- The Knowing Your Customer (KYC) rule requires financial institutions to verify customer identities to prevent fraud and terrorism.
- Establishing a risk profile for each customer at the outset of the business relationship with them is a key component.
- Continual monitoring of customer transactions standards helps detect suspicious activity.
The United Nations estimates that criminals around the world use legitimate banking systems to launder as much as $2 trillion annually. To help combat the use of illicit funds, US regulators require financial institutions to verify their customers’ identities, build a risk profile of each one, and continually monitor transaction activity.
Commonly known as the “know your customer” (KYC) rule, this practice allows banks, brokers, and other financial institutions to detect suspicious activity and prevent criminals and terrorists from moving money through the financial system.
What is the Know Your Customer rule?
Know Your Customer (KYC) is part of financial institutions’ legally required due diligence to verify the identity of customers and monitor their transactions. The rule was established by the Financial Industry Regulatory Authority (FINRA).
It requires financial institutions to authenticate the personal information of every individual customer or beneficial owner of a business, including documenting their names, birthdates, and addresses. They also must develop risk profiles for each customer and continually monitor their transactions for signs of illegal activity.
The KYC rule was designed to ensure compliance with anti-money laundering laws, detect suspicious activity, and prevent criminals and terrorists from using the financial system. This helps protect customers, investors, the reputation of the bank, and the integrity of global markets.
How does KYC work?
There are three main parts to a KYC compliance program:
- Verify a customer’s information
- Build a customer profile
- Continually monitor activity
Verify a customer’s information
Financial institutions are required to verify a customer’s information at the onset of a business relationship.
“In its simplest form, when a person opens a bank account, they are required to provide the bank several pieces of identifying information,” says Brandon Koeser, financial services senior analyst at RSM US LLP. “This information will also be used for ongoing bank account monitoring purposes to identify and report suspicious transactions or banking activities to the appropriate regulatory authorities.”
Build a customer profile
A key component of KYC is building a customer profile, also known as a customer risk assessment. This helps the financial institution better understand the customer’s preferences and behavior in their relationship with the bank. When the bank understands the nature and purpose of a customer’s relationship with the bank, it can help them understand what types of transactions the customer is most likely to make. This enables them to spot suspicious activity that is not in line with the customer’s usual activity.
“Ongoing monitoring is a significant part of KYC,” says Terry Monteith, SVP of products at payment software provider BlueSnap. “After the initial identity verification and risk assessment is complete, criminal activity could still happen. Monitoring for activity like spikes in spending, unusual cross-border unusual activity, or transactions involving sanctioned people or institutions helps combat nefarious activity.”
Who uses the KYC standard?
Financial institutions that must comply with the KYC rule include:
- US banks
- Mutual funds
- Brokers or dealers in securities
- Future commission merchants
- Introducing brokers in commodities
These are institutions that deal closely with your money and the handling of it.
Why is KYC important?
KYC helps to prevent crimes such as:
- Identity theft
- Money laundering
- Financial fraud
- Financing for terrorism
- Other financial crimes
“KYC is designed to prevent the banking system from being used as a means for criminal organization or enterprises to finance and conduct illicit activities,” says Koeser.
By creating a customer risk profile, a bank can determine what kind of transaction patterns would be normal for them and be able to easily detect suspicious activity.
“As an example, if someone opens an account and is determined to be a low-risk customer (so low dollar transactions and low transaction frequency) and the activity in the customer account flips overnight to high-dollar transactions and high-transaction frequency, the bank’s ongoing monitoring activities would flag this change in activity,” he says. “As a result, the bank could review the transaction activity, and if determined to be unusual or suspicious, notify the appropriate regulatory authority.”
An example of KYC in banking
KYC standards affect every consumer, whether they know it or not. For example, when you open a checking account, the bank will take steps to verify your identity, build a risk profile for you, and continually monitor your transactions. This protects both the consumer and the bank.
Here’s what that would look like in practice:
- You want to open a checking account. You submit an application.
- The bank asks for documentation to support personal identifying details. You can present an official document such as a driver’s license or passport to verify your name and birth date, and a utility bill to verify your address. Once these are supplied and verified, the bank can open an account for you.
- The bank builds a customer risk profile. Behind the scenes, the bank pieces together the information it has about you to create a customer profile or customer risk assessment. This data is used to predict your behavior based on your transaction history. For example, if you typically have a payroll deposit of $2,000 every two weeks, the bank will expect a similar amount of money to be deposited at the next interval. A large deposit of $10,000 or more not in line with the customer’s typical transactions would raise a red flag.
- The bank monitors transaction activity. If something looks out of line with your transactions, the bank can report it to the appropriate regulatory agency. For example, if you started moving large sums of money not in line with your usual banking, the bank would flag it and take a closer look.
It’s not uncommon to receive calls about suspicious activity in your account that you were unaware had been happening. This is how the system works for consumers as well as financial institutions tasked with safeguarding money. When the KYC rule is followed, participants can have more confidence in financial institutions and the markets that are affected.