Enhanced due diligence

What Is Enhanced Due Diligence?

Enhanced due diligence (EDD) is a rigorous and amplified level of scrutiny applied by financial institutions and other regulated entities to identify, assess, and mitigate heightened risks associated with certain customers, transactions, or geographic locations. It falls under the broader umbrella of Anti-Money Laundering (AML) and financial compliance measures. While standard Customer Due Diligence (CDD) involves basic identity verification and risk profiling, enhanced due diligence goes a step further, requiring a more profound investigation into the customer's background, source of wealth, business activities, and transaction patterns to uncover potential illicit financial activity like money laundering or terrorist financing. Regulators expect financial institutions to implement EDD as part of a robust risk-based approach to safeguard the integrity of the global financial system⁶⁹.

History and Origin

The concept of due diligence in finance has existed for decades, evolving significantly with the global fight against financial crime. Enhanced due diligence gained prominence with the increasing international focus on combating money laundering and terrorist financing. Key milestones include the establishment of the Financial Action Task Force (FATF) in 1989, which began issuing recommendations for AML and counter-terrorist financing (CFT) measures.

In the United States, Section 312 of the USA PATRIOT Act, enacted in response to the September 11, 2001, attacks, specifically mandated financial institutions to perform enhanced due diligence on correspondent accounts for foreign financial institutions and private banking accounts, particularly those involving Politically Exposed Persons (PEPs) or entities from high-risk jurisdictions⁶⁸. This legislative push, coupled with evolving international standards from organizations like FATF, solidified the requirement for enhanced due diligence as a critical component of a comprehensive compliance program. The Financial Crimes Enforcement Network (FinCEN) also played a crucial role, culminating in the issuance of its Customer Due Diligence Final Rule in 2016, which became effective in 2018, further clarifying and strengthening beneficial ownership requirements as part of overall due diligence⁶⁴, ⁶⁵, ⁶⁶, ⁶⁷.

Key Takeaways

• Enhanced due diligence (EDD) is a deeper level of scrutiny for high-risk customers or transactions, going beyond standard Customer Due Diligence (CDD).
• It is a critical component of Anti-Money Laundering (AML) and Counter-Terrorist Financing (CFT) frameworks globally.
• EDD aims to identify and mitigate risks such as money laundering, terrorist financing, and sanctions evasion.
• Triggers for enhanced due diligence include politically exposed persons (PEPs), complex ownership structures, cash-intensive businesses, and transactions in high-risk jurisdictions.
• Effective EDD involves verifying the source of funds, understanding beneficial ownership, and conducting ongoing Transaction Monitoring.

Interpreting the Enhanced Due Diligence

Enhanced due diligence (EDD) is not a static measurement but rather an ongoing, dynamic process of risk assessment and verification. Its "interpretation" involves a qualitative evaluation by financial professionals to determine the true nature of a customer relationship and whether the associated risks are acceptable. When performing enhanced due diligence, financial institutions collect extensive information to build a comprehensive risk profile. This includes scrutinizing the customer's source of funds, the origin of their wealth, their business activities, and the purpose of the business relationship⁶¹, ⁶², ⁶³.

For instance, if a customer is identified as a Politically Exposed Person (PEP), or if they are involved in complex international trade, the EDD process will involve a detailed examination of their financial networks and public profile to identify potential corruption or illicit financial flows⁵⁹, ⁶⁰. The collected information allows compliance teams to interpret whether a customer's declared activities align with their financial behavior, helping to identify red flags that might warrant further investigation or the filing of a Suspicious Activity Report (SAR). The goal is to gain "reasonable assurance" about the customer's legitimacy and the low probability of their involvement in financial crime⁵⁸.

Hypothetical Example

Consider "Global Trade Solutions Inc.," a newly established company seeking to open an account with "DiversiBank." While the initial Know Your Customer (KYC) checks reveal the company's registration and the identity of its stated director, the director is a non-resident of the country, and the company's declared business involves importing goods from a jurisdiction known for higher corruption risks. These factors trigger the need for enhanced due diligence.

