What's wrong with the risk-based approach?

The risk-based approach to regulation is under fire. In the UK, the Northern Rock debacle could result in a reworking of the supervisory system, which is being criticised as too hands-off. Defenders of the system point out that a failure such as Northern Rock is inevitable, as the term 'risk-based' indicates that occasionally something will not seem very risky but prove to be dynamite. Critics say such events shouldn't be allowed to happen, as they threaten financial stability.

At the other end of the spectrum, and somehow more disturbing, is what is happening to the risk-based approach to anti-money laundering regulation in the US. At our annual AML USA event in New York, senior financial services executives complained that the risk-based framework was being used to set the bar for compliance ever higher, with negative public policy consequences.

Executives express concern that the 'best practice' sections of the Federal Financial Institutions Examination Council's BSA/AML examination manual is becoming the standard benchmark for compliance among bank examiners. Also, regulatory rules are being made up 'on the hoof' through enforcement actions. One example is the recent Union Bank of California enforcement action, which says banks should perform due diligence on new and existing customer accounts, and close accounts "if the information available to the bank indicates the customer's relationship with the bank would be detrimental to the reputation of the bank." Said one executive: "The last time I checked the Bank Secrecy Act examination manual, that wasn't in there." Says another: "We now have prosecutors acting as supervisors."

Executives say regulatory risk is driving firms, not the risk-based approach. That is, compliance executives are prioritising their activities not by their AML risks, but by the latest regulatory headlines and enforcement actions. Said one: "What risks are we managing, and is that the right thing?"

This approach to AML regulation and enforcement can't be good for the industry. Setting aside the stress levels imposed on compliance executives, regulations should be written by regulators, in consultation with the industry. Thought should be given to the public policy implications. A 'risk-based' approach should mean just that.

Ellen Davis, Editor