What is Nested Relationship in Anti-Money Laundering?

Definition

A Nested Relationship in Anti-Money Laundering (AML) refers to a banking or financial arrangement where a smaller institution (such as a Money Service Business (MSB) or foreign financial entity) uses the account of a larger correspondent bank to conduct transactions on behalf of its own clients. The smaller institution’s clients’ transactions are “nested” within the larger bank’s account structure. This creates reduced transparency about the true originators and beneficiaries involved, increasing AML risks by obscuring the transaction chain.

Purpose and Regulatory Basis

Role in AML

Nested relationships facilitate smaller or foreign institutions’ access to domestic and international financial systems where direct correspondent relationships may not exist. However, this arrangement introduces significant AML vulnerabilities. The opacity inherent in nested relationships can be exploited for money laundering, terrorist financing, sanctions evasion, and other illicit finance activities.

Key Global and National Regulations

• Financial Action Task Force (FATF): FATF guidelines highlight the responsibility of correspondent banks to understand its respondent banks’ operations, including any nested relationships, as part of their risk assessments and enhanced due diligence processes.
• USA PATRIOT Act: U.S. law enforces enhanced due diligence requirements on correspondent banking accounts, especially involving foreign institutions, to prevent misuse by illicit actors.
• European Union Anti-Money Laundering Directives (AMLD): The EU AMLD mandates transparency and thorough due diligence in correspondent banking to address risks posed by nested financial connections.

Regulatory bodies emphasize transparency, risk-based controls, and enhanced customer due diligence (CDD) to mitigate the elevated risks posed by nested relationships.

When and How it Applies

Nested relationships are common in scenarios where smaller banks, MSBs, fintech companies, or foreign financial institutions lack direct access to global payment or clearing systems. They use accounts at larger correspondent banks to process payments on behalf of their clients.

Triggers and Examples:

• A small foreign bank uses its correspondent account at a large international bank to process transactions for its clients, hiding the end customers behind the correspondent bank’s relationship.
• A remittance service in a high-risk jurisdiction processes transactions through an account in a more regulated market held by another financial institution.

In these cases, the correspondent bank often cannot fully identify or monitor the ultimate parties involved, elevating compliance risks.

Types or Variants

While the classic nested relationship involves smaller institutions using correspondent accounts, variants include:

• Nested Banking: Where financial institutions fully nest their clients’ transactions inside correspondent accounts without transparent information flow.
• Nested Services Relationships: Introduced under recent AML regulations (e.g., in Australia’s AML/CTF Act amendments), these highlight cases where upstream providers rely structurally on downstream entities’ AML controls, effectively layering service models that increase compliance risks.

Procedures and Implementation

Financial institutions must:

1. Identify and disclose nested relationships: Banks should require disclosure of any nested accounts or downstream respondents using their correspondent accounts.
2. Conduct Enhanced Due Diligence (EDD): Apply EDD on respondent banks and their clients involved in nested arrangements, including beneficial ownership verification and risk assessments.
3. Transaction Monitoring: Implement advanced monitoring systems to detect unusual or suspicious transactions within nested accounts.
4. Ongoing Review: Continuously assess nested relationships for changes in risk profiles or regulatory requirements.
5. Restrict or Prohibit in High-Risk Cases: Some banks may adopt policies restricting or forbidding nested correspondent relationships where AML/CFT risks cannot be adequately mitigated.

Impact on Customers/Clients

From a client perspective:

• Customers of smaller institutions engaged in nested relationships may experience enhanced scrutiny or delays due to the correspondent bank’s AML controls.
• Certain clients or geographic jurisdictions might be restricted or denied services due to elevated risks in nested arrangements.
• Customers have rights to privacy but must comply with enhanced identification and verification requests due to the layered nature of nesting.

Duration, Review, and Resolution

Nested relationships require:

• Initial risk assessment and verification before establishing the correspondent account.
• Regular reviews and re-assessments of the nested relationship and the underlying clients, ideally at least annually or more frequently if risks change.
• Resolution measures include remediation of identified risks, enhanced transaction monitoring, or termination of relationships if compliance risks become unacceptable.

Reporting and Compliance Duties

Institutions involved in nested relationships must:

• Maintain full documentation on the identity of respondent banks and their clients.
• Report suspicious transactions related to nested accounts as per regulatory requirements.
• Cooperate with regulators and law enforcement for investigations involving nested transactions.
• Face penalties, fines, or legal actions if found facilitating illicit finance due to inadequate controls over nested relationships.

Related AML Terms

• Correspondent Banking: The broader relationship in which banking services are provided between financial institutions across borders, within which nested relationships can occur.
• Beneficial Ownership: Identification of the actual individuals benefiting from transactions, often obscured in nested structures.
• Enhanced Due Diligence (EDD): The intensified scrutiny required for nested relationships to manage elevated risks.
• Transaction Monitoring: The ongoing review of transactions to detect suspicious patterns, crucial in nested scenarios.

Challenges and Best Practices

Common Issues

• Opacity: Lack of transparency about the end customers behind transactions.
• Regulatory Pressure: Increased scrutiny and potential sanctions for correspondent banks insufficiently monitoring nested accounts.
• Operational Complexity: Managing multiple layers of institutions and their clients complicates monitoring and compliance.

Best Practices

• Establish robust risk-based controls with specialized monitoring systems.
• Require full disclosures of nested structures from downstream institutions.
• Apply continual enhanced due diligence.
• Restrict or close nested relationships where risks cannot be mitigated.
• Train staff on the complexities and risks unique to nested relationships to ensure awareness and proactive management.

Recent Developments

• Regulatory Updates: Some jurisdictions now explicitly define and regulate Nested Services Relationships, requiring enhanced CDD and transparency obligations.
• Technology Integration: Adoption of data analytics and AI-driven transaction monitoring systems enhances the ability to detect suspicious activity within complex nested arrangements.
• Global Cooperation: Increased international coordination to improve transparency and information sharing about nested correspondent banking networks.

A Nested Relationship in AML is a complex banking structure where a smaller institution uses a larger bank’s account to process its clients’ transactions, obscuring true transaction parties. While facilitating financial access for smaller or foreign entities, nested relationships pose serious transparency and compliance risks. Global regulations, such as FATF guidelines, the USA PATRIOT Act, and EU AMLD, require correspondent banks to perform enhanced due diligence and continuous monitoring to mitigate associated money laundering and terrorist financing risks. Institutions must implement rigorous policies, advanced controls, and clear disclosure requirements to manage nested relationships effectively. Understanding and managing nested relationships is critical to preserving financial system integrity and complying with AML laws.