Compliance Audit: Evaluating and Balancing Country Risk and Regulatory Risk

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Compliance Audit: Evaluating and Balancing Country Risk and Regulatory Risk August 2013 Lisa Bowyer, CAMS CONTENTS Introduction... 3 Regulatory Risk... 4 Country Risk... 5 Obstacles to assessment and evaluation
Compliance Audit: Evaluating and Balancing Country Risk and Regulatory Risk August 2013 Lisa Bowyer, CAMS CONTENTS Introduction... 3 Regulatory Risk... 4 Country Risk... 5 Obstacles to assessment and evaluation of Country Risk... 6 HSBC Case Habib bank Case Good regulatory practice... 7 Auditing the Risk assessment... 9 Frequency and scope... 9 Evaluating the Country Risk Assessment... 9 Assess the Application of the Risk Assessment Solutions Basel AML Index Conclusion INTRODUCTION An initial and on-going risk assessment is the foundation of any compliance system regardless of its scope and the starting point for an audit of a compliance system should be to review and evaluate the risk assessment. Whilst a variety of risks have been identified by standard setters and regulators for more than a decade, evaluating the risk assessment presents a difficult hurdle to clear cleanly to scope the audit and produce a high quality reliable report. Deficient Country Risk Assessment by Institution Deficient evaluation of Country Risk Assessment by Auditor Overall increased risk exposure Increased regulatory risk Increased regulatory risk The failure to accurately assess and appropriately apply country risk by an institution results in exposure to increased risk and this includes some regulatory risk. The failure by a compliance auditor to accurately and properly evaluate the risk assessment of country risk may result in further increased regulatory risk where the Institution is mandated to arrange periodic compliance audits. Deficient Evaluation of Country Risk Assessment and application Deficient Country Risk Assessment The ability to achieve the correct balance between regulatory risk and country risk assessments and evaluations is further hindered by the existence and use of white and black lists by regulators which are often reflective of political factors, limited, unreliable or based on old data. In this paper, we identify and explore the compliance processes reliant on country risk assessments and how to evaluate that in the audit process. We refer to features of reasonable methodologies for country risk assessments highlighting how the assessment can counter regulatory risk arising from regulatory high risk country black lists. Whilst some jurisdictions allow reliance to be placed on introducers and intermediaries if in white list countries (countries with equivalent regulation) but also require enhanced due diligence when clients or transactions involve high risk countries. A small number of regulators list high risk countries, a number define them and many do not include reference to either. 3 Country Risk Assessment Black and White Lists Compliance Processes Audit REGULATORY RISK The frequency and scope of compliance audits will directly affect regulatory risk. However, since the evaluation of the risk assessment is the foundation for the audit then any deficiencies in this evaluation could undermine the audit itself and thereby also increase regulatory risk. Flawed Country Risk Assessment Erroneous Evaluation of Risk Assessment Application of Risk Assessment only partially reliable Where this risk falls depends on the regime. Where the auditor s evaluation of the risk assessment fails to identify weaknesses in the risk assessment, then the auditor will face regulatory risk if the regulator approves auditors either formally or informally. In this case the institution also faces regulatory risk for the deficient risk assessment although it may be afforded some excuse if the auditor does not identify and report on the weakness in its evaluation. However, it may be argued that the risk assessment whilst the foundation for the audit, is affected by so many factors beyond the scope of a compliance audit 1 that the institution should be responsible for the evaluation of its risk assessment by additional independent means. Nonetheless, the auditor needs to be able evaluate the risk assessment as full and objective and its consistent application. The first step is to fully explain to the client the features of a reasonable methodology for risk assessments and stress the importance and relevance of this in the audit. To mitigate any liability, auditors should establish a benchmark for Reasonable Country Risk assessments for the purpose of compliance audits. This will enable the auditor to focus on the evaluation of the application of the risk assessment. 