The growth of derivatives, structured products, sophisticated technologies and the ease with which organisations operate across global locations are welcome recent transformations in the financial industry. However they have exposed financial institutions to huge operational risks.
So what is operational risk and how does it originate? How can it be measured and controlled? Can technology help reduce it? One of the key components of operational risk is money laundering – the practice of filtering ‘ill-gotten’ or ‘dirty’ money through a series of transactions in order to camouflage the illegal nature of the funds. So how can robust anti-money laundering (AML) processes reduce operational risk? And what part does technology play in this?
Defining Operational Risk
Operational risk is the collective term for the diverse risks inherent to any business practice. It includes risks relating to people, processes, systems and in addition natural disasters. Such risks can range from extreme events, such as terrorist attacks, to the most common failures in project management. According to the Basel Committee on Banking Supervision (BCBS), ‘Operational Risk is the risk of direct or indirect loss resulting from inadequate, or failed internal processes, people and systems, or from external events.’
Banks and financial institutions need to closely monitor various components of operational risk in view of their impact on reserve requirements and, ultimately, on overall profitability levels.
Some of the factors, which have brought operational risk into focus, are:
- Technology proliferation
- Boundary-less markets
- Innovative financial products
The Need for a Compliance Mechanism
The collapse of Barings Bank highlighted the need for banks and financial institutions to implement sound operational mechanisms with the appropriate checks and balances. At the same time, several governmental legislations such as the Sarbanes-Oxley Act for corporate disclosures and the US Patriot Act for combating money laundering and terrorist-financing further increased the focus on compliance.
Money laundering and terrorist-financing activities now face increased scrutiny from the international community – more so after recent global terrorist activity. New international regulations decree that financial institutions proactively identify and investigate potential money laundering activities. The Patriot Act and BCBS have reiterated the need for establishing sound anti-money laundering (AML) policies and processes. The Patriot Act has also emphasised adequate customer due diligence to avoid risks involving reputation, operations, legal, and concentration issues. Failure to act in accordance with these regulations can result in stiff penalties and bad publicity, as is evident from recent corporate scandals. There are some key steps that can help counter the impact of money laundering.
The Two-Step Process
A two-step process can ensure the complete effectiveness of any AML programme. First, banks and financial institutions need to fine tune their processes and policies and secondly, supplement these efforts with the implementation of the right technology. This method chiefly revolves around gaining a deeper insight into the wealth of information resident in, or being transferred across, various systems in the institution.
Step 1: Focus on policies and processes
A sound AML programme should comprise the following:
- Know Your Customer policy (KYC)
- Creation of customer profiles and risk indices
- Know Your Business programme (KYB)
- Know Your Customer’s Customer programme (KYCC)
- Know Your Employees programme (KYE)
Further, the US Bank Secrecy Act clearly mandates every financial institution to:
- Designate a compliance officer
- Develop internal AML policies and procedures
- Initiate ongoing employee training programmes
- Develop an audit process to test procedures as a part of its compliance policy
Financial institutions may need to realign their business processes to comply with these norms. This can be achieved through a business process re-engineering (BPR) programme with the following objectives:
- Introduce global best practices
- Align all processes with new technology
- Achieve faster turnarounds in customer service, whilst adhering to compliance guidelines
- Identify modifications required for the core transaction processing system to meet compliance goals
Apart from enabling compliance, these guidelines will also serve to significantly improve process efficiency.
Step 2: Focus on technology
The day-to-day operations of a typical bank encompass various activities such as opening accounts, depositing money, transferring funds or closing accounts. Spotting those transactions that are used as a foil to push laundered funds through can prove to be a daunting task.
Seemingly unrelated transactions need to be compared and scrutinised as the overall pattern of disguise may be spread across different activities and products, individually appearing quite normal. Moreover, once it is known that the approach used is vulnerable to exposure, a different approach can be used – thereby, demonstrating the fundamental need for the employment of advanced behaviour analysis tools and solutions.
Thanks to the emergence of new technologies, it is now possible to analyse complex transactions across branches, global locations and products. Banks and financial institutions can now explore the possibility of adopting real-time processing capabilities to meet the requirements of watch-list monitoring and transaction monitoring. Subsequently, these measures can be augmented by deploying state-of-the-art business intelligence solutions and data mining tools that can pinpoint suspicious activities with a high degree of accuracy.
The Way Forward
The Basel Committee has reiterated the need for a good AML programme to minimise legal, reputation, operational and concentration risks. A comprehensive compliance policy, along with a suitable technology solution, can assist financial institutions in combating money laundering and minimising operational risk significantly.
A sound KYC policy coupled with advanced behaviour detection techniques go a long way to addressing these needs. Although, some of the technology solutions catering to AML are expensive, the long-term benefits and the need to adhere to the strict protocols enforced by the regulations make them a worthy investment. Such investments eventually help to minimise the costs associated with the key components of operational risk and increase the business benefits to financial institutions.