Correspondent banking represents the cornerstone of the global payment system designed to serve the settlement of financial transactions across country borders. Various activities drive the need for cross-border correspondent banking: in trade finance where goods or services transferred across borders need to be settled; in international infrastructure and aid projects where funds need to be disbursed to vendors and contractors involved; and where an overseas worker looks to remit earnings back to his family back home. Each relies on the banking system, providing just examples of the need for cross-border correspondent banking services.
However in recent years, the number of correspondent banking relationships (CBRs) has declined globally. Data from the Bankers Almanac compiled by Accuity shows that between 2013 and 2016, the number of correspondent banking relationships declined from 360,785 to 223,247, representing a 38% decrease globally. That sharp fall in global correspondent banking relationships is especially significant when contrasted with the increase in the number of banks in the same period. The research shows the total number of financial institutions increasing from 42,708 to 45,893 as per Figure 1 below:
Figure 1: Comparison of Financial Institutions and Correspondent Relationships.
North America and Western Europe in particular have seen the largest reduction of CBRs, with falls of 46% and 39% reductions respectively, reflecting the general trend of the larger Tier 1 banks reviewing and retrenching their existing relationships. A large bank typically has multiple CBRs, as it deals with counterparty banks in different countries and currencies. It is not uncommon for multinational Tier 1 banks to have thousands of relationships, driven by clients’ requests to remit funds across borders in different currencies. World Bank research also supports this trend, with 75% of large banks reporting they had withdrawn from correspondent relationships.
The impact of the decrease in CBRs, combined with the increase in banks, demonstrates the significant decline of correspondent banking overall. There are three primary factors behind this decline; Regulatory drivers, emerging illicit payment corridors and changing payment models.
Regulatory drivers are certainly a significant factor in driving the decline. Over the past five years, the number of penalties for non-compliance with anti- money laundering (AML) regulations has increased. To date the biggest penalties levied have been BNP Paribas, fined US$8.9bn in 2014 and HSBC US$1.9bn in 2013 for various alleged money laundering offences, including the stripping of references to Iran in US dollar wire payments for clearing in the US.
As a result, large banks are concerned with the inherent risks of dealing with transactions from sanctioned countries, including Iran, North Korea and other high-risk countries in the Middle East, Africa and the Caribbean. The challenge for Western correspondent banks here is the lack of understanding of the customer base of their respondent banks in these high-risk countries. The concern is that these respondent bank customers may be high risk themselves, leading the western correspondent banks to withdraw their CBRs ‘wholesale’ as the cost of conducting enhanced due diligence on each of the respondent bank customers proves too cost prohibitive based on the perceived increase in risks in those countries.
Emerging illicit payment corridors
The second factor is the increase in criminal activity that drive illicit financial flows in new payment corridors. In the European Union (EU), migrant smuggling is a highly attractive business for criminal networks, activity having grown significantly in 2015 and 2016. Smugglers control the whole chain from recruitment to arrival in Europe. A joint Europol/Interpol report shows migrant smuggling worth US$4.85bn annually and growing.
Smuggling proceeds need to be laundered through the financial system, increasing overall transaction risks for correspondent banking. This puts further pressure on banks in Eastern Europe and North Africa to identify source of funds. Western banks, keenly aware of the risks and the reputational damage from being associated with migrant smuggling and the human tragedy of refugees from Syria and elsewhere are more likely to de-risk and withdraw entirely from these regions. There are other payment corridors that continue to see illicit financial flows, including drug smuggling revenues from Latin America and the Caribbean into North America with extensive de-risking occurs in these regions as well.
Changing payment models
The third factor driving the decline in CBRs is related to the changing payment model itself. Globally, payment patterns are changing, with greater volumes of lower value payments crossing borders. Payment and lending roles, traditionally serviced by centralised banking functions, are now being disintermediated by emerging payment service providers and financial technology (fintech firms). These firms offer an alternative to traditional cross border payments, with new technologies such as distributed ledger and new models like payment netting offering consumers and corporates various alternatives.
Digital commerce, driven by Amazon, eBay, Alibaba and others, offer their customers cross-border payment transfer services that do not rely on the traditional ‘rails’ of correspondent banking. Global digital commerce sales (which are typically lower value transactions) are projected to grow from US$1.3 trillion in 2014 to US$3.6 trillion in 2019. These trends drive innovation in cross-border payment services that look to lower or eliminate the current inefficiencies and high transfer costs in traditional cross-border banking services.
The declining trend of CBRs globally will continue, with an estimated rate of decline between 15% to 20% over the next five years from the current 38% decrease in 2016. Implementing financial counterparty know-your-customer (KYC) solutions will help with bank to bank risk modelling. However, this rate of decline may even accelerate as new cross border payment models developed by fintechs mature, become more embedded into the financial ecosystem and provide viable alternatives for corporates that have typically relied on traditional cross-border payment rails to transfer large value payments.
Digital commerce and the ‘Internet of Things’ (IoT) will continue to drive lower value cross-border transactions requiring lower cost payment platforms. Banks will no longer be the only channel for cross- border payment solutions. Indeed, for banks to continue to be relevant, they will need to either partner with fintech providers or develop new cross-border payment solutions that drive down costs, improve transparency and transfer times for their customers.
Perhaps JP Morgan’s chief executive officer (CEO), Jamie Dimon, expressed it best: “Silicon Valley is coming. There are hundreds of startups with a lot of brains and money working on various alternatives to traditional banking. [..] You have all read about Bitcoin, merchants building their own networks, PayPal and PayPal lookalikes …. there is much for us to learn in terms of real-time systems, better encryption techniques, and reduction of costs and “pain points” for customers.”