The financial industry is experiencing a big change. From any perspective, the trends are powerful and are ushering in a new reality for the challenge of balancing financial inclusion and managing risk.

Many forces are coming together that are making this era so unique. These factors include:

• A shift in the regulatory approach to risk
• An increased need for improved cross-border payment services
• New players providing innovative services
• Improved access to online banking, apps and mobile banking
• Regulatory technology (regtech) developments, led by artificial intelligence (AI) and machine learning

This article will analyze the underlying trends that triggered the conflict between risk management and financial inclusion, review steps already taken and identify trends that can help mitigate the remaining gaps.

Regulatory Perspective

Industry thought leaders, such as the Financial Action Task Force (FATF), have realized that focusing on risk management while ignoring the challenges of financial inclusion or technology-related trends is not sustainable in today’s financial environment. As a result, the Bank of International Settlements (BIS) and the FATF held closed and public discussions over the past two years, aiming to tackle these challenges while ensuring a safe yet improved payments industry.

These discussions culminated in several important directives to the financial industry and regional regulators to widen their perspective and understand that customers’ needs and expectations cannot be siloed from the risk management approach.

This is a positive and dramatic change. Prior to this era, the FATF was extremely strict, providing best practices and expectations without addressing how these standards should be translated into operational measures.

It should be noted that regulators asked banks to avoid de-risking for decades, as the risk to the global economy from alternative and nonregulated channels posed by de-risking was a much bigger problem, and most governments wanted their citizens to be connected to a stable financial/banking system. For risk management, the obvious preferred option is that more customers will be connected to the regulated environment.

Today, regulators have moved from a reactive to a proactive mode. Specifically, regulators have acknowledged that new technologies can provide a better solution to fighting financial crime.

Need for Improved and Affordable Cross-border Payment Services

The current global economy is heavily dependent on the Society for Worldwide Interbank Financial Telecommunication (SWIFT), which means the involvement of large global banks. The large banks were heavily exposed to fines and other enforcement measures resulting from exposure to indirect risks through correspondent banking and cross-border payment services.

It can be said that large banks are both the victims and the problem.

Global banking relies on trust. Banks must trust their counterparty banks to conduct their own risk management controls adequately.

In their efforts to avoid risks, banks realized risk management efforts are both expensive and ineffective. Large corruption schemes, such as “The Russian Laundromat,” “1MDB” and others, made it clear that the current controls just do not work.

In addition, reporters published a few investigations, such as the Panama Papers and coverage of the leak of Financial Crimes Enforcement Network (FinCEN) files, which revealed the weaknesses and vulnerability of the current situation. The outcome was the worst possible: The loss of trust.

The impossible risk management, together with that lack of trust, created the phenomena of “de-risking” banking relationships, meaning that in many territories, local banks that once had access to the global network were cut from correspondent lines and channels. This exclusion forced banks in these territories to rely on other banks’ relationships. As a result, the costs of due diligence and the operational costs per transaction increased dramatically. As always happens in such circumstances, the customers paid the price; cross-border transactions became expensive and slow.

The fear of failing to detect and prevent money laundering became the risk no bank wanted to be exposed to, resulting in them intentionally giving up pieces of this “cake.” It was only a question of time before alternatives would arise on the financial scene.

The New Players

In any business, there is no vacuum left empty and this is also the case for the global financial industry. In the past few years, the growth of financial technology (fintechs) engaged in cross-border payments has been significant in both volume and the share of global cross-border payments.

The ability of banks to provide a full range of services became both an advantage and a liability. Fintechs typically specialize in specific types of services, such as remittance services and digital wallets, thereby becoming more efficient and cost-effective than large banks for both FIs and financial customers in the developing world.

The question is why has it been easier for new financial service providers to engage in risky areas such as cross-border transfers?

As new tech-based businesses, fintechs can easily embrace and roll out new and more efficient anti-money laundering (AML) solutions based on AI and machine learning. They are not heavily invested in legacy methods operated by armies of compliance employees needed to execute rules-based controls that are not especially effective. To be fair, however, banks are under stricter regulations and stricter regulators than fintech businesses.

