What Are the Three Components of KYC?

Know Your Customer is a framework within the financial services industry. Its purpose is to safeguard the integrity of the financial system by preventing its misuse for illicit activities such as money laundering, terrorist financing, and fraud. Financial institutions are mandated to implement KYC procedures to ensure they understand with whom they are conducting business. This comprehensive approach helps mitigate significant financial and reputational risks for these entities.

Customer Identification Program

The Customer Identification Program (CIP) is the initial component of KYC, primarily focused on verifying the identity of new customers. This requirement, established under the USA PATRIOT Act and integrated into the Bank Secrecy Act, ensures that financial institutions can form a reasonable belief about a customer’s true identity. This foundational step is crucial for preventing identity theft and fraud within the financial system.

Financial institutions are required to collect specific identifying information from individuals and entities. For individual customers, this typically includes their full name, residential address, date of birth, and an identification number, such as a Social Security Number or a passport number. For businesses, collected information includes the legal registered name, physical address, and an IRS-issued tax identification number.

To verify the collected information, financial institutions employ both documentary and non-documentary methods. Documentary verification often involves reviewing government-issued documents like a driver’s license, passport, or birth certificate. Non-documentary methods may include cross-referencing information with public databases, credit bureaus, or other reliable independent sources. Financial institutions are also required to check customer information against government lists of known or suspected terrorists. Procedures must be established for maintaining records of the information obtained and the methods used for verification.

Customer Due Diligence

Building upon the initial identity verification performed by the Customer Identification Program, Customer Due Diligence (CDD) delves deeper into understanding the customer’s activities and assessing the potential risks they pose. While CIP confirms “who” the customer is, CDD focuses on “what” the customer intends to do and the nature of their financial activities.

A core element of CDD involves understanding the purpose and intended nature of the account relationship. This includes inquiring about the customer’s occupation, the source of their funds, and the expected transaction activity. For legal entity customers, CDD also requires identifying and verifying beneficial owners, typically individuals who directly or indirectly own 25% or more of the equity interest or exercise significant control over the entity. This helps uncover who ultimately owns or controls a company, preventing criminals from hiding behind complex corporate structures.

Financial institutions adopt a risk-based approach to CDD, meaning the intensity of due diligence varies depending on the assessed risk of the customer. Customers deemed to pose a higher risk, perhaps due to their occupation, transaction volume, or geographic location, will be subjected to Enhanced Due Diligence (EDD), which involves more rigorous scrutiny. This tiered approach ensures resources are allocated effectively to manage potential threats. The FinCEN CDD Rule, implemented in 2018, strengthened these requirements for U.S. financial institutions, emphasizing financial transparency.

Ongoing Monitoring

Ongoing monitoring represents the continuous and dynamic aspect of the Know Your Customer process, extending beyond the initial onboarding phase. This involves the systematic review of customer transactions and account activity throughout the entire business relationship. The purpose is to detect unusual patterns, deviations from expected behavior, or any transactions that appear inconsistent with the customer’s established profile.

This continuous oversight is important because a customer’s risk profile or activities can change over time. Ongoing monitoring ensures that the initial KYC assessment remains relevant and that emerging risks are promptly identified. Financial institutions leverage technology to analyze transaction data, looking for anomalies that could indicate illicit financial activity. If suspicious behavior is detected, it may trigger further investigation and potentially lead to the filing of a Suspicious Activity Report (SAR) with authorities.

In addition to transaction monitoring, ongoing monitoring involves periodically updating customer information and re-evaluating their risk profiles. The frequency of these periodic reviews often depends on the customer’s risk assessment, with higher-risk customers typically requiring more frequent reviews, possibly monthly or annually. For lower-risk customers, reviews might occur less often, perhaps yearly or every few years. This proactive approach allows financial institutions to adapt to changes in a customer’s circumstances and maintain a robust defense against financial crime.