AML Compliance for Neobanks: Key Regulations and Requirements Explained

Neobanks are revolutionizing the banking landscape, offering a user-friendly, digital-focused banking experience. These innovative banks operate exclusively through digital channels, without any physical branches, providing customers with a more convenient banking experience.

As these digital-only banks grow in popularity, they are increasingly confronted with a critical element underpinning their credibility and operational integrity – Anti-Money Laundering (AML) compliance. The importance of AML in banking cannot be overstated, and for Neobanks, it’s an area of fundamental concern.

This blog examines the rise of Neobanks and how they are shaping the industry & will look at the complexities of adhering to AML regulations for Neobanks, highlighting the essential requirements and mandates. Our main focus will be on the importance of a comprehensive AML program, examining how these regulations apply to neobanking.

AML Compliance for Neobanks

Neobanks are a new class of banks that operate solely through digital channels, eliminating the need for physical branches. Many prioritize mobile platforms, sometimes exclusively, and typically offer a limited range of financial products and services. Depending on their geography, these banking institutions are also referred to as challenger, digital, virtual, internet-only, or online banks.

One popular strategy among Neobanks is to unbundle high-margin products and services and offer them at a lower cost or with a better user experience. These banks may offer a free basic product, such as an account and payment solutions, and generate revenue through additional services, including transaction and trading fees.

Quick Overview of the History of Neobanks

Post the financial crisis of 2008-09, the banking sector suffered a significant loss of trust, leading to incremental reforms in developed markets. However, most banks globally relied on legacy technology systems and processes, indicating a reluctance to adapt to change. High penalties for non-compliance compounded the challenge.

Because of these hurdles, in the early 2010s, a new breed of banks known as neobanks emerged, capitalizing on the opportunities presented by Open Banking that allowed for the free flow of financial information. Neobanks are driven by the desire to introduce fresh offerings into the financial industry and leverage mobile technology to provide innovative banking solutions for individuals and businesses.

Neo Banks, introduced around six years ago, were primarily pioneered by FinTech players like Monzo and Atom Bank in the United Kingdom (UK). These banks also gained popularity in Australia, where not only crowdfunding was established but also legislation that allowed for removing constraints on these companies.

Monzo, Revolut, N26, and Atom Bank were some initial players who established themselves in the UK and Germany. In India, Niyo Solutions was among the first fintech companies to pursue neobanking in 2016.

Neobanks vs. Traditional Banks

When comparing Neobanks with Traditional Banks, they differ in several ways. However, one primary distinction is that Neobanks are purely digital and do not have physical branches. In contrast, Traditional Banks have physical branches that customers can visit to carry out their banking activities. Let us look at some key areas of distinction:

Attribute Traditional Bank NeoBank
Channel Brick & mortar establishment & online banking services Web and Mobile-based services
Fees Often higher fees and charges with minimum deposit requirements Neobanks keep operating costs low with 100% digital platforms, thereby allowing them to forego minimums and transaction fees.
Account Opening In-person, lengthy paperwork & documentation Easy virtual/digital application with 24-48 hours on-boarding
Products & Services Broad range of financial products Limited range of financial products
Licenses Traditional banks hold complete banking licenses Neobanks may have certain permits; however, newer banks often lack licenses, resulting in their need to collaborate with traditional banks for operation
Regulations Highly regulated with strict AML compliance requirements Similar regulations as traditional banks, often flexible in compliance

 

Neobanks and traditional banks present distinct advantages to clients, and the decision to opt for one over the other hinges on personal inclinations and requirements. Neobanks provide a convenient, cost-effective, and up-to-date digital interface. In contrast, traditional banks furnish a wide scope of offerings including, brick-and-mortar branches, strong reputation, and relationship banking.

Foundational Importance of AML Compliance In Neobanks

For Neobanks, establishing a successful AML program is not exclusively a regulatory obligation. It is the foundation of confidence, honesty, and safety in their digital financial service offerings.

National Competent Authorities (NCA), are organizations responsible for enforcing compliance with financial regulations in their respective countries. For example, the Securities and Exchange Commission (SEC) in the United States, the Financial Conduct Authority (FCA) in the United Kingdom, and the Federal Financial Supervisory Authority (BaFin) in Germany.

