Focus on the rising difficulties of carrying out correspondent banking activities

Currently, international attention is focused on the new “tariffs war” that the US and China have begun to wage. Many experts have expressed their concern on increasing trade barriers between the world’s largest economies. Rising regulatory scrutiny has also given many large institutions a cold feet which is being felt in some parts of the world considered “too risky” as has recently warned the IMF[1]. However, few will know that at the heart of all this lies a relatively small yet critical activity for international trade: correspondent banking (“CBK”). This activity is currently facing many challenges, both technical and existential.

What is correspondent banking?

Correspondent banking is an activity whereby a bank (“the correspondent bank” in that case) provides international payment solutions for financial institutions (either other banks or entities within the same banking group), through the use of a “nostro” or “loro” account (account established at one bank, for another). Correspondent banking services may be involved in a wide spread of transactions such as Global Trade transactions or Cash Management transactions. Correspondent banks therefore act as an intermediary between the “Originator”, and the “Beneficiary” of the cross-jurisdiction transaction, as described in the graph below.

Figure 1: Mapping of the entities involved in a typical CBK relationships


These financial institutions use / need correspondent services because they often do not have a local presence in the receiving jurisdiction, or simply lack the size or currency liquidity to be able to host such transaction activity in-house. As shown in the graph above, the correspondent bank, with presence in both originating and receiving jurisdiction, is able to effectively carry out the operation.

Before a correspondent banking relationship can be initiated, the customer signs an account agreement letter laying out the details of the service provided as well as the obligations from both parties. The bank acting as a correspondent bank then proceeds to charge a negotiated fee on each transaction (or other account service) requested by its client. Quite often, in practice, the clearing of major currencies such as the GBP or the USD are centralised and made only in a local centre (London, New York) and force local banks to enter into agreements with local US or UK banks to process international transactions involving these currencies.

Why is it a critical service line for banks and the world economy?

Correspondent banks, through these “nostro” or “loro” accounts, effectively enable banks to handle international monetary transactions for their own customers who would normally require foreign currency exchanges. Simply put: CBK is an enabler of international trade: such as those transactions that typically occur between an exporting corporation in a given jurisdiction to an importer in a different one.

Local remittance systems are therefore highly dependent on CBK access as the agreements contracted with correspondent banks enable local banks to offer international trade services to their own customers.

However, and that for a variety of reasons outlined below, the number of CBK relationships around the globe is shrinking.

Figure 2: Comparison of Financial Institutions and Correspondent Relationships.

Source: Accuity

Too complex? Too risky? Banks currently scrutinize their relationships with other financial institutions, which results into liquidity access issues (see below). The health of the Correspondent banking industry is a good indicator of the level of trust between peers within the banking sector, and thus the global economy sustainability. It should be remembered that one of the main symptoms of the 2008 crisis was banks more and more reluctant to offer liquidity to each other, till the whole banking system got very close to a deadlock.

We will take a look at some of the issues the banks are currently facing in the next chapters.

New competition & existential risks to the current CBK framework

As any traditional services, CBK constantly faces risks from global regulatory toughness or new technologies rising. We take a quick look at some of them below.

Tougher regulatory environment: Trade finance volumes & CBK relationships numbers are diminishing[2], and that for many reasons, however heightened regulatory standards clearly stands out as the main contender for the first place. Stricter Anti-Money Laundering and Know-Your-Customer rules, higher Basel-III capital requirements, increased risk aversion have all participated in making CBK a more complex environment for banks to evolve in.

And it is seen and felt in practice: Natalie Blyth, HSBC Holding’s global head for trade and receivables finance, told a November 2017 trade finance conference[3]: “The average trade transaction now requires manual checking of 65 data fields from 15 different documents, with 40 pages to be reviewed.”

For those that do not comply, the penalties are harsh: To date the biggest penalties levied have been BNP Paribas, fined US$8.9bn in 2014 as well as HSBC’s US$1.9bn fine in 2013 for various alleged money laundering offences.

Ironically, one could say that the heightened regulatory standards imposed on western banks to create a safer and sounder economy, and also to raise client individual protection, has affected mainly poorer and “riskier” countries, which now find it difficult to access liquidity.

The fast growing south East Asian countries are particularly affected by this. According to the Asian Development Bank (“ADB”), there is a $1.5 trillion gap between demand and supply of trade finance, half of which arises in developing Asia and 70% of which relate to MSME (small and medium companies) units and mid-cap companies[4].

