Solving correspondent banking’s woes
While AI solutions and ISO 20022’s rollout offer some relief, the challenges to correspondent banking remain acute in an era of ever greater de-risking, writes John Everington.
by John Everington
From the Venetian lenders of the 14th century right through to the modern era of international finance ushered in by the launch of Society for Worldwide Interbank Financial Telecommunications (Swift) in the 1970s, correspondent banking has acted as the bedrock for the spread of global commerce and trade, providing a nexus for banks, businesses and individuals in all parts of the world to access the international financial system.
Yet, with openings have come risks: from its earliest days, the greater global connectivity brought about by correspondent banking brought with it opportunities for money-laundering and the funding of illicit activities on an international scale.
Fast-forwarding to the hyper-globalised world of the 21st century, correspondent banking services have come under greater scrutiny than ever before, particularly in the wake of the terrorist attacks of September 11, 2001, which brought home the dangers of covert financing in a devastating way to the heart of the global financial system in New York.
With regulators and law enforcement agencies taking a hard line on even minor breaches in monitoring and compliance, correspondent banking has gone into reverse, as banks move to de-risk their operations.
“Twenty years ago correspondent banking was a widespread activity even among smaller banks because the compliance requirements were far lower,” says Alex Silver, managing director of Stern International Bank in Puerto Rico.
“Nowadays, it’s far harder for banks to justify given the higher risk profile and the greater costs involved.
Even for the larger banks, there are going to be customers they can’t service because of their revenue requirements and risk appetites.”
Downward trend
While global payment transaction values and volumes continue to rise, the number of active correspondent banking relationships has declined steadily over the past 20 years, as banks limit their exposure to perceived high-risk jurisdictions.
While such actions have undoubtedly served to close off mechanisms for illicit financing (and some relationships have ceased due to natural consolidation), the impact has also been keenly felt by law-abiding citizens and businesses.
“It’s important to not lose sight of the impact that de-risking has on individuals and small businesses who find themselves shut out of the global trade system because their bank doesn’t have a correspondent relationship,” says Deepa Sinha, vice-president of payments and financial crime at the Bankers Association for Finance and Trade (Baft).
“No private bank should be forced to do business with another bank.
But at the same time, businesses and individuals who are playing within the rules shouldn’t be prevented from doing business with who they want to.”
Efforts to stem the decline of correspondent banking relationships thus far have failed to keep pace with added complexities in risk management, as exemplified recently by the war in Ukraine and the growing politicisation of Western trade with China.
Nevertheless, efforts to tackle de-risking have recently moved up the political agenda in the US at least, with the publication of the US Treasury’s first de-risking strategy in May.
In the meantime, developments such as the belated rollout of new cross-border payment standard ISO 20022, together with the greater adoption of artificial intelligence (AI), may provide some relief for both correspondent and respondent banks going forward.
Global need
Tightening compliance regulations for international banks are not an exclusively 21st century phenomenon: the trend towards greater scrutiny of transactions with overseas intermediaries in the modern era began in earnest with the passing of the Bank Secrecy Act in the US in 1970, seven years before Swift’s messaging service went live with 518 institutions in 22 countries.
Yet the 9/11 attacks of 2001 prompted a watershed moment for compliance requirements across the world’s major financial centres, with the US Patriot Act, the EU’s second anti-money laundering (AML) directive and UK’s Proceeds of Crime Act all placing significant new requirements on banks to strengthen customer identification policies and enhance the monitoring of transactions to screen for illicit activities.
With the tighter regulations came the fines and settlements worth billions.
Virtually no major lender emerged unscathed, prompting banks to focus on reducing their exposure to potentially risky clients, particularly in challenging jurisdictions.
“Events such as the Twin Towers attacks and the global financial crisis always prompt a strong response from financial regulators, and quite rightly so, with banks thus having to adapt their risk approach accordingly,” says Steven Marshall, chief partnerships officer at Crown Agents Bank.
“In such an environment of increasing risk, banks will tend to default to their core business lines, because that’s what they understand the best and what their risk systems and policies are geared towards.”
Beyond refusing or terminating relationships in jurisdictions with a higher risk profile, the added compliance burden has affected corridors with lower risk profiles as well.
“Smaller correspondent banks that are operating in corridors that may already be generating low revenues are seeing that the cost of initial and ongoing due diligence relative to its revenue generation are making it difficult to continue doing business in some regions,” says Ms Sinha of Baft.
