Correspondent Banking: Times are Changing
We are all spending more money operating our correspondent network than we really need to. If your bank has more than one nostro account in each currency or needs more than the fingers on one hand to count the number of suppliers, that opening statement almost certainly applies to you too.
Correspondent banking presents a challenge. On the one hand it is an essential enabler; to do business in the financial services marketplace you need nostro accounts and depots. On the other hand, however, most banks have more than one account per currency and at least one supplier per currency, which increases the cost of doing business.
Even the most superficial comparison with other industries, such as auto manufacturing, would suggest that we banks are not very sophisticated in our supply chain management. In this paper, we will look at how our current situation arose, its pros and cons and suggest how this area of banking might develop over the coming years.
International correspondent banking has grown as a result of the increase in world trade. Historically, holding an account at a bank local to where the transaction was due to take place was essential, with instructions being exchanged by letter. Transaction charges were unknown and the correspondent banks lived off the client balances. The introduction of SWIFT in 1973 helped facilitate the exchange of instructions between banks, though it did not really change the basic process. In the 1970s, networks expanded as the financial services business became more global. The increase in cross-border investing drove the need for nostro and depot accounts. The 1990s saw the advent of the professional network management function and the introduction of transaction fees. The first fruits of this professionalisation were seen in the 1990s with the widespread adoption of global custody in the securities business. In some cases, the global custodian route was adopted, in others a regional custody approach was chosen. This is the most basic step in supply chain management; reducing the number of suppliers to simplify the management task. These initial steps were taken only on the securities side of the business. The advent of the euro was the first real driver of consolidation of nostro relationships. The advent of continuous linked settlement (CLS) ought to be another; though there are only the faintest signs of a discernable trend.
There is ready acknowledgement that the cost of putting a computer on the desktop is substantially higher than the cost of just the PC. Our IT colleagues refer to this as the TCO, total cost of ownership. If you are responsible for your banks’ correspondent network, once upon a time you probably congratulated yourself on negotiating attractive ticket prices. In practice, the ticket price is not the whole story.
In euro-land, the banks’ revenues are suffering from the directive on low-value payments. As a result, a lot more effort is being put into maximising revenues from existing business. One area where this is being felt is in the fees for repaired items. Our current experience is that banks are being far more precise in measuring repairs and that repair fees vary substantially, averaging at least €3 on top of the basic ticket charge. Actually confirming that you are being charged for the correct number of items and at the correct rate is a major challenge. There is an enormous variance in the quality of billing that banks provide, both in terms of transparency and timing. Some banks charge in one currency for fees incurred in several currencies, others have entirely separate bills for maintenance fees, repair fees, “our” fees on commercial payments. Some charge monthly, some charge every fee as a line item. Some banks even deduct repair fees from the amount they transfer.
The different cost components that need to be considered in relation to a nostro account are shown in Table 1: Total Cost of Ownership – Cost Components.
|Owning and Operating a Nostro Account|
For a nostro account, the TCO will be a function of the operational costs associated with doing business with multiple suppliers and accommodating any awkward and complex billing practices. As an organisation, your staff have probably adjusted to what they are confronted by, yet you are heavily dependent on knowledge that is in their heads and almost certainly have costs of doing business that are higher than they should be.
Let’s take a closer look at those potential costs and how high they might be:
|Item||Cost Implications & Considerations|
|Ticket fees||Today’s standard practice is that there is both an STP and a repair price. Quite rightly there is a spread between these prices and indeed in the future, we would expect this to grow. Do you have agreement with the nostro on the definition of STP and repair? Have you checked your activity recently, are you aware of repair charges|
|Account fees||These are the easiest item to control|
|Debit / credit interest||These charges are also straightforward to control. However, you have to accept that where you have multiple accounts in one currency, you will have interest costs arising from those days you are inadvertently long and short in different accounts|
|Item||Cost Implications & Considerations|
|Account operating||If the account exists, it has to be funded. Even with low activity levels, getting to zero all the time is nigh on impossible. If you have multiple accounts, there will be days when you are long in one and short in the other. If the account exists, it has to be reconciled. The costs of these tasks will rise if your nostro does anything other than post a single debit for fees at month end. Cost estimate:
Minimum, even for very low volumes, $10,000 per account a year
Normal: active accounts, $25’000 per account a year
|KYC||Your supplier will send you documentation each year to update. In an increasingly regulated world, there is an increasing amount of administration to perform.|
|Network management:||Terms and conditions need to be monitored, service level agreements negotiated, bills verified. We think an overhead of some two heads per 100 accounts is required. Cost estimate: $3,000 per account a year|
Almost all banks have too many bank accounts. Addressing the issue is certainly something that follows the 80:20 rule, with 80 per cent of the banks doing some sort of periodic spring cleaning. More often than not though, it is like painting the Brooklyn Bridge; it is a career and not a project, because as soon as you have finished, you have to start all over again. A few banks make strides. Coop Bank in Basel, Switzerland did just such a project in 2001.
