What is De-risking?

The FATF characterizes “de-risking” as the phenomenon of financial institutions terminating or restricting business relationships with clients or categories of clients to avoid, rather than manage, risk in line with the FATF’s risk-based approach.

Today, correspondent banks use de-risking as a tool to mitigate their compliance risk. However, this appears to go beyond the management of money laundering/terrorist financing risk.

FI’s are required to gather sufficient information about the respondent bank to understand the respondent bank’s operations, reputation, and quality of supervision, including whether it has been the subject of money laundering or terrorist financing investigations or regulatory actions, and to assess the respondent bank’s AML/CFT controls.

However, the FATF Recommendations do not require banks to conduct normal customer due diligence on their respondent bank’s customers when establishing and maintaining correspondent banking relationships, it’s likely that there could be some exceptions when there is certain high risk.

What are the drivers behind the trend of “de-risking”?

The phenomenon of de-risking can be traced back to a combination of factors, such as low-profit business lines in the realm of correspondent banking, the implementation of stricter risk management controls, and the pressure to adhere to increasingly rigorous regulatory requirements.

The profitability of correspondent banking is heavily reliant on a considerable volume of business. However, due to the reduced returns and the rise in competition stemming from technology-driven business models, numerous financial institutions have decided to terminate from such operations and seek better alternatives.

Moreover, following the Anti-Money Laundering and Countering Financing Terrorism (AML/CFT) Standards proposed by the Financial Action Task Force (FATF) and adapting to specific country requirements can substantially increase both costs and risks linked to sustaining or establishing relationships between correspondent banks and their respondent counterparts.

Uncertainty surrounding AML/CFT regulations, which includes understanding what constitutes acceptable risk-taking parameters, often leads to concerns about unintentional errors or noncompliance with particular guidelines. Given that it is difficult to assign a monetary cost to a significant portion of the overall risk involved, evaluating the risk-return ratio becomes a complex process. This complexity consequently places additional strain on relationships between correspondent banks.

A recent analysis conducted by the US Department of Treasury in April 2023 sheds light on an intriguing aspect: perceived supervisory expectations may also influence de-risking decisions. According to this report, banks claim that there is often misalignment between regulatory guidance concerning the “risk-based approach” and its interpretation by examiners. This discrepancy results in financial institutions fearing they may face violations and penalties even when adhering properly to the Risk-Based Approach guidelines.

What is the effect of de-risking over correspondent banking? 

Cross-border payments are vital for economic development in a globalized economy, payments flow through correspondent banks that operate in a huge network of bank relationships.

The recently published document by BIS showed that the number of correspondent banks fell by 20% between 2011 and 2018, even as the value of payments increased, there could be another factor that could affect the withdrawal however we can clearly say that de-risking has played a critical role.

Banks withdrew more from countries where governance and controls on illicit financing were poor, and less where economic growth and trade were robust. The retreat of correspondent banks might hurt the financial network web, raise the cost of cross-border payments, and drive respondent banks into uncharted territories.

Loss of bank access, where it is widespread and indiscriminate enough to be considered de-risking, has the potential to push countries to seek closer relationships with geopolitical competitors and cause significant macroeconomic damage.

How to manage being de-risked risk?

Financial organizations are terminating or limiting their business dealings with clients or specific client groups to evade risks rather than managing them effectively. De-risking is employed as a tool for mitigating compliance risks. Consequently, designing a robust Anti-Money Laundering/Counter-Terrorist Financing (AML/CFT) solution is fundamental in preventing de-risking, as correspondent banks prefer to ensure respondent banks have adequate risk control measures in place.

At the onboarding stage, some potential approaches include:

• Implementing automated AML/CFT techniques to improve customer due diligence processes.
• Utilizing AML monitoring systems with Artificial Intelligence (AI) capabilities for developing efficient risk scoring models that effectively classify customers into appropriate AML risk categories.

There are solutions leveraging AI that can mitigate money laundering threats while maintaining relationships with respondent counterparties. Such solutions streamline Know Your Customer (KYC) and screening procedures, thus enhancing overall profitability, and decreasing compliance costs.

Post-onboarding, transaction monitoring becomes crucial for tracking and managing the ongoing risks associated with existing clients. Technological advancements can facilitate the development of AML solutions capable of scrutinizing and evaluating customer transaction behavior in comparison to their initial onboarding profile. Such systems can efficiently detect anomalies and raise alerts to compliance teams, enabling them to report to regulators when necessary.

Respondent banks must acknowledge the importance of maintaining transparent communication with their foreign correspondents. Engaging in continuous dialogue is essential—providing updates on changes to AML and CFT regulations within their country, while discussing any audit findings or regulatory examination results along with relevant action plans.