The Definition of Compliance Risk and Its Impact on Banks, RIAs, and Fintechs

Key Takeaways

• Compliance risk encompasses both regulatory risks and conduct risks.
• Proactive risk management can help a financial organization avoid legal costs, strengthen its reputation, and improve its operations.

Compliance risk should be a top concern for all financial institutions–from established banks to emerging fintechs. Failing to comply with the numerous regulations governing the financial industry can result in:

• Severe legal penalties.
• Damaged reputations.
• Significant financial losses.

This article continues the series on the fundamentals of compliance, building upon the previous discussion of the basic compliance meaning. It will first explain compliance risk by establishing its definition and types, then delve into real-world examples of compliance failures in the financial industry to demonstrate the potential impact on banks, RIAs, and fintechs.

The Definition of Compliance Risk

When a corporation fails to remain compliant with the laws, regulations, and policies governing it, the organization is taking on the potential risk of legal penalties, financial loss, and damage to its reputation. This is known as “compliance risk.”

These risks can be defined in two categories:

Regulatory Risk

This involves taking the risk of potential sanctions and financial penalties due to non-compliance with existing laws and regulations.

An Example of Regulatory Risk:

• A bank has been failing to report customer transactions of $10,000 or more to authorities–a requirement of “The Currency and Foreign Transactions Reporting Act of 1970,” also known as “The Bank Secrecy Act.”
• The bank is failing its obligations with transactions from $10,000 to $20,000 because its leadership believes that in today’s economy such amounts should not warrant reporting, when adjusting for inflation.
• However, it has no authority to make such a decision and is taking on significant risks of penalties from the U.S. Government.

Conduct Risk

This type of compliance risk relates to the inappropriate, unethical, and unlawful actions of an organization’s management and employees. It may not result in federal scrutiny or regulatory penalties, but it opens an organization up to litigation and damage to their reputation, and the financial loss that both of these can trigger.

An Example of Conduct Risk:

• Two employees at a branch location of a national bank are competing for the same promotion to branch manager. These two employees decide to have a competition–who can sell the most financial products (e.g. credit cards, auto loans, mortgages), thereby bolstering their performance metrics and leading the “winner” to receive the promotion.
• These two employees begin touting the bank’s financial products to customers who might not be able to afford or even need the products.
• While the aggressive sales tactics may not be illegal, they are certainly unethical. And when management realizes the tactics of these employees and fails to intervene–since they are improving the branch location’s profit margins–they are bringing the risk of lawsuits and reputation damage to the company.

These examples of regulatory and conduct risk illustrate the importance of effective management for banks, RIAs, and fintechs. Being proactive about managing compliance risks offers financial organizations advantages, including:

1. Avoiding Legal Costs: Managing both regulatory and conduct risks lowers the chance of fines, class-action lawsuits, and other legal challenges, as well as the costs associated with them.
2. Solidifying Reputation: Adhering to strict internal and external compliance policies builds and maintains trust with customers, the media, and the general public.
3. Improving Operational Efficiency: Managing compliance risks not only reduces legal costs and improves a reputation, it can also help an organization streamline its processes and reduce errors.

Banks, RIAs, and fintechs that take the utmost care with compliance risk management will reduce the chance of penalties, earn trust from the public, and build a culture of integrity at their organization.

Where Compliance Risks Often Appear at Financial Institutions

Compliance risks can appear in many forms at financial institutions. That’s why proactive risk management and knowing these threats is critical.

To assist with managing compliance risks, examine these aspects of an organization for potential threats:

Data Collection and Handling

Depending on where a financial institution conducts business, they may be subject to certain data protection laws. For instance, if a company operates in Europe they must adhere to the “General Data Protection Regulation” (GDPR). Businesses with any operations in California need to follow the “California Consumer Privacy Act” (CCPA).

To lessen the risk of litigation or reputational damage, financial organizations must:

• Evaluate how they handle sensitive customer data (e.g. Social Security numbers). 
• Establish a comprehensive privacy policy.
• Employ robust security measures to prevent data breaches.

Failing to handle data correctly, and not taking the potential regulatory sanctions of improper data handling seriously, can have an adverse effect on businesses. Wells Fargo Bank, for instance, had to pay $8.5 million to settle with the state of California for violating its privacy laws when it recorded customer phone calls without adequate disclosure. Citibank also had to pay $420,000 to settle with California for a data breach resulting from “a known technical vulnerability” that the company did not address.

Cybersecurity

Cybersecurity threats are on the rise, with nearly “65 percent of financial organizations worldwide [reporting] a ransomware attack,” according to insights. These threats aren’t limited to ransomware; they can include simple phishing attempts to complex state-sponsored attacks.