They started from a base of 175 nostro accounts, eliminated 75 per cent and saved CHF500k per year2. That is an impressive saving considering this was just a spring clean.
Closing bank accounts ought to be a simple administrative process. In our business, it is anything but and, indeed, the degree of difficulty is on a par with obtaining building permission for a new football stadium in downtown Zurich. From experience, it seems to matter very little how active an account is; closing it has a fair chance of starting a small war. Reciprocity and relationship are the most often cited reasons for objecting to a closure. The latter is the most simple to deal with. If you are serious about reviewing and reducing the number of accounts, you will have to ask some hard questions about what having the account does for your organisation. The arguments in favour of the provider will vary, though you can expect them to include: “they visit us and keep us up to date on the market”. Those updates can potentially eat up a lot of organisational time; if you operate in 40 currencies and get visited by three or four of the banks in a year, spending two and a half hours with each of them, that is some two weeks of effort just to administer the relationship. This assumes only one of you goes to the meeting. The proverbial free lunch is also a factor. The objective test to apply is: “Does this relationship add meaningful value to our organisation that we would lose if we close the account?” Reciprocity is a more complex and grey issue. The typical large bank will spend tens of millions of euros a year on custody and payment services. To operate day-to-day, you need the services, so you have to spend. You can though, chose with whom to spend it. If you have a transaction business, then you will have a rightful desire to see your organisation spend money with those who will buy from you. For smaller and medium sized banks, the more objective approach would be to look at both the TCO issues we cite above and all the relationship costs we have just described.
Increasingly, payment systems are offering remote access to RTGS systems to banks in other countries. This type of option is something that is at least optically attractive; RTGS systems will typically have very low transaction charges. On closer examination, it is often the case that this option is more suited to high volume shops that have dedicated experts for such links. RTGS operators do not generally have a client service organisation and treat all the payments input in a binary fashion; you either get it right or you get it wrong.
A recent study3from Accenture and the University of St. Gallen suggested that banks will need to consider one of three approaches in terms of core processing and outsourcing. These are summarized in table 3. In terms of custody and correspondent banking, option II, in-sourcing, is the option that is least likely to be attractive. Reducing the number of suppliers by using a global custodian or a small number of regional custodians both for securities and payments is an approach that is consistent both with option I and with option III.
|I||Independence||In-house production of non-strategic processes with the aim of achieving maximum possible independence from outside suppliers|
|II||Scale||In-sourcing of activities from other banks with the view to achieving greatest possible economies of scale|
|III||Focus||Outsource non-strategic processes and focus on core competencies|
Only with a very extreme interpretation of the scope of the in-house production proposition of option I would you insist on having separate relationships in every currency. Is one supplier the right answer? In some cases, the answer will be yes. Generally, this will be the case for small banks, where no one currency is particularly important. Most likely, in any country, self-clearing in the local currency for domestic payments will be a sensible option for all but the smallest institutions.
For the medium sized banks there are some important considerations when thinking about the major currencies. There may well be some funding and treasury considerations that warrant maintaining direct relationships with a nostro provider in these currencies. For any bank in Europe, we think any justification would be limited to the euro and the US dollar. Figure 2, gives an impression of how we think an effective network would look.
1KYC: Know Your Customer. All the formal, mandatory compliance work that a bank is required to perform with its clients
2Source: ClearIT, Issue #9, May 2001. ClearIT is a publication of Swiss Interbank Clearing AG.
3The Swiss Banking Industry in the Year 2010, May 2004, (Accenture and University of St. Gallen)