KYC, Laundering and Regulators: a Lose-Lose Situation

I chaired a meeting today about KYC: Know Your Customer.

KYC is a wonderful thing that is debated in many financial circles and is an area that I could blog about for two minutes, but I think I need to take a little longer than that.  Therefore, I’m going to write a few blogs about the subject.  Apologies if it turns you off, but it’s a pretty important area and, in order to do it justice, deserves two or three slices of thought.

The main thing that struck me today was the law of unintended consequences.

I’ve blogged about this before too, but it’s to do with regulators regulating incorrectly.

Regulators regulate to get a result.

An outcome.

The achievement of a principle.

Whether you prefer principles-based regulation or outcomes-based regulation, the principle is that people who are using banks for illicit processing of dirty money should be caught, and the outcome should be that money launderers, drug runners and terrorists are caught.

That’s the principle and outcome behind FATCA, the Foreign Account Tax Compliance Act, the Patriot Act and more.

As you can see, it is highly US-driven and has resulted in severe fines for companies caught in the light of NKTC (Not Knowing Their Client).

HSBC is the main case in point, with a $1.9 billion fine for money laundering breaches in 2012, many of which were related to firms that fell below their radar.

Firms that were credit transfer agencies, and were too small to check.

Interestingly, in Citibank, they had the same issue but were not treated in nearly the same way, so treating banks fairly is not in the parlance of the US regulators.

That’s a point I will come back to, but it is not the point of today’s column.

Today, the point is this:  regulators have forced banks to get rid of dodgy counterparties and, in so doing, have forced the issue underground.

The issue of money laundering and dodgy finance has moved from the big bank network to the small bank network, thanks to the way the regulators have fined HSBC, Standard Chartered and more for money laundering breaches.

HSBC, JPMorgan, Barclays and others have thrown so many companies off their network that these companies – many of them smaller banks in emerging economies – have had to find alternatives to enable them to process cross-border and, specifically, to process in USD (US Dollar).

JPMorgan closed God’s accounts for this reason (well, the Vatican’s anyways) as did HSBC

In HSBC’s case, the issue of regulatory non-compliance caused so much fear that they ejected many other accounts too, from foreign embassies in dodgy nations such as Papua New Guinea to Brett King’s account.

I can understand the latter ... but Papua New Guinea?

The thing is that it is all wrapped in fraud, money laundering, compliance, audit, identity management and ultimately KYC.

Know Your Client.

A complex process that banks believe they must own, as risk of getting it wrong is so high that it is now worth it.

The real problem here however, is that you eject the Bank of Dodgy Leader from Dodgy Nation and what does he do?

He gets a ‘nested account’.

A nested account is one that becomes a counterparty to a bank that is respectable.

In fact, it ends up that you get nests within nests.

So HSBC and JPMorgan throw me off the network and I end up with the Bank of Nowhere.

The Bank of Nowhere allows me to do cross-border transactions via the Bank of Somewhere.

The Bank of Somewhere is a counterparty of the Bank of Everywhere.

Only the Bank of Everywhere is on the SWIFT network, and so my transactions become hidden.

Not only that but the risk management system on the global network becomes hidden, because the regulator has driven my business into a cover network.

What I mean by this is that the more the regulators squeezes the simple  target – the global transaction banks and the SWIFT network – the more the real target moves underground.

The result is the law of unintended consequence: the regulators squeeze the bona fide banks and the target trades that the regulators wants to catch become so opaque and hidden in the network that they will never find them.

Either that, or pour all your money into Bitcoin of course.

For me, the KYC debate from the regulator’s viewpoint is one where the regulators are using a hammer to crack a nut.

They have targeted the bank’s network to address the issue rather than the issue itself.

I think the regulator has in fact made the issue worse, rather than better.

It would be better for the regulator to work with the banks to encourage the money launderers and terrorists to wash their money through the network and get caught.

Instead, for their own reasons, they are doing the opposite: making the banks culpable for the launderers and terrorists and forcing the terrorists and launderers to move their money into covert counterparty operations.

All well and good?

Sure ... until they find the hidden network and the shadow bank system overwhelms the open network and the transparent bank system.

So what is the answer?

More on that tomorrow, but it is obvious that it is not squeezing the global banks and their customers.