De-Risking Explained

Businesses tend to reduce their exposure to certain types of customers or business activities that are perceived as higher risk—sometimes avoiding certain clients, products, and segments altogether. However, this approach comes with challenges. Let’s look into what de-risking is in more detail, what it can protect against, as well as some best practices.

What is de-risking?

According to FATF, de-risking is “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”.

In other words, “de-risking” is when financial institutions, such as banks, brokers, credit unions, or investment companies, reduce their exposure to certain types of customers or business activities that are perceived as higher risk for money laundering and/or terrorist financing (ML/TF). This can involve terminating relationships with clients or discontinuing services in order to minimize the overall risk to the institution.

 De-risking is often a response to regulatory pressure, increased compliance costs, or concerns about potential legal and reputational risks associated with certain clients or transactions.

In addition to restricting certain types of customers and clients, de-risking can also exclude certain products, or geographic locations, or industries considered high-risk for ML/TF. 

Forms of de-risking

De-risking can take on various forms, including:

1. Selective client onboarding. Companies may become more selective in onboarding new clients, conducting thorough due diligence prior to the commencement of a business relationship and avoiding certain categories of clients altogether.
2. Product and service limitations. Companies may limit or discontinue offering certain products or services that are associated with higher AML risk.
3. Termination of relations. Companies may even choose to terminate relationships with clients or businesses that are considered high-risk.
4. Geographic restrictions. Some businesses may prefer to cease operations in certain geographic regions that are considered high-risk for money laundering or terrorist financing (ML/TF).

De-risking challenges

De-risking can indeed help businesses manage their risk exposure. However, there are concerns associated with this strategy. De-risking can lead to financial exclusion of legitimate businesses and individuals, especially in higher-risk regions, making it difficult for them to access services or products (especially banking services). Moreover, de-risking may not necessarily eliminate underlying AML risk, as it could drive illicit financial activities further underground.

Regulators and international organizations have recognized the challenges posed by de-risking and have encouraged financial institutions to adopt risk-based approaches to AML compliance instead.

Suggested read: Anti-Money Laundering (AML) Policy: Step-by-Step Guide (with Template)

What de-risking can mitigate

De-risking can be used to mitigate a number of risks, including:

1. Money laundering
2. Terrorist financing
3. Regulatory non-compliance (By avoiding high-risk customers or transactions, businesses can lower the likelihood of non-compliance with AML regulations)
4. Reputational harm (Dealing with high-risk customers can pose reputational threats)
5. Operational failures (De-risking can help simplify operations and reduce the likelihood of error)
6. Legal trouble (There may be legal consequences for financial institutions that inadvertently facilitate money laundering or other illicit financial activities. De-risking aims to minimize legal risks by avoiding relationships with entities or transactions that could lead to legal complications).

Suggested read: Risk Management in Fintech and How Artificial Intelligence Can Help

De-risking strategies 

1. Customer segmentation. Financial institutions may categorize customers based on risk profile, allowing them to apply different levels of scrutiny and due diligence to higher-risk customers and vice-versa.
2. Enhanced Due Diligence (EDD). De-risking often involves implementing more rigorous due diligence procedures for customers or transactions that are considered higher risk, requiring additional information and scrutiny.
3. Risk scoring and monitoring. Companies can set up automated risk scoring and continuous monitoring of high-risk users throughout the use of their services. When users flag suspicious behavior, they can be sent for manual review or even automatically rejected, at any time.
4. Termination of high-risk relationships. Financial institutions may terminate or avoid establishing relationships with customers or businesses perceived as high risk, even if they can potentially bring profit.
5. Reducing exposure to high-risk services. Companies may limit or stop offering certain products or services that are associated with higher ML risk. This can include implementing vigorous AML screening to prevent false positives, coupled with source of funds and business verification.
6. Geographic restrictions. Companies may build stricter verification levels for onboarding users from greylisted countries or emerging markets
7. Continuous monitoring and periodic review. Companies can implement face authentication checks for large transactions and run periodic verification checks to lower the risk of account takeovers.
8. Transaction monitoring and reporting. Companies can implement robust transaction monitoring systems to identify and report suspicious activities promptly, reducing the risk of inadvertently facilitating illicit financial transactions.

De-risking best practices

• Implement face authentication checks either periodically or when users carry out specific transactions to ensure legitimate user identity.
• Add extra identity and address verification layers, like database checks or geolocation, for high-risk users or those from greylisted countries.
• Couple source of funds questionnaires and business verification in your AML screening to prevent false positives and high-risk exposure.
• Use behavior pattern monitoring and analysis tools to detect and investigate suspicious user transactions.
• Use workflow automation to help you route multiple verification scenarios.
• Implement checks like bank account or credit card verification not only for EDD, but to also prevent chargeback fraud, stolen accounts, and card issues.

FAQ

• What is the de-risking process?

  The de-risking process involves a strategic assessment by companies to reduce exposure to high-risk individuals, entities, activities, or regions in order to minimize compliance- and operations-related risks associated with money laundering or terrorist financing.

• What are the effects of de-risking?

  De-risking helps businesses mitigate risks like money laundering or AML non-compliance. However, it may also lead to financial exclusion of legitimate  individuals and businesses and the possibility of driving illicit financial activities further underground.