By Sinead Cruise and Chris Vellacott
LONDON (Reuters) - Private banks managing the financial affairs of the world's wealthy face spending millions of dollars every year on vetting new clients, as regulators get tough on banks that harbor tax cheats and money launderers.
While the world's rich are getting wealthier and putting more money into private banks, a growing proportion of the cash is from geo-political troublespots in the Middle East and Asia.
That is leading the banks, mostly based in Europe and the United States, to spend hundreds of hours on costly checks aimed at meeting regulators' demands to root out bad clients, eating into their profit margins.
Paul Kearney, head of Kleinwort Benson's private investment office, said his team incurs between 5,000 and 25,000 pounds ($7,600-$37,800) of costs in vetting each new client, depending on the background intelligence required and the jurisdiction in which the research is undertaken.
"Currently the international client base is the faster growing so we would expect our costs to increase in the next 12-24 months," he said, adding costs could equate to up to 10 percent of the first year's earnings from that account.
Some in the industry question whether all the effort will make much difference.
One London-based lawyer specializing in super rich clients, whose firm rejected one customer who turned out to be selling restored Soviet military hardware in the Middle East, said sophisticated criminals would always be hard to identify.
"If someone wants to get through the process and they are an inappropriate person, they will almost certainly have the necessary documentation and a front to get themselves through," he said, speaking on condition of anonymity.
But with regulators cracking down on banks, and plans to prosecute individuals as well as their employers currently being discussed in some countries, more money managers feel they have to invest some of their profits in trying to reduce their risks.
"It is expensive, that is true, but you cannot think of it as it once was, because you cannot go back in time," said George King, head of portfolio strategy at Royal Bank of Canada's private banking arm, of the tougher vetting process.
"The burden for not doing it well or incorrectly, in terms of reputational risk or fines is both enormous and growing."
Top banks, including HSBC
Increased vetting costs come on top of rising administrative and regulatory expenses that have already made the competitive business of wealth management much less lucrative for banks.
Data from the 2013 World Wealth Report compiled by RBC Wealth Management and Capgemini shows the investable wealth of the world's so-called "high net worth" individuals rose by 10 percent to a record $46.2 trillion in 2012, after dropping 1.7 percent in 2011.
The flow of money into the $18.5 trillion global wealth management sector increased 23.7 percent in 2012, reversing a 27.9 percent outflow in 2011. However, average pretax profit growth was 5.3 percent in 2012, down from 12.3 percent in 2011, with high costs blamed for the dip, consultancy Scorpio Partnership said.
The cost of complying with regulation will continue to rise, according to PwC's annual Global Private Banking and Wealth Management Survey, published last month.
Respondents said they expected risk and regulatory compliance expenses to account for seven percent of annual revenue in two years, up from five percent today. Participants from the Americas are bracing for even higher costs - roughly equivalent to nine percent of revenues in the next two years.
"The ability to understand and manage the avalanche of regulatory and risk issues ... will likely require private banks to continue investing heavily," said Justin Ong, Asia Pacific leader in PwC's global private banking arm.
Some banks have even resorted to rejecting accounts that are too small, risky or labor-intensive to turn a profit from.
"It is worth noting that the costs of the enhanced due diligence process may be incurred with the end result being a decision not to engage with the prospective client," Kleinwort Benson's Kearney said.
For some in the industry, though, the battle against criminals comes down to a mix of experience and instinct.
"You have to be very confident of the origins of the funds you are dealing with. If not, it's very simple, you have to walk away," said Rupert Robinson, CEO of Signia Private Wealth.
"You can do due diligence on a prospect to the 'n'th degree and you might be able to find evidence of some bad behavior but it is almost impossible to uncover things like fraud. If you have any doubt, you just have to say no."
($1 = 0.6621 British pounds)
(Editing by Mark Potter)