The NCAs have observed that opening bank accounts online has become much more convenient and accessible. Due to this trend, NCAs have noticed that in some jurisdictions, neobanks are gaining a foothold in the market.

In essence, the shifting landscape of the banking industry is influenced by digitalization and the rise of neobanks. These changes present both opportunities and challenges, including the need for robust regulatory compliance, such as AML measures, across neobanks.

What is Money Laundering

Are Neobanks at a Higher Security Risk Than Traditional Banks?

Neobanks and traditional banks possess distinct security characteristics, and it would be incorrect to assume that either is inherently more vulnerable to security risks. However, over time, conventional banks have built robust Anti-Money Laundering (AML) frameworks and systems. This allows them to comply with regulatory standards and effectively mitigate the risks associated with money laundering and terrorist financing, giving them a competitive edge.

Neobanks operate solely through digital channels, including mobile applications and web-based platforms. Therefore, they are susceptible to cyber threats, including phishing attacks and data breaches. To maintain the safety of customer data, secure transactions, and prevent unauthorized access, neobanks must prioritize the implementation of robust security protocols. Given their reliance on digital infrastructure, this is a critical aspect of their operation.

What is the Regulatory Framework for Neobanks?

It is worth noting that neobanks are currently not subject to direct regulation. Instead, the regulated entity is the bank with which Neobank has partnered. These partner banks are overseen by examiners, such as the FDIC, Federal Reserve, or Comptroller of Currency (OCC), for all deposits held by a fintech’s customers.

As part of standard audits and regulatory inspections, these partner banks must demonstrate to regulators that they have appropriate supervision and authority over the fintech in their portfolio.

Neobanks, although not directly regulated, must adhere to the standards and practices of their partner banks, which can be seen as a quasi-regulatory body. During the onboarding phase, neobanks are closely monitored and required to provide extensive documentation to meet their partner bank’s due diligence requirements.

As the neobank industry continues to grow, regulators are beginning to recognize the similarities in operations between neobanks and legacy banks. The absence of direct regulation is unlikely to continue, especially considering the size and complexity of some neobanks, which can surpass those of smaller banks.

The Consumer Financial Protection Bureau (CFPB) has taken a bold step towards leveling the playing field between new and established banks by inspecting non-banking entities, including neobanks. As per the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the CFPB is authorized to employ lawful means to prevent companies from engaging in practices that may harm their customers.

Similarly, the OCC has recommended that neobanks adhere to conventional banks’ regulatory standards. This move by the CFPB and the OCC aims to create fair competition and promote the protection of consumers in the financial industry.

Key AML Regulations and Requirements for Neobanks

1. Customer Due Diligence (CDD)

Neobanks place great importance on Customer Due Diligence (CDD). It is a vital procedure for verifying the identities of their customers and preventing any illegal activities like money laundering, terrorist financing, and fraud.

Moreover, it is a mandatory step aligned with the anti-money laundering (AML) and know-your-customer (KYC) regulations. Therefore, only by executing these protocols, banks ensure that their customers’ identities are legitimate and that their accounts are being used for lawful purposes.

For example, Revolut, a neobank located in the UK, employs a strong customer due diligence process. When an individual applies to create an account, they must provide personal details such as their full name, date of birth, and proof of residence.

Revolut also requests that customers take a photo of themselves for facial recognition and an image of a valid government ID for identity verification. The type of government ID required, such as a passport, driver’s license, or ID card, may vary depending on the country.

2. Know Your Customer (KYC)

Neobanks implement the regulatory process known as Know Your Customer (KYC) to identify and authenticate their customers. KYC is a crucial aspect of the wider anti-money laundering (AML) standards that banks must comply with globally. KYC aims to prevent various illicit activities such as financial fraud, identity theft, terrorist financing, and money laundering.

What is KYC?

It is mandatory for all banks to follow the relevant Know Your Customer (KYC) regulations while bringing in new customers. These regulations require banks to authenticate the identity of the person who is initiating a new account, even if they are not personally present in a branch. As neobanks primarily operate through online and mobile channels, it becomes crucial for them to adhere to the norms enforcing digital identity authentication.

