Customer Due Diligence in financial institutions

Over the past two centuries, financial institutions (FIs) have made great strides in their development, which can be clearly seen in the quality of services they offer and the way they adapt to the modern market, making them indispensable in all areas of our lives.

Unfortunately, however, this has also added certain public security risks, as FIs have attracted not only law-abiding actors, but also those who wish to engage in illegal activities for their own benefit, using FI services to conceal their actions.

As a result, there is a need to respond to this threat, which has led to the creation of special governmental and non-governmental organisations (e.g. FATF) to regulate this phenomenon and create recommendations and procedures to help prevent and detect money laundering activities.

One of the tools for preventing such activities is CDD.

What is CDD?

Customer Due Diligence (CDD) is a set of measures that must be carried out by primary financial monitoring entities, such as FIs, before engaging with potential customers, as well as in the course of conducting business relationships to combat money laundering and terrorist financing.

The measures taken by FIs in the course of CDD include:

1. Identification and verification of the client (his/her representative) by obtaining identification documents and his/her place of residence is the initial stage of CDD, also known as KYC – know your customer;
2. establishing the ultimate beneficial owner of the client or his/her absence, including obtaining the ownership structure in order to understand it, and data that allows to establish the ultimate beneficial owner, and taking measures to verify his/her identity (if any);
3. establishing (understanding) the purpose and nature of future business relations or financial transactions;
4. monitoring on an ongoing basis the client’s business relations and financial transactions carried out in the course of such relations, as to the compliance of such financial transactions with the information available to the primary financial monitoring entity about the client, its activities and risk (including, if necessary, the source of funds related to financial transactions);
5. ensuring that the received and existing documents, data and information about the client are up to date;

The list of measures may vary depending on the jurisdiction of the FI, but the items listed above are the basis of CDD in all countries, as the data obtained as a result of customer due diligence provides an opportunity to assess the risk of cooperation with such a customer.

What checks are performed based on the information provided during CDD:

• Verification of a person’s nationality – is important, as the FATF and other governmental organisations prohibit cooperation with terrorist countries, those in military conflicts, and those that are too risky due to corruption

• Verification of the source of a person’s income – allows the FI to understand where the fixed capital of an individual or legal entity comes from, which results in an appropriate assessment of whether the funds may come from illegal activities

• Substance – criteria that determine the existence of a company as a real one, not one that was created for money laundering, and not for the purpose of obtaining legitimate profit from business activities. This may include establishing real ties between the shareholder and the company, having its own office, employees, accounts with other financial institutions, etc.
• Checking for a person’s presence on sanctions lists or PEP (politically exposed person) status – Establishing whether a person is on international sanctions lists helps FIs avoid penalties from financial monitoring for violating sanctions requirements.
  Identification of a person as a PEP is a certain indicator that indicates the need for enhanced due diligence (EDD), as such persons are much more vulnerable to money laundering activities given their powers as a public authority.

The purpose of CDD

Customer due diligence is aimed at mitigating risks and preventing criminal groups and terrorist organisations from penetrating the legitimate financial system. Criminals use a variety of methods to disguise the origin of funds deposited with banks. Therefore, financial institutions are required to carefully verify the legitimacy of each customer.

Due diligence applies to every person with whom a financial institution plans to interact. Financial institutions seek to obtain a complete picture of the customer and their sources of income to ensure that they are legitimate and comply with applicable anti-money laundering and counter-terrorist financing laws.

The main goal of CDD is to ensure transparency so that banks and FIs understand who they are dealing with and what risks may arise in the course of cooperation.

As part of the KYC and AML (anti-money laundering) checks, customers receive a risk rating, ranging from low to high, which helps financial institutions make decisions on whether to start, terminate or further monitor cooperation.

Failure to comply with anti-money laundering requirements can have serious financial and reputational consequences.

In terms of financial consequences, they are mainly in the form of fines for non-compliance with anti-money laundering and counter-terrorist financing legislation imposed by local authorities with jurisdiction over the FIs of the respective countries.

Reputational consequences can sometimes be even more damaging to FIs than fines from financial monitoring, as news that a company either fails to comply with the requirements to check clients against sanctions lists or verify the source of their income can lead to consequences where other FIs are unwilling to partner with such a company, which can significantly reduce its market position.

This news may also affect the trust of existing or potential clients in such an institution, as they cannot be sure that the institution itself will not go bankrupt or be liquidated due to violations of the law, and that their funds will be safe and returned.

Conclusion.

It is extremely important for financial institutions to implement an in-depth CDD procedure adapted to the regulatory requirements of the country in which they operate, as if such a procedure is carried out correctly, the FI protects itself from unnecessary hassle and risks of receiving fines, loss of reputation, and will be able to systematise data about its customers, which can further help in carrying out an analysis aimed at identifying risks for them as a business.

The CDD procedure itself has become an absolute norm among all FIs, but even the initial correct implementation of such a procedure will not guarantee its constant relevance, so it is always worth paying attention to the innovations of regulators in the field of anti-money laundering in order to always be protected both from the risks of becoming a tool for money laundering and to protect the interests of FI clients from further negative consequences of non-compliance with such a procedure.