AML Risks in Correspondent Banking: A Comprehensive Overview

Team FOCAL
January 10, 2024

In the thriving and ever-advancing global finance, correspondent banking forms the cornerstone of international transactions. With its ability to facilitate international trade and provide seamless cross-border transactions, correspondent banking might seem like the perfect global method. However, correspondent banking creates an intricate web across the world. Consequently, it introduces a complex list of challenges and obstacles that pose a threat to the integrity of the global financial system. 

In this article, we will delve into correspondent banking AML (Anti-Money Laundering) risks, mitigation challenges, guidelines, and implementation strategies. Our goal is to shed light on the crucial problems that financial institutions face in order to protect the integrity of the global financial system. Read along as we peel back the layers of complexity that accompany correspondent banking and look at the required strategies to lessen the constant threat of money laundering.

What is Correspondent Banking?

Correspondent Banking is an essential aspect of the global financial system; picture it at the heart of the network connecting banks across borders. Correspondent banking forms reciprocal and mutually beneficial relationships between banks and financial institutions, where one bank can provide financial services on behalf of another bank.  These services include money transfers, business transactions, currency exchange, and trade documentation. 

Correspondent banking is an incredibly useful tool, as otherwise, one bank or financial institution would need to pull through the time-consuming and highly expensive process of opening a branch in a country when they wish to provide or use a banking service there. 

What is an Example of Correspondent Banking?

To explore examples of correspondent accounts, let’s assume that we have a corporation in Canada that runs operations globally. Its international financial transactions can be maintained and streamlined through accounts with a domestic bank in Canada, but to run transactions in foreign countries, correspondent banking is needed. 

For example, if the corporation needs to purchase goods from a supplier in Spain, this is how the process would ensue:

  1. The Canadian corporation would request that their bank send the agreed-upon amount to the supplier in Spain using Canadian dollars.
  1. The domestic Canadian bank would calculate the amount in euros.
  1. The domestic bank will take out the amount from the corporation’s account in Canadian dollars. 
  1. Through its correspondent accounts, the domestic bank would send out instructions to its correspondent bank in Spain, and the correspondent bank account in Spain would ensure that the supplier in Spain receives its payment.

Using this strategic method, funds are moved efficiently and seamlessly across borders. Correspondent banking allows different corporations to engage in international trade more easily.

Money Laundering Through Correspondent Banking

Just like correspondent banking, money laundering transcends borders. Money laundering is a widespread issue with even more pervasive repercussions. Its risks seriously threaten the integrity of the global financial system. 

The United Nations Office on Drugs and Crime estimates the amount of money laundered globally ranges anywhere between $800 billion and $2 trillion in a single year, which is approximately 2-5% of global GDP. Despite the huge number, it remains a rough estimate as some money going through the laundering cycle remains under the radar.   

What Part Does Correspondent Banking Play in the Process of Money Laundering?

Two of the most important aspects of correspondent banking are its international and interconnected nature. This provides an opportunity for criminals to obscure the origin of their funds. Money laundering criminals abuse and exploit correspondent banks, especially within the context of the integration and layering stages of money laundering. Inadequate AML controls make it especially easy for criminals to commit money laundering.

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How Do Money Laundering Criminals  Exploit Correspondent Banking?

  • Layering: Money laundering criminals start a convoluted chain of transactions between several correspondent banks, building a maze that hides the funds' true source. Because of the complex layering process, it is extremely challenging for authorities to trace the funds and track the criminals.
  • Smurfing: Money laundering criminals use this method that entails breaking up large amounts of illegal funds into smaller and more manageable transactions. Even with existing AML systems to identify suspicious financial activity, money laundering criminals can avoid detection by staying below reporting thresholds.
  • Jurisdictional Differences: Money laundering criminals take advantage of the fact that different regulatory frameworks are found in different jurisdictions. They use correspondent banks based in jurisdictions with weaker AML regulations to obtain access to the global financial system.
  • Lack of Due Diligence: Money laundering criminals often take advantage of gaps in transaction monitoring, inadequate risk assessments by correspondent banks, and inadequate Know Your Customer (KYC) procedures. They move their illicit funds through the correspondent banking network stealthily by exploiting these vulnerabilities.
  • Shell Companies: Money laundering criminals create and use shell companies as a covert method. Correspondent banks unknowingly enable these transactions and thus, make it more difficult to identify the real beneficiaries of those shell companies and their real uses of the funds.

Correspondent Banking AML Risks

Correspondent banking is an essential element of the international trade and payment system, making it vital for the efficient functioning of cross-border transactions. 

