The looming crisis in correspondent banking

Ahead of the G20 summit in Hangzhou in September, Mark Carney, chair of the Financial Stability Board, wrote a letter to world leaders accompanying a glowing report into the effects of financial regulatory reforms.

Marking his own homework, Carney awarded the FSB A* grades for making the large international banks and the financial markets much more resilient, adding special praise for having achieved this while maintaining the overall provision of credit to the real economy. 

The FSB assures G20 leaders that emerging market economies have not noticed any serious unintended consequences from implementing the reforms. And while the FSB concedes that attention still needs to be paid to maintaining an open and integrated financial system, it says that regulatory reforms appear to have helped avoid retrenchment and market fragmentation.

This is hogwash.

Throughout this period of re-regulation, international banks have been in outright retreat from large parts of the developing world, not just exiting countries but also cutting cross-border lending and terminating correspondent banking relationships with local banks. This has hampered the flow of remittances on which some smaller developing economies depend and impeded corporate trade-related payments, especially in dollars, which local banks cannot handle if they have been cut off from correspondent banks with access to the Federal Reserve System.

The withdrawal of correspondent banking relationships has reached a critical level in some of the worst affected countries. And this will have systemic consequences if not addressed. It will disrupt financial services and cross-border flows, including trade finance and remittances, potentially undermining financial stability, inclusion, growth and development goals.

Who says so? Well, the IMF does. 

A staff paper published over the summer notes that across the Caribbean, to take just one example, at least 16 banks in the region across five countries have lost all or some of their correspondent banking relationships. The full extent of the impact has yet to be quantified, but the unmeasured effect has been a loss in business confidence and in the ease of some basic transactions, such as paying in dollars for raw materials from one country that might be turned into finished goods and then exported. 

So, please ignore the complacent words of the FSB, which eventually, on page 33 of its 45-page self-congratulatory epistle, nods to the decline in correspondent banking, only to assert that this is not an effect of agreed post-crisis reforms. That is rubbish. Banks retreating in the name of de-risking to comply with new regulatory requirements have abandoned these smaller developing economies on the edge of exclusion from the global financial system.

Perhaps read instead Euromoney’s article which looks at how banking regulation has combined in a perfect storm with a rise in nationalism and protectionism and a generational reversal of global trade volumes to put the concept of global banking, rather than the existence of global banks, at threat. 

Changes in regulation around anti-money laundering and combating the financing of terrorism, national banking regulators’ desire to ring-fence large banks’ capital and liquidity close to home, the allocation of higher operational risk weights to banks with international businesses and the need to cut costs in response to compliance expenses have all driven this.

The financial system may well be safer. But it no longer works for everyone. 

Is there a solution? The FSB makes desultory mention of greater use of know-your-customer utilities and legal entity identifiers to slow the withdrawal of correspondent banking relationships, but these are hardly an incentive to restore links that have already been cut.

The excluded, including small businesses exchanging trade payments across borders and expatriate labourers remitting small sums, will find a way to transmit value almost certainly outside the regulated banking system. 

The Ripple network is offering direct settlement of cross-border business-to-business payments across a distributed ledger at much lower cost and higher speed than through correspondent banking networks.

There would be a delicious irony if the unimportant corporate customers in those smaller economies that the conventional banks abandoned should become the ones that drive development of new cross-border payments technology that one day replaces them.

A recent McKinsey-Sifma study suggests that using blockchain for cross-border B2B payments could generate some $50 billion to $60 billion of value for customers from lower fees and at-market exchange rates, as well as better security and speed. 

This used to accrue to the banks. That’s food for thought for the leaders in global finance as they gather in Washington for the annual IMF/World Bank meetings.