A Politically Exposed Person poses a higher risk regarding potential involvement in crime. That puts PEPs, due to their prominent position or influence, at a higher risk of being involved in various criminal activities, such as money laundering, terrorist financing, bribery, or corruption.
Companies stay in line with financial crime compliance requirements by implementing proper processes for PEP identification and verification and further Enhanced Due Diligence (EDD) procedures. However, while extra caution is necessary for financial institutions that are dealing with PEPs, it’s important to understand that being classified as PEP does not automatically make the person a criminal.
Over time, financial institutions have been dealing with numerous PEP status changes, which influenced how governments and financial institutions treat it. For example, the PEP status applies not only to the individuals themselves but also to their family members and close business associates.
Keep reading to find out more about PEPs, compliance, and related challenges that businesses face.
The Definition of a Politically Exposed Person (PEP)
A Politically Exposed Person (PEP) is an individual with an elevated status who is more vulnerable to engaging in activities such as bribery, money laundering, or corruption. Often, PEPs hold significant public roles within an international organization or a government.
Financial institutions consider PEPs to pose a higher risk because they have higher chances of participating in financial crimes, such as money laundering. Identifying and labeling a customer as a politically exposed person doesn’t automatically ban a company from engaging with them. The PEP check is a single element in a more complex AML process that enables financial institutions to conduct a proper risk assessment.
What is the Importance of PEPs in the Context of KYC/AML Compliance?
In the context of Know Your Customer (KYC) and Anti-Money Laundering (AML) compliance, politically exposed persons are very important because they pose an elevated risk of financial crime. According to the United Nations Office on Drugs and Crime (UNODC), an estimated 2-5% of the GDP is laundered annually. This means that at least €715 billion and up to 1.87 trillion are laundered every year.
The Anti-Money Laundering Law defines PEPs as natural persons who hold or have held prominent public functions. Financial institutions and other entities dealing with PEPs must implement heightened due diligence measures to manage these risks and avoid involvement with individuals linked to crime.
In practice, that means identifying PEP status and conducting ongoing due diligence. This step can include obtaining more details about the origin of the customer’s wealth and conducting periodic reviews of the account to ensure its legitimate use, as well as monitoring transactions for indications of money laundering or other illicit activities.
Politically Exposed Person (PEP) Regulations
To prevent the misuse of the financial system, non-financial businesses and financial institutions must implement AML measures to establish PEP verification processes. In simple words, companies must integrate AML screening mechanisms into their AML programs.
This obligation is incorporated into the AML legislation of most countries, specifically requiring PEP screening. In Europe, PEP checks are incorporated into the Anti-Money Laundering Directives (AMLDs), with significant strengthening observed in the fifth directive (5AMLD), implemented in 2020. Although PEP status doesn’t automatically imply criminal behavior, 5AMLD mandates ongoing monitoring of these individuals. This means updating their risk profiles in response to any status changes.
Related: PEPs and Sanctions Checks Explained
Who is Considered a PEP According to the FATF?
The Financial Action Task Force (FATF) regularly updates its recommendations, including PEP rules, which makes it hard for companies to stay compliant with ever-evolving regulations. The FATF requires financial institutions to check whether their customers or beneficial owners have the Politically Exposed Person status or have associations with PEPs.
The FATF’s definition of a PEP is similar to the one provided by the United Nations Convention Against Corruption (UNCAC). It describes politically exposed persons who “are, or have been, entrusted with prominent public functions, along with their family members and close associates.”
The FATF defines PEPs as individuals meeting certain criteria:
- Close associates. PEP associates include close relatives of parliamentarians, individuals with beneficial ownership of legal entities, family members, or those involved in companies where the government is the sole or majority shareholder.
- Government officials. A PEP can also be a government official, for example, a senior official in the judiciary, legislative, or executive branch. Diplomats and parliament members, such as ambassadors, are also PEPs.
- High-positioned individuals in organizations. Major political parties designate key figures, including central bank board members, high-ranking military officers, or senior executives of government-owned businesses, as politically exposed persons.
Identifying PEPs is crucial, as sometimes, just one indicator related to a politically exposed person could signal financial abuse. Since PEP checks involve large volumes of data, companies use AI and automated RegTech AML solutions for their risk assessments and as a way to boost the effectiveness of PEP checks.
Types and Examples of Politically Exposed Persons
There are six types of politically exposed persons, which include:
Foreign PEPs (individuals who currently hold or have previously held significant offices or positions in or on behalf of a foreign state), Domestic PEPs (individuals who currently hold or have previously held significant offices or positions within their own country), International Organizations, Family Members, Close Associates, and National PEPs.
In the 40 Recommendations of the FATF, two newly issued recommendations specifically address PEP management, emphasizing that, within high-risk business relationships involving domestic or international PEPs, institutions should adopt additional measures regarding foreign PEPs.
Here are some examples of individuals who warrant the label of politically exposed persons:
Central Financial Institutions
Members of the Court of Auditors and individuals serving on the boards of central banks.
High-ranking officers in the armed forces typically receive PEP status.
