UK: FSA Small Firms Financial Crime Review

This article first appeared on www.complinet.com

FSA to small firms: must try harder

The FSA's recent review of small firms and their responses to their financial crime regulatory of requirements was spurred by critical evaluations of the sector by the Financial Action Taskforce and National Audit Office, both in 2007. The FSA visited some 159 small firms, which it described as a "manageable sample size" of the total of around 16,500 small firms that it regulates. The report is emphatically not guidance, but it includes a number of "questions to ask yourself", which are recommended reading.

Reducing financial crime is of course one of the FSA's five statutory objectives. The statutory definition of financial crime includes any offence involving fraud or dishonesty, misconduct in or misuse of information relating to a financial market or handling the proceeds of crime. However, for the purposes of the review the FSA did not look at market abuse, preferring to focus on the financial crime risks it sees as most relevant to the small firm sector: anti money laundering, data security and fraud. Firms are identified as potentially at risk from:

Awareness encouraging, implementation "generally weak"

The FSA appeared broadly satisfied with the level of awareness of fraud crime issues anti money laundering obligations and customer due diligence. This was not enough to mitigate the 'several weaknesses' it found across the sector, mainly in the area of implementation of AML and anti-fraud controls.

Anti Money Laundering

The FSA found a "good general awareness of AML systems and controls". However, where external consultants had produced policies and procedures, these had generally not been tailored by the senior management of the firms to suit their particular business. In particular, the FSA noted a lack of financial crime risk assessments of different products. More worryingly, only a minority of firms had enhanced due diligence procedures in place to deal with high risk customer situations. The most common reason for this was that the firm believed their customers were low risk: however, they were unable to demonstrate how they had made this assessment.

Additionally, only 26% of all firms visited had any sanctions procedures in place and that of those that did have procedures, none had identified a "hit" on the UK sanctions list. Only a very small proportion of firms knew what to do with such a hit, namely to refer it to the Asset Freezing Unit of HM Treasury.

Homework: risk assess your business

All firms, irrespective of their size and irrespective of the level of involvement of their particular compliance consultants, must conduct a risk assessment of their business and the products that they sell. The risk assessment needs to be recorded, kept on file and updated as the firm evolves, whether through selling to new markets, with new customers or otherwise. Firms must have written procedures for applying enhanced due diligence to higher risk situations. A risk assessment that says "none of our clients are high risk" is unlikely to pass muster.

Monitoring activity

Firms appeared to demonstrate confusion between transaction monitoring and general monitoring of customer activity. While 40% of IFAs had monitoring systems capable of identifying suspicious activity, only 9 of those IFAs had effective procedures for managing hits on the system.

Suspicious activity reports: just 3 out of 159 firms reviewed had submitted an SAR to SOCA. While the majority of firms were aware of their responsibilities to report suspicious activity, a small number did not know where to send them or still believed that they should be sent to NCIS.

Record keeping: the majority of files and records reviewed were "in good order and were easy to navigate."

Homework: dust off the internal reporting procedure

Applied properly, an internal reporting procedure is both an effective monitoring tool - all employees become the eyes and ears of the firm – and an important safety valve – if an MLRO does not share the suspicion of the person reporting to him, he may elect not to report on it to SOCA. One MLRO at an IFA firm who said that he would forward all internal SARS to SOCA without exercising any judgment himself as to the seriousness of those SARS, now appears in the table at the end of the report under the heading "examples of poor practice".

Data security and outsourcing

Over half the firms visited shared customer data with third parties, but of those less than a quarter had confidence that the third parties they dealt with had robust procedures for dealing with data security issues. The FSA observed a "number of firms" who allowed unaccompanied or unsupervised access to their premises and very few queried with their suppliers how staff were vetted.

Homework: data loss can happen to anyone

The FSA is plainly concerned that multiple thefts of data from small firms with poor security can present as much of a threat as one CD or laptop lost by a large institution. Firms need to think carefully about physical security, particularly of electronic data, as well as allowing unsupervised access to work areas where sensitive details may be on display.

Fraud

While most firms had appointed a senior manager or managers to take responsibility for fraud investigations, few firms provided specific fraud training to staff. Over half the firms visited had assessed how their business could be used to commit insurance fraud and those that had conducted a risk assessment were aware of insurance fraud risk indicators specific to their business.

Of the 87 firms who conducted investment business, some 40% had identified or defined higher risk customers or countries. However, most of those firms did not then apply any enhanced due diligence in respect of these customers. In relation to mortgage fraud the level of KYC checks varied across the sector but the majority of firms obtained two forms of identification.

Homework: train staff in recognising fraud threats

While small firms seem generally to have nominated someone who would be responsible in the event of a fraud issue arising, few firms provided specific fraud training to staff. Small business owners and managers should remember that training staff to spot fraud is an important risk management tool for the business as a whole. The FSA refers to a visit to one GI broker who had a system whereby customers were able to contact the firm by telephone to notify changes to personal details, including address. However, the security questions that were asked related to information that was all in the public domain and left the firm (and the customers) at substantial risk.

Staff/internal fraud

Less than half the firms visited carried out full background checks or referencing before appointing staff. Most of these firms said that their employees were family or close friends or had been referred by a known associate.

Homework: Review your recruitment and vetting procedures

It is a feature of small firms that they are very often family businesses or ones in which friends are recruited. Firms very often are simply not of a size to justify formal recruitment and HR structures – but that does not of course lesson their obligations. As much a sound management principle as it is financial crime risk reduction, small firm owners and managers should still carefully consider a candidates suitability for a position and where the post is high risk one, consider conducting enhanced vetting checks such as Criminal Records Bureau checks. Conducting such checks and making these assessments are a small firm's defence when that "it will never happen" moment happens.

Conclusion

The FSA found generally good awareness of money laundering, know your client procedures and fraud risks across the small firm sector, implementation of responses to many of these was generally weak. Small firms need to focus on an appropriate system for how to identify and deal with higher risk customers or situations such as non face-to-face, PEPs, or any other high risk situations. Knowledge and implementation of the financial sanctions regime was particularly weak and firms should tailor their internal policies and procedures to their business more and in particular should assess their particular products for financial crime risk. Formal vetting and appropriate referencing of staff was weak in several firms. Use of close colleagues or family members often meant that a person's integrity and honesty was not formally considered. While the FSA noted that the small firm sector had paid more attention to financial crime issues, the FSA considers the sector to be "generally weak in its assessment and mitigation of financial crime risks."

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