KYC- Knowing Your Customers is the Heart of a Sound BSA Program

When evaluating the strength and effectiveness of a given bank’s BSA program, one of the key areas of focus will be the system used by the bank to get to know who their customer are and what it is that the do.   The process of obtaining proper identification, background information and making an assessment of the overall BSA/AML risk presented by a customer can collectively be called the Know Your Customer (‘KYC”) process.   We have found that this process is just as much art as it is science.  In addition, we note that the stronger the KYC portion of a program is, the more likely it is that the overall program will pass regulatory muster. 

 

KYC and CIP a Potent One-Two Punch

The basis for the requirements of KYC is the USA Patriot Act.  The Patriot Act requires a bank to develop a program for properly identifying its customers. 

The CIP is intended to enable the bank to form a reasonable belief that it knows the true identity of each customer. The CIP must include account opening procedures that specify the identifying information that will be obtained from each customer[1]

The Patriot Act is very specific about the types of identification that must be presented and received by a Bank when opening an account.  Customers must be able to fully identify who they are using official documentation.  However, as the examination manual (and many an examiner) points out, simply getting the proper identification of the customer is not enough.  The real key is to be able to develop a “backstory” on the customer.  The ability to be able to put a customer’s activity in the proper context is a real key to determining the level or existence of suspicious activity.  For example, a business account that shows cash deposits of $6, 000 every other day might at first blush appear to be an example of structuring.  However, if you knew that the customer was a coin operated laundry and that the owner emptied the machines every other day, would that change your mind?  In context, the activity of a particular customer comes into clear focus.  By the same measure when activity is viewed that does not fit in with the back ground of the client, then you have true suspicious activity. 

The ability to truly know and understand the nature of your clients is the very best way to protect against terrorist financing and money laundering.  

 

KYC-Compliance and Marketing

The fact is that the more information that you have about a customer the better.  This is true in the compliance area, but it is also true in the area of marketing.  Information about a customers needs is a direct pipeline into the various products that your bank may offer.  Getting information about what a new business operator plans can provide a wealth of marketing opportunities.  “You say that you want to open a new restaurant? Perhaps we can interest you in a line of credit, a mobile banking app, or electronic bill pay!  The more information the merrier!  This same information can be used to develop a risk profile for BSA/AML purposes.  

We strongly suggest that a marriage or cross selling and BSA can be a happy and prosperous one!  One of our more innovative has used this approach.  The compliance group has joined forces with marketing to develop account opening forms that are mutually beneficial.  Questions such as:

·         How did you happen to find out about our bank?

·         How do you envision getting your customers to pay you?

·         Have you considered ACH rather than wires?

The answers to these questions are used both to create a strong KYC file and a marketing profile. 

 

KYC is only as Strong as the Documentation you maintain

One of the complaints we often hear from our clients goes something like this- “we know our clients well, but the regulators did not give us credit for know them.  The fact of the matter is that without documented evidence of your knowledge, you will not receive credit for knowing your customer.  There must be a clear record of the information that you have developed about a customer and the analysis that goes with the information.  It is not enough to merely maintain a file filled with statistics about the number of wire received and sent, the fact that these wires represent a growth in the business is the analysis that indicates a strong knowledge of the customer.  [2]  It is critical that a KYC contain facts, statistic and analysis.  It is the analysis that outs the context the transactions that are being viewed.  

Bringing KYC to Life

A fact of life for BSA staff trying to monitor customer activity is the staff that opens accounts is the eyes and ears of BSA.   They are the people that are looking directly into the eyes of the new customer and have the best opportunity to get all of the relevant information directly from the client.   It is also a sad fact of life that often times, the people who open accounts and start relationship with customers receive only a cursory training on BSA.  Many banks do the annual online training for this area.  And while there is no argument that this training meets the regulatory requirement, we recommend an additional step.  It has been our experience that when people understand the purpose and the goal of a regulation, compliance is able to get much stronger “buy-in”.  Therefore, we recommend that the BSA take the additional step of extensive KYC training for the people who are starting relationship with customers.  Make sure that the lending and customer service staff understands the goal of KYC and the consequences of noncompliance.  

By developing a strong narrative for a customer, a bank can clearly define what is and is not suspicious activity

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[1] FFIEC Bank Secrecy Act Anti-Money laundering Examination manual

[2] Again, we note that information about a business growing presents a marketing opportunity! 

Why IS there an Equal Credit Opportunity Act (AKA Reg. B)? 

