Why Correspondent Banking’s Shrinkage Means Risky Business For FIs

Correspondent banking is among the most vital avenues for businesses — from international conglomerates to small firms in emerging markets — to facilitate business across borders. But global financial watchdogs are sounding the alarm of an ongoing decline in correspondent banking relationships (CBRs).

The World Bank Group’s International Finance Corporation (IFC) published new data last year that found 27 percent of 300 global banks surveyed across 92 countries reported a drop in the number of correspondent banking relationships they have. This decline, the IFC noted, is linked to a cutback in services.

Analysts cited the rising pressure of regulations on global financial institutions to cut risk exposure, which has led to financial institutions (FIs) pulling away from emerging markets.

IFC Financial Institutions Group Director Marcos Brujis said in a statement at the time that this trend has profound implications for citizens of developing economies.

“Trade, economic growth and the remittances that families depend on are at risk when banking relationships deteriorate,” he said.

The latest analysis suggests this trend isn’t slowing down either.

“There is a clear downward trend in both the number of active corridors and the number of active correspondents per month from 2011 to mid-2017,” wrote the Financial Stability Board in its correspondent banking report published last month. Researchers found a steeper decline in these relationships in the beginning of 2017 too.

But the impacts of a decline in correspondent banking relationships are complex and go beyond a reduction in consumers’ and businesses’ access to cross-border payments services, whether they’re sending or receiving money.

Ed Sander, president of risk and compliance technology provider Arachnys, said that while regulations designed to mitigate risk are largely to blame for the decline in CBRs, the drop in correspondent banking relationships may actually lead to greater risk for FIs.

“It’s a dual-edged sword,” he told PYMNTS. “Most global FIs, when they initiate transactions with correspondent banks, have a checklist of AML [anti-money laundering] controls required for that correspondent bank to participate in its CBR network. It’s a very large umbrella a global FI will cast over its CBR relationships.”

But the decline in correspondent banking relationships in recent years means institutions have to find other avenues through which to move money, and those paths aren’t always adhering to stringent AML and other regulatory requirements, Sander explained.

“Risk usually increases, honestly, when a global FI begins to shed its correspondent banking relationships,” the executive noted. “Money movement doesn’t go away. Does a river stop flowing just because you stop paddling in it? Of course not.”

When CBRs decline, FIs turn to intermediary banks that Sander said don’t always participate in the stringent due diligence CBR networks do.

“Intermediary banks often fall outside of the blanket of protection a global FI is anchoring,” he said. “They often aren’t subject to, or [are] able to execute on, the same regulatory controls that other institutions have.”

This means risk exposure for the financial institution as well as major corporations that rely on the correspondent banking networks to not only facilitate their cross-border transaction needs, but to also mitigate risk of those transactions.

A recent paper from PricewaterhouseCoopers described this phenomenon as the “risks in de-risking.” While institutions turn away from their correspondent banking relationships to de-risk, this activity in turn leads to a reduction in financial intelligence quality, restrictions on basic banking services, more fragmented global financial services and a motivation for money laundering perpetrators, terrorists and other criminals to turn to underground channels to commit financial crimes.

As Sander said, a river doesn’t stop flowing because you stop paddling in it, and money won’t stop moving across borders just because a bank cuts off some of its correspondent banking partners. While criminals will find other avenues to launder money, similarly, corporates will migrate outside the traditional financial services space to facilitate their cross-border transaction needs as a result of the reduction in CBRs.

“Just because a large, global FI decides to exit a portion of the world, is business going to stop? The obvious answer is ‘no,’” Sander said. “Money will always find a way to move through a network, and money will always find a way to move. It’s not going to be a situation where business just stops. They’ll just find another channel.”

According to Sander, this trend is similarly coupled with risk.

For small- and medium-sized enterprises, this means the effects of CBR’s decline is less acute.

“In the mid-sized segment, I’d be surprised if it has an impact because you have so many digital money movement platforms,” he said. “So these companies are just moving to a different channel outside of the [traditional] financial system.”

These new market entrants may not be able to handle the regulatory requirements of larger enterprises, however.

The European Banking Authority (EBA) published its FinTech Roadmap last month with its focus fixed on maintaining a balance between innovation, customer security and regulatory compliance. Part of this initiative, the EBA noted, will be to explore how FinTechs are able to identify and assess AML and terrorist financing risks.

But regulators are still in their early stages of addressing this challenge, and because the flow of money will not stop and wait for their conclusions, financial institutions and multinational corporates have to address risk mitigation and compliance issues arising from the continuing decline in CBRs.

Sander said cloud technology has emerged as a critical component of this effort.

“When I first got into the financial cloud business, no one used any kind of cloud platform for compliance,” he said. “It’s an entirely different ballgame today. Just about every single digital challenger is 100 percent a cloud platform, and Arachnys is part of that same family. When firms, whether they’re global FIs or digital challenger platforms, use a cloud-based solution for due diligence, it is not only going to give businesses a safe haven to increase their cross-border payments; it will also make cross-border payments activity safe, compliant and incredibly easy.”