BANKS ARE GETTING SQUEEZED BY THE FIGHT AGAINST DIRTY MONEY / THE WALL STREET JOURNAL

Banks Are Getting Squeezed by the Fight Against Dirty Money

As governments make them the front-line defense against financial fraud, banks have to be more cautious. That’s hurting returns.

By Paul J. Davies

Photo: F. Martin Ramin/The Wall Street Journal 

Every few months it seems some bank is nailed in a multi-billion dollar money-laundering scandal. The latest is Danske Bank , DNKEY -6.85%▲ which may win the prize for sheer audacity, with more than $230 billion of potentially suspicious cash flowing through a tiny branch.

The banks pay fines, promise to behave and the scandal is generally forgotten. But investors are wrong to ignore the long-term impact. Governments have made banks the front-line defense against a range of crimes. Combined with the weight of post-financial crisis regulations, the pressure to spot wrongdoing among clients adds costs and acts as a brake on the entrepreneurial spirits of business-winning bankers. The result is lower returns to investors.

This rise in scandals has its roots in the globalization of finance since the 1990s and in a political and regulatory push to make banks responsible for policing criminal and terror-related money flows.

Banks can’t complain: Many of these cases could have been avoided if they had better controlled their people and processes, especially those far from headquarters taken on through acquisitions, and if they had been more careful in choosing clients.

It may be that they grew too fast. Since the mid 1990s, the cross-border financial assets and liabilities of advanced economies surged from 130% of their combined GDP to more than 570% last year, according to the Bank for International Settlements. Banks helped drive this through deal making: Cross-border acquisitions by banks from the U.S. and Western Europe into new and emerging markets surged in the late 1990s and peaked in the mid-2000s, according to Dealogic.

This expansion helped banks bolster revenues and profits after the dot-com crash and again after the financial crisis. But it took them into less-developed markets and resource-rich countries where governments or organized crime can play a greater economic role. Banks didn’t understand or ignored the increased risks of exposure to corruption and laundering.

There is no good measure to show whether dodgy transactions grew in line with global finance: Launderers tend not to file tax returns. What is certain is that banks were given increasing responsibility for catching them. Before 1986, money laundering wasn’t even a federal crime in the U.S. The real change began in 2001—starting with the Patriot Act in response to the Sept. 11 terrorist attacks, and with Europe’s third anti-money laundering directive in 2005. Banks were increasingly required to report suspicious transactions and identify dubious customers.

This is a problem for bankers at the front line of winning new clients and transactions. They want to be entrepreneurs, convincing a client to act, promising support from their bank’s services or balance sheet, closing their deal and getting paid. What they don’t want is to be slowed down in making good on their promises, or worse being stopped from fulfilling them.

Danske is perhaps the most surprising case yet: Huge flows passing through a tiny foreign branch, where many of the clients were not even residents, failed to arouse suspicions higher up. But plenty of others have also tripped up on branches or individuals that had too much freedom: Think of HSBC ’sMexican scandal and Deutsche Bank ’smirror trades in Russia, or Goldman Sachs ’sbond deals for a corruption-ridden government fund in Malaysia.

Banks need to be more cautious: In the same month the true scale of Danske’s case emerged, Dutch Bank ING was hit with €775 million ($893 million) in penalties and Credit Suissewas rebuked for lax procedures although it paid no fine. The Department of Justice is now looking at Danske, which could make its fine much larger than these.

But restraints on bankers’ spirits is about more than tackling laundering, or even sanctions breaches, for which BNP Paribaswas hit with $9 billion in penalties by U.S. authorities in 2014, by far the largest for any such failure. It is about fraud and risk control generally. Many banks have rightly centralized management, beefed up monitoring of their clients and their own people and cut their appetite for risk. 
This can cause problems: When bankers feel too shackled by reporting and approval committees they may walk away. More cautious banks may react slowly to opportunities and lose out to less scrupulous, or less regulated, rivals. The balance is hard to strike for global banks.




Yet high returns today at the cost of fines or penalties tomorrow is a fool’s business model.

More restrained bankers pursuing profits more prudently is the right approach. It is another reason that investors will have to get used to lower returns from the industry. But it is a very good reason.