4 Flawed Country Risk Assessment Correct Evaluation of Risk Assessment Can Application of Risk Assessment be evaluated by factoring in flawed risk assessment? When a risk assessment is evaluated as deficient, communication with the client is necessary and the scope and timing of the audit may be changed. The audit report should clearly note any concerns regarding the risk assessment and limitations of the review to ensure the report is of value and also to manage the auditor s liability and regulatory risk. COUNTRY RISK Country risk, in conjunction with other risk factors, provides a useful indicator to potential money laundering risks. According to the Wolfsberg Principles, the evaluating factors that may result in a determination that a country poses a higher risk include if the country is: Subject to sanctions, embargoes or similar measures issued by, for example, the United Nations ( UN ). Identified by the Financial Action Task Force ( FATF ) as non-cooperative in the fight against money laundering or identified by credible sources as lacking appropriate money laundering laws and regulations. identified by credible sources as providing funding or support for terrorist activities Identified by credible sources as having significant levels of corruption, or other criminal activity 2. The Third EU Money Laundering Directive refers to third country equivalence but the proposed 4 th Directive will remove the provisions relating to positive equivalence , as the customer due diligence regime is becoming more strongly risk-based and the use of exemptions on the grounds of purely geographical factors is less relevant. The current provisions of the Third Money Laundering Directive require decisions to be made on whether third countries have anti-money laundering/combating terrorist financing systems that are equivalent to those in the EU. This information is then used to allow exemptions for certain aspects of customer due diligence. The non-exhaustive list of geographical risk factors referred to in the Directive, are set to remain the same, only the use and application will change. ANNEX 3 POTENTIALLY HIGHER GEOGRAPHICAL RISK FACTORS (a) countries identified by credible sources, such as FATF public statements, mutual evaluation or detailed assessment reports or published follow-up reports, as not having effective anti-money laundering/combating terrorist financing systems; (b) countries identified by credible sources as having significant levels of corruption or other criminal activity; (c) countries subject to sanctions, embargos or similar measures issued by, for example, the United Nations; (d) countries providing funding or support for terrorist activities, or that have designated terrorist organizations operating within their country. ANNEX 2 GEOGRAPHICAL LOWER GEOGRAPHICAL RISK FACTORS (a) other EU Member States; (b) third countries having effective anti-money laundering/combating terrorist financing systems; (c) third countries identified by credible sources as having a low level of corruption or other criminal activity; (d) third countries which are subject to requirements to combat money laundering and terrorist financing consistent with the FATF Recommendations, have effectively implemented those requirements, and are effectively supervised or monitored in accordance with the Recommendations to ensure compliance with those 5 requirements. Many regulators now require that a risk based approach be adopted by institutions and the absence of rules and prescription mean that all and any risk assessment requires full and careful attention. A risk assessment must not be arbitrary. The more comprehensive and objective an assessment is, the lower the regulatory risk. Risk Assessment Mistakes Not considering a variety of sources for the assessment Inconsistent application Failing to update assessment Thus, an already potentially subjective process may require more than reasonable steps to fully assess risks and there should be design changes in response to new events. An obvious pitfall is to not respond to key changes to business plan or changes in the business environment 3 and generally the frequency of updates of the risk assessment depends on the type of institution and its experiences. OBSTACLES TO ASSESSMENT AND EVALUATION OF COUNTRY RISK The country risk assessment serves many purposes within the compliance system and the needs of those differ. Recently, both Sanctions and Corruption compliance have been added to existing AML and AFT compliance systems and country risk can have different implications for those. High risk country lists further complicate the process unless well designed, ideally as a resource. 4 Black lists will usually increase regulatory risk and hinder business unnecessarily. Since fixed lists may not accurately reflect country risk and may not give clear direction on how the list is to be applied, regulatory risk may be increased. HSBC CASE 2012 The HSBC case involved a failure to observe official US warnings about the risk of money laundering in Mexico. 5 The Annual International Narcotics Control Strategy Report (INCSR) issued by the US State Department 1 annual report issued by the lists Mexico as high risk because of the prevalent drug crime in the country. Although HSBC failed to adopt the highest risk rating for Mexico based on the US reports, the primary problem was that the bank s own risk rating system and compliance process was flawed or overridden. Whilst acceptable for the client risk rating process to override the country risk assessment this was not documented correctly. 