PEP Due Diligence – Breadth and Complexity

Corporate Clients, AML, Banking & Finance

Introduction

This is the second of a series of articles diving into the classification of financial services clients as ‘Politically Exposed Persons’ (PEPs). This series of three articles outlines the purpose and consequences of PEP status and how the process of PEP status designation and due diligence can go wrong at various stages. 

This article discusses several issues that arise from the PEP scheme. It focuses on the broad and complex nature of the guidance on identifying PEPs provided by the Financial Conduct Authority (FCA) and the FATF (Financial Action Task Force) and how this broadness can lead to misinterpretation and wider designation of PEP status than is appropriate. This can also lead to firms refusing their services to certain clients. It is the FCA guidance that UK financial service firms (‘firms’) must follow and that will be the focus of this article. For an explanation of what PEP status is, its purpose and effects, see our previous article: PEP Classification – What is a PEP?

Breadth and Complexity

The FCA and FATF guidance on the identification of PEPs is broad by design; it allows for a wide range of people to be caught under the PEP umbrella in order to maximise the probability that those committing financial crime are inhibited or prevented from doing so by the checks that firms must make. The guidance therefore emphasises the need to assess PEP status on a case-by-case basis, taking into account a variety of factors. 

While this broad approach achieves its purpose, the FCA relies on firms to use good judgement in their interpretation of the guidance and in the conclusions they draw from research, in what is a complex assessment. This space for judgement is fertile ground for wide interpretative variation and broad application to proliferate. Indeed, in its recent report on the treatment of domestic PEPs, the FCA found that seven of the fifteen firms surveyed were using definitions of PEPs and RCAs (relatives and close associates) that were not in line with FCA guidance. 

By way of example, the FCA guidance states that PEPs are defined as people who have been entrusted with a ‘prominent public function’, along with their RCAs. It is acknowledged that the definition of a ‘prominent public function’ will vary according to the nature of the function held by a person’. While the guidance goes on to provide a list of higher and lower risk indicators relating to the individuals’ associated role and country, there is an expectation that firms can afford and are willing to conduct the necessary research to assess the risk level and apply good judgement. This space for judgement can include particularly subjective assessments like whether a person has ‘true executive power’ and whether a mid-ranking official could be acting on behalf of a PEP. Similarly, deciding who qualifies as a close associate or family member is not so simple. For example, it will not necessarily be clear to a firm whether the sibling or aunt of a ‘higher risk’ PEP warrants RCA status. In all, this process is unavoidably complex, costly and highly subjective.

Potential Consequences

A number of issues arise from this system. The cost and complexity of researching and making this assessment leads to misjudgement and misapplication; some firms inevitably mischaracterise individuals as higher or lower risk than is appropriate, undermining the efficacy of the scheme. Other firms will avoid such issues by assuming a low risk appetite. In the latter case, firms can refuse to offer their services to a certain range of PEPs; this is known as ‘de-risking’ and is in line with FCA and FATF guidance. Notwithstanding, a worrying trend of firms refusing services to and closing accounts of apparently lower-risk clients has been reported in the media over years. While this achieves the goal of preventing potentially illicit transactions, it is an unavoidably blunt tool and unfairly affects innocent parties. In addition, where firms apply a loose interpretation of the guidance, an even larger number of customers fall within the definition of a PEP or RCA. This in turn exacerbates the risk of misapplication and de-risking, and dilutes the PEP label, further reducing its efficacy.

Conclusion

While the FCA’s broad guidance is multi-faceted by design and works to ensure as many illicit transactions and enterprises are caught by AML regulation, it also brings unwanted consequences. Many firms do not have the resources to correctly interpret and apply the guidance while others do not have the appetite to risk relationships with clients they do not fully trust. It cannot be known the frequency at which financial services firms misapply the guidance but it is evident that low to no-risk clients are and have been affected by mislabelling and de-risking. Innocent parties have had to face greater barriers to the banking system and some have seen services refused.  Not only is this unjust, it works counter to the scheme’s goals.

If you would like to know more on similar topics, keep following this series, follow our LinkedIn and subscribe to our newsletters. If you believe you may have been unfairly affected by the PEP scheme, whether it be PEP designation or de-risking, please get in contact to see how we can help.