In the intricate world of financial compliance, the term politically exposed person (PEP) has become more prominent. Financial institutions (FIs) must screen for PEPs due to regulatory and compliance requirements, but why is screening for PEPs so important, and what do these institutions stand to gain or lose if they do not implement effective screening practices? This blog will dive into the concept of politically exposed persons, what they are, and why it is crucial for FIs to conduct extensive and rigorous screening of them.
What is a PEP?
The term PEP is commonly used in the financial industry to refer to individuals who are or have been entrusted with a prominent public function, as well as to their immediate family members and close associates. Their positions of power and influence put them at a higher risk of bribery and corruption.[1]
PEPs include:
- Leaders of cities and towns, such as mayors
- State and provincial leaders, including members of the executive and legislative branches (governors, members of the state assembly, attorneys general, etc.)
- Leaders of the judiciary, (senior judges and members of supreme courts)
- Senior appointed officials (heads of federal agencies)
- National level members of the executive or legislative branches
- Political parties and other political influence groups (may include PACs, unions, and lobbying groups, etc.)
- State-owned entities
- International governing bodies (UN, EU, Arab League, NATO, etc.)
- International sporting bodies (FIFA, UEFA, IOC, etc.)
Some jurisdictions will limit this definition. Others will expand on it.
The definition of PEPs is also extended to those related to or closely associated with these individuals. This is due to the potential for indirect involvement in illicit activities, creating a complex, but traceable web of financial crime risks.
While jurisdictions may differ on their specific definitions of PEPs, most make the following distinctions:
Domestic
Individuals who hold prominent public functions domestically. Mayors, governors, council members, state legislators, police chiefs, heads of state, government ministers, senior judiciary members are all examples. Some jurisdictions only require screening of foreign PEPs, implying that domestic PEPs are considered to pose less risk in some cases.
Foreign
Individuals who hold prominent public positions in a foreign country. This category includes foreign heads of state, members of a legislative assembly, senior judicial/military officials, ambassadors, leaders of political parties, etc. The definition also includes senior executives of state-owned corporations.
Identifying PEP Risk
Creating a PEP risk profile is a complex, multifaceted process that considers the total risk posed by a certain individual. There are many factors such as location, position type, and external pressures that combine to create a risk profile. Screening for PEPs allows for these factors to be analyzed quantitatively, conveying not only which PEPs carry the most risk, but also why. The process of analyzing the risk posed by PEPs can be broken down into four categories:
Country risk
Identifying the financial, economic, and political factors within the country from which a PEP operates is crucial in building a risk profile. Countries that lack press freedom can shield corrupt politicians through media control, enabling them to get away with financial crimes. The variability of these factors across nations makes risk calculation extremely complicated, but with proper risk scoring and profiling practices, these risks can be quantified and mitigated.
Event timelines
Global events have a significant impact on the risks associated with certain PEPs. A prime example is elections, which may involve illegal campaign funding, bribery, extortion, and other financial crimes. Economic downturns may cause PEPs to illegally smuggle cash into foreign institutions. Global conflict can lead to war profiteering.
Position level and locale
Position and locale heavily influence the risk profile of PEPs. The more influence a person holds, the more risk they pose to financial institutions due to the larger scale of their actions. Locale is another factor that merges with position level when developing risk profiles. For example, a high-ranking official in a stable and transparent government may have a smaller risk profile than a lower ranking official in a less transparent government.
Relationships
Understanding the network and relationships of PEPs is a crucial factor in identifying risk. Close relationships are often used to avoid direct cash payments and fraud detection. The risk posed by the network of a PEP is a key element in PEP screening and is the reason that the definition of PEP is extended to close relationships and associations.
Why do financial institutions need to screen for PEPs?
PEP screening is a key part of the FATF Recommendations and is one of the criteria used by FATF to establish if a country has proper anti-money laundering (AML) controls. PEP Screening is, therefore, a standard requirement for most financial systems around the world. The primary reason financial institutions screen for PEPs is to mitigate the risk of involvement in money laundering, corruption, and other financial crimes. Identifying and monitoring PEPs allows for these risks to be mitigated — protecting the integrity of financial institutions and enabling them to take preventive action against financial crime. Here are several key reasons why financial institutions need to screen for PEPs:
Risk mitigation
PEPs often have access to substantial public funds and resources, increasing the risk of these assets being misappropriated for personal gain. By identifying PEPs, financial institutions can implement a risk-based approach to verify who they do business with. Customers and individuals identified as higher risk by this system will be analyzed with an elevated level of due diligence. Failure to comply with screening policies can result in significant fines or reputation damage. Implementing proper screening practices allows financial institutions to reduce the risk of doing business with criminals.[2]
Regulatory compliance
Although extensive PEP screening is recommended for mitigating risk, regulatory bodies worldwide require financial institutions to implement a specific standard screening process. The intergovernmental Financial Action Task Force (FATF), a global money laundering and terrorist financing watchdog, sets international standards and monitors countries for compliance to these standards.
In the U.S., the Financial Crimes Enforcement Network (FinCEN), part of the Department of the Treasury is the main regulatory body responsible for requiring financial institutions to screen and monitor PEPs as part of their AML and counter-terrorist financing (CTF) efforts.
Institutional reputation
Enabling financial crimes through lax screening processes could have detrimental effects on an institution’s reputation. Active and rigorous screening for PEPs can not only decrease the risk of doing business with financial criminals but can bolster the public image of an institution by demonstrating their commitment to keeping their customers’ assets safe.
End Notes
[1] FinCEN, Advisory, “Advisory on Human Rights Abuses Enabled by Corrupt Senior Foreign Political Figures and their Financial Facilitators”, June 12, 2018, https://www.fincen.gov/sites/default/files/advisory/2018-07-03/PEP%20Facilitator%20Advisory_FINAL%20508%20updated.pdf
[2] Tookitaki, “Understanding PEPs: Definition, Types & Risk Levels According to FATF”, October 12, 2021, https://www.tookitaki.com/compliance-hub/what-are-politically-exposed-persons-peps#:~:text=Types%20of%20PEP%20Defined%20by,positions%20in%20a%20foreign%20country.