3. Enhanced Due Diligence (EDD)

Enhanced Due Diligence is a heightened level of scrutiny and assessment that goes beyond the usual Customer Due Diligence (CDD) methods. It is a technique employed by financial institutions, including neobanks, to thoroughly examine clients, transactions, or business relationships with higher risk levels.

As part of the EDD  process, it is necessary to collect comprehensive information about the customer’s funding sources, operations, ownership structure, and the existence of any politically exposed persons (PEPs) who may be involved.

Implementing EDD is of utmost significance when serving customers from areas with high-risk, politically influential individuals, or businesses that are susceptible to financial crimes. The primary objective of neobanks adopting EDD is to bolster their risk management measures and adhere to regulatory obligations while reducing the possibility of financial and reputational harm.

4. Record Keeping

Reporting suspicious activity means recognizing and informing authorities or regulatory agencies of any actions, conduct, or trends that provoke suspicion of probable financial offenses, like financing terrorism or money laundering. Financial institutions, neobanks included, are responsible for reporting such activities to aid in the fight against illegitimate activities within the banking network.

AML Compliance Challenges Faced by Neobanks

Neobanks, just like conventional banks, confront unique challenges, especially regarding Anti-Money Laundering (AML) compliance. Let’s delve further and understand the challenges neobanks face while maintaining operational integrity and credibility.

1. Data Limitations

Neobanks, which are online exclusives, may encounter difficulties obtaining comprehensive historical customer information similar to that available to traditional banks. This data insufficiency may complicate confirming customer identities and identifying suspicious activities arising from unusual patterns.

Without a substantial record of transactions, detecting sudden alterations in customer behavior that could indicate potential fraud or money laundering may be challenging. As such, neobanks may face a significant challenge in meeting AML compliance standards due to this lack of data.

2. Cracking the Code for Cross-Border Transactions

Neobanks have a global presence with customers from different countries and regions, making it challenging to comply with anti-money laundering (AML) regulations. AML rules can vary significantly in different countries, making it difficult for Neobanks to adhere to multiple and sometimes contradictory regulations.

Addressing such varying regulations can be a time-consuming and resource-intensive task for neobanks. Furthermore, they have to keep up with regulatory changes across multiple jurisdictions, which could further complicate their AML compliance efforts.

3. Limited Pool of Skilled Workers

Developing and implementing a strong AML compliance program can be expensive, necessitating considerable expenditure on sophisticated technology, skilled staff, and continuous training. Being startups or relatively new companies, many Neobanks have restricted resources compared to established traditional banks.

In 2021, N26 was directed by BaFin, the financial regulatory authority in Germany, to enhance its measures against money laundering due to the bank’s inadequacies in IT monitoring, customer due diligence, and staffing levels for AML control. Again the next year, i.e., 2022, N26’s Italian division was instructed by the Bank of Italy to halt the enrollment of new clients, and the anti-money laundering protocols were flagged for potential enhancement.

The examples above indicate that N26 must invest substantially in expenses and operational efforts to implement the necessary changes. These examples also shed light on the challenges that neobanks might face while balancing their growth and complying with regulatory standards.

AML Solution

Navigating the AML Compliance Landscape

The AML compliance landscape can be complex and multifaceted, with different regulations and requirements depending on the country or jurisdiction. Despite these complexities, it is essential for Neobanks to proactively comply with AML regulations to protect their customers and their institutions and strengthen the financial system’s integrity.

To achieve full AML compliance, Neobanks must continuously invest in robust compliance programs incorporating the latest technologies, rigorous employee training, and staying current with evolving AML regulations. While the journey may be daunting, securing the sustainable growth of the neobanking industry is necessary.

Related Blogs

Selecting A Compliance Solution For...

For start-up companies still in their early stages, compliance can be one of the...

Read More

A Complete Guide To AML...

AML regulations are legal controls that require businesses to prevent, detect, and report money...

Read More
AML

Anti-Money Laundering (AML): Unravelling Its...

Explore the world of Anti-Money Laundering (AML) and decode its history, delve into its...

Read More
AML