International Sports Committees
Includes committee members that can influence decisions related to major sporting events, making them subject to FATF’s PEP definition.
Politically exposed individuals include Members of Parliament.
PEPs can range from the head of state to assistant ministers.
Consider ambassadors and chargé d’affaires as politically exposed persons as well.
Politically exposed individuals incude key figures within supreme courts, constitutional courts, or high-level judicial bodies.
PEPs may include senior executives and former board members who still wield influence.
Family Members of PEPs
This includes spouses or partners, parents, children, siblings, uncles, aunts, and in-laws.
Close Business Relationships
Individuals with a close business relationship or joint beneficial ownership of legal entities or arrangements with a PEP.
Sole Beneficial Ownership
Anyone with sole beneficial ownership of a legal entity established for the de facto benefit of a PEP falls within the PEP category.
Politically Exposed Person Risk Levels
Previously, governments and financial institutions depended on PEPs who voluntarily disclosed their PEP status. However, this method proved to be ineffective since some individuals chose to conceal their status or provide inaccurate disclosures. That said, PEPs typically have three risk levels, with some presenting higher risk than others.
PEP risk levels can be classified based on whether the PEPs are:
- Low risk. For example, mayors and local and state districts, urban assembly members, supranational or international business officials, as well as senior functionaries.
- Medium risk. For example, head officials of judiciaries, banks, military, law enforcement, high-ranked civil servants and religious organizations, ambassadors, and consuls.
- High risk. For example, prominent political party members, parliament members, head officials of judiciaries, banks, and law enforcement agents.
In cases deemed as high risk, enhanced due diligence (EDD) is necessary to assess various parameters surrounding the client’s transaction. The FATF’s 40 Recommendations explain that failure to comply with CDD measures by Designated Non-Financial Businesses and Professions (DNFBPs) can result in actions such as not opening the account, terminating business relations, or submitting a suspicious transaction report.
Politically Exposed Person Red Flags
The FATF has established red flags, helping companies determine if an individual is a politically exposed person. These red flags serve as indicators of potential suspicious activity that help companies uncover cases of money laundering and other financial crimes.
The FATF’s list of red flags leading to PEP-related potential abuses includes:
- Identity shielding. PEPs can attempt to conceal their identity or stay out of the spotlight by using shell companies or intermediaries, assigning legal ownership to others, and creating confusion about ownership and industries.
- Suspicious behavior. For example, the inability to provide valid information, being secretive about the source of funds and wealth, providing false or insufficient information, having been denied an entry visa, engaging in consistent wire transfers or cash-out, lacking credible explanations for certain business relationships or transactions, or constantly transferring funds across countries.
- Position in the company. This involves holding authority or ownership over DNFBP concerning financial institutions and having regulatory control over business approvals, licenses, the corporation’s funds, as well as operations and policies, including the informal ability to oversee mechanisms against money laundering or terrorist financing.
- Industry. This is particularly important in industries like banking, finance, military and defense, arms trade, mining and extraction, public goods provision, and businesses that work with the government or state agencies.
- Transaction. For example, large transfers in and out of the PEP’s account, frequent cash withdrawals or deposits, sudden activity in an account after a long time frame of inactivity, wire transfers lacking economic explanation or beneficiary information, steady cash flows, using multiple bank accounts without a proper reason, and being involved anonymous payments or transactions from unknown third parties.
- Service and product. This includes real estate firms, foreign clients, service and trust providers, dealers in high-value transport vehicles, and dealers in other luxury goods, such as precious stones and metals.
- Local risks. This helps indicate whether the customer comes from a country known for a high-risk corruption level, a domestic or foreign high-risk country, a country with a mono-economy, or from countries not signatories of the United Nations Convention Against Corruption (UNCAC).
How to identify Politically Exposed Persons (PEPs)?
Effective customer due diligence (CDD) is essential to identify whether the beneficial owner of an entity is a politically exposed person or if an individual can be classified as a PEP. To achieve this, companies use various CDD measures, including:
- Verification of identity using reliable documents.
- Investigation of the ownership structure of a company.
- Screening against dedicated PEP databases.
Financial institutions depend on reliable data sources to screen individuals and identify if they should be labeled as PEPs. These sources for PEP identification consist of government databases, public registers, international organizations, and accessible PEP databases.
Your Checklist for an Effective PEP Screening Process
Companies should use accurate information to guarantee an effective PEP screening process. That’s why businesses often develop a systematic approach to PEP screening, such as automatically checking risk levels and scanning PEP databases through AML compliance software for more accurate PEP identification.
Effective PEP checks consist of a few key components:
- Implementing an AML screening process
- Using a risk-based approach to AML
- Updating records, including PEP lists, regularly
- Using advanced, automated solutions for more efficient PEP checks
- Continuously monitoring for regulatory changes and reporting suspicious activity
For an effective PEP screening process, you need to tick all of the requirements out of the box, and at iDenfy, we can help you achieve this with a complete KYC/AML compliance package, including AML screening and automated PEPs and global sanctions checks.
Get started today.