As anyone in compliance can attest to, there are Myriad consumer compliance regulations.  For bankers, these regulations are regarded as anything from a nuisance, to the very bane of the existence of banks.  However, in point of fact, there are no bank consumer regulations that were not earned by the misbehavior of banks in the past.  Like it or not these regulations exit to prevent bad behavior and/or to encourage certain practices.   We believe that one of the keys to strengthening a compliance program is to get your staff to understand why regulations exist and what it is the regulations are designed to accomplish.  To further this cause, we have determined that we will from time to time through the year; address these questions about various banking regulations.  We call this series “Why is there….” 

A Little History

The consumer credit market as we now know it grew up in the time period from World War II and the 1960’s.  It was during this time that the market for mortgages grew and developed and became the accepted means for acquiring property, financing businesses, developing wealth and upward mobility.  By the late 1960’s the consumer credit market was booming. 

The Equal Credit Opportunity Act (“ECOA”) and regulation B are not nearly as old as you might think. In fact, the first attempt at regulating credit access was the Consumer Credit Protection Act of 1968.  This legislation was passed to protect consumer credit rights that up to that point been largely ignored.  The 1968 was passed as the result of a continuing growth in consumer credit its effects on the economy.  For example, in the year before the regulation was passed, consumers were paying fees and interest that equaled the government’s payments on the national debt!  One of the goals of the Consumer Credit protection Act then was to protect consumer rights and to preserve the consumer credit industry.  

The Civil Rights Movement was occurring at the same time as the passage of the CCPA and in 1968, the Fair Housing act was passed by Congress.  The FHA was designed to assist communities that that had been excluded from credit markets obtain access to credit.  We will discuss the Fair Housing Act in more detail next month.  

One of the things that the CCPA did was to empanel a commission of congress called the National Commission on Consumer Finance.  This commission was directed to hold hearings about the structure and operation of the consumer credit industry.  These hearings were conducted throughout 197.  The commission made its report and disbanded. 

Unintended Consequences

 While performing the duties they were assigned,   the members of the National Commission on Consumer Finance conducted several hearings about the credit approval process for consumer loans.  The stories and anecdotes from these hearings raised a tremendous public outcry about the behavior of banks and financial institutions that were in the business of granting credit.   One of the common themes of the testimonies given was that women and minorities were being left behind when it came to the growth of the consumer credit market.  Public pressure forced additional hearings on the consumer credit market, and the evidence showed that women in particular and minorities in general were being given unfair and unequal treatment by banks. 

What was Going On? 

So what was it that bans were doing that was causing a concern?    There were several practices that had become normal and regular for banks when the applicant for consumer credit was a woman or a member of a racial minority group.  

Women had more difficulty than men in obtaining or maintaining credit, more frequently were asked embarrassing questions when applying for credit, and more frequently were required to have cosigners or extra collateral. [1]  When a divorced or single woman applied for credit she was immediately asked questions about her life choices, sexual habits, and various other personal information that was both irrelevant to the credit decision and not asked of men. 

Racial minorities had difficulty even obtaining credit applications let alone credit approvals.  In cases, where members of minority groups attempted to get a loan applicant, there were either told that the bank was not making consumer loans,  or that the area that the person lived was outside of the lending area of the bank. 

For applicants that receive public assistance, child support of alimony, banks would not consider these as sources of income under the theory that they were temporary and might disappear.  

Despite being subjected to embarrassing or incorrect information, in the cases where women and minorities persisted and completed a credit applications, banks would drag out the process for interminable time periods and would engage in strong efforts to discourage the applicant from going forward.  

In many cases, when a person lived in a neighborhood that was predominately comprised of minorities, the borrower was told that the collateral did not have enough value without further explanation. 

The ECOA

Though these stories created a great deal of interest, the CCPA was not amended until 1974 when the first Equal Credit Opportunity Act was passed.  This Act prevented discrimination in credit on the basis of sex and marital status. 

 In 1976, the ECOA was amended to prohibit credit discrimination on the basis of  

1.       Race, color, religion, national origin, sex, marital status or age

2.       When all or part of the applicants income derives from public assistance

3.       If the applicant had filed a former claim of discrimination  

The 1976 amendment also added the requirement that the financial institution had to notify the applicant of the reasons for a decline.   Regulation B establishes the rules that implement the ECOA.  .    These include the following: 

1.       Limitations on the types of information that can be requested in a credit application.

2.       Limitations on the characteristics that can be considered about an applicant.

3.       Rules on when an applicant’s spouse can be requested to sign a loan applicant

4.       Rules on the time limits for when a credit decision can be made.

5.       Copy of Appraisals An applicant on a real estate secured loan now must receive a copy of the appraisal or evaluation used to establish the value of the collateral

6.       Collection of Government Monitoring Information- In cases of loan requests for the purchase or refinancing of a primary residence, government monitoring information (race, sex, and ethnicity) must be obtained. 