CBK ease of access is also one of the factors used by the rating agencies, thus creating situations where the cost of public borrowing has also gone up due to a lack of CBK access[5]. It appears that all

Open Banking: The PSD2 directive which comes within a global regulatory trend moving more towards “Open Banking” has allowed for the development of alternative systems to traditional cross-currencies transactions. It is notably allowing banks and Fintechs to build applications and services through open Application Programming Interfaces (“APIs”), which are essentially decentralised systems based on networked accounts. APIs also effectively enable applications to share data without sharing account credentials, thereby making them more secure thanks to the available data. Besides the many start-ups (Revolut and TransferWise to name a few), established banks do have the means and access to technology which can enable them to also innovate and “fight back” in that area, BBVA have already started investing in these new systems[6].

Blockchain: On the horizon there also exists opportunities to use Blockchain technologies to improve straight-through processing. The use of Blockchain technology for international payments allows for effective and accurate live payments tracking and instant payments processing, information on every beneficiary and originators would also be readily available to the bank, making the AML TM processes more efficient and cheaper to run for the banks. Most major banks are currently investing in this technology, however it is not yet mature and most still believe that for the time being, the current CBK framework will remain.

New market entrants in this area are usually quite small and relatively rare for now, although the risk may lie not with start-ups, but rather with large tech giants and their enourmous investment capabilities, as Marjan Delatinne (Global Head of Banking at Ripple) argued in a conference in June 2018 that today a Google or other big tech giant could provide an equivalent global system, if they so wished.

Operational risks and rising costs

Correspondent bank bear full responsibility for the funds that are going “through” its accounts, which results in raising bank exposure to a large range of risks and in the obligation to develop an adequate set of controls to put in place.

Terrorist Funding (“TF”) risks: TF risks are different in nature from the traditional AML risks banks face. Terrorist Funding is notably quite dependent upon the location of conflicts, which can move from a country to another, as well as temporary flows of jihadi fighters going to and from fighting areas / their homeland.

The correspondent bank must carry out monitoring on both the originator characteristics as well as the beneficiary (KYCC), on the top of the carrying out standard monitoring over its direct customers, the respondent banks. Implementation of transaction monitoring solutions that allow for more flexibility in scenarios chosen is therefore critical to efficiently identify terrorist funding.

An inefficient & excessively high number of Business Units (BUs): Opening new BUs, offering services in an increased number of currencies are two main levers for reaching out for growth opportunities. However, growth strategies can produce adverse effects in the form of inefficiencies: too many BUs for too few accounts and major currency trading issues. As we have seen in practice, centralisation initiatives (including transaction monitoring systems and AML investigation teams) and grouping per currency can also create cost-cutting opportunities throughout CBK activities.

Cyber security threats & rising investment costs: recent high profile cyber security failures have highlighted the criticality of defending itself against cyber-attacks. Moreover, the new GDPR regulation has accompanied a wider move towards a strengthened IT architecture and processes. However the costs of such measures are high and rising (IMF, 2017) and poses a further problem on the profit margins of CBK activities.

What are the solutions?

Besides all these risks, today and for the foreseeable future, correspondent banking remains the model of choice by the banks and their customers, although new technologies will surely be applied to this old model in the next few years explains Simone Del Guerra[7] (Global Head of Transactional Sales at UniCredit).

As a central unit for international banking system sustainability, Correspondent banking activity will have to match other banking businesses transformation patterns. Data quality is one of the major challenges today for banking industry and this particular business is no exception.

Artificial intelligence has not quite yet reached the CBK activities (or not entirely at least), yet this is a missed opportunity: the quantity of data that flows through the bank’s CBK systems is a vast mine of all kind of behavioural build and risk level information on the transaction participants (banks, originators & beneficiaries). Today, investigating the large amount of alerts created by CBK transaction monitoring systems has become a financial black hole for banks as most of the work still has to be done by hand. Different solutions have been created independently by the banks to reduce the “noise” (excess / non relevant alerts) emanating from the transaction monitoring tools. This is notably made harder by the fact that there are few solutions on the market outside the traditional transaction monitoring tools, and banks have therefore started investing in in-house solutions to “optimise” the alert creation process and create less, but more relevant alerts. The use of Artificial intelligence solutions in this particular case would be of great value, especially considering the technology is available on the market.