Correspondent banking is of paramount importance to the global payments system today, particularly for banks that would like to access financial services in different geographies and provide cross-border payments services to their customers, bolstering international
trade and financial inclusion. Even payments solutions that do not require customers to have bank accounts to transfer funds – such as remittances – utilise correspondent banking networks.
Banks have historically had a strong and extensive network of correspondent relationships, but this is changing and there is evidence that banks are reducing the number of these partnerships. This is occurring within respondent banks that do not generate
sufficient volumes to recover the cost of compliance and are in regions that do not have sufficient information or processes to reduce KYC risk.
Further to this, some banks are becoming reluctant to provide correspondent banking services in particular foreign currencies where the risk of economic sanctions seems to be higher. As explored by the
Bank of International Settlements (BIS), non-US banks – particularly in emerging European countries – are increasingly withdrawing from providing services in US Dollar.
“Some correspondent banks are increasingly reluctant to provide correspondent banking services in certain foreign currencies in which the perceived risk of economic sanctions, the regulatory burden related to AML/CFT or the uncertainties related to the implementation
of these requirements and the potential reputational risk in case of non-compliance seem to be higher. There are indications that correspondent banking activities in US dollars are increasingly concentrated in US banks and that non-US banks are increasingly
withdrawing from providing services in this currency except for some ancillary services. Simultaneously, the very same non-US correspondent banks might still be willing to provide correspondent banking services in their domestic currency.”
The reality is that in today’s world, the cost of correspondent banking has increased, and only some parts of the business are profitable. Due to this, many banks have been cutting off less profitable customers or regions, especially in situations where
the returns do not equal the investment cost – which is the case for correspondent banking relationships that must bear the burden of AML regulation. This can have a severe, negative impact on the country’s GDP and financial inclusion.
The G20 has endorsed a roadmap, developed by the FSB, in coordination with the Committee on Payments and Market Infrastructures (CPMI) and other relevant organisations, to enhance cross-border payments. It lays out a comprehensive set of actions covering
19 ‘building blocks’ identified by the CPMI across five focus areas. The
FSB report outlines how the timelines for building block 4: aligning regulatory, supervisory and oversight frameworks for cross-border payments and building block 6: reviewing the interaction between data frameworks and cross-border payments.
The report provides an example: “the development of preliminary ISO 20022 harmonisation guidelines by a joint task force of ISO 20022 specialists from the CPMI and the SWIFT Payments Market Practice Group (PMPG), which should set minimum guidelines for core
data components across the cross-border payments chain.”
Governments and regulatory bodies across regions are also developing intra-regional cross-border payment systems in a bid to develop a global harmonised solution. Another example is P27, the single pan-Nordic payment infrastructure for the region’s 27 million
citizens, incorporating real-time, batch, domestic, and cross border payments to be carried out quickly and securely on a single platform.
According to the BIS, the value and volume of cross-border payments has increased by 2% and 7% respectively in 2020, while correspondent banking relationships contracted by 4% that same year, resulting
in a total decline of 25% from 2011 to 2020. This could be due to changes in the lending environment and more robust financial regulation through capital controls and compliance regulation which in turn, has led to a reduction in risk appetite.
The
Leibniz Centre for European Economic Research (ZEW) also revealed that due diligence costs and financial crime compliance are reducing risk appetite. Because this leads to decreased profitability and increased risk of fines, correspondent banking relationships
can be strained and could lead to a withdrawal of relationships in areas where there are weak compliance practices and money laundering, harming developing economies.
Finextra spoke to Jamie Woodcock, product manager, Currencycloud; Sulabh Agarwal, global payments lead at Accenture and Alla Gancz, UK payments leader at EY about why some banks are now reluctant to provide correspondent banking services in foreign currencies,
whether correspondent banking is profitable and alternatives to this payment method.
Why is correspondent banking important?
Woodcock highlighted that there are challenges on both sides of the correspondent banking relationship. “We're at a bit of an inflection point where the current regulatory frameworks that the large banks are operating within are really causing a lot of negative
impacts that affects the smaller banks in certain markets and certain regions,” Woodcock said. According to Agarwal’s view, withdrawal of these relationships and the subsequent lack of correspondent banks would be problematic.