Cyberattacks can lead to downtime, reputational damage, litigation, and regulatory sanctions. For instance, in November 2024, Bank of America faced a data breach that affected 57,000 customers. According to Forbes, Bank of America failed to notify customers for approximately 90 days, potentially violating state and federal laws that require swift notification. This case demonstrates the potential failure to detect a cybersecurity vulnerability, manage compliance risks, and adhere to regulations.

Emerging Compliance Risk Areas

• Increased Regulatory Scrutiny: According to statistics from Corlytics, “Global enforcement [of regulatory compliance] reached [a] record high in 2024, with over $19.3 billion in fines” across industries. While data from a study by Fenergo found that North America accounted for 95% of the world’s regulatory fines against financial institutions, with the U.S. Government issuing “over $4.3 billion in fines.” With this increased oversight, banks, RIAs, and fintechs must give their compliance risks the necessary attention.

• Ethical Lapses: As mentioned earlier with “conduct risk,” and evident in the potential failure to notify customers in the Bank of America case, unethical conduct and mismanagement can lead to compliance violations. To avoid such an escalation of risks, companies need to establish clear policies, consistent training, and strict monitoring for employees and stakeholders.

• Process Inefficiencies and Technology Failures: As evident in the Citibank case, outdated technology can lead to vulnerabilities. Financial institutions must keep pace with evolving risks and conduct regular audits, process reviews, and infrastructure upgrades.

• Adapting to New Regulatory Trends: Audits, process reviews, and improving technology are also perfect times for financial institutions to review and adapt their compliance policies. Regulations evolve every year and adapting to them is vital to avoiding fines and maintaining efficient operations.

Being knowledgeable about the areas where risks can appear in the financial industry allows banks, RIAs, and fintechs to build effective strategies that not only prevent regulatory fines, but improve a company’s reputation and day-to-day operations.

Goldman Sachs and 1MDB: A Prime Example of Compliance Risk Mismanagement and Its Impact

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The Goldman Sachs and 1Malaysia Development Berhad (1MDB) scandal is a notable financial industry controversy that highlights the importance of stringent compliance risk management practices. 

Established by former Malaysian Prime Minister Najib Razak in concert with financier Jho Low, 1MDB endeavored to boost economic growth in Malaysia. The legendary Goldman Sachs Group and its subsidiary, Goldman Sachs Malaysia, took part in the deal, assisting with selling a staggering $6.5 billion worth of bonds. 

However, according to Reuters, U.S. and Malaysian authorities alleged that, “$4.5 billion [of the funds raised from the sale of the bonds] was siphoned away, with some diverted to offshore bank accounts and shell companies linked to Low.” Goldman Sachs, on the other hand, reaped millions from selling the bonds, despite facing increasing scrutiny for its role.

Today, with the benefit of hindsight, the compliance risk mismanagement that fueled these events is clearer. The failures of Goldman Sachs include:

Inadequate Risk Assessment and Due Diligence

Goldman Sachs failed to properly vet who it was partnering with in the bond sale. Reuters goes on to say in its reporting that, “Goldman has said 1MDB officials and former Malaysian government officials lied to it about how bond sale proceeds would be used.” However, the financial institution should have still performed proper risk assessment and due diligence, and not just accepted those claims.

Weak Internal Controls

This lack of risk assessment and due diligence points to weak internal controls, as does former Goldman Sachs Malaysia banker Roger Ng being found guilty of fraud. Ng’s actions demonstrate a failure to prioritize compliance at every organizational level of Goldman Sachs.

The compliance risks that Goldman Sachs and its leaders took by partaking in the 1MDB scheme had a significant impact on its organization. The consequences for Goldman Sachs included:

• Loss of market standing and business: As news broke of the 1MDB scandal, Goldman Sachs’ stock tumbled. 
• Reputational Damage: Goldman Sachs lost trust among clients and stakeholders. This weakened the bank’s position within the financial community.
  
  • In fact, leadership at Goldman Sachs had to engage in damage control, as evidenced by their publicly stated commitment to improve their compliance risk management and other operational procedures.
• Substantial Fines: The Securities and Exchange Commission (SEC) charged Goldman Sachs with violating the “Foreign Corrupt Practices Act” (FCPA). The bank received fines of more than $2.9 billion, far exceeding the millions it earned from the 1MDB bond sale.
• Prosecution: The sentencing of former Goldman Sachs Malaysia banker Roger Ng for fraud underscores the significance of Goldman Sachs' compliance and internal oversight failures, as well as the dire consequences.
  

Conclusion

Learning from the 1MDB scandal and other information explored in this article, banks, RIAs, and fintechs must remember that managing compliance risks is as much about adhering to regulations as it is about cultivating trust, maintaining integrity, and achieving success.

Key takeaways from this article include:

• Compliance risk encompasses both regulatory risks and conduct risks.
• Proactive risk management can help a financial organization avoid legal costs, strengthen its reputation, and improve its operations.

To ensure your organization is managing its compliance risks well, use Luthor, the AI-powered marketing compliance review platform for banks, RIAs, and fintechs.