A Closer Look at KYC Procedure: Know Your Customer Process Overview

The film "Catch Me if you Can" is an example of how easily one person with the ability to forge checks and fake his identity can steal more than a million dollars from banks in the United States. No matter how fun and iconic this movie is, it shows that it is possible to cheat the banking system.

The "Know Your Customer" procedures established by banks include all necessary measures to ensure that their customers are genuine and to assess and monitor risks. In this article, I intend to look at the origins of the KYC process, its purpose, and the problems that have arisen as this process has become more formalized.

How are the Know Your Customer and Anti-Money Laundering rules established?

The origins of KYC can be traced back to the 1970s, when the Financial Action Task Force was established by the Group of Seven countries to combat money laundering.

In the 1980s and 1990s, concern grew about the use of financial systems for criminal purposes. In response, governments and financial institutions began to develop measures to prevent money laundering, including the introduction of KYC procedures.

The Financial Action Task Force (FATF) monitors countries' compliance with these standards, and more than 200 countries have committed to implementing them. Countries that do not meet the standard are placed on a grey or black list.

Following the events of September 11, 2001, the Patriot Act was introduced in 2002 to update the BSA and prevent further terrorist attacks in the United States. Similar patterns have been observed around the world, with countries such as the United Kingdom enacting the Proceeds of Crime and Terrorism Act.

As a result of this international coordination, these standards have been adopted worldwide. Thus, wherever a sovereign country exists, KYC and AML regulations exist as well.

What problems can be prevented through KYC?

Today, non-compliance with KYC requirements can result in significant fines and penalties. Current KYC procedures take a risk-based approach to mitigating identity theft, money laundering, and financial fraud:

• Identity theft

KYC is instrumental in establishing the legal identity of customers and can prevent fake accounts and identity theft through forged or stolen identification documents.

• Money laundering

Criminal organizations, both organized and unorganized, use dummy accounts in banks to store funds for drugs, human trafficking, smuggling, extortion, and other illegal activities. KYC regulations limit their ability to avoid suspicion by spreading funds across multiple accounts.

• Financial fraud

KYC helps prevent fraudulent financial activities, such as using fake or stolen IDs to apply for loans and then receiving funds through fraudulent accounts.

What distinguishes KYC from AML?

AML (Anti-Money Laundering) and KYC (Know Your Customer) are two different concepts in the financial industry. 

AML refers to a set of laws and regulations that financial institutions must follow to prevent money laundering. 

On the other hand, KYC is an essential element of the AML framework and requires organizations to identify their customers and verify their identity.

Although financial institutions are responsible for developing their own KYC processes, AML laws and regulations may vary by jurisdiction or country. This means that financial institutions must establish KYC procedures that comply with the specific AML standards of each jurisdiction.

Turning the KYC verification into red tape

The financial services industry still faces a significant challenge in tackling financial crime. Since 2008, regulators have imposed fines totaling more than $403 billion for KYC and AML violations. Additionally, top-tier banks spend approximately $1 billion annually on operations related to financial crime prevention. 

The primary measures for financial institutions' KYC and AML activities are unable to address new fraud. Despite the evolution of these processes over the past decade, their effectiveness remains problematic. While users and businesses moved to digital and connected solutions, financial crime measures continued to rely on outdated controls.

There are a number of typical issues that occur throughout the customer journey that affect the performance of financial services. The first problem you may face is fragmented and unverified information that can lead to inaccurate risk classification. There is also the possibility of systems generating false alerts.

Another problem is costly and time consuming reviews of customer profiles resulting in backlogs, as well as unnecessary reviews due to inaccurate risk classification. 

Finally, less than 10% of the Suspicious Activity Reports that come to the Financial Intelligence Units are of immediate use by authorities.

The problems arise as financial organizations attempt to meet compliance obligations resulting from the increasing regulatory requirements and a legacy of inefficient technologies and operations.

This creates critical compliance risk and exposure to fines, as well as an increased focus on administrative tasks rather than risk management. As a result, KYC has become a bureaucratic exercise rather than a customer verification exercise.

How do limitations affect the KYC procedure? 