DiversiBank's compliance team initiates EDD. They request additional documentation, including the company's full Beneficial Ownership structure, details on its suppliers and customers, and a comprehensive breakdown of the anticipated transaction volumes and types. They verify the source of funds for the company's initial capital, requesting bank statements and financial records from the ultimate beneficial owners. They also conduct adverse media searches globally, looking for any negative news or regulatory actions against the company, its directors, or its beneficial owners. Furthermore, they perform an in-depth risk assessment of the high-risk jurisdiction involved. Through this enhanced due diligence, DiversiBank aims to determine if the heightened risks associated with Global Trade Solutions Inc. can be adequately mitigated before onboarding them as a customer.

Practical Applications

Enhanced due diligence is a cornerstone of modern financial regulation, primarily applied in scenarios where the risk of money laundering, terrorist financing, or other financial crime is elevated. Its applications span various sectors and situations:

• High-Risk Customer Onboarding: Financial institutions apply EDD when establishing relationships with Politically Exposed Persons (PEPs), individuals or entities from high-risk jurisdictions, or those engaged in cash-intensive businesses⁵⁶, ⁵⁷. This also includes private banking clients and complex corporate structures⁵⁴, ⁵⁵.
• Correspondent Banking: Banks must perform rigorous enhanced due diligence on their Correspondent Banking relationships with foreign financial institutions, especially those operating in offshore or high-risk territories, as mandated by regulations such as Section 312 of the USA PATRIOT Act⁵¹, ⁵², ⁵³.
• Unusual or Complex Transactions: Any transaction that appears unusual, lacks a clear economic rationale, or involves abnormally large sums can trigger EDD. This helps detect atypical patterns that might indicate illicit activities⁵⁰.
• Mergers and Acquisitions (M&A): While not strictly AML-focused, acquiring companies often perform enhanced due diligence on target companies to uncover hidden financial, legal, or reputational risks before finalizing a deal.
• Regulatory Compliance: EDD is mandated by international standards set by the Financial Action Task Force (FATF) and national regulations like FinCEN's Customer Due Diligence Rule, ensuring financial entities meet their legal obligations⁴⁶, ⁴⁷, ⁴⁸, ⁴⁹.

A notable real-world example highlighting the critical importance of robust enhanced due diligence is the Danske Bank money laundering scandal. Between 2007 and 2016, Danske Bank's Estonian branch was involved in processing approximately €200 billion (around $225 billion) in suspicious transactions, much of which originated from non-resident customers, some from high-risk countries like Russia. ⁴⁵Investigations revealed significant deficiencies in the bank's Anti-Money Laundering (AML) controls, including insufficient knowledge about its non-resident customers and a failure to adequately apply due diligence measures to identify Beneficial Ownership. ⁴³, ⁴⁴The scandal resulted in Danske Bank pleading guilty and agreeing to pay over $2 billion in fines to U.S. and Danish authorities for violations of AML laws. ⁴⁰, ⁴¹, ⁴²This case underscores the severe consequences of failing to implement effective enhanced due diligence.