Nothing great exists without high risks to its beneficiaries. Banks and financial institutions are exposed to the dangers of money laundering and terrorist financing through correspondent banking due to its wide reach and complex nature. 

What Are the Challenges Amplifying Correspondent Banking AML Risks?

Correspondent Banking Relationship Risks, or correspondent banking AML red flags, Include:

  • A Lack of Familiarity With Respondent Bank's Clientele: Know Your Customer (KYC) is a fundamental but tricky part of correspondent banking AML. Correspondent banks operate internationally, but they often have limited access to the respondent bank’s customers, which makes it challenging to verify client information efficiently.
  • Decentralized Structures: The emergence of decentralized finance (DeFi) has added another complex layer to the correspondent accounts AML. Monitoring transactions effectively has become increasingly difficult for many non-traditional institutions that utilize difficult-to-track virtual currencies.
  • Shell Companies: The correspondent banking AML landscape is made more complicated by the usage of shell companies. Shell companies are not all bad, as they are used legally by organizations for business and tax reasons. However, correspondent banking relationship risks include the danger of shell companies, which money laundering criminals take advantage of to hide true ownership and execute illegal banking operations. 

Read more: The Top 10 AML Red Flags: Safeguard Your Business from Crime

Challenges in Mitigating Correspondent Banking AML Risks

As we uncover the risks of AML correspondent banking, we face another layer of complexity with the various challenges that make mitigating these risks even more difficult. These obstacles range from budgetary limitations to discrepancies in regulations, and they highlight the difficulties involved in maintaining the integrity of the international financial system.

Some of the challenges faced by correspondent banking AML include:

  • High Costs and KYC Obstacles: Know Your Customer (KYC) and Customer Due Diligence (CDD) efforts present incredibly high costs. These challenges are amplified when the transactions are cross-border. In this case, important information -such as ID numbers and government data- is less accessible and harder to verify.
  • Different Regulations in Different Jurisdictions: One of the major challenges of money laundering risks in correspondent banking is the varying regulatory frameworks in different jurisdictions. Fraudsters often take advantage of these differences by strategically finding overseas financial institutions in jurisdictions with laxer financial regulations and opening correspondent banking accounts there. The lack of consistency in regulatory frameworks makes it increasingly difficult for the list of correspondent banks to enforce reliable AML procedures.
  • Lack of Sufficient Systems: There are correspondent banks that function as small and dispersed organizations and lack advanced mechanisms that are essential for verifying and monitoring the identities of their clients and financial sources. This could make them unable to comply with strict AML compliance standards, which creates weaknesses in their defense against illegal financial activities.
  • Reliance on the AML Capabilities of Foreign Banks: Domestic banks tend to rely on the AML capacity of their foreign partner when they process transactions for them. In turn, if their foreign partner’s AML compliance standards are not up to par with the domestic bank’s expectations, this dependence could present a vulnerability. Thus, it is imperative for the list of correspondent banks to cooperate and standardize their AML programs.

FATF Guidelines on Correspondent Banking AML Red Flags

Now that you are more aware of the money laundering risks in correspondent banking and the challenges that accompany correspondent banking, you can feel more at ease knowing that correspondent banking AML is an issue that is taken very seriously and prioritized by the Financial Action Task Force (FATF)

The FATF is an intergovernmental organization that develops policies to combat money laundering and terrorism financing. Within correspondent banking, the FATF acknowledges the challenges and intricacy of correspondent banking and has put forth extensive guidelines to mitigate these risks. 

1. Respondent Bank’s Due Diligence

The FATF recognizes that foreign correspondent banking inherently carries more risks than domestic banking. Thus, it emphasizes the need for increased due diligence as an essential addition to mitigate the accompanying risks effectively. 

2. Comprehending the Type of Business Operated by the Respondent Institution

The FATF encourages correspondent institutions to collect enough information to understand the nature of business of the respondent institution, and how it fits with the pre-identified risks. This is the first step towards identifying and controlling possible AML risks.

3. Verifying Respondent Organization Data and Evaluating Recorded Risks

The FATF recommends that while establishing new correspondent banking relationships, any information received directly from the respondent institution should be independently verified. This verification should include beneficial ownership records, corporate registries, and registries of competent authorities in order to guarantee the legitimacy and accuracy of the information. 

4. Ongoing Correspondent Banking Transaction Monitoring

The FATF emphasizes the importance of continuously monitoring AML correspondent banking account activity. The benefits of continuous transaction monitoring include guaranteeing compliance with financial sanctions and monitoring changes in transaction patterns that could indicate suspicious activity. 

5. Demand for Transaction Information

The FATF recommends correspondent institutions develop internal procedures to inspect any flagged transactions. One of the AML correspondent banking examples in this case is asking the respondent institution for transaction details, offering clarification, and helping to address any issues that have been raised.

