What is the risk of jurisdiction?
Jurisdictional risk refers to the risk that arises during operation in a foreign jurisdiction. This risk can come simply by doing business or by lending money in another country. In recent times, jurisdictional risk has increasingly focused on banks and financial institutions which are exposed to the volatility that some of the countries where they operate may be high risk areas for money laundering and terrorist financing.
Key points to remember
- The risk of jurisdiction arises when operating abroad.
- More recently, this type of risk has increasingly focused on banks and financial institutions.
- Jurisdictional risk can also be applied at times when an investor is exposed to unforeseen changes in laws.
- The FATF publishes quarterly two reports that identify jurisdictions with weak measures to combat money laundering and the financing of terrorism.
Functioning of jurisdictional risk
Jurisdictional risk is any additional risk arising from borrowing and lending or doing business in a foreign country. This risk can also refer to times when laws change unexpectedly in an area in which an investor is exposed. This type of jurisdiction risk can often lead to volatility. Therefore, the increased risk of volatility means that investors will demand higher returns to compensate for the higher levels of risk they face.
The increased risk of volatility means that investors will demand higher returns to compensate for the higher levels of risk they face.
Some of the risks associated with jurisdictional risk that banks, investors and businesses may face include legal complications, currency risks and even geopolitical risks.
As mentioned above, the risk of jurisdiction has recently become synonymous with countries where money laundering and terrorist activities are high. These activities are generally considered widespread in countries designated as non-cooperative by the Financial Action Task Force (FATF) or identified by the United States Treasury as requiring special measures due to concerns about money laundering or corruption. Due to the fines and punitive sanctions that can be imposed on a financial institution involved – even inadvertently – in money laundering or the financing of terrorism, most organizations have specific processes to assess and mitigate the risk of jurisdiction .
The FATF publishes two documents publicly three times a year and has done so since 2000. These reports identify regions of the world that, according to the FATF, are making little effort to combat money laundering and the financing of terrorism. These countries are called non-cooperative countries or territories (NCCT).
In August 2019, the FATF listed the following 12 countries as controlled jurisdictions: Bahamas, Botswana, Cambodia, Ethiopia, Ghana, Pakistan, Serbia, Sri Lanka, Syria, Trinidad and Tobago, Tunisia, Yemen. These NCCTs have shortcomings with regard to the implementation of anti-money laundering policies, as well as the recognition and fight against the financing of terrorism. But they all committed to working with the FATF to fill the gaps.
The FATF has placed North Korea and Iran on its call to action list. According to the FATF, North Korea still poses a great risk to international finance due to its lack of commitment and its shortcomings in the areas mentioned. The FATF also expressed concern about the proliferation of weapons of mass destruction in the country. The organization noted that Iran has emphasized its commitment to the FATF but has not implemented its plan. As such, the country remains on the list of calls to action and has until October 2019 to implement the Palermo conventions and the financing of terrorism.
Examples of jurisdictional risk
Investors may incur a jurisdictional risk in the form of a currency risk. Thus, an international financial transaction may be subject to exchange rate fluctuations. This can cause the value of an investment to drop. Currency risks can be mitigated by using hedging strategies, including options and futures.