Unsolved mystery
In such circumstances, the decline in active correspondent banking relationships has been a global phenomenon, with sub-regions in Micronesia, the Americas and Africa the worst affected, with little clarity as to why such relationships are terminated.
“Many countries that we deal with are doing the right thing and are acting in the right way but are still getting de-risked,” says Mr Marshall.
“Often there’s very little transparency as to why such relationships are terminated by the bigger banks, with the answer almost always coming down to risk versus revenue.”
Such actions can have a dramatic effect on economic development within de-risked countries.
“The hesitancy of international banks to facilitate transactions originating from Somalia impedes essential services like remittances, which contribute 25% of Somalia’s gross domestic product,” Yasin Ibar, CEO of the Somali Bankers Association, told The Banker.
“The measures restrict Somali banks’ ability to transact globally, which affects business growth and economic development.”
The number of correspondent banking relationships in Somalia fell by 10% in 2022, with the number of eastern African active correspondents decreasing by 38% between 2011 and 2022, according to Swift.
“In addition to the impact that it has on individuals and businesses in the affected markets, one of the biggest unintended consequences of de-risking is that it shifts transactions into less regulated networks,” says Swift’s chief strategy officer Thierry Chilosi.
“It’s in regulators’ interest to try to keep such flows in corridors where there is transparency.”
Currency alternatives
With banks in many countries finding correspondent banking in major currencies like the US dollar and the euro challenging, many interviewed for this piece suggested that those jurisdictions may look for other alternatives.
“If there are no correspondent banking options in US dollars and euros open, sometimes banks will have no other choice but to turn to other currencies.
It’s already starting to happen,” says Rudolf Putz, head of the trade facilitation programme at the European Bank for Reconstruction and Development.
Mr Ibar of the Somali Bankers Association says that while the dollar remains central, de-risking could encourage a shift towards alternative currencies like the Chinese renminbi, though such a change would be greatly dependent on Somalia’s trade and geopolitical relationships.
While talk of de-dollarisation has increased in the past two years in the wake of the war in Ukraine – since early 2023, Argentina, Brazil and Bolivia have all announced the use of the Chinese yuan to replace some dollar trade transactions – the greenback looks certain to remain the world’s dominant medium of exchange for many years to come.
Research from JPMorgan published in June found that the dollar’s use in trade financing had remained constant over the past two decades, accounting for 88% of trade finance even as the US’s share of global exports fell to just 9%.
Reversal of fortune
While regulators have always been mindful of the adverse impact of bank de-risking on correspondent banking worldwide, market participants admit that there are no obvious and easy solutions to reversing the trend.
“Banks and banking associations, central banks, regulators and government agencies all need to work together to tackle the issues affecting the industry,” says Ms Sinha.
Solutions advocated by Baft include models where initial know your customer (KYC) checks and requirements can be outsourced to trusted third parties, with another option being the establishment of hub-type respondent bank bodies that can provide covering relationships for smaller respondent banks.
This hub concept is one of the solutions mooted in the US Treasury’s first ever de-risking strategy, published in May 2023, as mandated by the US AML Act of 2020.
The strategy document proposes the creation of a publicly chartered corporation to consolidate regional financial flows into one respondent banking customer at sufficient volume to improve profitability for potential correspondent banks.
“If structured appropriately to address supervision, compliance and oversight considerations, such an approach could encourage banks to take on correspondent relationships, provided sufficient AML/countering the financing of terrorism supervision from a credible regulator,” the strategy said.
Such a body could be used in regions that are heavily dependent on US dollar correspondent banking, but would rely on the sourcing of compliance professionals with the requisite experience and skills to establish it, says Stern International Bank’s Mr Silver.
“The problem with that is that you have to make sure that now this regional bank is going to have the ability to carry out compliance at a level that makes the big banks happy,” he adds.
A new standard
While such new models have been mooted for many years without coming closer to reality, a long-trailed upgrade to correspondent banking’s fundamental architecture is underway, with the adoption of the ISO 20022 messaging standard for cross-border payments.
The standard, which replaces Swift’s long-running MT standard (in place since the 1970s), promises to improve payment processing efficiency and transparency, offering greater interoperability with other payment messaging standards in use around the world, replacing proprietary message formats with a standard format and data element definition.
A report from Capgemini estimates that structured data from ISO 20022 could reduce screening hits by between 25% and 30%, resulting in significant cost savings for banks.
EY anticipates that by the end of 2023, 79% of the total volume and 87% of the total value of high-value payments worldwide will use the new standard.
Yet the migration to the new standard, which began in mid-March, is likely to be of little initial benefit for smaller respondent banks in the short term.