6. Explicit Conditions for the Correspondent Banking Partnership

The FATF advises correspondent institutions to formalize and explicitly define their agreements with respondent partners prior to offering correspondent services. This allows correspondent banks to effectively mitigate risks from the get-go. 

7. Open Communication and Dialogue

The FATF recommends keeping lines of communication open and continuous with respondent institutions. Effectively and proactively interacting with partners will enable cooperation and mutual understanding of AML policies and expectations. 

8. Adjusting Mitigation Measures For Risk Evolution

The FATF notes that correspondent institutions should modify and adapt their risk management plans based on evolving AML/CFT risks. This flexibility in adjusting mitigation strategies provides for a dynamic response to shifting risk environments.

Implementing Anti-Money Laundering Measures in Correspondent Banking

After reviewing the Financial Action Task Force guidelines for correspondent banking AML risks, it probably solidified the notion that the intricacy and interconnectedness of the corresponding banking system create vulnerabilities for money laundering and exploitation of the global financial system. In order to protect against these risks, financial institutions and regulatory authorities need to implement effective and comprehensive AML procedures. 

Let’s explore some key strategies for strengthening correspondent accounts AML strategies.

  • Enhanced Due Diligence (EDD): EDD actually forms the basis of a robust AML framework. Correspondent banks should broaden their extensive due diligence framework to include not only their domestic clients but foreign respondent banks as well. This proactive approach is crucial to fully comprehend risk profiles both before and during the business relationship.
  • Compliance with International Standards: Better listen to the experts, as the best way to form a global defense against money laundering is by complying with international standards. Complying with AML standards developed by the Financial Action Task Force and other recognized international entities strengthens correspondent banking’s defense against money laundering.
  • Correspondent Banking Transaction Monitoring: Correspondent banks should utilize the latest technology advances to enhance their monitor transaction systems. These systems act like diligent security experts, closely examining financial transactions to flag suspicious activities indicating possible money laundering. This proactive approach minimizes the possible impact of illegal financial flows.
  • Information Sharing: Due to the interconnected nature of correspondent banking, information sharing is one of the most powerful tools that can be used to guard against money laundering. It is vital for correspondent banks to cultivate an environment that requires information sharing between financial institutions and regulatory bodies. The industry can work together to stay ahead of changing threats by establishing a transparent network where potential risks and emerging money laundering trends are shared. This cooperative strategy allows the different partners to adapt to ever-changing financial risks.

Conclusion

In conclusion, it is apparent that the battle against money laundering and illicit activities requires a detailed comprehension of the exploitation methods of criminals, as well as the risks facing financial institutions. Cooperation and knowledge-sharing between financial institutions and regulatory bodies is imperative for employing the best proactive and defensive methods against money laundering and for remaining compliant with international AML standards. The fight against evolving AML risks is a modern, cutting-edge, and cooperative one.

FAQs

Q1. How Does Correspondent Banking Work?

For correspondent banking to commence, a correspondent account must be established between banks from different jurisdictions. There are two different correspondent accounts a bank could hold: a Nostro account and a Vostro account.

‘Nostro’ comes from a Latin word that means ‘ours’, and thus represents the bank’s ‘our’ money that is deposited at the other bank. ‘Vostro’ in Latin means ‘yours’, and thus refers to the other bank's money that is deposited at your bank.

This account’s main benefit is that it enables a domestic bank to conduct money transfers or carry out payments in the local currency of the other bank. This ensures a smooth and fast process of cross-border financial transactions. In turn, domestic banks can extend their reach and gain access to foreign financial markets and international clients.

The SWIFT Network, or The Society for Worldwide Interbank Financial Telecommunication, is typically the method used for payments and transfers in correspondent banking.

Q2. What is the Difference Between a Correspondent Bank and a Beneficiary Bank?

A correspondent bank is a bank providing services on behalf of another bank, typically the respondent bank. The correspondent and respondent banks are often from different countries and have a partnership between them (correspondent banking).

A beneficiary bank is the financial institution that holds the bank account of the intended recipient (beneficiary) of a funds transfer.

Q3. What is Correspondent Banking in KYC?

When in a corresponding banking partnership, the correspondent bank account provides services on behalf of the respondent bank and depends on the respondent bank to perform KYC (Know Your Customer) due diligence on the client.

Q4. What are the Major Challenges Faced by Banks in KYC Compliance?

The most common major challenges faced by banks in KYC (Know Your Customer) compliance are ineffective record keeping, long onboarding processes, low rates of conversion, false positives that waste time and resources, and high onboarding costs.

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