The Customers

During the evolvement of de-risking, trend customers—those using new digital money transfer platforms—became “the potential enemy.”

It is true that bad customers, meaning criminals and terrorists, manipulated the financial industry for decades and earned the right to be treated as the industry’s worst enemies. But most customers are honest people who need to transfer funds for legitimate purposes. These customers have the right to gain access to the global economy at a reasonable price.

Habits have changed. We frequently purchase products online and travel or move to foreign countries. Cross-border payments are no longer a rare event as they are conducted regularly. In this era of globalization and digitalization, people are more aware of alternative cheaper digital services, including digital payment services.

Technology-related Opportunities

Fintech and regtech are proving to be a strong combination to enable a payments ecosystem that is faster, safer and more efficient and cost-effective. But how can these solutions drive both risk management and financial inclusion at the same time?

In July 2021, the FATF completed comprehensive research that included interviewing many experts and consulting with private sector players to publish guidelines regarding AI and the opportunities offered by new technologies.¹ The FATF guidelines even mentioned the potential of such technologies to improve financial inclusion and the implications such progress can drive.

AI and machine learning are more effective from a risk management perspective for reasons including:

• Maximization of data—As digital payment velocity increases, financial business managers are exposed to enormous volumes of data. Risk indicators exist within the data. All you need is machine learning capabilities to find them.
• Dynamic analysis—We all change our habits, but bad actors change their criminal schemes even faster. Static rules were never effective and are now even more redundant in managing risks.
• Variety of products and services—As mentioned above, there are many new ways to transfer money.
• Misperception of financial institutions—Perhaps the most significant root cause for the problem in financial crime risk management is that the financial industry is expected to conduct due diligence per customer, understand the financial profile and detect unusual activity. As financial players are not government agencies, part of this “line of defense” ends mostly with suspicious activity reports filed to financial intelligence units. Financial crime fighting by the industry is not realistically achievable using general rules based on well-known red flags and related specifically to financial products. Machine learning, and especially “unsupervised” machine learning, does exactly what is expected. It learns the financial behavior of each customer, builds “normal” profiles and detects unusual cases.

How does this help financial inclusion? Decisions can be more accurate, fact-based and, most of all, conducted in a timely manner. These advantages turn de-risking upside down. Once a financial service provider can trust the risk management controls, the ability to open the door to banks and customers they would not work with previously is obvious; hence financial inclusion is achievable.

Next Steps

• Regulators—Regulators should embrace effective new solutions and conduct open discussions with banks, fintechs and regtechs on a regular basis. Public-private partnerships can drive progress on the risk management side of things.
• Banks—The Wolfsberg Group called on banks in December 2019 to embrace “effective” AML controls and reconsider whether to continue with ineffective controls. Can you imagine a business unit that provides zero value would survive more than a few months? Why should risk management be measured differently? It is time to expect measurable outcomes.
• Early adopters—Banks and fintechs that identified the value of new technologies could set an example through knowledge transfer to the industry.
• Fighting the siloed approach—Financial crime risk management is still siloed in most places. So much is invested in know your customer processes or ongoing customer due diligence that is disconnected from the ongoing behavioral analysis, we are often “blinded” as a result. I would suggest taking it even further: The next step is to remove the walls that stand between business and risk management processes to maximize the data collected.

Conclusion

At the end of the day, financial crime risk management is expected to fight financial criminals. If there are ways to stop, detain, prevent and detect criminal activity and slow down child and human trafficking, terrorism and drug trafficking, we cannot afford to be weak. Regulators or financial service providers know that we all understand it is critical to financial inclusion as well. There are no excuses!

Yaron Hazan, vice president of regulatory affairs, ThetaRay

1. “Opportunities and Challenges of New Technologies for AML/CFT,” Financial Action Task Force, July 2021, https://www.fatf-gafi.org/media/fatf/documents/reports/Opportunities-Challenges-of-New-Technologies-for-AML-CFT.pdf