The KYC process has several limitations that may affect its effectiveness in detecting and preventing financial crime. The most important of them are highlighted below:

• Limited scope: KYC procedures have a limited scope and may not cover all potential financial crime risks. Criminals may use sophisticated techniques to conceal their identity or funds, and KYC procedures may not always detect them.

• Human error: the Know Your Customer procedure involves human judgment and decision-making, which can be prone to errors and inconsistencies. Employees may overlook important information or fail to follow up on red flags, which can lead to gaps in the review process.

• Lack of standardization: the KYC processes vary from financial institution to another one and country to country, leading to inconsistencies and gaps that criminals can exploit. This lack of standardization can also increase compliance costs for financial institutions.

• Technological limitations: the process can be limited by technology. Outdated systems and processes may hinder the ability of financial institutions to conduct thorough KYC processes.

As a result, the focus on bureaucratic procedures and documentation in KYC has detracted from its effectiveness as a tool for identifying and preventing financial crime, leading to a perception that it is a mindless exercise with little real impact.

In addition, there is an increased focus on compliance and risk management, which has led to a more rigid and process-oriented approach to KYC that emphasizes customer convenience and comfort.

KYC - really about KNOWING your customer?

In certain cases, KYC has become an example of a pointless bureaucratic process that has no real impact on achieving its intended goal because the process has focused too much on paperwork and documentation rather than identifying and preventing financial crime.

There is a story about a former FBI agent who allegedly received payments from a wealthy Russian oligarch to help him "get off the sanctions list".

First, the sheer volume of documentation required for KYC has made the process cumbersome and time-consuming, causing delays and frustration for customers. Financial service providers often need to obtain a large amount of information from customers, regardless of their risk profile or the level of risk associated with their account. This can place a disproportionate burden on low-risk customers, who may feel that their personal information is being reviewed unnecessarily.

Yet all this data, which could be used to personalize offers and improve service for each individual customer, is simply stored and not used for the sake of better UX.

Secondly, the focus on regulatory compliance and risk management has led to a more rigid and standardized approach to KYC, with little room for flexibility or customization. This can result in a one-size-fits-all approach to customer verification, which may not be effective in identifying potential risks or preventing financial crime.

Finally, despite the extensive documentation and paperwork involved in the KYC process, it is not always effective in identifying fraudulent or criminal activity. Some individuals or entities may provide false or misleading information, which can go undetected by the KYC process. Additionally, the process may not be able to detect more sophisticated forms of financial crime, such as money laundering or terrorist financing, which require more advanced techniques and technologies for detection.

How does KYC improve the verification process?

Despite threats to the process of user identification, the KYC procedure resists money laundering by using innovative approaches to data collection and storage.

This has evolved with the advancements in technology, and many innovations have been introduced to make the process more efficient, effective, and secure. 

Digital identity verification

The use of digital technologies such as biometrics, facial recognition, and AI-powered software has made the identity verification process faster and more accurate. It allows for real-time verification of customers' identities, making it easier for businesses to onboard customers quickly. 

At SDK.finance, we provide a digital process for collecting KYC documents, which can be later verified either manually or through a pre-integrated KYC vendor.

Artificial Intelligence (AI)

AI-powered software has made it possible to automate many aspects of the KYC process, such as risk assessments, document verification, and monitoring of customer activities. It allows for faster processing times, reduces errors, and improves compliance.

Data analytics

Data analytics tools are used to analyze customer data and detect patterns and anomalies that may indicate potential risk. It enables businesses to identify high-risk customers and take appropriate measures to mitigate risks. For example, SDK.finance's FinTech Platform allows you to get a comprehensive overview of each customer's profile: personal data and documents, accounts, activity logs, transactions and status.

These innovations have significantly improved the KYC process, making it more efficient and secure. As technology continues to evolve, we can expect to see more advancements in KYC compliance.

Conclusion

The KYC process has become increasingly formal and bureaucratic, leading to its inefficacy in preventing financial crimes such as fraud, identity theft, and money laundering. Despite the significant fines and penalties imposed on non-compliance with KYC requirements, the process remains flawed due to outdated regulations and a legacy of inefficient technology and operations.

The evolution of digital and interconnected solutions has further highlighted the inefficiency of the KYC process. Financial institutions need to re-evaluate their KYC procedures, modernize their technology and operations, and adopt a risk-based approach to ensure a transparent and financial system.