What is Nested Banking in Anti-Money Laundering?

Definition

Nested banking, in an AML context, is defined as a banking arrangement where a financial institution—often a smaller or foreign one—conducts transactions for its own clients using the accounts of a larger correspondent bank. This means the smaller institution’s customers’ transactions are “nested” within the larger bank’s account structure, causing reduced transparency about the ultimate parties involved in the transaction chain.

Purpose and Regulatory Basis

Role in AML

Nested banking arrangements facilitate access to international and domestic financial systems for smaller institutions that lack direct correspondent banking relationships. However, they also introduce significant AML risks by obscuring the true originators and beneficiaries of funds, potentially enabling money laundering, terrorist financing, and sanctions evasion.

Key Regulations

• Financial Action Task Force (FATF): Provides global AML standards requiring correspondent banks to understand the nature of their respondent banks, including any nested relationships, as part of risk assessments.
• USA PATRIOT Act: Enforces enhanced due diligence on correspondent accounts, particularly for foreign institutions to prevent misuse for illicit finance.
• European Union Anti-Money Laundering Directives (AMLD): Require transparency and due diligence in correspondent banking relationships, addressing risks from nested financial connections.

Regulators mandate strict controls and transparency to mitigate the risks introduced by nested banking structures.

When and How it Applies

Real-World Use Cases

• A local MSB opening an account with a large international correspondent bank to process remittances for its customers.
• Regional banks nested within a larger bank’s correspondent relationship to enable cross-border payments where direct relationships do not exist.

Triggers and Examples

For example, a small foreign bank without direct international access processes transactions through a regional bank’s correspondent account with a global bank. The global bank may see only the regional bank as the customer but not the smaller bank’s ultimate customers, causing gaps in due diligence coverage.

Such nesting arrangements often exist without full knowledge or consent of the correspondent bank, increasing AML monitoring complexities.

Types or Variants

Nested Correspondent Banking

Where multiple respondent banks (smaller or regional banks) use a single intermediary bank’s correspondent account to access international financial services.

Nested Account Structures

A nested account may be held by an MSB or smaller institution inside the correspondent bank’s system, used to route client transactions through the larger bank’s framework.

These variants mainly differ in scale and the parties involved but share the common challenge of reduced transparency for the correspondent bank.

Procedures and Implementation

Compliance Steps

1. Enhanced Due Diligence (EDD): Conduct thorough background checks on smaller institutions using correspondent accounts.
2. Disclosure Requirements: Require respondent banks to disclose any nested relationships at account opening and throughout the business relationship.
3. Transaction Monitoring: Deploy specialized systems to monitor nested transactions for suspicious patterns.
4. Risk-Based Approach: Assess each nested relationship individually for risks related to jurisdiction, customer types, and transaction volume.
5. Ongoing Review: Continuously evaluate nested accounts through periodic reviews, updating risk profiles accordingly.

Institutions may also implement contractual clauses restricting or prohibiting nested accounts in high-risk scenarios.

Impact on Customers/Clients

From the Customer Perspective

• Customers of MSBs or smaller banks may have limited visibility into which larger institutions actually process their funds.
• There may be additional compliance checks and verification steps due to the complexity of the nested relationships.
• Some services could be restricted if nested accounts are under heightened regulatory scrutiny.

Institutions should communicate clearly with clients about compliance requirements and potential transaction limitations.

Duration, Review, and Resolution

• Duration: Nested relationships continue as long as correspondent accounts remain open and business justifies them.
• Review: Institutions must conduct periodic risk and compliance reviews to reassess the legitimacy of nested accounts.
• Resolution: If risks outweigh benefits or if illicit activity is suspected, banks may terminate correspondent relationships or impose restrictions.

Effective lifecycle management is crucial to controlling nested banking risks.

Reporting and Compliance Duties

• Documentation: Maintain records of nested relationships, due diligence findings, and transaction monitoring reports.
• Suspicious Activity Reporting (SAR): Report suspicious transactions linked to nested accounts promptly to regulators.
• Regulatory Filings: Comply with local and international AML reporting requirements related to correspondent banking.
• Penalties: Failure to manage nested banking risks adequately can lead to heavy fines, sanctions, and reputational damage for correspondent banks.

Institutions must have clear policies and staff training around nested banking compliance.

Related AML Terms

• Correspondent Banking: The broader framework within which nested banking occurs.
• Money Service Business (MSB): Often the smaller entities involved in nesting.
• Enhanced Due Diligence: Heightened scrutiny applied to nested financial relationships.
• Beneficial Ownership: Identifying true owners behind nested accounts.
• Sanctions Screening: Checking nested accounts against restricted party lists.

Understanding nested banking aids comprehension of these connected concepts.

Challenges and Best Practices

Challenges

• Lack of transparency about end customers.
• Difficulty monitoring layered transactions.
• Increased AML/CTF risk exposure and regulatory scrutiny.
• Operational complexity in managing nested account structures.

Best Practices

• Implement robust EDD and continuous monitoring.
• Demand full disclosure of nested relationships.
• Use advanced transaction monitoring systems.
• Limit or prohibit nesting in high-risk jurisdictions.
• Provide regular staff training on nested banking risks.

These practices help institutions balance operational benefits with compliance obligations.

Recent Developments

• Increasing regulatory focus worldwide on nested accounts to combat money laundering and terrorist financing.
• Adoption of advanced AI-driven transaction monitoring tools to detect suspicious nesting activity.
• Some global banks outright banning nested correspondent relationships unless strict controls exist.
• Regulatory guidance evolving to require greater transparency and proactive risk mitigation in nested banking.

Staying updated on these developments is vital for effective AML compliance.

Nested banking is a common yet complex feature of modern correspondent banking that enables smaller financial institutions to access larger banking networks. While legitimate in many cases, it presents significant AML risks due to reduced transparency and increased potential for illicit activity. Effective management through enhanced due diligence, transaction monitoring, full disclosure, and robust compliance programs is essential for financial institutions to mitigate these risks and satisfy regulatory requirements. Recognizing and properly handling nested banking arrangements is crucial for maintaining strong anti-money laundering defenses.