What it means
Banks, brokers, insurers and many other businesses are required by law to understand their customers. The aim is to stop criminals from using the financial system to hide the proceeds of crime or to fund illegal activity.
Knowing the customer is also good business, because it reduces the chance of losses from fraud and legal penalties. A typical KYC check starts with identity.
For an individual, that means a government-issued photo identification and proof of address, and for a company, it includes registration documents and the names of directors. The firm must also identify the beneficial owners, who are the real people who ultimately own or control the business, even if they sit behind layers of companies.
The next step is to understand the purpose of the relationship and the expected activity. A firm will ask what the customer does, where funds come from and what kind of transactions are likely.
These details create a profile, so that unusual activity, such as sudden large payments from abroad, can be spotted and reviewed. Firms use a risk-based approach, which means that higher-risk customers face more checks.
Examples are politically exposed persons, who hold prominent public positions, customers in high-risk countries and businesses that handle large amounts of cash. Lower-risk customers may go through simpler checks, although some basic steps are always required.
KYC is not a one-off exercise. Firms must keep information up to date, monitor transactions and review high-risk accounts more often.
If a customer cannot provide satisfactory information, the firm may refuse to do business or end the relationship, and in some cases must report suspicious activity to the authorities. For people outside finance, KYC often shows up as requests for documents when opening an account, taking a loan or onboarding with a supplier.
Understanding the reasons behind it makes the process less frustrating. Businesses that prepare documents in advance, and keep ownership information current, can complete onboarding much faster.
In practice
Real-world examples.
Example
A start-up opens its first business bank account. The bank asks for its incorporation certificate, proof of address and passport copies for each director and for every shareholder holding 25% or more. The founders prepare the documents in advance and the account is open within days.
Example
A wealth manager takes on a new client who has just sold a business. As well as identity checks, the firm asks for the sale agreement and bank statements to confirm where the money came from. The documents are kept on file in case of a regulatory review, and the manager sets a date to refresh them in a year.
Example
A payments company notices that a small retailer's account suddenly receives large transfers from several countries. The compliance team reviews the customer's profile, asks for explanations and invoices, and files a report when the answers do not add up.
Case study
Seen in the real world.
Marlin Bay Brokerage is an illustrative, fictional firm that onboarded customers online. To grow quickly, it accepted a scanned passport and a self-declared address, with little checking of where the money came from.
An internal review found that 40 of its 2,000 new accounts shared the same address and funding source, and several were linked to a scheme to move stolen funds. The regulator fined the firm $1,500,000 and required it to review every account.
The firm spent a further $800,000 on better systems and staff. The illustrative lesson was that KYC checks cost money, but the cost of getting them wrong is far larger, and a clear process at the start protects both the firm and its honest customers. The firm's new rules required a second person to review any account where the source of funds could not be shown, and the compliance head reported the number of rejected applications to the board each quarter.
Watch out
Common mistakes.
- Treating KYC as a one-time form to complete at onboarding, when ongoing monitoring and periodic reviews are also required.
- Checking the company but not the people behind it, when identifying the beneficial owners is a core requirement.
- Applying the same checks to every customer, when a risk-based approach expects more scrutiny for higher-risk cases and a lighter touch where the risk is plainly low.
Questions
People also ask.
What does KYC stand for?
It stands for Know Your Client or Know Your Customer, the process of verifying who a customer is and understanding their financial activity.
Why do banks ask so many questions?
They are legally required to prevent money laundering and fraud, and they can face heavy penalties if they cannot show they carried out proper checks. Each answer helps them build a profile of what normal activity looks like for you.
What is a beneficial owner?
It is a real person who ultimately owns or controls a business, usually through a significant share of the ownership or voting rights. Sales and procurement teams who understand this can set realistic expectations with new customers and suppliers about how long onboarding will take.
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