Agarwal stated that “without correspondent banking relationships, it would be much more complex and costly for banks to facilitate cross-border transactions, and this could have a negative impact on global trade and economic growth. They are also important
for maintaining financial stability by allowing cross-border money flows in a controlled and transparent way and reducing the risk of money laundering and the funding of criminal activities,” he said. But how are these relationships actually evolving?
Agarwal continued to say that “correspondent banking relationships are changing because of a range of factors, including regulatory developments, technological advancements, increased digital adoption, advancements in alternate payment methods, and changes
in global trade patterns. This change has more recently accelerated because of geo-political disruption and the Covid-19 pandemic.”
Accenture provided a list of four ways that correspondent banking relationships are changing:
- New specialised money transfer operators/aggregators are directly connecting into local payment schemes across multiple geographies, negating the need for local correspondent banks for payments clearing.
- Some correspondent banks are increasingly reluctant to provide correspondent banking services in certain foreign currencies and hold relationships in geographies where there is a high risk of economic sanctions.
- Increased penetration of mobile technologies, the rise in alternate forms of currency (CBDC, stablecoins and other forms of currencies) and the efforts by the Financial Stability Board (FSB) to enhance cross border payments could result in new partnership
models.
- Industry initiatives such as P27, m-Bridge, Immediate cross border payments (IXB) could create an alternative to current cross border payment flows through correspondent banking.
In a similar vein to these points, Gancz agreed that the “complicated structure of correspondent banking relationships and the additional risk involved in sending funds cross-border means such payments currently come at a high cost.
“There are usually multiple correspondent banks in the chain, with each one carrying out certain activities - all charging a fee for their service. However, emerging fintechs are starting to provide alternative cross-border options which will mean correspondent
banking will have to become more transparent and cost efficient. Looking further ahead, new multilateral cross-border payments platforms and emerging distributed ledger technology (DLT) solutions have the capability to reimagine the future.”
Why are some banks now reluctant to provide correspondent banking services in foreign currencies?
Regardless of other goals, profit is a bank’s key priority, and the cost of correspondent banking is getting higher and higher. Banks will cut off less profitable customers or regions, especially in situations where the returns do not equal the investment
cost – which as explored before, is the case for correspondent banking relationships that endure AML regulation.
Woodcock explained that “the regulatory requirements on US correspondent banks effectively makes them liable for any kind of anti-money laundering regulatory violations of any of the banks that they offer their services to.”
He went on to say that if, for example, JP Morgan was offering correspondent banking services to respondents in a region where there is a perceived or an actual higher risk of money laundering or terrorist financing, there has to be a commensurate reward
for the risk that the bank is undertaking.
Woodcock furthered that “larger banks in more established economies with a large amount of flow could afford to pay potentially higher prices to mitigate that risk. If it’s worth JP Morgan’s time and money to take on that regulatory risk, then maybe it’s
worth it. But what we’re seeing in most cases, or a lot of cases, is that the larger banks – particularly US banks – are coming to the conclusion that the risk is not worth the reward.”
We must also consider that these relationships may not be on a one-on-one basis or between two banks. There may be many layers of nested correspondent banking relationships where a large global bank may have a correspondent banking relationship with a large
national bank, who would then sell the global bank’s correspondent banking services on to a set of smaller regional banks.
What this also means is that the global bank is exposed to risk on multiple levels. “The large global bank can choose to increase their prices for those transactions or that relationship to recompense the added overhead in monitoring, screening or conducting
KYC on those customers, but what we are seeing more and more often is that banks are deciding to withdraw entirely from a country, from a region, from a certain market,” Woodcock added.
This is occurring at an exponential rate across parts of Eastern Europe, Africa, the Middle East and certain parts of Asia such as the small Pacific Island countries. While correspondent banking has declined by 25% from 2011 to 2020, the demand for cross-border
payments has increased because more unbanked and underbanked consumers are wanting to make payments. However, the demand is massively outpacing supply – which as discussed, is shrinking due to large banks withdrawing.
Why are some banks now reluctant to provide correspondent banking services in foreign currencies?
After banks withdraw, they are not able to offer a certain set of currencies to their customer base which could mean they are losing groups of customers such as SME customers, high-net-worth individuals, or consumers that use a large bank’s services through
a respondent bank.