 

What is Regulation B designed to do?  

There are two main goals of the ECOA and its implementing regulation, Regulation B.

·         Enhanced Credit Opportunities for women and minorities

·         Greater consumer education

Credit Opportunities

One of the complaints about consumer banking regulation that is often raised is that it promotes bad loans.  However, for the inception of these regulations, Congress made clear that these laws apply only to credit worthy individuals.  It has never been the case that Congress or the regulators want banks to make bad loans.  The problem was and is that people who are truly creditworthy were being overlooked and excluded based on factors that were outside of their control. 

The law then is designed to prevent discrimination on an   illegal basis.  Even today, a great deal of disagreement over what discrimination might mean.  Of course, each and even decision to make or not make a loan is a form of discrimination.  That is part of the natural process of decision making.  Instead here what is prevented is discriminating on an illegal basis; making the adverse action based on who the applicant is rather than their credit worthiness. 

There are two tests for illegal discrimination. The first is the effects test.  Under this test, if the overall effect of a credit policy results in an uneven or disproportionate negative result, it may be in violation of the regulation.   Suppose for example, a bank decided that it would not include temporary work income as income for credit applications.  In this case, the decision to do so would be applied across all lines and to all borrowers.  However, the effect of this decision would impact women and minorities in greater numbers because temporary workers are way more likely to be women and minorities in the assessment area of the bank.  This would be an effects test violation of regulation B. 

The second test is the intent test.  This test is pretty straight forward.  This would be cases where a lender intended to treat applicants differently based on who they are and in fact did so.  While this area was largely in evidence in the 1960’s when these laws were first enacted, the number of cases of intentional discrimination has significantly reduced over the years.  

Borrower Education

The borrower education portion of the ECOA and Reg. B is typified by the notice requirements.  In an effort to make banks inform the applicant about the decision that was made, the regulations require a quick and concise decision process.  The notice requirement is designed to let the applicant know the specific reasons why their credit application was declined so that they can address the problem. If there are problems with the credit report, then the borrower needs to know what the problems are and who is reporting them.  In this manner the borrower is informed and the bank is kept “honest” about its decisions. 

The reasons that the examiners test adverse actions for timing and accuracy is that borrowers should have the ability to know exactly what is wrong and have an opportunity to fix it.  This is the reasoning behind requiring a copy of an appraisal report.  

Why are there a Regulation B and the ECOA?

The development of the consumer credit market brought with it a series of bad behaviors that directly and negatively impacted the ability of women and minorities to obtain credit.   These behaviors included asking women to check with their husbands before getting a loan, denying a single woman credit, discouraging minorities from applying for credit and outright refusal to grant credit.  

The law and regulation are designed to open up credit to all who are worthy by limiting practices that unfairly exclude groups of people and by making sure that applicants are fairly informed of the reasons for a denial.  

Embrace your inner compliance officer by knowing that this regulation is well earned, well intended and provides a good outcome for people who would otherwise not be able to obtain credit through no fault of their own. 

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[1] Gates, Margaret J., "Credit Discrimination Against Women: Causes and Solution," Vanderbilt Law.

Marketing in the Age of UDAAP

The beginning of the New Year brings about new energy, new plans for “Taking on and ruling the world” and new ideas for how to make the New Year the best ever!  For many banks this new energy includes new ideas for how to market their banks and to obtain new customers.  For our clients, while we encourage innovation and reaching out to the customers, we also offer a word of caution.  Be careful, what you market and especially, how you market!  

The Unfair Deceptive Abusive Acts or Practices rule (“UDAAP”) is a burgeoning area of regulatory pursuit. This is one of those very sophisticated areas of regulation that look at the impact of practices versus simple compliance with the letter of the law.    Much like Fair Lending laws, it is possible to be in technical compliance with UDAAP and still have a regulatory problem, if the impact of a particular practice causes harm. 

