Regulatory scrutiny and growing cost pressures are severely impacting Know Your Customer (KYC) and Anti-Money Laundering (AML) operations of financial institutions. Discussions with several banks have revealed they are finding it hard to keep track of constantly evolving regulations, interpret and implement global regulatory changes at a local operational level, collect and refresh information from numerous sources and systems across different businesses and jurisdictions, manage and analyze growing volumes of structured and unstructured data to identify patterns, networks, and beneficial owners, while containing costs amidst a difficult economic environment.
Banks so far have looked to address the challenges by hiring more staff, as traditional rule-based KYC-AML technology necessitates significant dependence on manual efforts. But too much reliance on manual efforts can make the process costly, error prone, and inefficient. Banks therefore need to think out of the box and consider new and innovative solutions to alleviate operational and cost pressures.
Adoption of Artificial Intelligence-enabled solutions could be one way to mitigate current challenges, increase efficiency, and reduce costs, as they can not only automate significant parts of operations but also offer superior insights through advanced capabilities for analyzing structured and unstructured data. In a new report, Celent discusses several challenges plaguing financial institutions’ Know Your Customer (KYC) and Anti-Money Laundering (AML) operations, and proposes how Artificial Intelligence (AI) enabled solutions can help in addressing them. This report was commissioned by NextAngles, an Mphasis Fintech venture, while Celent kept full editorial control. The report is available for download here.
The CFTC has recently revealed the instant messages written by Citigroup traders related to benchmark manipulation. Having recently published a report on Market Surveillance industry trends and soon to publish another one on the leading vendors, this seemed quite relevant. Current surveillance systems, be it for trade or communications surveillance, use the latest technology to capture possible instances of market abuse or manipulation. The capabilities are far beyond what was available a few years ago, and are holistic and comprehensive in nature. But in the end, the system is only as good as the people using it. The recent revelations have put a question mark over not just the traders involved in the benchmark manipulation scandal, but also the management of some of the leading institutions. Some firms are now going to great lengths to monitor their traders, but this is not an end in itself. The industry culture has to be transformed. The next instance of manipulation will not be in the same place and firms would have to overcome the motivation to profit in order to ensure compliance. The rise in the levels of regulation in the last few years probably would play the part of a positive reinforcer in the decision-making process and help influence industry culture, but is not a guarantor of propriety.
Uh Oh #1: More granular regulatory reporting and requirements around the level of “free” assets on an institution’s balance sheet look to be coming. There are profound implications for how financial firms manage and inventorize the components of their assets, liabilities and shareholders’ equity at any given time (including collateral).2) Risk-sensitive deposit insurance: “… deposit insurance schemes could be made risk-based (e.g. through the inclusion of a dedicated risk premium in deposit guarantee pricing), taking into account the funding structure of insured institutions in normal times. The pricing could differ depending on… resolution rules.”
Uh Oh #2: “Pricing in asset encumbrance in deposit insurance schemes” seems to imply regulatory capital/RWA increases, through Basel IV or sooner through Basel III.5??3) Expansion in scope of stress testing: “…banks should be asked to perform regular stress tests that evaluate encumbrance levels under adverse market conditions.”
Uh Oh #3: Expansion of dimensions to stress test – in this case, related to asset encumbrance levels, funding scenarios and collateral frameworks. Institutions need to ensure stress testing practices are sustainably repeatable and sufficiently automated.4) Oversight and possible regulation of the currently unregulated: “Central banks and prudential authorities need to closely monitor and oversee market responses to increased collateral demand and their effects on interconnectedness… in securities financing markets [e.g. securities lending, repo] and for shadow banking activities.”
Uh Oh #4: There seems to be an undertone that anything “unregulated” is “bad” and risky. We anticipated this trajectory in our recent “Shadow Banking Products in Europe and North America” report and highlight how different products are used, risk management implications and technology advancement opportunities that various products may represent in the coming years. What’s coming could include the possible central clearing of securities lending and repo activities, more position/exposure reporting, restrictions on re-hypothecation of assets and other forms of transparency reporting, etc.
One wonders if regulators are now stepping into the territory of choking economic activity. Do we really need to fix what is not really broken? Is transparency for transparency’s sake necessarily beneficial to the way markets operate?5) Extend of collateral rehypothecation permitted: “A particular aspect that has received considerable scrutiny in the policy debate on securities financing markets is the extent to which rehypothecation activities should be permitted. The recent crisis experience suggests that greater reliance on rehypothecation in financial intermediaries’ balance sheets will increase interconnectedness and make them more vulnerable to financial shocks. Rehypothecation of client assets can also delay the recovery of assets or even impose losses on beneficial owners.”
Uh Oh #5: “Interconnectness” of the financial system is a concern, but it is also inevitable given the manner capital, derivative market reforms and collateralization rules are implemented. Instead of working to stop this interconnectedness from happening, regulators could do well to put in place “in-time circuit breakers” in the financial system to only “trip” when stress scenarios and adverse market conditions bubble up (pardon the pun).Whilst the above points remain “thinking points” and nothing is concrete, it does provide us with a possible glimpse of what is coming. If we think that regulatory burdens in the financial industry are onerous now, regulators are only getting started! Keep your strategy nimble and technology sufficiently flexible – built not just for current requirements, but for future changes. These changes may come sooner than you think! ————– For more detailed perspectives, please see the following: Maximizing Collateral Advantage: A Survey of Buy Side Business and Operational Strategies Shadow Banking Products in Europe and North America Equipping the Front Office for the New Risk Environment Cracking the Trillion Dollar Collateral Optimization Question Strength Under Fire in Risk Management