. While this approach is designed to allow flexibility, it also introduces ambiguity and enormous subjectivity around which actions are actually required to meet international AML/CFT standards. Inadequate risk avoidance has replaced effective risk management.
Rather than reducing the risk of criminal activity in the global financial sector, risk reduction potentially increases systemic vulnerability. Encouraging high-risk clients to become nested accounts in smaller financial institutions that may lack adequate AML/CFT capabilities and controls. De-risking reduces the visibility of well-regulated global institutions. Such a consequence was almost certainly not the intention when the RBA was implemented and does not objectively increase safety.
Innovation and technological solutions for risk reduction
Risk reduction is a problem of exclusion that is solved by inclusion – specifically, the inclusion of actors and technology.
As the digital economy has evolved, the need to update and expand definitions of compliance concepts such as customer due diligence (CDD) and know-your-customer (KYC) rules has increased. Identity management must now consider reconciling online identities with offline identities, as well as account for individuals who remain without identification.
The new legislation should explore the elasticity of KYC – the idea that these rules can be expanded to fit the realities of economic development and security that span digital and traditional markets. Improving access to financial services through technological improvements in identity authentication can lower barriers to entry for those unable to access these services due to identification requirements.
Blockchain-based technological solutions that strengthen the global dominance of the US dollar – including stablecoins and central bank digital currencies (CBDCs) – should accelerate. This will ensure that market efficiency, privacy concerns and interoperability with other economic blocs – such as with Caribbean partners – are well considered,
CBDCs have an extremely high adoption rate in the Caribbean, with eight Eastern Caribbean countries fully deployed. As the US continues to explore the development of its own digital dollar, interoperability with other countries’ CBDCs should be a priority as a means of strengthening US competitiveness in the global economy and dramatically improving the deployment of capital in these regions.
Blockchain analytics, such as those developed by Elliptic, exemplify 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 allow 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.
Many challenges remain in addressing the balance between financial integrity and inclusion. However, there are also many opportunities to address these issues by operationalizing public and private sector initiatives that address concepts such as identity and transaction tracking. The transition to a digital economy gives banks the opportunity to innovate, effectively manage and mitigate risks. Technological innovations such as blockchains serve as relief for all stakeholders involved in the risk reduction puzzle.
Read Liat Shetret’s full testimony here
Compliance with Financial Services Regulations