UDAP versus UDAAP

While the Federal Trade Commission (FTC) has the authority to protect consumers against unfair or deceptive acts or practices (UDAP) in commerce generally; tis responsibility is delegated to the federal banking regulators for national banks, savings associations, and credit unions.   In the past, though this authority existed, it was rarely used to produce enforcement actions in the banking area.   There have been very few regulations or rules that have been published in this area, so the definitions that are used come from policy statements of the FTC.  These statements define the first two aspects of the rule.  According to these pronouncements: 

What is “unfair’?

• The practice causes or is likely to cause substantial injury.
• The injury cannot reasonably be avoided.
• The injury is not outweighed by any benefits.

What is “deceptive”?

• The practice misleads or is likely to mislead.
• A “reasonable” consumer would be misled.
• The presentation, omission or practice is material.

What do these standards mean for products?  Note that these definitions generally refer to conditions that are terms of the product.  Any product can be subject to a UDAAP claim, but the ones that most often fall under these two standards are ones that have add on fees or interest charges that are triggered by conditions within the product.  Here is a list of the products that get the most scrutiny under the rubric of UDAAP: 

• Overdraft programs
• Check/debit processing order
• Loan payment processing
• ATM fees
• Loans with balloon payments
• Credit life and disability insurance sales
• Rewards programs
• Gift card sales
• Credit Card programs

Recently, the CFPB was given rulemaking authority in this area and has added a definition for the second “A” in UDAAP. 

What is “abusive”?

• The practice materially interferes with the consumers ability to understand a term or condition of a product or service.
• The practice takes unreasonable advantage of a consumer’s lack of understanding of the risk, costs and conditions of a products or service.

The focus of this part of the rule has been on the advertising that financial institutions use to promote products.   When the products that are offered have complicated terms, the information given to consumers has to fully and completely explain the worst case scenario for the customer.   If the advertising material or disclosure given to the customer is misleading or inaccurate, then a UDAAP concern can be found.  

We believe that it is also critical to pay particular attention to the second part of rule that defines abusive; a practice that takes advantage of a customer’s lack of understanding of fees and costs of a product.   We believe that this part of the rule requires that banks to vigilant not only about disclosures they give to customers, but also about the level of fees that are being charged to the customer.   An add-on interest charge may make economic sense.  It may also be designed with a legitimate business purpose in mind.  The fee can be applied to all customers that have a specific type of account and therefore, not a violation of fair lending or equal credit opportunities laws.  However, these types of fees can adversely impact customers of limited means.  As a result, these sorts of additional charges on an account can represent a UDAAP concern. 

Fees associated with overdrafts a particular matter of concern for regulators.   Even in cases when customers have been made aware of the facts that fees will be charged and have agreed to pay the overdraft fees, it is clear that regulators will consider large fees paid by customers who consistently overdraw accounts to be a matter for UDAAP review.   [1]

Some Quick Tips:  

Recent enforcement actions under UDAPP include actions for the lack of vendor management[2], telemarketing[3] and the previously mentioned overdrafts.   These actions suggest the need for compliance officers to monitor several areas when considering UDAAP compliance: 

Vendors: if they are being used to do marketing compliance staff should review the material being used to ensure that it is accurate and complete;

Marketing:  Compliance staff should also do the same for marketing materials that are being used in house;

Credit Add-on products:  Credit insurance, credit score tracking and the like increase the inherent risk of consumer products.  Compliance testing should include these products;

Overdrafts: Compliance officers should monitor the overdraft programs to ensure that fees as well as the number of transactions do not rise to the level of abusive. 

 

 

 

 

 

 

 

 

 

 

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[1] A $137.5 million Settlement has been reached in several class action lawsuits about the order in which RBS Citizens Bank, N.A., including its Citizens Bank and Charter One brands, and Citizens Bank of Pennsylvania ("Citizens Bank") posted Debit Card Transactions to consumer deposit accounts. 100BBR 827

[2] July 2012: CFPB and The Office of the Comptroller of the Currency (OCC) fined Capital One $60 million in penalties and forced it to pay restitution of $150 million. Regulators found that Capital One’s outsourced customer center was misrepresenting credit card add-on products to subprime customers. Its telemarketing scripting contained

many inaccuracies.

 

[3] September 2012: CFPB and FDIC fined Discover $14 million in civil penalties and forced it to pay a restitution of $200 million. Regulators found issues with the telemarketing sales of credit card add-on products, such as credit insurance, credit score tracking, and identity theft protection with claims that customers were enrolled without consent or that agents were suggesting the products were free.