Anti-money laundering regulations in the Pacific, a double-edged sword

Around the world, new measures are being introduced to deal with increasingly sophisticated money laundering and terrorist financing schemes. The compliance constraints imposed by the Anti-Money Laundering and Anti-Terrorist Financing (AML/CTF) rules aim to make it harder for criminals to hide and use their illicit money. However, the unbanked and the poor in some of the world’s least developed countries have unwittingly become collateral damage of the regulatory process. This blog explains how stricter AML/CTF rules are affecting financial inclusion, remittances and banking entry in the Pacific.

The main channel for cross-border payments is the correspondent banking relationship, an arrangement under which a (correspondent) bank holds deposits on behalf of a client bank in another jurisdiction, providing payments and other financial services. Simply put, correspondent banking connects a country’s economy to the global financial system by facilitating cross-border payments and currency exchange for trade, investment and remittance purposes.

As the global AML/CFT regulatory and enforcement landscape has become more strict, banks are required to conduct a thorough review of transactions on their customers’ accounts and better understand their financial arrangements, through Know Your Customer (KYC) and Customer Due Diligence (CDD) procedures ). Failure to comply with these regulations usually results in heavy financial penalties and reputational damage. In 2020 alone, fines related to AML and KYC non-compliance against financial institutions reached $10.4 billion worldwide.

In response, international banks are paying greater attention to the effectiveness of their sponsors’ AML/CTF program and jurisdictional requirements. In order to minimize their exposure to money laundering risks and reduce the risk of fines, international banks have begun to reduce correspondent relationships with partners they deem risky, a process known as risks “. This leads to a decline in correspondent banking relationships globally, with the Pacific being the most affected, as shown in the graph.

As these relationships become more difficult to maintain, the fear of losing a correspondent banking relationship is evident; and the measures taken by national banks to mitigate such risk are considerable.

First, the process of carrying out bank transactions has become increasingly strict. For example, vanilla farmers in Papua New Guinea (PNG) forbidden to deposit their harvest income in the bank, due to the lack of documents such as invoices to prove the source of the funds. The formal sector in the Pacific is not spared either. There is anecdotal evidence that legitimate cash-intensive businesses have had their bank accounts closed by banks as part of their risk reduction strategy.

It’s not unexpected. Bank of the South Pacific (BSP), PNG’s largest bank with operations in six other Pacific countries, moved quickly to to hire 40 additional AML/CTF analysts to strengthen their CDD procedures, after the implementation of BSP. find breaking the country’s AML/CTF rules last year.

Another consequence is the disruption of remittance flows. Remittances have always been a characteristic Pacific island economies, where they constitute a large part of household cash income and provide a safety net for many families. Remittances represent 8%, 25% and 42% of the GDP of Fiji, Samoa and Tonga respectively.

In the extreme case, a complete loss of correspondent banking relationships, people could lose access to cross-border payments and funds transfer services entirely. Although this is unlikely to happen, any further withdrawal from the relationship in the region is detrimental, as it could make remittances more expensive and increase the use of unregulated channels to transfer money.

Furthermore, the increasing difficulty for financial institutions to establish a new correspondent relationship with an international bank raises the barrier to entry into the banking sector, since a correspondent relationship is a prerequisite for obtaining a banking license.

In the Pacific, most correspondent services are provided by Australian and New Zealand banks. However, these banks have become very cautious with existing correspondent relationships, and even terminated a few, after being slap with record fines for AML/CTF violations. With a small market size and weak regulatory and enforcement capabilities, many international banks believe the risk of operating in the Pacific is not worth taking. For smaller domestic financial institutions, this makes more difficult get a new banking license.

This blog offers three solutions.

First, customer due diligence procedures should be simplified for activities and sectors that pose a low risk of money laundering and terrorist financing. The global AML/CTF watchdog, Financial Action Taskforce, provides flexibility in the application of its AML/CFT regime, where a country may decide to exempt a specific type of activity from standard customer due diligence procedures to take into account financial inclusion.

For example, in India, small bank accounts with low transaction limits can be opened by people without proof of identity for up to 12 months before official documents are required to maintain the bank account. This is relevant for the Pacific, where much of the population is made up of rural smallholders who have little or no immediate access to government-issued identity and income documents.

Second, Pacific authorities should actively address their vulnerabilities to meet AML/CFT compliance expectations. Some progress has been made in to improve the KYC reporting capability of domestic banks and minimize disruption of remittance flows. But we can do more.

One of them is to adapt the AML/CFT regulatory framework and guidelines to the country context. Analysis find that AML/CTF legislation in many developing countries has overly stringent CDD requirements that exceed the country’s regulatory and enforcement capabilities. A more realistic AML/CTF framework will help domestic financial institutions better manage compliance expectations and mitigate the risk of losing a correspondent relationship.

Finally, new technologies and government intervention have the potential to circumvent AML/CFT barriers. Recent innovations such as Numeric identity, central bank digital currencies, distributed ledger technology and artificial intelligence have been tried in various jurisdictions. The Central Bank of Tonga has stepped in to provide a remittance service to the Tongan diaspora. If the private sector withdraws, governments may need to step in to overcome an induced market failure.

Regardless of the combination of measures taken, urgent action is required. The last thing the Pacific needs is to be disconnected from the global financial system.

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This research was undertaken with the support of the UNA-UPNG Partnership, an initiative of the PNG-Australia Partnership, funded by the Department of Foreign Affairs and Trade. Opinions are those of the author alone.