Limitations and Criticisms

Despite its crucial role in combating financial crime, enhanced due diligence (EDD) faces several limitations and criticisms. One significant challenge is the inherent complexity of identifying and verifying Beneficial Ownership, especially for opaque legal structures like shell companies and trusts. ³⁹Criminals continually innovate, using sophisticated methods to obscure their identities and the true source of funds, making it difficult for even the most robust EDD processes to keep pace.
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Another criticism revolves around the high compliance costs associated with implementing comprehensive EDD procedures. ³⁵, ³⁶Financial institutions invest heavily in technology, staff training, and data sources to meet regulatory requirements, yet the effectiveness of these efforts in significantly deterring or recovering criminal proceeds is sometimes questioned. ³³, ³⁴Some studies suggest that the global Anti-Money Laundering (AML) regime, despite its expense, has a limited impact on criminal finances, with compliance costs often far exceeding the value of recovered illicit funds.
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Furthermore, the implementation of EDD can lead to "de-risking," where financial institutions choose to terminate relationships with certain customer segments or entire regions deemed too high-risk, rather than manage the complex and costly enhanced due diligence process. ³¹While intended to protect the institution, this practice can inadvertently exclude legitimate individuals and businesses from accessing financial services, particularly in developing economies or for sectors like non-profits that operate in challenging environments. The reliance on risk assessment can also introduce biases or narrow focus, potentially overlooking new or evolving threats. ³⁰Ultimately, while enhanced due diligence is essential for regulatory compliance and risk management, its practical application faces ongoing challenges related to cost-effectiveness, adaptability to new financial crime typologies, and potential unintended consequences for financial inclusion.
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Enhanced Due Diligence vs. Customer Due Diligence

The distinction between enhanced due diligence (EDD) and Customer Due Diligence (CDD) lies primarily in their scope and depth. Customer Due Diligence is the foundational process applied to all customers during the onboarding stage and throughout the business relationship. It involves identifying and verifying the customer's identity, understanding the nature and purpose of the business relationship, and conducting ongoing monitoring. ²⁶, ²⁷, ²⁸This typically includes collecting basic identification documents, verifying addresses, and establishing a baseline risk profile for the customer. CDD aims to answer the question, "Who is this customer?".
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In contrast, enhanced due diligence is a more intensive and rigorous set of measures triggered when a customer or transaction is identified as presenting a higher risk of money laundering or terrorist financing. ²², ²³, ²⁴EDD goes beyond basic verification by requiring additional information, more extensive verification of sources, and a deeper analysis to better understand and mitigate potential risks. ²⁰, ²¹This might involve establishing the source of wealth and source of funds, conducting more thorough background investigations, examining complex Beneficial Ownership structures, and implementing more frequent and stringent Transaction Monitoring. ¹⁶, ¹⁷, ¹⁸, ¹⁹Where CDD seeks to establish identity and purpose, enhanced due diligence seeks to confirm the legitimacy of higher-risk clients, asking, "Can I trust this customer given the heightened risks involved?".
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FAQs

What triggers enhanced due diligence?

Enhanced due diligence is typically triggered by factors that indicate a higher risk of money laundering or terrorist financing. Common triggers include customers identified as Politically Exposed Persons (PEPs), complex corporate structures, businesses operating in high-risk jurisdictions or cash-intensive industries, unusual or unexplained transactions, or negative news associated with the customer or their associates.
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How does technology assist with enhanced due diligence?

Technology, including artificial intelligence (AI) and machine learning, plays an increasingly vital role in enhanced due diligence. It helps automate data collection, perform adverse media screening, analyze vast amounts of transaction data for suspicious patterns, and verify identities more efficiently. While human oversight remains crucial for complex cases, technology enhances the speed, accuracy, and comprehensiveness of the EDD process, contributing to a more effective Compliance Program.
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Is enhanced due diligence a one-time process?

No, enhanced due diligence is not a one-time obligation. For high-risk customers, it involves ongoing monitoring of transactions and regular reviews of customer information to ensure that their activities remain consistent with the financial institution's understanding of their risk profile. ⁶, ⁷, ⁸As risks evolve, so too must the application of EDD measures.

What are the consequences of failing to perform enhanced due diligence?

Failing to perform adequate enhanced due diligence can lead to significant penalties for financial institutions, including hefty fines, reputational damage, and regulatory enforcement actions. ³, ⁴, ⁵Such failures can also expose the institution to being unwittingly used for illicit activities like money laundering, fraud, or terrorist financing, undermining global efforts to combat Financial Crime.¹, ²