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Green Compliance: Adding Potential Complications to Your KYC Onboarding – by Encompass

“Green” is all the rage right now. Professionals are seeing increasing public discourse around climate change, environment, social and governance (ESG), diversity and inclusion and corporate social responsibility. Governments and regulators are taking note and even proposing guidelines as well as regulations to address the various green initiatives. Investors and the public are increasingly demanding that companies identify climate-related risks in their financial results.

The 2021 United Nations (U.N.) Climate Change Conference will undoubtedly result in governments worldwide issuing additional industry regulations to limit carbon emissions and impose penalties for noncompliance.

The Growing Importance of “Green” Regulations Globally
While climate change has been in the news lately, a quick web search for “ESG regulations” highlights the growing importance of creating a regulatory framework required for compliance.

The European Union’s (EU) sustainable finance action plan, introduced in 2018, focuses on creating global sustainability policies. Note 1.

“It is not a stretch to potentially consider noncompliance with ESG regulations as another predicate crime that impacts civil society.”

Part of that strategy is making ESG investing more transparent to improve disclosure, leading to the creation of Sustainable Finance Disclosure Regulation (SFDR). As part of the SFDR, financial institutions (FIs), including asset managers, insurance and fund investors, must disclose how they consider the various ESG risks as part of their investment decisions. It is important to recognize that the EU is looking to create sustainable investments through the European Green Deal, announced in 2019 and where at least one trillion euros of sustainable investment is planned over the next 10 years. As of March 10, 2021, certain FIs are now required to make mandatory ESG disclosures or face the risk of penalties and other enforcement actions. Note 2.

Interestingly, the demand to invest in ESG compliant funds continues to increase—driving assets under management up to 29% and the fourth quarter of 2020 to nearly $1.7 trillion from the prior quarter, according to Morningstar. Note 3.

These regulations are by no means just limited to the EU. On June 16, 2020, the U.S. House of Representatives passed the Corporate Governance Improvement and Investor Protection Act, which would require public companies to disclose the link between ESG metrics and their long-term business strategy. Note 4.

This act would also create a new sustainable finance advisory committee that would recommend policy changes to the Securities Exchange Commission to facilitate capital flow toward environmentally sustainable investments. While this act works its way through Congress, it is important to recognize that this initiative highlights the increasing focus around ESG and climate disclosure regulations.

In the U.K., a recent speech by the CEO of the Financial Conduct Authority (FCA), Nikhil Rathi, at the launch of the “HM Treasury Women’s Finance in Charter Annual Review,” highlighted the need to ensure that diversity and inclusion be included in the hiring plans of any firm. Note 5.

Rathi highlighted evidence that calls for a strong business case for diversity. He warned that if there are no improvements in diversity, especially at the senior level, the FCA would consider using its regulatory enforcement power. He ended his speech by stating that there needs to be some form of diversity, not only because it is a social good but because diversity can reduce risks when underserving diverse communities. He warned that diversity and inclusion could become regulatory issues. Indeed, even in the U.S., NASDAQ has taken the lead by listing rules that require all companies listed on U.S. stock exchanges to explain why they do not have at least two directors from diverse backgrounds. In the U.K., regulatory discussions are underway to make similar listing requirements.

The Impact on Anti-Money Laundering Regulations
So how do these trends impact compliance with anti-money laundering regulations? Note that to be punished for noncompliance, there must be a series of predicate crimes that lead to enforceable actions and subsequent penalties. Examples of current predicate crimes include proceeds from drug trafficking, human smuggling and tax avoidance, to name a few. What is interesting about tax avoidance as a predicate crime is that this was considered a financial crime only relatively recently, Note 6 –  as the pressure by governments to collect tax revenue increased, the Financial Action Task Force amended its Recommendations in 2012. It is not a stretch to potentially consider noncompliance with ESG regulations as another predicate crime that impacts civil society. The implication is that compliance officers would now need to include ESG compliance as part of their standard due diligence efforts.

What would be required is additional workflow processes and data sources that can provide the appropriate level of compliance with ESG requirements. For example, when looking at carbon emissions, firms that do not accurately report on the level of carbon emissions risk a penalty and a lower ESG rating and report on a designated database. This lower rating would then be used by the bank as part of a due diligence process to rank the firm’s risk. The FI may then choose not to onboard this potential client because the low ESG rating would not meet their risk standards. Another example would be where investors looking to invest in a mutual fund would need to assess the sustainability ranking of that fund to determine their risk rating. A low-risk rating or prior noncompliance with ESG standards could result in a lack of investment.

Adding New Data Sources to Track “Green” Compliance
Interestingly, new data sources would now be required to track ESG ratings or other green compliance indicators. As regulatory enforcement actions become more visible against firms that do not comply with ESG requirements, the need for solutions that provide this data becomes more important. These may be rankings provided by regulators or by premium data source providers. FIs may decide to draw from multiple data sources to compile their overall ESG ranking. FIs may need to prioritize their risk ranking requirements during the onboarding process. A low ranking may be considered a higher or unacceptable risk for that FI and could be used as a basis for denying a new bank account. Imagine using a NASDAQ list that includes a low ESG rating as a result of lack of diversity as criteria for the onboarding process. Again, this is not outside the realm of possibility here, where additional criteria and subsequently data sources are required for the onboarding process.

There are several implications here; not the least is the increased costs of compliance because of introducing additional criteria for onboarding. Today, FIs are struggling with basic know your customer (KYC) onboarding processes, and new criteria will increase complexity in their operations, potentially resulting in noncompliance with these new regulatory requirements. FIs should ensure that they have their current KYC onboarding processes in place.

Dr. Henry Balani, global head of industry and regulatory affairs, Encompass Corporation, henrybalani@encompasscorporation.com

This article was also published in ACAMS Today – https://www.acamstoday.org/green-compliance-adding-potential-complications-to-your-kyc-onboarding/

Notes;

1. “Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability-related disclosures in the financial services sector,” EUR-Lex, November 27, 2019, https://eur-lex.europa.eu/eli/reg/2019/2088/oj

2. Lilian Welling-Steffens, Sabine Schoute and Marijn Bodelier, “The EU Sustainable Finance Disclosure Regulation Enters into Force,” The National Law Review, March 22, 2021, https://www.natlawreview.com/article/eu-sustainable-finance-disclosure-regulation-enters-force

3. Simon Jessop and Kate Abnett, “Sustainable fund assets hit record $1.7 trln in 2020: Morningstar,” Reuters, March 9, 2021,https://www.reuters.com/article/us-global-funds-sustainable/sustainable-fund-assets-hit-record-1-7-trln-in-2020-morningstar-idUSKBN29X2NM

4. “H.R.1187—Corporate Governance Improvement and Investor Protection Act,” Congress, June 17, 2021, https://www.congress.gov/bill/117th-congress/house-bill/1187/text

5. Nikhil Rathi, “Why diversity and inclusion are regulatory issues,” Financial Conduct Authority, March 17, 2021, https://www.fca.org.uk/news/speeches/why-diversity-and-inclusion-are-regulatory-issues

6. Lucia Rossel, Brigitte Unger, Jason Batchelor and Jan van Koningsveld, “The Implications of Making Tax Crimes a Predicate Crime for Money Laundering in the EU,” Oxford Scholarship Online, February 2021, https://oxford.universitypressscholarship.com/view/10.1093/oso/9780198854722.001.0001/oso-9780198854722-chapter-13

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