Vijaya Ramachandran and Thomas Rehermann
Combating money laundering and the financing of terrorism are critical to global safety and security. Yet such efforts have unintended consequences when they cause banks and other financial institutions to dissolve client relationships and withdraw from markets considered to be too risky. This can be particularly damaging to the world’s poor and economically vulnerable — and to the organizations that serve them.
A technology called blockchain has emerged that may help address these problems.
First, some background. Regulators now require banks to adhere to economic and trade sanctions and to assess and mitigate money laundering and terror financing risks — or face stiff penalties if they don’t. However, these regulations are relatively new and it is not yet entirely clear how banks and other entities should manage the risks involved, a situation that can result in the application of overly simplistic risk assessment methodologies. Additionally, the imposition of legitimate fines on some large banks for contraventions of anti-money laundering, counter the financing of terror, and sanctions laws can have a chilling effect on banks’ lending policies, and have led some banks to adopt understandably conservative positions.
This risk averse stance has driven many banks to discontinue services to many businesses, market segments, and countries that are seen as high risk, marginally profitable, or potential sources of costly fines, monitorships, or even prosecutions. Essentially, they are “de-risking” by ceasing to engage entire categories of services and customers, rather than judging the risks of clients and activities on a case-by-case basis.
Those most affected by this de-risking include the families of migrant workers, small businesses that need to access working capital or trade finance, and organizations that provide life-saving aid in conflict or disaster situations.
Migrants who want to send money home via remittances require a healthy money transfer organization sector. Yet as a result of de-risking, many such organizations have seen their access to banking services denied, downgraded, or made more expensive. As a result, often only larger money transfer organizations have access to bank accounts, and many smaller players have been forced to close.
Overall, the cost of sending money is rising globally. The average fee to send $200 increased from 7.37 percent in the fourth quarter of 2015 to 7.45 percent in the first quarter of 2017. Given that remittances from migrant workers total $440 billion a year (more than three times total foreign aid), these fee increases are likely to have a significant negative impact on the recipients of remittances, who often live in poor countries.
Organizations that serve poor countries are also feeling the effects of de-risking. Last month, Charity and Security, a U.S.-based nongovernmental organization, published a report that found that two-thirds of U.S.-based nonprofits working abroad are struggling to access financial services.
In addition, de-risking by banks can push customers to less transparent service providers, thus reducing the transparency of financial flows and damaging the broader effort to uncover and root out nefarious financing activities.
Is blockchain the answer?
The term blockchain derives from the manner in which data are stored. Transactions are recorded in time-stamped “blocks” that form a chain of transactions. This chain is stored by all users on a network, so that every time a new block is verified and added, the entire chain is updated across all users.
Traditionally, when buying, selling, or verifying the ownership of an asset, individuals have had to rely on a trusted third-party institution, usually a bank, credit card company, or government entity. Blockchain technology provides an alternative to this method using cryptography and computer code to generate the same level of trust.
Also, regulations that require financial institutions to “Know Your Customer” are extremely costly to comply with — financial institutions spend on average $60 million a year to do so — and time consuming, with verification procedures that can take months. Blockchain’s technology, which encodes a record of valid transactions with time stamps, combined with biometric identification features can be an effective and inexpensive way to verify customers and their transactions.
The most recent EMCompass Note examines how blockchain technology can help mitigate the effects of de-risking by reducing regulatory compliance costs while increasing the transparency of transactions. Blockchain is not a perfect technology, nor is it hacker-proof. It is an evolving technology — so understanding its scope and limitations is critical to its success in addressing problems such as de-risking.
About the Authors of the EM Compass Note
Vijaya Ramachandran, Senior Fellow, Center for Global Development (firstname.lastname@example.org)
Thomas Rehermann, Senior Economist, Thought Leadership, Economics and Private Sector Development, IFC (email@example.com)