While ISO 20022 has been adopted wholesale by banks in Europe, the US, the UK and other developed markets, the adoption has been far slower by respondent banks in smaller countries.
“The challenge will always be felt most acutely by those institutions that have the least capacity to adopt such solutions, in terms of their tech stacks and the resources and personnel required,” says Mr Marshall at Crown Agents Bank.
“It is counterproductive if emerging market banks are unable to adopt new technologies and we end up with a two-tier system and a greater level of de-risking despite the new tech.”
Swift’s Mr Chilosi says that 15% of payment instructions on its network had shifted to ISO 20022 between the beginning of the migration to the new standard in mid-March and the end of July, with the overwhelming majority of payments using the new standards being made between major financial institutions thus far.
He notes that the full migration to ISO 20022 across Swift’s network would be a gradual one, with both standards supported until November 2025, and that Swift’s Transaction Manager platform enables banks to communicate using a combination of MT and the new standard in the meantime.
What AI can do
Alongside the move to ISO 20022, a series of AI solutions are emerging that promise to take out some of the headache from the KYC and monitoring process for both correspondent and respondent banks.
“AI has the potential to be a game-changer for areas such as background checks and monitoring of transactions,” says Ms Sinha.
“Monitoring for breaches has so far been a very manual process.
It will always be a human-led process first and foremost, but AI could take a lot of the burden off humans and therefore streamline the process considerably.”
Stern International Bank last year announced a deal with AML RightSource to use the company’s QuantaVerse solution to support the bank’s financial crime compliance operations.
Yet Mr Silver cautions that such solutions are a complement to rather than a replacement for traditional compliance functions within banks.
“Software solutions, AI or otherwise, will help shorten the processes involved and lower the number of processes that require human intervention, which is great,” he says.
“Yet you need to have the right people who understand the software and have sufficient understanding of compliance for it to become a part of your workflow, and for it to be robust enough to defend in front of a regulator or an auditor.
As correspondent banking relationships decline in the midst of de-risking, the number of compliance personnel with the requisite skills has also declined.
Those that are qualified tend to be snapped up by the larger banks, which exacerbates the problem.”
A problem solved?
While the rollout of ISO 20022 and the development of ever-smarter software solutions are set to ease pressure on correspondent banking, some have questioned whether more comprehensive changes are necessary.
“It has been nearly 50 years since Swift came into existence, and there hasn’t been a fundamental systematic overhaul of the international finance system since then,” says Co-Pierre Georg, a professor at EDHEC Business School in Nice.
“The world today is fundamentally different to the one in which Swift was introduced, so I think we need to think about how we can design a new system that caters to modern needs and is fit for purpose for the next 10 years and beyond.”
As discussions surrounding the creation of a digital euro continue, the role of wholesale central bank digital currencies (CBDCs) in the international payments landscape is increasingly coming to the fore.
Eleven countries worldwide had launched a CBDC at time of writing, with 21 pilot projects underway and a further 32 in development, according to the Atlantic Council.
In October, Swift announced that it had successfully demonstrated seamless cross-border transactions involving CBDCs and tokenised assets, and in March said that 18 central and commercial banks had found “clear potential and value” in its application programming interface-based CBDC connector for cross-border payments.
The Bank for International Settlements (BIS) meanwhile published a “blueprint for the future monetary system” in June, which proposes a new type of financial market infrastructure – based around what it describes as a unified ledger – that can capture “the full benefits of tokenisation by combining central bank money, tokenised deposits and tokenised assets on a programmable platform”.
The report’s author, BIS head of research Hyun Song Shin, tells The Banker that such a new infrastructure may help smooth processes for correspondent banking, while cautioning that it would not do away with the major de-risking challenges.
“Correspondent banking is being held back first and foremost not by technology but by business models, particularly when you’re dealing with jurisdictions that are seen as more high risk,” he says.
“Tokenisation is not going to be a panacea that removes such challenges, but it may allow for easier ways of dealing with AML and KYC concerns due to the increased technical capabilities it brings.”
Such fundamental overhauls remain a distant prospect, however, if the adoption of ISO 20022 for cross-border payments is a guide: the standard was developed nearly 20 years ago.
And while innovations based on CBDCs may well hold potential, care must be taken that benefits are made available to those that need them the most.
“Innovation and new systems are all well and good for larger banks, but there is the danger that if you introduce too many new innovations at the same time, smaller parties that don’t have as much capital to invest will be left behind,” says Mr Chilosi.
“This will lead to greater fragmentation in the international payments space.”
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