Evolution of correspondent banking: Can compliance help defend the model?
By Emmanuel de Bouard, Head of Cash Clearing Services for SG GTB - 2016
“Derisking opens the door to a parallel system in correspondent banking. Smaller banks, or those operating in higher risk countries may not be able to find clearers, which could have an impact on trade. These actors will appear further down the line and may be served by other banks that are willing to work with them or Fintechs that may go less deeply into transactions. In extreme cases transactions may be conducted in cash.”
Correspondent banking faces pressure from regulation, geopolitics, and new payment providers, as well as rising costs, shrinking margins, and evolving customer expectations. Banks are expected to transact payments more quickly and cost-effectively, with greater transparency toward customers and regulators, while mitigating compliance and reputational risk. How will the changing model and emerging payments methods affect compliance practitioners and processes? Can compliance add value to the evolving correspondent banking model, thus helping to ensure its long-term sustainability?
- Regulation has an impact on many different areas of correspondent banking. In regards to liquidity, for example, regulators do not consider balances on correspondent banking accounts as stable and therefore they cannot be used for liquidity ratio purposes. At the same time, they charge for funds deposited at the Central Bank. This makes therefore things difficult as we have to tell customers that we now require their accounts to be at zero balance at the end of the day, but funded first time next day for us processing their payments. At the same time, there are anti-money laundering (AML) laws which are not harmonised across countries. Large banking groups have to deal with AML regulations in North America, Europe and Asia. Banks have to respect the regulations of the countries in which they operate and make no transgressions. Any bank with a large correspondent banking network will have to align every subsidiary and customer with these regulations despite facing discrepancies.
- Another regulatory challenge that has to be met is the strengthening of know your customer (KYC) rules. In many cases now banks need to know not only everything about their customers, but also about their customers’ customers. This could become infinite and there is a moment when the KYC controls have to stop. Correspondent banking relies on trust, but in this environment trust is being overruled by evidence. Compliance teams will insist on evidence that a particular customer should be trusted before they are onboarded or business is done with them. This can be the case even with long-standing customers.
- Regulation is of course necessary, but in general it imposes many constraints on correspondent banks that are difficult to tackle. New customers cannot be brought into the network without the involvement of the compliance department. The regulators have only one approach: there must be no default, no errors when it comes to adhering to regulation.
In a perfect world, compliance would bring more transparency and knowledge about customers, which should prove to be a competitive advantage over other players that don’t have the same level of controls. An inability to comply with the many regulations affecting correspondent banking or to control compliance effectively could result in some competitors in the correspondent banking market withdrawing.
- Because large banks operate widespread networks, they must consider their subsidiaries as they would their customers. Compliance should apply to these subsidiaries in the same way. This approach has been particularly appropriate following the large fines dealt out to banks whose subsidiaries were engaged in illegal activities such as money laundering. Subsidiaries must be subject to the same controls as external customers so that the bank has better knowledge of what is going on and the overall compliance picture of the group, despite the rules they must follow are the same within the Group, and therefore better known than those of an external customer.
- The definition of a ‘high risk’ bank in the correspondent banking network is open to interpretation. Some banks that are very engaged with Africa, for example, may be considered high risk by other banks. Banks that have faced very large fines for transgressions might also be defined as high risk. The definition differs from one bank to another but there is a danger that if everything is defined as high risk the term will mean nothing. There is a high level of de-risking taking place at present because banks feel they cannot get the information they would like in order to make a decision about doing business with a particular counterparty. Compliance departments err on the side of caution and recommend exiting from a relationship in such cases.
- Another reason to exit from doing business with a particular correspondent banking partner could be the cost of compliance. If a counterparty does not yield sufficient return in order to cover the costs of controls etc, a bank may decide to close that account. However, a customer that may not bring a great deal of revenue but is not costly in terms of compliance may be kept on as a client.
- Regulations run counter to the acceleration of payments that regulators are requesting. In a world where payments are meant to be transacted more quickly, there will be little time to conduct the controls necessary for AML and sanctions adherence for example. Banks will consider if they cannot conduct controls because they are too onerous for a particular bank, they will refuse to work with that bank. Therefore, many of the smaller or ‘riskier’ banks will not have access to an instant payments system. Again there will be two systems: instant payments for banks that are deemed safe, and slower payments for those that require more controls. It is likely that Fintechs will step into the gap and service the latter banks.
- There are many controls on correspondent banking that have made it a safer environment and have added value. But at the same time the results from these controls and regulations are not at the level of the investment banks have had to make. There is little evidence that these controls have stopped any acts of terror, for example.