How well are institutions coping with money-laundering regulations Lee Coppack investigates

On 15 January 2004, the Financial Services Authority (FSA) fined the Bank of Scotland £1.25m for failing to keep proper records of customer identification as required by the FSA's anti money-laundering rules. The FSA said it had found weaknesses in the bank's systems and controls for keeping customer identification records across its retail, corporate and business banking divisions.

However, said the FSA, after the failings were discovered, the bank's parent company HBOS 'promptly and effectively implemented a robust remedial action plan' across the whole of the group. 'This action has caused compliance rates to improve significantly from January 2003, and the FSA is satisfied that the bank has dealt with the issue appropriately', it stated.

Ten months later, on 26 November 2004, the Bank of Scotland wrote to the directors of 56 Blackheath Park Ltd, asking them to re-verify their identities as account holders as part of the fight against crime and terrorism.

The letter warned, 'Due to the importance of this initiative, failure to provide this information could result in future difficulties in the normal operation of your account.'

The directors of the company, which owns the freehold of a converted house, were surprised - because it has never had an account with the Bank of Scotland. The account number quoted in the letter is held by the business of a former tenant in the house, Nick Lindridge, who had never been a director.

As one of the directors of 56 Blackheath Park Ltd, I was concerned about the implications of this error, and so was Lindridge. The bank responded, 'This is an isolated incident which relates specifically to an error made during our mailing exercise, for which we apologise. We have since carried out a review of our processes to ensure that this error is not repeated.'

Such an error is not unusual, according to solicitor Keith Dempster of the anti money-laundering team at London law firm Marshall Ross & Prevezer.

"Many institutions are struggling with applying the regulations. Our experience is that application of the regulations is proving to be difficult, and some institutions are being very slow in starting to provide services, particularly to new customers."

Bank risks

A survey by KPMG, Global Money Laundering Survey 2004: How Banks are Facing up to the Challenge, found that anti money-laundering requirements are now a high priority issue for banks. 'The last 20 years, and most particularly the last five, have seen unprecedented activity by governments, regulators and supra-national bodies in the anti money-laundering sphere.

As a result of this rapid development, anti money-laundering has become a key issue for senior management, because the possibility of an anti money-laundering related failure now poses significant potential reputational risk, both domestically and for banks' international operations,' comments KPMG.

However, at least two-thirds of those taking part in the KPMG survey, which included responses from 209 banks based in 41 countries, came from people whose jobs involve compliance or anti money-laundering control.

Banana Skins, a regular study of bank risks by the Centre for the Study of Financial Innovation, most recently published in 2003, found that the perception of risk varied considerably, depending on whether the response came from a banker, a regulator or a user of banking services, such as corporate treasurers. Banana Skins reported that money-laundering only came in at number 14, reduced in importance from the previous year 'despite all the fuss'. Customers regarded money-laundering issues as a higher priority than did the banks and regulators.

Instead, from a sample of 231 replies from 31 countries, Banana Skins highlighted growing concern about the use of complex financial instruments, which came first among issues overall and first in the minds of customers and regulators, but only third as far as the bankers were concerned. 'The survey reveals widespread concern, not just about the burgeoning use of credit derivatives to transfer risk, but the fact that no one really knows how much risk is being traded in this way or where it is ending up,' says the report. Bankers continued to regard credit risk as their number one priority and macro-economic factors as second.

Certainly, HBOS, one of the UK's largest financial institutions, devotes space in its annual report for the year to 31 December 2003 to its policies for managing derivatives and credit risk. It does not comment on money-laundering issues, but touches briefly on the fine in its corporate social responsibility report. 'This is an area where we take our responsibilities seriously ... we also ensure that we learn from our mistakes.'

Since 2001, the FSA has also fined four other financial institutions for breach of anti money-laundering regulations. The largest fine was £2,320,000 levied on Abbey National companies in December 2003. Two other listed banks have been fined for anti money-laundering breaches: the Royal Bank of Scotland £750,000 in December 2002 and the Bank of Ireland £375,000 in September 2004.

In none of these three cases, does the FSA fine appear to have affected the stock market performance of the banks' shares, nor in the case of the Bank of Scotland, that of HBOS. HBOS shares have performed exceptionally well over the last year and in mid-January were trading around their 12 month high.

A lot of washing

Laws requiring organisations such as banks, to verify the identity of their customers and report suspicious activity date from the mid-1980s and have increased steadily in scope since then. Two events increased demand for better monitoring and detection: the discovery that 23 banks in the UK had accounts linked to the deceased Nigerian strong man Sani Abacha and his family, and the well-funded terrorist attacks of September 11 2001.

Whatever the risk profile, the cost of complying with anti money-laundering regulations is clearly considerable, and rising. In 2003, KPMG estimated an annual cost of about £90m per year for each reporting organisation.

In 2004, KPMG commented, 'The cost of anti money-laundering compliance has risen significantly over the past three years, with the average reported increase being 61%. None of our respondents reported a decrease in investment. Most also envisage a continuing increase in expenditure over the coming three years, at a lower, but still substantial, rate.'

It is not clear how effective this expensive exercise is, nor how well the results are being monitored. The National Criminal Intelligence Service (NCIS) receives suspicious activity reports (SARs) from banks, other financial institutions and professional advisers. In November 2004 alone, the NCIS received 14,241 SARs, of which nearly 10,000 came from banks, but it will not disclose how many of the reports result in further investigation.

The Home Office, which collects and publishes statistics on crime, says it does not collate figures on money-laundering convictions, nor does the Crown Prosecution Service.

In 2004, more than half the respondents to the KPMG survey 'considered the requirements could be made more effective.' Better feedback from governments and financial intelligence units, as well as better coordination at global level were some of respondents' wishes.

The British Bankers' Association (BBA) produces money-laundering guidance notes for its members and is looking at ways that the requirements could be more risk related. For example, Jeremy Thorp, director, financial crime, for the BBA says "We are considering if the present means of identity requirement needs revision, in particular in cases of low risk, such as, for example, basic bank accounts."

Heads you win

There is no indication that banks are looking for wholesale revision of the anti money-laundering regulations, partly because the fact that it is a global regime means that costs are not anti-competitive. Keith Dempster also argues that knowing their clients better is an opportunity for banks. It allows them to ask clients about their businesses, which will make it easier for to meet their business needs, develop existing relationships and allow tailor services. "Knowing more about clients can create a stronger relationship and generate more business."

KPMG has similar views. Enhancements to the anti money-laundering process will allow banks greater leverage and benefits from their compliance investment to improve their understanding of individual customers and their customer relationship management processes. 'There are also opportunities for operational savings through linking the anti-money laundering process with fraud prevention and credit control.'

- Lee Coppack is a risk management and insurance writer, E-mail: SKINS - THE RISKS FACING BANKS

1. Complex financial instruments, especially credit derivatives
2. Credit risk
3. Macro-economic risks - the global economy
4. Insurance
5. Business continuation, the result of the threat of terrorism
6. International regulation
7. Equity markets
8. Corporate governance
9. Interest rates
10. Political shocks
11. Fraud
12. High dependency on technology
13. Domestic regulation
14. Money-laundering
15. Hedge Funds
16. Risk management
17. Banking market over capacity
18. Currencies
19. Grasp of new technology
20. Management incentives
Source: Centre for the Study of Financial Innovation.