In Woodcock’s view, “As a consumer, I’m going to go to a bank that can offer the cross-border payments I need, but this is particularly an issue in some of these smaller countries where all the banks have been cut off. It’s not a question of walking down
the High Street to a competitor. If a correspondent bank is withdrawing from a region entirely, that leaves me as a customer with nowhere to go.
“Now I’m losing access to those critical currencies all together, which is acutely felt by small to medium businesses who, for example, then are no longer able to import important goods and services they would need to pay for in a foreign currency such as
US Dollars, which can have a really profound impact on the economy and on trade within that region.”
Gancz continued this point to explore how while “some banks do not provide correspondent banking services in foreign currencies,” it may be “because of the added risk of relying on another bank to carry out the necessary due diligence, such as KYC, AML,
and sanction screening. This is because if these checks and processes are not done or done incorrectly, the initiating bank may be liable for regulatory fines and runs the risk of reputational damage.”
Agarwal detailed that “some correspondent banks are increasingly reluctant to provide correspondent banking services in certain foreign currencies and hold relationships in certain geographies with a risk of economic sanctions. Recent global geo-political
events have further strengthened this view. Credit risk, liquidity risk, liability and reputational risk can be more difficult to manage for transactions in foreign currencies.
“Additionally, new standards on cyber risk, competition for alternative payment methods, and high costs particularly for smaller transactions or transactions in less commonly traded currencies are also reasons why banks may not be willing to provide these
services,” he said.
Woodcock agreed that sanctions have a huge part to play because correspondent banking in a sanctioned country is impossible. “It is next to impossible to send money into Syria via our correspondent banking network. If you send USD into Syria, no US bank
is going to allow that transaction through. It essentially means that that country is financially excluded from correspondent banking via Swift. It makes it very, very hard to get funds to people that need them within those countries.
In addition to this, Gancz clarified this point and provided an alternative to correspondent banking. “Correspondent banks can’t send funds to sanctioned countries. Individual and businesses in sanctioned countries are limited to traditional options, such
as cheque and cash, which are more costly and take longer to reach beneficiary. However, some countries are building their own rails to open up and facilitate international payments, presenting a challenge to the established ecosystem.
“However, the emerging concept of Regulated Liability Network – or RLN – offers a promising new way to help improve global liquidity management and cross-border payments through ‘on-chain’ finality of settlement between participating institutions. This approach
involves tokenising the liabilities of regulated institutions – including central banks, commercial banks, and e-money. The RLN can be integrated in the existing ecosystem through interoperability and is compliant with existing laws and regulations, and we
believe it is the next significant wave of innovation in cross-border payments.”
How to re-design correspondent banking for the 21st century
Being cut off from your bank is a dire situation to be in. Woodcock provided advice and stated that redundancy must be a top priority for banks.
“It's no longer a given that your relationship is going to be there in six months’ time. And you do not want to be in a position where the bank gives you three months or less notice, which has happened. Three months is not long enough to get alternative
arrangements in place. Redundancy is required and that is at a huge cost to banks where it's very expensive to set up and maintain another correspondent banking relationship.”
He added that this is becoming part of the cost of doing business, but, this sort of increased consolidation is only affordable to larger banks. Working with a fintech company however, can offer much faster onboarding when establishing redundancy upfront
or replacing a lost correspondent relationship entirely. Fintechs also typically offer multiple currencies through a single relationship, resulting in much lower onboarding costs and liquidity requirements.
Agarwal also mentioned that there are “viable alternatives to correspondent banking, particularly for banks without large amounts of working capital or located in smaller markets. Some of these alternatives include using fintech solutions that provide single
access to multiple local real-time payments/automated clearing house (ACH) infrastructures, proprietary money transfer operators (MTOs) networks and mobile payments in certain regional areas. Additionally, other alternatives include distributed ledger technology
(DLT) payment networks, central bank digital currencies (CBDCs), mCBDC and stablecoins. Some of these are in early stages of development.”
Gancz added that “Payments as a Service (PaaS) allows banks to partner with suppliers to gain access to the cross-border payments system and does not require the entity to set up individual correspondent banking relationships. In addition, banks and central
banks around the world are starting to recognise the huge potential of the emerging new forms of digital currencies – including CBDCs, deposit tokens, stablecoins, and cryptocurrencies - and DLT technology more broadly, which have the ability to redefine payment
infrastructure of the future, helping improve and transform clearing and settlement times and processes, and could also make cross border payments more available for smaller markets.”