6 Pertinently the primary country risk in Mexico is of drug trafficking and corruption, which relates to source of funds but Mexico s regulation of AML is considered to be acceptable and some regulators include Mexico on a white list. This illustrates how lists can confuse the assessment and thereby present additional regulatory risk. 1 Department of State Bureau for International Narcotics and Law Enforcement Affairs 6 Despite the information and warnings regarding money laundering risks in Mexico, from 2002 until 2009, HSBC assigned its lowest risk rating for AML purposes to Mexico. As a consequence, under bank policy, clients from Mexico were not subjected to enhanced monitoring, unless they were also designated a Special Category Client, which was a relatively rare designation that indicated high client risk. This meant that client risk, of which country risk is an element, overrode the country risk. As a result the bank did not conduct AML monitoring on most of its Mexican client accounts and wire transfer activity involving substantial funds. HABIB BANK CASE 2012 In May 2012 the UK Financial Services Authority imposed fines on Habib Bank. Almost half of its client base was outside the UK and about half of its deposits came from jurisdictions which reportedly had less stringent AML requirements or were perceived to have higher levels of corruption than the UK. Habib maintained a high risk country list which excluded certain high risk countries 7 on the basis that it had group offices in those countries, which the bank argued gave it local knowledge of these countries, which negated the otherwise assessed higher risk of money laundering. Where deposits or clients were located in high risk countries, the regulator found that the bank failed to conduct adequate enhanced due diligence. The regulator noted that the bank s belief that local knowledge of a country through a group office mitigated the higher money laundering risk posed by that country was entirely misconceived. Guidance 8 issued by the regulator the year before the Habib case highlighted examples of poor practice: Ranking higher risk countries as low risk because they had lots of dealings with the entities there. Exempting relationships from country risk assessments because the bank s parent had a presence in the higher risk country. The lesson to be learned from this case is that it is safer to conduct a risk assessment using objective data and sources. To override risk assessments resulting from regulatory or credible sources presents significant regulatory risk. The better approach is to adopt and record the higher risk assessment but then tailor the enhanced due diligence or other compliance process according to all the factors and risks present. In all the cases the higher and more independent the approval obtained for the decision the better wherever there are high risk factors. GOOD REGULATORY PRACTICE The Jersey Financial Services Commission has issued excellent and extensive guidance on country risk assessments 9 including a very useful resource listing countries and factors affecting the country risk of each. It advises that the following types of countries or territories may be considered to present a higher risk, those: With strategic deficiencies in the fight against money laundering and the financing of terrorism e.g. Identified by the FATF as having strategic deficiencies. Identified as major illicit drug producers or through which significant quantities of drugs are transited, e.g. those listed by the US Department of State in its annual International Narcotics Control Strategy Report. That do not take efforts to confront and eliminate human trafficking, e.g. those listed in Tier 3 of the US Department of State s annual Trafficking in Persons Report. that have strong links (such as funding or other support) with terrorist activities, e.g. those designated by the US Secretary of State as state sponsors of terrorism; and those physical areas identified by the US (in its annual report entitled Country Reports on Terrorism) as ungoverned, under-governed or ill-governed 7 where terrorists are able to organize, plan, raise funds, communicate, recruit, train, transit and operate in relative security because of inadequate governance capability, political will or both. That are involved in the proliferation of nuclear and other weapons, e.g. those that are the subject of sanctions measures in place in Jersey, or, as appropriate, elsewhere. That are vulnerable to corruption, e.g. those with poor ratings in Transparency International s Corruption Perception Index or highlighted as a concern in the Worldwide Governance Indicators project, or whose companies engage in bribery when doing business abroad, e.g. those with poor ratings in Transparency International s Bribe Payers Index. in which there is no, or little, confidence in the rule of law, in