The impact of 4AMLD on bank valuations: Deep dive into research findings

When new regulations are published, often, it is questioned whether they are truly effective and make a difference to those affected.

While the regulations may serve the intended purpose, do they end up costing more than they are worth? Does the intended target of the regulations actually benefit? These questions are answered in a research article that Encompass’ Head of Delivery and Customer Success, Dr Henry Balani, alongside academic colleagues, produced and had published in the academic journal ‘Research in International Business and Finance’.

In this blog, Henry, a renowned industry figure, shares some of his findings and insight, telling how the 4th Anti-Money Laundering Directive (4AMLD) has impacted on valuations of banks across Europe.

About the research

The research focused on understanding the impact of 4AMLD on banks’ stock price and systemic risk. We know that the European Union (EU) regularly updates regulations to detect and limit money laundering within the banking industry, with the 6th Anti-Money Laundering Directive (6AMLD) currently in review.

By forcing banks that operate to follow certain rules, the desired outcome is to prevent ‘dirty money’ from flowing through the European banking system.

We are all, by now, familiar with the need to prove who we are when opening up a bank account. This process, also known as ‘Know Your Customer’ (KYC), is where government issued identification and documentation is required when opening up either a personal or corporate bank account. If these KYC checks turn up suspicious or criminal behaviour banks are required to report to the authorities.

Increasingly, as financial transactions have become more global and sophisticated, the possibility of nefarious transactions involving bad actors has increased – driving the need for sophisticated KYC processes. This raises the costs to banks, as they need to implement the technology solutions to meet these demands and, as such, face a dilemma of being forced to meet regulatory demands and potentially losing revenue every time they onboard a new customer.

Stock valuations increase and risk declines

The findings of the research, however, provide a different, more contrarian conclusion. As a result of introducing 4AMLD, stock valuations across the banking sector in fact have increased, with total risk declining. While unexpected, this means that 4AMLD is good for European based banks, as the market sees the benefits of regulations outweighing the cost of implementing them.

These findings are reinforced when examining bank specific characteristics. Larger, more profitable banks saw a more positive benefit, while those with more non-traditional revenue streams – think investment banking, brokerage services, asset securitization – also saw a greater increase to their stock market valuations compared to more traditional banks, such as commercial and retail banking. On top of that, we saw that banks that operate in richer EU countries (UK, Germany) benefited more when compared to poorer EU countries (Greece, Romania).

As a result of introducing 4AMLD, stock valuations across the banking sector in fact have increased, with total risk declining… 4AMLD is good for European based banks, as the market sees the benefits of regulations outweighing the cost of implementing them.

4AMLD has forced more stringent compliance

Why is this? The introduction of 4AMLD has forced greater compliance and streamlined the capturing and reporting of potential money laundering activities. Banks are required to implement standardized and consistent KYC onboarding and detecting processes within their operations. Also, the role of reporting potential money laundering is clear – banks are now required to file suspicious activity reports to the relevant central authorities, reducing potential process ambiguities.

Larger banks typically already have the required resources to comply with new regulations, lowering the costs of compliance per transaction. Banks with a more diverse portfolio of financial services typically already have sophisticated compliance tools. Clarity of process is a positive for market investors and financial analysts, who now feel more confident of the bank’s operations as a result of clarity of their KYC processes. Because of this, we would expect to see rising bank stock valuations.

When examining country specific characteristics, the findings show that banks operating in richer EU countries experienced greater positive valuation effects. A possible explanation here is that banks in poorer countries, with weaker financial services infrastructure, face greater challenges (and higher costs) in setting up their compliance infrastructure to comply with the provisions of 4AMLD. In this case, the costs outweigh the benefits. Banks in richer countries, however, have an easier time when it comes to complying , driving their valuations higher when compared to others.

What we have learnt is that the benefits outweigh the costs in relation to 4AMLD and compliance. It unlocks these benefits by creating and incentivising more coordination efforts among banks to catch potential money laundering activities.

These efforts may not have been replicated by bank management on their own in the absence of regulation. While the research, in this case, was focused on specifically 4AMLD, you are likely to find similar results using the same methodology for both 5AMLD and 6AMLD. Bankers and regulators should take note: regulations work, protecting consumers from nefarious activities, and banks positively benefit from these regulations.