particular the quality of contract enforcement, property rights, the police and the courts, e.g. those highlighted as a concern in the Worldwide Governance Indicators project. In which there is no, or little, confidence in government effectiveness, including the quality of the civil service and the degree of its independence from political pressures, e.g. those highlighted as a concern in the Worldwide Governance Indicators project. that are politically unstable, e.g. those highlighted as a concern in the Worldwide Governance Indicators project, or which may be considered to be a failed state, e.g. those listed in the Failed State Index (central government is so weak or ineffective that it has little practical control over much of its territory; non-provision of public services; widespread corruption and criminality; refugees and involuntary movement of populations; sharp economic decline). That are the subject of sanctions measures that are in place in Jersey or elsewhere, e.g. those dealing with the abuse of human rights of misappropriation of state funds. That lack transparency or which have excessive secrecy laws, e.g. those identified by the OECD as having committed to internationally agreed tax standards but which have not yet implemented those standards. with inadequate regulatory and supervisory standards on international cooperation and information exchange, e.g. those identified by the Financial Stability Board as just making material progress towards demonstrating sufficiently strong adherence, or being non-cooperative, where it may not be possible to investigate the provenance of funds introduced into the financial system. Contrary to the Habib case, the recent guidance from the Jersey regulator, states that a relevant factor in the assessment would be the institution s familiarity with a country or territory, including knowledge of its local legislation, regulations and rules, as well as the structure and extent of regulatory oversight, for example, as a result of a relevant person s own or group operations within that country. Without giving an institution the ability to factor this in is to take away a disproportionate amount of valuable knowledge and information that can be more accurate than public data sources. Also, contrary to the 2011 FSA guidance, the JFSC states that the transparency of the customer may indicate lower risk. For example, persons subject to public disclosure rules, e.g. on exchanges or regulated markets or subject to licensing by a statutory regulator. In conclusion, the Jersey regulator s approach is an excellent one to follow in the assessment of country risk. Further, in both the Habib Bank and HSBC cases the significant regulatory risk that resulted in the fines was more a result of the abuse of the banks own processes rather than directly a result of the regulatory requirements. By way of illustration it is noted that the FSA generally commended banks with sophisticated risk assessment models that are consistently applied. 10 8 AUDITING THE RISK ASSESSMENT FREQUENCY AND SCOPE Many regimes now also require compliance with sanctions orders and have anti-corruption legislation in place. Whilst in most jurisdictions there is no requirement to audit systems designed to ensure compliance with Sanctions and Corruption regulation, in many cases the penalties are high and strict liability applies, and given that AML, ATF, corruption and sanctions risks are inextricably associated with each other, then it makes sense to include sanctions and corruption within the scope of any compliance audit. Given that country risk is closely relevant to all, then at least the risk assessment would entail all four and should be included in the risk assessment evaluation. 11 What is very important to examine is how sanction lists of countries might be confused with high risk countries for AML and AFT purposes. Some rationale for the ranking should thus be evident in the risk assessment. 12 The focus and design of the audit regarding country risk should be: Evaluate the Country Risk Assessment Assess the Application of the risk assessment EVALUATING THE COUNTRY RISK ASSESSMENT The auditor should check that risk assessment: Is based on objective sources Has more than one set of results Is fit for purpose Is updated periodically A concern will arise and should be discussed with the client and reported upon, if a single list is used for numerous processes such as client acceptance, residence of client, source of funds and enhanced processes for example PEPs. The following chart documents how different categories of risk evidenced by a variety of data sources are relevant to compliance processes: Category of Risk Money Laundering and Terrorist Financing Financial Transparency and Standards Public Transparency and Accountability Compliance Process Client risk (source of funds, source of wealth, residence) Acceptance of and reliance on Counterparties Decline business Know your client (understanding business) Monitoring Reliability of documents
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